Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

THE DAILY EDGE: 23 JULY 2019

Chicago Fed National Activity Index Steadies

The Federal Reserve Bank of Chicago reported that its National Activity index was little changed at -0.02 during June. That came after rising to -0.03 in May from April’s -0.73. The three-month moving average also was steady last month versus May at -0.26, after April’s weakening to -0.47. During the last twenty years, there has been a 70% correlation between the Chicago Fed Index and the q/q change in real GDP.

The National Activity Diffusion Index, which measures the breadth of movement in the monthly series, also was steady at -0.11. That was down from the peak of 0.47 in April 2018. (…)

The CFNAI is a weighted average of 85 indicators of national economic activity. It is constructed to have an average value of zero and a standard deviation of one. Since economic activity tends toward trend growth rate over time, a positive index reading corresponds to growth above trend and a negative index reading corresponds to growth below trend.

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CFNAI and Recessions(Advisor Perspectives)

Stimulating deal!
White House and Congress Reach Deal on Spending, Debt Ceiling Congressional and White House negotiators reached a bipartisan deal to raise federal spending and lift the government’s debt limit.

Congressional and White House negotiators reached a deal to increase federal spending and raise the government’s borrowing limit, securing a bipartisan compromise to avoid a looming fiscal crisis and pushing the next budget debate past the 2020 election.

The deal for more than $2.7 trillion in spending over two years, which must still pass both chambers of Congress and needs President Trump’s signature, would suspend the debt ceiling until the end of July 2021. It also raises spending by nearly $50 billion next fiscal year above current levels.

The agreement forgoes the steep spending cuts initially sought by the administration, providing for about $320 billion in spending over two years above limits set in a 2011 budget law that established automatic spending cuts, known as the sequester. (…)

The accord also marked another example of Washington’s rising tolerance for deficits, among both Democrats, who prize domestic spending, and Republicans, who consistently seek more money for the military.

A key sticking point in the negotiations was how to pay for the cost of the spending increases. The deal extends small cuts to Medicare beyond fiscal year 2027 and extends fees collected by Customs and Border Protection, amounting to $77 billion worth of savings to offset the cost. Those routine budget accounting moves fall short of the $150 billion in spending cuts originally sought by the administration. (…)

Stimulating deals!
Central Banks Are in Sync on Need for Fresh Stimulus Central banks around the world are poised to unleash the most synchronized monetary stimulus since the financial crisis one decade ago

(…) “We see the economy as being in a good place and we’re committed to using our tools to keep it there,” Federal Reserve Chairman Jerome Powell told Congress July 10, indicating the U.S. central bank is ready to cut interest rates later this month.

The European Central Bank also sent a clear easing signal in the minutes of its June meeting, which said there was broad agreement among officials that they “needed to be ready and prepared” to reduce rates and resume asset purchases to provide more stimulus.

Already some central banks in the Asia-Pacific region have lowered rates this year, including Australia—which has cut rates twice to 1%—New Zealand, India, Malaysia and the Philippines. Central banks in Korea and Indonesia reduced rates last week, as did South Africa’s. (…)

“What central banks are trying to do is get ahead of the curve. We have not seen a substantial deterioration in the economy,” said Neil Shearing, chief economist at consulting firm Capital Economics. (…)

For now, fine-tuning rates may be enough. The global economy is slowing but doesn’t appear to be near a recession or destabilizing crisis, and unemployment is quite low in most developed economies. Inflation has weakened below the 2% target that most large central banks consider optimal but the danger of outright price declines, known as deflation, appears remote. (…)

Central bankers have morphed from being data-dependent to being risk managers as trade wars boost uncertainty.

