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: 14 DECEMBER 2018

China Economy Flashes New Warning Signs Industrial production slows and retail sales growth falls to lowest level in more than 15 years

(…) Value-added industrial output in China rose 5.4% in November from a year earlier, slowing from a 5.9% on-year increase in October, the National Bureau of Statistics said. A median of forecasts from economists expected 5.9% growth for November. They thought industries would get a boost after the government scaled back wintertime production restrictions intended to ease pollution. (…)

Automobile production shrank 3.2% last month from a year earlier, extending a 0.7% contraction in October. Chemical materials and products rose 1.9%, decelerating from 4.4% growth. Retail sales rose 8.1% in November from a year earlier, slowing from an 8.6% year-over-year gain in October. (…)

Separately, central bank Governor Yi Gang told a forum on Thursday that China needs “relatively loose” monetary conditions to counter an economic downturn, though he said that could affect the yuan’s value, according to a transcript posted on Chinese news portal Sina.com. (…)

Government efforts to bolster growth and confidence did appear to show up in investments in factories, buildings and other fixed assets. Such investment outside Chinese rural households climbed 5.9% in the January-November period from a year earlier. It was faster than the 5.7% increase recorded in the January-October period and slightly exceeds economists’ expectations.

Mr. Ding of Standard Chartered said November’s data points to slower economic growth in the fourth quarter of this year, of about 6.4%, a tick down from 6.5% growth in the third quarter, with full-year growth likely at 6.6%.

  
  
Seaborne Exports Plummet at Southern California Ports Retaliatory tariffs from China likely cut into demand after exporters pulled forward outbound shipments in earlier months

Outbound container volume at the neighboring ports of Los Angeles and Long Beach fell 11.8% in November from the same month last year, the first decline since the spring after seven straight months of export growth.

Much of the goods trade between the U.S. and China flows through the Southern California ports and this year’s trade dispute between the two nations has played out at port terminals and on roads and railways in this region—often hitting earlier and more directly than at other seaports around the country. (…)

Exports at California’s Port of Oakland were flat in November, while Georgia’s Port of Savannah, the East Coast’s second-largest gateway, reported a 4.4% annual decline.

Source: @acemaxx, @PictetWM (via The Daily Shot)

White House to Officially Delay China Tariff Hike to March 1, Sources Say
China says to halt additional tariffs on U.S.-made cars from Jan. 1
U.S. confirms soybean sale to China, but size disappoints

The U.S. Department of Agriculture (USDA) announced private sales of 1.13 million tonnes of U.S. soybeans to China, confirming sales Reuters reported a day earlier. (…)

“Having a million, million-and-a-half tonnes is great, it’s wonderful, it’s a great step,” USDA Deputy Secretary Steve Censky said at an Iowa Soybean Association annual meeting on Thursday. “But there needs to be a lot more as well, especially if you consider it in a normal, typical year, we’ll be selling 30 to 35 million metric tonnes to China.” (…)

U.S. Import Prices Weaken As Petroleum Prices Fall; Export Prices Also Decline

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The implications of tighter conditions (BlackRock)

The recent correction in risk asset markets has caused a noticeable tightening in financial conditions. This means financial conditions are providing less of a boost to economic growth – and could potentially cause the Federal Reserve to alter its policy decision making, we believe. (…)

Tighter financial conditions suggest that growth in the US and Europe will likely decelerate in the coming twelve months. The sell-off in financial markets since the summer and ongoing Fed policy tightening would be consistent with US GDP growth slowing to just under 2.5% next year from almost 3% now. The market sell-off since September has
alone caused a tightening in financial conditions equivalent to a 35 basis point decline in the US Growth GPS. (…)

We believe monetary policy tightening – beyond that priced by the market – would only be required by the Fed to engineer a “soft landing” if other factors do not bring growth down to around 2%. Growth at 2% is the level that we and the Fed believe to be sustainable because it is in line with the pace of growth of potential output.

