Personal Income and Outlays: June 2019

Personal income increased $83.6 billion (0.4 percent) in June according to estimates released today by the Bureau of Economic Analysis. Disposable personal income (DPI) increased $69.7 billion (0.4 percent) and personal consumption expenditures (PCE) increased $41.0 billion (0.3 percent).

Real DPI increased 0.3 percent in June and Real PCE increased 0.2 percent. The PCE price index increased 0.1 percent. Excluding food and energy, the PCE price index increased 0.2 percent.

The U.S. consumer spends steadily. Labor compensation is clearly accelerating, boosting personal income and spending but, likely, increasingly pressuring corporate margins:

July Regional Fed Manufacturing Overview

Federal Borrowing Soars as Deficit Fear Fades Borrowing by the federal government is set to top $1 trillion for the second year in a row as higher spending outpaces revenue growth and concern about budget deficits wanes in Washington and on Wall Street.

The Treasury Department said Monday it expects to issue $814 billion in net marketable debt in the second half of this calendar year, bringing total debt issuance to $1.23 trillion in 2019. That would represent a slight decline from borrowing in 2018, when the Treasury issued $1.34 trillion in debt—more than twice as much as the $546 billion it issued in 2017.

The budget gap for the fiscal year that ends Sept. 30 is on course to exceed $1 trillion, following the 2017 tax cuts that constrained federal revenue and a previous two-year budget deal that raised spending nearly $300 billion above spending caps Congress enacted in 2011. (…)

The current bipartisan budget agreement, set for approval by the Senate this week, would boost federal outlays and suspend the government’s borrowing limit for two years, adding further to annual deficits into the future. It would lift spending $44 billion above fiscal year 2019 levels, or 3.5%, not including emergency war funding or one-time funding for the 2020 census. (…)

At the same time, mainstream economists are increasingly questioning whether larger federal debt and deficits might be tolerable if put toward programs that would bolster long-term economic growth.

The Congressional Budget Office estimated last week the budget deal would add $265 billion to federal deficits over the next decade, though projected deficits could be as high as $1.7 trillion during that time if spending continues on the same trajectory. (…)

Huawei Shows Resilience in Face of U.S. Blacklisting Huawei Technologies said its first-half revenue rose 23% from a year earlier, as the technology giant appeared to shrug off the impact of a U.S. supplier blacklisting.

(…) “We continue to see growth even after we were added to the entity list,” Mr. Liang said. “That’s not to say we don’t have difficulties ahead. We do, and they may affect the pace of our growth in the short term.” (…)

One indication of the U.S. blacklisting’s toll on Huawei is a slowdown in its smartphone sales in overseas markets. Mr. Liang said those sales are at about 80% of their level before the Commerce Department’s action. (…)

Mr. Liang said Tuesday the company hasn’t seen any impact from the U.S.’s entity listing on its 5G wireless rollout. Huawei has so far signed 50 commercial 5G contracts world-wide, including 11 contracts in the weeks since the entity listing was announced, he said. (…)

But for key technologies that are subject to the licensing rules–including Android–Mr. Liang said Tuesday the company has yet to receive word on whether licenses are forthcoming. (…)

Trade jitters running high at U.S. companies ahead of new U.S.-China talks Worries about the U.S.-China trade war are running high during the current U.S. quarterly reporting season, with companies as diverse as Juniper Networks and O’Reilly Automotive bemoaning the consequences but saying they are finding ways to weather the storm.

(…) Of S&P 500 components that have reported their second-quarter earnings, export-focused companies have beaten analysts’ expectations 77% of the time, while companies focused on the domestic economy have exceeded expectations just 66% of the time, according to an analysis by Credit Suisse.

That suggests that export-oriented companies are feeling the trade war less than investors expected, said Patrick Palfrey, an earnings analyst at Credit Suisse. (…)

Investors were surprised last week after Texas Instruments said that U.S.-China trade tensions were not hampering its ability to conduct business in China, while Intel said on Thursday that customers worried about potential tariffs on chips were preemptively buying processors.

“We really think the Q2 action was pulling from the second half into the first half,” Intel CFO George Davis told Reuters following the earnings report. “Depending on how the trade discussions go, there could be some additional activity there, but we’re not expecting at the same level, if at all, during the third quarter. We’re forecasting demand based on the signals we’re getting from our customers.” (…)

Wait, wait! Beating expectations is only one thing, and, maybe, not the most important one. Factset yesterday:

(…) For companies that generate more than 50% of sales inside the U.S., the blended earnings growth rate is 3.2%. For companies that generate less than 50% of sales inside the U.S., the blended earnings decline is -13.6%. (…)

For companies that generate more than 50% of sales inside the U.S., the blended revenue growth rate is 6.4%. For companies that generate less than 50% of sales inside the U.S., the blended revenue decline is -2.4%. (…)

How China Cuts Rates Without Cutting Rates

(…) Right now, the economy still needs more help: Producer price inflation is flirting with zero, small banks are struggling, and the labor market is in trouble. But there are also very strong voices within the government calling for a hard line on debt control.

In this situation, a new toy looks particularly useful. After relying heavily on its one-year medium-term lending facility—currently pegged at 3.3%—to fund banks in recent years, the central bank has debuted a new tool. This is dubbed the targeted medium-term lending facility, and has a one-year rate of 3.15%. In theory, only banks that “provide strong support to the real economy” can use the facility, which is meant to boost small- and private-sector lending, but the central bank has discretion. These loans can be rolled over twice to last three years, meaning they are both cheaper and longer-lasting than their predecessors.

Replacing some maturing medium-term loans with funds under the new facility helps lower longer-term borrowing costs without making big headlines, or flooding money markets with liquidity, like cuts to reserve ratios typically do. This is exactly what the PBOC has been doing, most recently on July 23. (…)

• The PBoC is absorbing bad debt onto its balance sheet

In response to rising financial stress in China — as evidenced by rising bond defaults, increasing numbers of non-performing loans and rumours of yet another bank bailout over the weekend — the People’s Bank of China has stepped into action.

Since 2016, when we believe policymakers threw in the towel on their half-hearted attempt to rebalance, instead doubling down on the increasingly inefficient old growth model, the stock of assets held by the PBoC against other depository corporations has almost quadrupled.

If such lending is done to encourage banks to purchase non-performing loans with an implicit understanding that the central bank will not demand repayment should the lender default, then this effectively writes off the bad debt.

The PBoC’s books balance as its assets simply switch from the original claim on the bank to ownership of the non-performing collateral. If we are right, and the PBoC is absorbing bad debt onto its balance sheet, then this could amount to as much as 8 trillion yuan and rising.

• Grant’s ADG informs us that

Over the weekend, three separate state-owned Chinese banks announced an agreement to each buy “at least” 17% of Bank of Jinzhou Co., Ltd. (416 on the Hong Kong exchange). The bank, which has RMB 748 billion ($112 billion) of assets as of June 30, 2018, has seen its shares suspended since April, made the sale at a roughly 40% discount to its last closing price, per Bloomberg. The deals were completed with “support and guidance of the local government and financial supervising authorities,” according to a statement from the Bank of Jinzhou.

The trouble at Bank of Jinzhou (predicted by China expert Carl Walter on the July 5 Grant’s Current Yield podcast) follows the takeover of Baoshang Bank Co., Ltd. and represents the latest evidence that something is not right in the world’s second-largest economy. China’s reported GDP growth rate in the second quarter fell to its lowest since at least 1990, while June industrial profits dropped 3.1% year-over-year, a figure which analysts at Bloomberg Intelligence suggest “may understate the magnitude of the deterioration.” (…)

Reuters reported Friday that China Construction Bank Corp. has agreed to cough up RMB 2 trillion ($291 billion) worth of “comprehensive financial support” for the Hunan province over the next five years. The region, located in the central part of the country, has seen its financial condition deteriorate to the point where the city of Leiyang “did not have enough money to pay its civil servants” in May, according to local media.  As noted by prof. Christopher Balding on Twitter, the bailout represents slightly more than half of the region’s GDP.

While growth wanes and signs of trouble continue to appear across the financial system, China’s capital markets got a boost with last week’s debut of the Star Market, a science and tech-focused stock exchange styled after the Nasdaq. But as reported today by Yicai Global, China’s Securities Regulatory Commission on July 26 suspended 43 IPOs and refinancings (including some on the Star Market) while it investigates allegations that auditor Ruihua Certified Public Accountants falsified company information.  

The regulators accuse Ruihua-audited chemical maker Kangde Xin Composite Material Group Co,. Ltd. of inflating profits by RMB 11.9 billion from January 2015 to December 2018.  During that period, the company reported RMB 14.6 billion in adjusted gross profit and RMB 6.2 billion in net income. Ruihua, China’s second-largest auditor, inspecting the books of almost one-third of publicly-traded companies. 

EARNINGS WATCH

We now have 222 S&P 500 company reports in, a 76% beat rate and a +6.3% surprise factor leading to a +0.6% expected earnings growth rate for Q2, up from+0.3% on July 1. Revenues are expected up 3.6%, unchanged. Trailing EPS rose to $163.56 but still trail their end-of-June level of $163.99. Technology earnings are seen down 4.0%.

• S&P 400 Mid-Cap earnings

140 of the 400 companies have reported. The earnings beat rate is 66% (52% on revenues) and the surprise factor +5.5% (+0.2%). The blended growth rate for Q2 is –4.4% on revenues up 1.4%. Excluding Energy, the earnings growth rate is –1.4% on revenues up 2.2%. Technology earnings are seen down 6.0%.

• S&P 600 Small-Cap earnings

163 reports in. The earnings beat rate is 58% (46% on revenues) and the surprise factor +4.7% (+0.7%). The earnings blended growth rate is –9.3% on revenues up 2.9%. Excluding Energy, the earnings growth rate is –8.6% on revenues up 2.9%. Only 2 sectors (Real Estate and Financials) are expected to grow earnings in Q2. Technology earnings are see down 20.9%.

Meanwhile in Europe, Refinitiv reports:

Through July 23, 69 companies in the STOXX 600 Index reported earnings for Q2 2019. Of these, 52.2% reported earnings above analyst estimates. In a typical quarter (since 2011), 50% of companies beat estimates and 41% miss estimates. In aggregate, companies are reporting earnings that are 0.1% below estimates, which is below the 3.8% long-term (since 2011) average surprise factor.

Of these, 50% exceeded analyst revenues expectations. In a typical quarter (since 2011), 55% of companies beat estimates and 45% miss estimates. In aggregate, companies are reporting revenues that are 0.8% above estimates, which is above the 0.3% long-term (since 2011) average surprise factor.

The estimated earnings growth rate for the STOXX 600 for Q2 2019 is -0.5%. The estimated revenue growth rate for the STOXX 600 for Q2 2019 is 0.9%.

Back to the USA, Goldman Sachs’ David Kostin just revised his numbers:

We lower our top-down S&P 500 EPS estimates to $167 in 2019 [current consensus is $165] and $177 in 2020 [$184], representing growth of +3% and +6%. We forecast sales growth of +5% and +4% in 2019 and 2020, roughly in line with nominal US GDP growth. We expect net profit margins will fall by 39 bp in 2019 before rebounding modestly in 2020 and 2021 (+14 bp and +5 bp). Most of the reduction to our EPS estimate stems from the YTD slowdown in economic growth, lower oil prices, and weaker margins than expected, particularly in the Info Tech sector. (…)

We introduce a 2021 EPS estimate of $185 [current consensus is $201], representing growth of 5%. Our 2021 EPS estimate assumes a continuation of the economic expansion and roughly flat net profit margins. (…)

 

We raise our year-end 2019 price target to 3100 (from 3000) and introduce a year-end 2020 price target of 3400. Our targets imply 3% appreciation through year-end 2019 (implying a 24% full-year gain) and a 10% increase in 2020. Our valuation model implies the forward P/E multiple remains stable at 17.6x in 2019, before expanding in 2020 to 18x as interest rates remain low and elevated policy uncertainty is more than offset by the tailwind from continued economic expansion.

A few comments of my own:

• 5% revenue growth for 2019 looks more and more ambitious. Q1 was +6.1% but Q2 is +3.6% and Q3e Q4e +3.5% and +4.4% respectively. As seen earlier, mid and small cap revenue growth rates are even lower. Total Business Sales for the U.S. were up 1.5% in May (+1.8% ex-Petroleum), from +2.8% in Q1 and 3.8% in Q4’19 and +6.1% for all of 2018. The slowdown is significant with no signs of a turn yet. Ed Yardeni illustrates the close links:

• Similar ambition on the margin assumptions. Tax reform is behind us and economy-wide pretax margins keep falling under the weight of rising labor costs, increased competition and supply chain disruptions. Unless revenue growth accelerates meaningfully, these pressures will intensify.

We can also assume that gross margins are being pressured by bloated inventories:

And finally, there is the trade war risk. Here’s Kostin’s take on that:

If the trade war escalates and a 25% tariff is imposed on all imports from China, current S&P 500 EPS estimates could be lowered by as much as 4%, assuming no substitution, pass-through of costs, or major impact to economic growth. There is considerable uncertainty around the corporate reaction function to tariffs, which makes modeling the link between tariffs and earnings difficult. We assume that consensus estimates currently include tariffs in place. But in the event of an escalation, the ultimate EPS impact would likely be smaller than 4%; S&P 500 firms would need to raise prices by roughly 1% to offset the impact of tariffs. Managements have highlighted their supply chain flexibility and pricing power during quarterly earnings calls.

I would not bet the farm on this last sentence.