Goldman Sachs:

Our own assessment remains that the justification for rate cuts at the current juncture is tenuous in terms of the Fed’s own mandate. We were unconvinced of the need for easier policy even at the time of the June 18-19 FOMC meeting, and virtually all of the information since then has come in on the stronger side. President Trump postponed the threatened tariff escalation versus China, all of the major economic reports—including payrolls, retail sales, the manufacturing surveys, core CPI, and UMich 5-10 year inflation expectations—have surprised on the upside, and financial conditions have eased further since the meeting. Our outlook for the next year is for real GDP growth in the 2%-2½% range, unemployment falling below 3½%, and core PCE inflation rising to 2%+. (…)

The FOMC’s primary rationale for a rate cut is that the trade war and the global slowdown have increased uncertainty about the outlook, and this uncertainty is weighing on capital investment. This argument is logically sensible and supported by anecdotal evidence from the Beige Book and to some degree by the recent data shown in Exhibit 2. But so far measures of uncertainty are not particularly elevated, and capex expectations—while much lower than in 2018—remain roughly in line with the expansion average. As a result, this risk to growth looks fairly mundane at this point, in our view.

Moreover, we have broader reservations about the argument that cuts are needed to insure against downside risk. Our new analysis of the role of credit markets in the transmission of monetary policy to the real economy shows that near-term downside risk from financial conditions shocks is already low, and further easing would have only small incremental positive effects. But medium-term downside risk could well rise with a further policy-driven improvement in credit market sentiment, because the latter is strongly mean-reverting. (…)

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  • Financial conditions in the Eurozone have also been easing.

Source: Natixis (via The Daily Shot)

The People’s Bank of China added liquidity today using unconventional tools. Its medium term lending facility provided CNY200 billion while its targeted medium term lending facility added CNY297.7 billion, both for one year at interest rates of 3.3% and 3.15%, respectively. TMLF funding can be rolled over twice and so is viewed as a three year liquidity injection with an annual interest rate of 3.15%. (…)

We consider this liquidity management exercise to be the start of the easing cycle:

  1. The newly added liquidity is cheaper in terms of interest costs. Borrowing via MLF and TMLF for one-year at 3.3% and 3.15%, respectively, is cheaper than interbank borrowing at 3.1% for three months.
  2. The injection via MLF and TMLF, though, was a net absorption of liquidity, and saw the three-month interbank interest rate move lower, from 3.4% on Monday to 3.1% today.
  3. The use of MLF and TMLF replaces regular open market operations – the duration of the liquidity injection is longer and therefore liquidity in the market should be more stable.

(…) The Chinese economy will need more liquidity and lower interest rates in 2H19 to support investment in infrastructure projects. (…)

FYI:

The new Fortune Global 500 list goes live this morning [yesterday], and marks an important world power transition. The number of companies on the list based in China, including the 10 in Taiwan, reached a record 129—exceeding for the first time the number of companies based in the U.S. (121).

The Fortune Global 500 ranks companies on size, and of course, size is not everything. Many of the largest Chinese companies are state-owned enterprises which owe their heft to government-supported monopolies in the world’s most populous market, and aren’t necessarily the world’s most dynamic companies. Nevertheless, the list signals a significant global power shift. Ten years ago, there were only 43 Chinese companies on the list. Twenty years ago, there were just eight. And a boatload of fast-growing private Chinese companies are rapidly working their way up the ranks. (…)

You can find the full list here. (Fortune)

U.S. CONSUMER WATCH

Credit card spending grew in the second quarter. (The Daily Shot)

Source: @FT, @trevornoren; Read full article

But weekly data suggest a deceleration in July:

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NATIONAL SECURITY

(…) Advocates say the ban is needed to protect an American industry from subsidized Chinese competition. They also claim cameras, location trackers and other gear in Chinese buses and trains could provide surveillance and strategic information to China’s authoritarian government.

“It’s in the national interest to make sure we have viable rail and bus industries and to protect us from spying and sabotage of our public transportation system,” said Rep. Harley Rouda (D., Calif.). (…)

Their intent is to shut China out of the U.S. market, since about a third of capital expenditures by local transit agencies come from the federal government. (…)

So far, CRRC manufactures only passenger railcars in the U.S., a field that has no U.S. competitors. But the Chinese company also makes freight cars, and its U.S. rivals fear CRRC’s potential to overrun the sector. CRRC says it has no plan to make freight cars in the U.S. (…)

(…) “The CEOs expressed strong support of the president’s policies, including national security restrictions on United States telecom equipment purchases and sales to Huawei,” the White House said. “They requested timely licensing decisions from the Department of Commerce, and the president agreed.”