In the eurozone, our FCI suggests a slowdown in GDP growth to substantially less than 1.5% next year – financial conditions are already tight enough for growth to moderate to a level close to potential. We believe this implies that the ECB may decide to keep interest rates at record lows for most of 2019. But fiscal stimulus among member states could also support eurozone growth, changing the picture for the ECB. (…)

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Economic Outlook from Freight’s Perspective

(…) The current level of volume and pricing growth is suggesting that, while it’s still growing, the U.S. economy is simply not growing at the rate it was and that it may have reached its short-term expansion limit. The 0.6% YoY increase in the November Cass Shipments is a deceleration from the 6.2% achieved last month and is an even more marked deceleration from the low double-digit levels achieved in the first five months of 2018.(…) many modes are continuing to report “limited amounts of capacity” or even “no capacity” at any price shippers are willing to pay. (…)

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ECB Cuts Growth Forecasts as It Ends Bond-Buying Program The European Central Bank cut its economic growth forecasts Thursday, highlighting the risks confronting Europe’s economy even as it ended its massive four-year stimulus program.

“It’s a climate of great uncertainty,” ECB President Mario Draghi said at a press conference, citing trade tensions, vulnerabilities in emerging markets and volatility in financial markets. He spoke after the ECB confirmed it would keep its key interest rates—which include a minus 0.4% rate on bank deposits held at the central bank—unchanged at least through the summer of 2019. (…)

The ECB lowered its 2018 forecast for gross domestic product growth in the eurozone by 0.1 percentage point to 1.9% and shaved its 2020 forecast by a similar amount to 1.7%. (…)

The ECB softened its decision on QE by pledging to hold its €2.6 trillion stock of bonds for “an extended period of time” after its first interest-rate rise, which investors have penciled in for late 2019. (…)

U.S. Budget Deficit Widened in First Two Months of Fiscal 2019 Tariff revenue rose 86% in October, November from same period a year ago

The government ran a $305 billion deficit in October and November, compared with $202 billion during the same period a year earlier, the Treasury Department said Thursday.

Federal outlays climbed 18% the first two months of fiscal 2019, which began Oct. 1, and total receipts rose 3%.

Much of the increase in the deficit was attributable to a shift in the timing of certain payments, the Treasury said. The first day of December fell on a Saturday this year, so payments that would have been made then were moved up to Nov. 30, boosting spending for the period.

If not for the timing shift, outlays would have risen 4% from a year earlier, and the deficit would have been $20 billion higher.

Revenue in October and November was bolstered by a significant boost in customs duties, which rose 86% to $11.8 billion due to an increase in tariffs. (…)

The budget deficit rose to $882.6 billion for the 12 months ended November, or 4.3% of gross domestic product. The last time the 12-month deficit exceeded 4.3% of GDP was in May 2013.

On a 12-month basis, revenues were up just 0.2% from a year earlier, while outlays were up 5.1%.

The federal budget deficit is projected to hit $1 trillion in the current fiscal year, up from $779 billion in the previous fiscal year, the White House and Congressional Budget Office have said. (…)

Net interest costs on the debt rose 7% in October and November, reflecting a gradual rise in interest rates since last fall. (…)

BUBBLE WATCH

The biggest bubble this cycle is in the fixed income market, particularly in leveraged loans. Something just pricked the bubble:

Consider that, as Grant’s explains, “the well-informed leveraged-loan market usually does not move without reason. (…) Leveraged-loan borrowers report monthly – and those monthly reports, addressed to the creditors alone, are rich in detail, including internal financial projections. (…) More likely, then, we judge, the recent softness in loan prices is an augury of something not bullish.”

We’ve been there before as this ETF illustrates. The recent drop may again be a reaction to lower oil prices but it sure bears watching.

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There are no signs of significant deterioration in overall corporate earnings for Q4 2018. Analysts estimates for Q4 S&P 500 earnings were reduced in the last week but still point to a 16.4% growth rate. As well, corporate preannouncements are also not signalling distress half way into the last month of the quarter.

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But everybody’s pretty nervous.

U.S. Stock Market Exodus Is Second-Biggest on Record, BofA Says Investors flee equity funds in the second-biggest weekly exit, in a rush for havens.

U.S. stock funds bled $27.6 billion in the days through Dec. 12, which includes last Friday’s plunge in the S&P 500 Index that capped the worst week for the gauge since March, according to BofA’s note, which cited EPFR Global data. This is the second-biggest redemption since February’s spike in the VIX volatility measure, according to Jefferies Financial Group Inc.