Derek Scissors, a resident scholar at the conservative American Enterprise Institute, said the White House action suggests Mr. Trump sees the company mainly as leverage against Beijing and not a genuine threat. (…)

As the U.S. considers special licenses for Huawei, China appeared to be taking steps to increase purchases of U.S. farm products.

The Chinese state-run news agency, Xinhua, reported Sunday that some Chinese firms have asked U.S. companies about the prices of their agricultural products. These firms have also submitted applications to the State Council, requesting the cabinet remove the tariffs imposed on these goods so that the companies may make these planned purchases, the report said, citing unnamed government agencies. (…)

Xinhua and China Central Television also reported that the U.S. recently exempted 110 Chinese industrial imports from hefty tariffs and said it is encouraging U.S. companies to continue to provide goods for “relevant Chinese companies.” (…)

Huawei’s U.S. based research arm, Futurewei, slashes more than 70 per cent of workforce

China’s Huawei Technologies Co Ltd said it is slashing more than 600 jobs at its Futurewei Technologies research arm in the United States after being placed on a trade blacklist by the U.S. government.

Futurewei, which employed 850 people in the United States, began laying off workers on Monday, Reuters reported earlier, citing employees, including one who spoke as he left the company’s Silicon Valley campus. (…)

CHERRY BLOSSOMS!

The pits: How China’s U.S. tariff jab choked a cherry import boom

(…) Across China’s metropolises, the appetite of a burgeoning middle class for expensively fresh U.S. cherries has become a symbolic casualty of China’s festering, tit-for-tat trade battle with the United States. A business that grew to nearly $200 million in 2017 from zero in 2000 has now withered to little more than a tenth of its volume peak, customs data shows.

With import tariffs for U.S. cherries set at 50%, Beijing has relaxed regulations allowing imports from Central Asia – a region that just happens to be central to President Xi Jinping’s epic ‘Belt and Road’ infrastructure project, an intercontinental initiative worth hundreds of billions of dollars. (…)

Supplies from Uzbekistan leapt to nearly half of the May total, Reuters’ calculations show, from zero a year earlier, while the U.S. share of the cherry import pie shrank to 38% from nearly 80% in May 2018 – and a near monopoly in May 2017. (…)

For Victor Wang, the China representative of U.S. Northwest Cherry Growers, it’s now a case of trying keep head above water.

Wang said it took 17 years of marketing and government lobbying to help make U.S. cherries some of the most coveted fruits in China – at one stage his suppliers were even exporting more to China than across the border to Canada. But that all changed in 2018, when two rounds of Chinese tariff hikes added 40 percentage points to import charges. (…)

He said many Chinese media and business partners, including Chinese e-commerce giant Alibaba (BABA.N), have declined to provide coverage or to run promotions.

Alibaba confirmed that U.S. cherry promotions were halted but rejected any suggestion that was related to U.S.-China tensions. It said the move was due to “market-related factors”, including seasons, holidays and unspecified business opportunities. (…)

(For a graphic on ‘China’s cherry imports by origin, May 2017-2019’ click tmsnrt.rs/2jZrJFi)

EARNINGS WATCH

From RBC:

We estimate that roughly 70% of the [77] S&P 500 companies that have reported so far have described demand as healthy, up from 65% last week. More importantly, among the 20 companies currently in the “mixed or weak” category, half have said that conditions are improving or are expected to improve in the back half of the year. This is a positive shift from our last update, when we pointed out that among the early reporters, only 2 of the 7 in the mixed/weak demand camp pointed to signs of improvement.

So far, a third of the companies that have reported 2Q19 results have emphasized cost savings initiatives and restructuring plans in their earnings calls (down from 45% in our last update).

[Financials see] evidence of a strong consumer, little to worry about in terms of credit quality, decent loan growth, a reduction in the asset sensitivity of balance sheets, a resilient corporate backdrop, and a commitment to buybacks and dividends.

THE DAILY EDGE: 22 JULY 2019:

Restaurants Sweeten Pay and Perks to Find Scarce Workers Restaurants are sweetening pay packages and adding perks like more scheduling flexibility to attract and retain workers in the tightest job market in decades.

(…) More than 7.5 million restaurant and hotel workers quit last year, the most since the Bureau of Labor Statistics began releasing that metric in 2001. Around 10.7 million food-service and hotel workers were hired last year, but there were an average of nearly 900,000 job openings in the restaurants and accommodation sector in each month of last year, a record, federal figures show. And quit rates this year are even higher. (…)

A recent Harri survey of restaurant employers found that 85% reported half their staff turning over annually on average, incurring thousands of dollars in costs.

Many restaurants are raising pay, of their own volition or by law. Nearly two dozen states and some big cities have raised minimum wages this year. U.S. hourly restaurant pay was $14.79 in May, the highest since that survey began in 2006, according to BLS figures that typically include tips. The National Restaurant Association predicts restaurant wages will rise 4.7% on average this year, outpacing total private-sector growth of 3.3%. (…)

Bundesbank Sees German Unemployment Rising on Economic Downturn

Total output probably contracted in the second quarter, the Frankfurt-based institution said in its monthly report. While domestic demand likely continued to support growth, softer momentum is starting to leave its mark on the labor market. (…) “A recovery in exports and industry isn’t yet in sight.”

Call me Trump: U.S. had ‘very good talk’ with China; in-person talks may follow U.S. President Donald Trump said on Friday that U.S. Treasury Secretary Steve Mnuchin had a very good talk with his Chinese counterpart, amid signals from China that officials could soon meet face-to-face in their bid to end a yearlong trade war.

(…) “We’re dealing with China. … They’re not doing very well. They had the worst year they’ve had in 27 years. We’re having the best year we ever had,” he said. “Let’s see what happens.” (…)

High five Trade war is harming American economy more than China’s, claims official sent to US to defend Beijing’s position

China’s slower economic growth was due more to government efforts to cut manufacturing overcapacity and rebalance towards a service economy and less about the trade war, Bi Jiyao, vice-president of the Chinese Academy of Macroeconomic Research, told a group of former US diplomats and other China watchers in New York.

The trade war had caused American exporters to lose market share in China, he said, so US President Donald Trump was wrong to think China’s slower economic growth would force Beijing to make concessions.

After trying to whittle down excessive manufacturing capacity, “the economy is shifting from high-speed growth to a high-quality environment”, Bi said.

“The US has lost market share in China. Now you rank as the No 3 trading partner with China, overtaken by the Asean region.” (…)

  • U.S. exports to China dropped 30% last month. China’s exports to the U.S. dropped too, but only by 8%, springing the U.S. trade deficit on goods to $30 billion. (Fortune)
  • Stephen Roach: “I was in China last week. And the general sense was that the economy, while slowing in the manufacturing sector, the larger, more rapidly growing services sector was likely to provide a source of resilience.” ‘During his latest talks, he didn’t observe a heightened sense of anxiety over the ongoing trade war.’  According to Roach, the climate suggests China will resist moving aggressively to cut a trade deal out of economic slowdown fears.’ (CNBC)
  • Mnuchin had “a very good talk” but said on CNBC that “there are just a lot of complicated issues.” One of which is next:
  • China-US talks could resume, but tariffs must go, state media say

And this other “complicated issue”

(…) A White House official confirmed the meeting would take place, noting that Google (GOOGL.O) and Micron (MU.O) would attend, but said it had been called to discuss economic matters.

The subject of Huawei was expected “to come up but that it is not the reason why they are convening the meeting,” said the official, who spoke on condition of anonymity. (…)

This is from KKR:

Simply stated, we think that a modern day ‘cold war’ of sorts has emerged between China and the United States. Consistent with this view, we think that we are at an inflection point for global supply chains, particularly those that rely on proprietary technology. Just consider that out of $70 billion Huawei spent buying components in 2018, some $11 billion in Huawei allocations went to U.S. firms including Qualcomm, Flextronics, and Broadcom. Without question, these relationships are now all in play in a world where it appears U.S. national security concerns have trumped more traditional trade priorities.

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Japan-South Korea trade dispute implications

The ongoing trade dispute between Japan and South Korea could have serious consequences to the global semiconductor industry if a resolution cannot be identified in the near term. According to IHS Markit’s Technology division, SK Hynix and Samsung Electronics supplied 61% of memory components in 2018 that are used in a variety of electronics systems. Potentially many electronic devices and systems that employ DRAM and/or NAND flash could face supply allocation challenges if there is any protracted disruption of Japanese exports of key materials to the South Korean semiconductor industry.

South Korean exports of memory chips reached USD 127 billion in 2018, with China and the US being key markets. China imported USD 300 billion of semiconductors in 2018, with South Korea, Taiwan and the US being key suppliers. Since China is heavily reliant on imported semiconductors, its electronics supply chain is vulnerable to disruption of South Korean supplies of memory chips. The US imported USD 54 billion of semiconductors in 2018, with South Korea and Taiwan being key suppliers, even though the US is also a major global producer of chips.

If supply constraints arise in South Korean memory chip production, the price of memory components could significantly increase due to the inability of the other memory suppliers to meet global demand. End products, including servers, mobile handsets, PCs and a variety of consumer electronics would be impacted. Consequently, some US electronics firms, which have large production hubs in either the US and China, are vulnerable to supply shortages of South Korean memory chips, given the importance of South Korea as a supplier of chips to both China and the US.

The South Korean export sector has already seen a sharp contraction in exports during the first half of 2019 due to weak Chinese demand and the downturn in global electronics orders. Any protracted disruption of Japanese exports of the key materials to South Korea could disrupt the global electronics supply chain, since South Korea is a dominant global producer of memory components used in many electronics products. (…)

The use of trade sanctions as a negotiating lever in government-to-government negotiations has escalated over the past two years, with negative repercussions for world trade growth and new export orders. Exports are a key growth engine for many Asian economies, and the shockwaves from increased trade sanctions are having a negative impact on many exporting companies across the APAC region. A larger number of countries are also using trade policy countermeasures in retaliation for trade sanctions against their countries.

Trade disputes and trade sanctions are throwing sand into the wheels of world trade flows, eroding the progress made by decades of trade liberalization under the General Agreement on Tariffs and Trade (GATT) and WTO.

The Japanese trade measures taken against South Korea will add to global trade tensions at a time when Asia’s export sector is already facing strong headwinds from the US-China trade dispute as well as the slowdown in global electronics sector new orders.

With both Japan and South Korea suffering from contracting exports during the first half of 2019 due to the impact of the US-China trade war and the global electronics sector downturn, the additional impact of an escalating Japan-South Korea trade row is further bad news for the exporters of both nations.

With public sentiment in South Korea swinging towards some forms of retaliatory measures, such as boycotting the Tokyo Olympics, and some South Korean retail stores already having stopped selling Japanese products, there is a danger that the trade frictions could escalate into a protracted trade war unless some negotiated compromise can be found. An escalating bilateral trade dispute between Japan and South Korea will also endanger regional momentum for further trade liberalization. It is also likely to damage the further progress of negotiations between China, Japan and South Korea towards establishing a new trilateral free trade agreement.

With South Korea having significant vulnerability in its manufacturing supply chain to imports of manufactured parts and materials from Japan, the new export restrictions applied by Japan could create disruption in the South Korean manufacturing supply chain, notably for the electronics and chemicals sectors.

In the medium term, these Japanese government export controls on South Korea are likely to trigger trade diversion effects, as South Korean firms try to reconfigure their global supply chains to reduce their dependency on Japanese inputs and seek alternative supply sources for critical products. This could be damaging in the medium to long term to Japanese exporters, as South Korea may eventually substantially reduce its reliance on imports of Japanese parts and materials for its manufacturing supply chain.

But where is it safe to procure now that politics interfere so easily and significantly?

BTW, the United States is also at loggerheads with the Eurozone and India; while passage of the USMCA remains bogged down.

Fed Officials Signal Quarter-Point Rate Cut Is Likely in July Federal Reserve officials signaled they are ready to cut interest rates by a quarter-percentage point at their coming meeting, while indicating the potential for additional reductions.

(…) The market on Thursday was pricing in as high as a 71% chance of the Fed lowering its federal funds rate by 0.5 percentage point after its July 30-31 meeting, according to CME Group. That was the highest odds this year. The bet is raising the eyebrows of many investors, given the broad consensus that the U.S. economy is generally healthy and officials’ typical preference for moving deliberately in cutting rates. (…)

Those who believe the Fed will make a deeper rate cut say that, with interest rates already at low levels, the central bank has less room to move rates slowly to stave off an economic downturn. That is why Mr. Williams said Thursday that “it pays to act quickly to lower rates at the first sign of economic distress.” (…)

(…) Directionally, Wall Street’s focus on manufacturing makes sense. After all, manufacturing activity is more volatile than the rest of the economy. And the slowly evolving economic statistics remain disproportionately geared to manufacturing despite the falls in its GDP and employment shares to 11% and 8%, respectively. The overrepresentation of manufacturing in the official statistics reflects its previous dominant role in the economy, combined with the tendency for statistical systems and methods to change only slowly. Additionally, the sector still accounts for 37% of the S&P 500 market cap.

However, we warn against putting excessive weight on manufacturing data because the sector now accounts for a relatively small share of the volatility in overall output and job growth.(…)

The upshot is that it is important not to get too obsessed with ups and downs in manufacturing data to assess the overall pace of economic growth. We are therefore not too worried about the Q2 slowing of manufacturing data, which likely reflects an inventory adjustment, weaker foreign growth, and 2018 dollar appreciation.

About the widely discussed “inventory adjustment” apparently needed after U.S. corporations front-loaded purchases to beat rising tariffs, the chart below confirms that inventories are on the high side but it seems to be the more result of weakening sales rather than front-loading.

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So far, the 79 S&P 500 companies that have reported Q2 results have an aggregate revenue growth rate of 2.8%. At about the same time during the Q1 earnings season, the 82 companies that had released showed aggregate revenue growth of 3.0%. Analysts expect revenues to rise 3.4% for all of Q2, down from 5.7% in Q1.

The recent improvement in retail sales is supporting total GDP growth in Q2 and helping expectations for a rebound in manufacturing output as The Daily Shot shows:

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But the Daily Shot also reveals that sales managers are not seeing the rebound just yet in Q3:

Source: World Economics

EARNINGS WATCH

Through July 19, 79 companies in the S&P 500 Index have reported earnings for Q2 2019. Of these companies, 77.2% reported earnings above analyst expectations and 20.3% reported earnings below analyst expectations. In a typical quarter (since 1994), 65% of companies beat estimates and 20% miss estimates. Over the past four quarters, 76% of companies beat the estimates and 18% missed estimates.

In aggregate, companies are reporting earnings that are 5.3% above estimates, which compares to a long-term (since 1994) average surprise factor of 3.3% and the average surprise factor over the prior four quarters of 5.3%.

Of these companies, 64.6% reported revenues above analyst expectations and 35.4% reported revenues below analyst expectations. In a typical quarter (since 2002), 60% of companies beat estimates and 40% miss estimates. Over the past four quarters, 63% of companies beat the estimates and 37% missed estimates.

In aggregate, companies are reporting revenues that are 0.9% above estimates, which compares to a long-term (since 2002) average surprise factor of 1.5% and the average surprise factor over the prior four quarters of 1.0%.

The estimated earnings growth rate for the S&P 500 for 19Q2 is 1.0%. If the energy sector is excluded, the growth rate improves to 1.6%. The estimated revenue growth rate for the S&P 500 for 19Q2 is 3.4%. If the energy sector is excluded, the growth rate improves to 4.0%.

The estimated earnings growth rate for the S&P 500 for 19Q3 is -0.1%. If the energy sector is excluded, the growth rate improves to 1.0%. (Refinitiv)

Last week was a pretty good week for earnings overall. The 80 companies (as of this a.m.) that have reported have aggregate earnings growth of 8.4%, up from 6.2% at the same time during Q1 (82 companies). Upward revisions got a little stronger last week:

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Maybe we have seen the worst on revisions which “are the most negative since the financial crisis of 2008-09 and are weak across all major countries, including the United States and Europe.” (Schwab)

Number of revisions to earnings for MSCI World companies

Trailing EPS are currently $163.56, down from their May/June level and barely up since January ($162.25). This lull in EPS growth, combined inflation stabilized at the 2.0-2.2% level, has flattened the Rule of 20 Fair Value line (yellow), creating more headwind for equities and increasing the risk of greater volatility from non-financial events.

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TECHNICALS WATCH

Lowry’s Research continues to see that “the weight of evidence heavily favors an ongoing, healthy bull market. (…) the forces of Supply and Demand provide little support for [a] bearish outlook. Major market tops, historically, take months to develop in a process that includes rising Supply, falling Demand and deteriorating breadth. Currently, none of these developments are present.”

Except for small caps:

Small Company Shares Fall Behind in Sign of Economic Worry While the most-closely watched U.S. stock market gauges have hit new records, shares in smaller U.S. companies have taken a beating.

(…) The Russell 2000 index, a gauge that tracks companies with smaller stock-market capitalizations, has lost 9% over the past year, while the S&P 500 index tracking the biggest American corporations has rallied about 6% on hopes of rate cuts from the U.S. Federal Reserve. A measure of the relative fortunes of small versus big company shares shows the level of the small-cap benchmark earlier this month at about 51.8% of the level of the bigger gauge, or the lowest level since March 2009. That figure stood above 60% around a year ago.

The divergence is raising flags for some investors. Small-cap stocks, which generate more of their revenues from domestic operations, typically rise ahead of a wider market rally and fall ahead of a broader capitulation.

“This is simply about fears of an economic slowdown,” said Benjamin Nahum, portfolio manager for the Neuberger Berman small and midcap intrinsic value strategy. “You don’t really want to own them if you suspect it’s late-cycle,” he added.

Around 82% of the revenue for Russell 2000 companies is generated within the U.S., compared with 50% for S&P 500 companies, according to Sally Pope Davis, a portfolio manager at Goldman Sachs Asset Management. (…)

The Russell 2000 trades for 21.6 times projected earnings over the next 12 months, down from 23.2 times a year ago, according to data from Refinitiv. The S&P 500’s multiple has widened in that period to 16.8 times, up from over 16 years ago. Smaller businesses typically trade at higher valuations because investors see the potential for an accelerated growth trajectory, while larger corporations are seen as more mature and stable. (…)

Pointing up Well, it’s not “simply fears of an economic slowdown”. As I explained in SMALL STILL NOT BEAUTIFUL on June 11, S&P 600 companies have an earnings problem. Small caps’ “potential for an accelerated growth trajectory” has not been realized for 15 years when considering dollar profits. Per share earnings plot much better thanks to humongous buybacks since 2000 but debt has also ballooned while margins have contracted. The end result is that 660 Russell 2000 companies are currently losing money (61 S&P 600 companies vs 3 S&P 500 companies). Beware of P/E multiples on small caps indices, they often only compute on profitable companies…

USA?

“United”? This is an amazing chart, showing the ‘current conditions’ indicator by political party affiliation. The divergence between Republicans and Democrats hit the highest level since the 2016 elections.

Source: @TheTerminal (via The Daily Shot)

This gap may well explain that gap:

Source: Pantheon Macroeconomics (via The Daily Shot)

Goldman Says Stocks Likely Won’t Go Up Much Higher

(…) “The S&P 500 index trades near fair value relative to interest rates,” the Goldman strategists wrote. It’s also appropriate relative to profitability and historical price-to-book valuations, they added.