Instead of U.S. equities, market players flocked to Japanese and emerging-market equity funds, as well as government bonds as global equity funds saw a record weekly outflow of $39 billion, according to BofA. Investment-grade bond funds also set a historical precedent with an $8.4 billion redemption, the data show.

These charts from Steve Blumenthal are as of Dec. 12:

Volume Demand vs. Volume Supply (NDR)

13/34–Week EMA Trend Chart

Island with a palm tree Note: I will be on vacation next week.

THE DAILY EDGE: 13 DECEMBER 2018

China Prepares to Increase Access for Foreign Companies China is preparing to replace an industrial policy savaged by the Trump administration as protectionist with a new program promising greater access for foreign companies.

China’s top planning agency and senior policy advisers are drafting the replacement for Made in China 2025, President Xi Jinping’s blueprint to make the country a leader in high-tech industries including robotics, information and clean-energy cars. The revised plan—Beijing’s latest effort to resolve trade tensions with the U.S.—would play down China’s bid to dominate manufacturing and be more open to participation by foreign companies, these people said.

Current plans, they said, call for rolling out the new policy early next year, when the U.S. and China are expected to be accelerating negotiations for a deal to end their bruising trade battle. China has signaled other measures as well, including lowering tariffs on auto imports and increasing purchases of U.S. agricultural products. (…)

The revision is also likely to be treated with skepticism in the U.S. Officials in the Trump administration have called Made in China 2025 a threat to fair competition, saying it encourages state subsidies for domestic companies and forces technology transfer from foreign partners. Some U.S. officials are likely to see the changes as more cosmetic than real. (…)

Chinese officials backing the proposed changes emphasize that China needs to move away from Made in China 2025 and state-led development for its own reasons. Mr. Xi’s economic adviser, Vice Premier Liu He, and other senior officials have criticized Made in China 2025 for creating waste. Cheap loans made available by various levels of government, for example, have led to extreme overcapacity among electric-vehicle battery makers in the past couple of years, making the sector less viable.

A more market-driven approach to upgrading the manufacturing sector would produce better economic returns and help rekindle the Chinese leadership’s commitment to overhauls, the people briefed on the matter said. Mr. Xi has stressed a shift to higher-quality growth, and China this month marks the 40th anniversary of the market-oriented changes that transformed the country from one of the world’s poorest.

Beijing is also planning to announce policies aimed at introducing fairer competition among state-owned, private and foreign firms based on the concept of “competitive neutrality,” the people said. (…) Under the concept, governments are prohibited from favoring state-owned companies over privately owned ones. (…)

U.S. Consumer Prices Flat in November, Posing Dilemma for Fed CPI report suggests underlying inflationary pressures remain stable as the central bank gears up to raise interest rates this month

U.S. consumer prices were flat in November, the Labor Department said Wednesday, restrained by tumbling oil prices last month. With November’s reading, the inflation index was up 2.2% from a year earlier, down from a 2.5% annual change in October and a 2.9% change in July.

A measure of inflation that strips out volatile food and energy categories, so-called core prices, was a bit firmer. The index rose 0.2% on the month, the same pace of growth as in October, and up from 0.1% readings in both August and September. Over a year, it was up 2.2%, staying within a range of 2.1% to 2.3% that has prevailed since March. (…)

Monthly changes in core CPI reveal very stable trends over two-year periods. The 2.0% target has been reached and is proving very stable in spite of stronger GDP growth and increased consumer demand.

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Accelerating wage growth has not translated into accelerating prices for Services (63% of CPI) and housing-related inflation (33%) has been stable in the 2.8-3.0% range during the last 18 months. Core Goods prices (20%) are down 0.4% YoY and up only 0.8% annualized in the last 3 months (although up 3.0% annualized in the last 2 months. Tariffs?)

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SENTIMENT WATCH
The Bull Case For Stocks Is Compelling An economic slowdown might actually extend the life of the expansion and the bull market in equities.

Good piece from Chuck Lieberman, Chief Economist, and Chief Investment Officer at Advisors Capital Management, LLC.

With my own comments:

(…) The market is now priced for the fear of an imminent recession, which is unlikely. Barring some unexpected adverse shock, equities represent an exceptional buying opportunity.

Let’s start with market valuations. The S&P 500 Index is trading at about 15 times expected 2019 earnings of $178 per share below the average of about 16.2 times over the past 50 years. By itself, this is sufficient to suggest stocks are cheap, but that valuation is skewed by a few very large, rapidly growing firms that are valued at dramatic premiums to the average.

Excluding the “FANG” group of stocks (Facebook, Amazon.com, Netflix, and Google-parent Alphabet, plus throw in Microsoft for good measure), the remaining 495 stocks in the S&P 500 are priced at less than 13 times expected 2019 earnings. That’s not the only sign of cheapness. The appropriate price/earnings multiple for the stock market is inversely related to the level of interest rates, since valuations are discounted flows of future earnings. With rates still at historically low levels, stock multiples should be decidedly above historical averages. Historically, with inflation around 2 percent, the average price earnings multiple has been around 19 times earnings.

The facts:

  • Expected EPS for 2019 are $175.95 per IBES/Refinitiv.
  • The average P/E on forward EPS is 15.8 since 1968 but is is 13.0 since 1953 and 12.9 since 1983. Pick your period! At 2655, the S&P 500 is selling at 15.1x forward EPS.
  • The median P/E on forward EPS is 15.8 since 1968, 12.5 since 1953 and 12.4 since 1983.
  • Actually, the Rule of 20 says 2% inflation means fair P/E of 18.0, but on trailing earnings. Inflation is actually 2.2% so fair P/E = 17.8. It is now at 16.5 on trailing EPS (pro forma for the tax reform over 12 months), about 8% undervalued.
  • According to Ed Yardeni, the forward P/E on IT stocks is 16.0 vs 15.4 on S&P 500 ex-IT. Here’s the LT chart FYI:

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According to Value Line, more than 100 companies trade at forward price/earnings multiples below 8. There hasn’t been so many cheap since the peak of the credit crisis in late 2008, when forward earnings projections were probably not worth much anyway. The last time the market saw more stocks with single-digit price/earnings multiples was in 1984, after inflation was coming off its peak of 10 percent, 30-year Treasury bond yields were coming down from 15 percent, and Fed policy rates had decreased from above 20 percent.

The facts:

  • 42 S&P 500 companies trade below 8x forward P/E, 89 below 10.0x and 141 below 12.0x.
  • The median P/E on S&P 500 companies is 16.0x right on its 50 year median (15.8) but well above its longer term level of 12.5.
  • Using the Morningstar/CPMS universe of 2171 companies, 213 (9.8%) trade below 8x, 397 (18%) below 10.0x and 617 (28%) below 12.0x. The median is 16.9x.

Beware using forward multiples. They can prove elusive in tough conditions.

(…) The retreat in stock prices reflects a fear that the Fed might raise rates sufficiently to precipitate a recession, or that one may be underway already. This seems to be fear run amok. Some point to the slowdown in housing as signaling weakness, although there are multiple factors at work here. More expensive homes are under exceptional pricing pressure because of the loss of property tax deductions. In the Northeast, lower-priced homes continue to sell rapidly, mid-priced homes sell slowly, and expensive homes sell by appointment, if that frequently. In multiple communities, homes priced above $1.5 million to $2 million have two years’ supply on the market.

The facts:

  • It is true that the housing market is weak in the Northeast, particularly in the NYC area, but the Northeast is the smallest housing market in the U.S.  and housing weakness is seen across the USA. The truth is that all interest rate sensitive sectors are weakening in a typical cyclical fashion when the Fed is hiking.

The nearly inverted yield curve is another factor used to project a recession. It is factually true that every recession in the post-World War II period has been preceded by an inverted yield curve. However, not every inverted yield curve is followed by a recession. Plus, the average period between inversion and recession is more than two years. Purveyors of the doom-is-nigh thesis are getting ahead of the data.

Nothing could be more attractive for corporate profits and stock prices than for the economy to continue expanding at a moderate 2 percent pace while rates remain low. The mere suggestion of some sort of detente between the U.S. and China on trade could trigger a massive rally and a new manic phase. And that would be entirely consistent with the market’s normally erratic behavior.

Agreed, with the caveat that the consumer sector needs to remain solid and that the Fed proves flexible and timely. Inflation has slowed measurably per the PCE deflator below 2.0% which should allow at least a pause in the Fed’s hiking expedition. At 2.0%, any economy is fragile to any kind of shocks.

And, speaking of potential shocks: