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: 15 NOVEMBER 2018

Inflation Jumps, but Is Likely to Slow The consumer-price index increased 0.3%, the largest monthly gain since January

Yes, everything points to slower inflation in coming months.

  • Core CPI growth remains below 0.2% MoM (+1.6% annualized in last 3 months)

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  • Core Services have decelerated throughout 2018, indicating that there is no major cost-push from wages:

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Sticky-Price CPI Rose in October
The Atlanta Fed’s sticky-price consumer price index (CPI)—a weighted basket of items that change price relatively slowly—rose 2.0 percent (on an annualized basis) in October, following a 2.7 percent increase in September. On a year-over-year basis, the series is up 2.4 percent.

  • The Sticky-Price CPI is showing no signs of acceleration. If anything, it is suggesting slower inflation ahead:

  • The flexible cut of the CPI (brown line below) -a weighted basket of items that change price relatively frequently- tends to react much faster to demand/supply conditions. It has turned up in 2018 but remains subdue within its recent range:

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The recent drop in oil prices adds to downward pressures on inflation throughout the economy. All good for the world economy, interest rates, profits and non-energy equities. Caveat:

One reason there is little apparent tariff effect on prices might be that companies, having seen earlier sets of tariffs from Washington, raced to import goods before the tax went into effect. In the third quarter, goods imports rose an annualized 10.3% from the second quarter, according to the Commerce Department, and inventories swelled.

That could help retailers and other consumer-facing companies keep prices low during the coming holiday shopping period, but the cushion on prices will only last so long.

If President Trump follows up on his plan to raise the tax on the goods hit with tariffs in September to 25% at the end of the year, prices could experience a sudden lurch. (WSJ)

In the meantime, the Rule of 20 P/E has fallen below 19.0 at 18.9 while the Rule of 20 Fair Value (yellow line) keeps climbing with rising trailing earnings and slowing inflation. Fair Value is now 2868, up 19% from its January level as trailing EPS have jumped 21%.

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Global Economic Slowdown Deepens
Fed Tracking World Growth Worries, Powell Says

(…) “You’ve seen a bit of a slowdown—not a terrible slowdown,” Federal Reserve Chairman Jerome Powell said Wednesday evening. “You still see solid growth, but you see growing signs of a bit of a slowdown. And it is concerning.”

One-time events played a role in some of these bumps, including a typhoon and earthquake that hit Japan and bottlenecks at German auto plants associated with new emissions standards.

But across the globe, economists and business executives warned about a common denominator that is hurting growth: trade battles among the U.S., China and others. Tariffs are hitting some businesses, and worries about the impact of worsening trade discord are also weighing on sentiment. (…)

“I’m very happy about the state of the economy now,” he said. “Our policy is part of the reason why our economy is in such a good place right now.”

One risk is that U.S. economic growth could slow in coming years as recent fiscal stimulus from tax cuts and spending increases wears off, Mr. Powell said during a moderated discussion at the Dallas Fed with the reserve bank’s president, Robert Kaplan.

A separate challenge is that U.S. growth continues to outpace the rest of the world, putting strains on some emerging-market economies that face headwinds from a stronger dollar.

“The U.S. economy is just really strong, and it is stronger than many other major economies right now,” he said. (…)

Mr. Powell said Wednesday the main challenge facing the Fed now is to consider how much further and at what pace to raise rates. He said the central bank would evaluate “really carefully…how the markets and the economy and business contacts are reacting to our policy.” (…)

Mr. Powell said Wednesday he was optimistic the U.S. economy could sustain a higher growth rate, which could potentially allow for faster growth without a large increase in inflation. “You always want to be on the optimistic side of this economy,” he said. (…)

China Outlines Possible Trade Concessions to U.S. Before G20, Sources Say

The commitments for now fall short of the type of major structural reforms that President Donald Trump has been demanding, two of the people said, cautioning that a long road lies ahead in negotiations. One person said that talks between the world’s two largest economies are continuing and constructive. (…)

Most of the document appeared to be a rehash of previous changes already made by Beijing, such as raising equity caps on foreign investment in certain industries, according to one person. It did not contain the sort of commitment to change industrial policies such as Xi’s “Made in China 2025” that Washington has been seeking, according to one person familiar with the discussions.

Two other people familiar with the talks also said the Chinese offer was a sign of what they characterized as constructive discussions between the two sides ahead of the planned G20 meeting between the two leaders. (…)

Treasury Secretary Steven Mnuchin and Xi’s main economic emissary, Liu He, spoke last Friday for the first time in months. Since then, lower-level discussions have been held and Larry Kudlow, the head of Trump’s National Economic Council, on Tuesday said the two capitals were in touch “at all levels.”

On the American side, the discussions are currently being led by Mnuchin and the Treasury, which has raised questions among some observers about the process.

Mnuchin is seen as an advocate within the administration of a deal, while others such as Robert Lighthizer, the U.S. trade representative, have been pushing to continue raising pressure on Beijing to try to push for more meaningful reforms. (…)

Scissors, who has previously advised the Trump administration on its China trade stance, said in an interview Wednesday the most likely outcome of the Trump-Xi meeting at the G20 was a “cease fire,” or a deal to avoid any further escalation in tariffs while the two sides hold deeper discussions.

But he said the chasm between the two sides on issues such as Chinese industrial policy and intellectual property theft remained vast and that any post-G20 negotiations were likely to be difficult as a result. (…)

The president has deferred until next year a decision on imposing 25 percent tariffs on imported automobiles and is considered likely to hold off on new trade restraints on Chinese imports when he meets China’s President Xi Jinping later this month at the Group of 20 summit — refraining for now from moves that would mean higher prices for American consumers.

Larry Kudlow, the director of the National Economic Council, this week also publicly rebuked a prominent advocate of hard-line trade measures, White House adviser Peter Navarro, saying he was “way off base” with recent remarks assailing Wall Street supporters of a compromise with China.

“The recent market turmoil, House election result and angst in farm states has the Trump team rattled on trade,” said one multinational executive, who spoke on the condition of anonymity to speak freely about White House deliberations. “The president still wants to pull the trigger on crazy stuff like an autos tariff, but he’s lost some of his swagger, and a lot of people around him are saying he needs to back away from extreme action.” (…)

Favorite Stock Market Crystal Ball May Have a Crack in It High-yield bonds, one of the stock market’s best-known bellwethers of doom and gloom, might be missing a beat when it comes to predicting the next meltdown.

(…) So far, the evidence is leaving investors scratching their heads. High-yield credit spreads—the extra yield investors demand to hold junk bonds over ultrasafe Treasurys—narrowed in the months leading up to the S&P 500 slumping 7% in October, its worst month in over seven years. Junk bonds outperformed during that selloff, with the ICE BofAML U.S. High Yield Index declining only 2% last month.

That could mean all is well with stocks. But some wonder if the predictive power of junk bonds won’t work this time. Changes in the market, central banks distorting asset prices, and the surge of tech stocks, which don’t tend to issue junk bonds, has sapped high yield of its previous highly predictive quality. (…)

I don’t pretend to know exactly why HY bonds are still holding except to suggest that investors probably are not sniffing a recession just yet and that the enormous profits this year are obviously helping debt ratios. That said, the hunt for yield still seems very much present:

The Case of the Disappearing Collateral Investors are literally giving away the store to squeeze out meager returns from the picked-over market for corporate debt.

Demand for riskier bonds and loans has been so intense that companies selling them are able to move valuable assets beyond the reach of creditors. And investors continue to make it easier for them to do so by agreeing to terms in new debt sales that offer them fewer and fewer protections. (…)

The erosion in lender protections—which has made it easier for businesses not only to shift assets from lenders but issue more debt and use asset-sale proceeds for purposes other than paying down debt—is expected to have meaningfully negative impact on debt investors during the next wave of bankruptcies. The typical recovery on leveraged loans will likely decline to 61% of face amount in the next downturn, compared with the 77% historical average, according to Moody’s Investors Service. (…)

“Look Ma, no hands”Not using hands!

Uber Posts Slower Sales Gains, Widening Loss Ahead of 2019 IPO Results for the three months ending in September show that Uber is still growing quickly but is likely to be unprofitable for some time.

The ride-hailing company on Wednesday announced third-quarter revenue rose 38% from a year earlier to $2.95 billion, but that was less than the second-quarter year-over-year jump of 63%. Its loss widened to $1.07 billion from $891 million in the second quarter.

Uber has accrued roughly $2.5 billion in losses this year, not including the sale of its unprofitable businesses in southeast Asia and Russia. Last year, Uber lost about $4.5 billion. (…)

In documents for a bond offering last month, Uber said it expected it wouldn’t reach a profit for at least three years. (…)

Unicorns (e.g. Uber, WeWork, AirBnB, Palentir) seem to be piling up losses at the same rate that their valuation is rising. According to Grant’s, CB Insights counts 287 unicorns worldwide with a collective value of $952 billion, most losing money and most planning a 2019 IPO. The last time we saw something similar was in the late nineties. Maybe they lost their window. Tech stock indices are the only sectors left with a rising 200-day moving average, but for how long. The FAANGs have lost 18% of their combined market cap since Aug. 30.

Devil Big Tobacco Warns Against Menthol Ban

Will they put their warning on packages?

THE DAILY EDGE: 14 NOVEMBER 2018

OCTOBER 2018 CPI

Released this morning:

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  • Core CPI up 0.2% in October and 2.1% YoY but is +1.2% annualized in the last 3 months. Good, especially given oil’s recent drop which will bring fuel and gasoline prices sharply lower during the important holidays period.

  • Core Services prices are not accelerating, indicating no major cost push from wages just yet.
  • Food prices have been weak all year and declined some more in recent months.
  • Consumer discretionary income will be strong during Q4 and early 2019.
Auto More Signs of Trouble in China’s Auto Market In another sign of China’s deteriorating auto market, sales of Geely cars here declined in October, ending a hot streak of 46 straight months of year-over-year growth as U.S.-China trade tensions drag down the world’s biggest car market.

Geely is the main domestic brand of Zhejiang Geely Holding Group Co., which owns Volvo Cars. It has been on a roll for the past four years, with sales tripling between 2014 and 2017, to 1.24 million. Geely is now the second-best-selling car brand in China, after VolkswagenAG’s VW brand, with a 6% market share, according to auto intelligence company LMC Automotive.

But a 10% year-over-year sales decline last month showed that not even Geely can defy gravity in a sinking market. Passenger-car sales in China have fallen for the past four months year-over-year, and are on course to notch up an annual decline for the first time in nearly three decades.

Most auto makers, foreign and domestic, are struggling. Ford Motor Co.’s passenger-car sales in China were down 45% in the first nine months of the year, while sales of the Fiat Chrysler Automobiles NV-owned Jeep fell 35%, and General Motors Co.’s Buick sales were down 9%, according LMC Automotive.

Only the premium segment has seen consistent growth, with Cadillac sales up 30% in the first nine months of 2018, and the German trio ofAudi , BMW and Mercedes-Benz all growing by 10% to 13% over the same period.

Sales of Geely-brand cars were up 27% year-over-year in the January to September period before the slowdown finally bit last month. (…)

China Bet Its Economic Future on Consumers, and They Aren’t Spending Enough China’s economic slowdown spilled over to consumers and home buyers last month in a turn that economists said points to difficulties ahead, even as the government tries to bolster growth by boosting infrastructure investment.

(…) Retail sales rose 8.6% in October from a year earlier, slowing from a 9.2% on-year gain in September, and while automobiles have been slowing in recent months, a broader range of consumer products—such as stationary and jewelry—also slowed sharply. (…)

Housing sales rose 9% last month from a year earlier, compared with an 11% gain in September, a drop that some economists and analysts attributed to restrictions on purchases governments imposed over the past two years, when prices and sales were soaring. (…)

Value-added industrial output rose 5.9% in October from a year earlier, accelerating slightly from a 5.8% on-year increase in September. Mr. Zhang of UBS said some of that gain likely reflected a front-loading of orders. (…)

Investment in roads, buildings and other fixed assets, outside rural households, climbed 5.7% in the January-October period from a year earlier, Wednesday’s data showed. It was faster than the 5.4% increase recorded in the January-October period. Investment in railroads and other infrastructure projects, which dropped earlier in the year, rose 3.7% in the first 10 months, compared with 3.3% growth of the first nine months. (…)

Natural Disasters Take a Toll on Japan’s Economy Japan’s economy shrank slightly in the three months through September, owing largely to a typhoon and an earthquake, but economists said a return to growth is likely if trade friction doesn’t worsen.

The world’s third-largest economy contracted at an annualized pace of 1.2% in the third quarter of 2018, roughly in line with forecasts, after expanding at a 3% annual pace the previous quarter. (…)

Exports declined 1.8% from the previous quarter as heavy rains disrupted auto production. A powerful typhoon that hit Osaka and flooded its airport as well as an earthquake on the northern island of Hokkaido weighed on tourist spending.

Private consumption, which accounts for nearly 60% of gross domestic product, also declined slightly. Bad weather kept consumers at home, while increases in fresh-food and energy prices made them reluctant to spend elsewhere, economists said.

The Nikkei Japan Composite PMI rose sharply from 50.7 in September to 52.5 in October. “November PMI data will be important to assess whether the stronger monthly improvements in output and new business are knee-jerk reactions.”

Germany’s Economy Contracts for First Time in Years Economists say the economy isn’t in danger of slipping into a recession soon

Gross domestic product—the broadest measure of goods and services produced in an economy—fell 0.8% in annualized terms in the third quarter, data released Wednesday by the Federal Statistical Office showed.

That marks the first decline in Germany’s quarterly GDP since the first three months of 2015, when it fell by an annualized rate of 0.5%, and is well below the 3.5% rate registered in the U.S. during the third quarter. (…)

Economists said that bottlenecks in the approval of passenger cars in the wake of a new emissions-testing protocol hit automotive production. Exceptionally low Rhine water levels—the river is a major transportation route for oil and other goods—depressed activity further. (…)

Germany’s statistics body said that the decline in Germany’s GDP was largely caused by developments in foreign trade, as exports dropped and imports rose from the second quarter.

Export expectations in the manufacturing sector hit the lowest level in almost two years in October, according to a survey of about 2,300 manufacturers by the Ifo Institute, a supply-side economics think tank.

The German government and economic institutes have already trimmed their outlooks. The government’s council of economic experts now expects growth of just 1.6% this year, compared with 2.3% projected previously. For 2019, they predict growth of 1.5%. (…)

Markit’s PMI points to 1.5-2.0% growth in the near future:

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The service sector followed manufacturing in recording a loss of momentum at the start of the fourth quarter, though the good news was that the slowdown in service sector business activity growth in October was less severe than signalled by the earlier flash PMI estimate.

In isolation, the latest numbers look generally positive: service providers reported rising inflows of new business thanks to a strong domestic market, helped by sustained strong employment growth, and on the whole they remained optimistic about the outlook. But given the deteriorating manufacturing performance, there is now greater onus on services to drive the economy, and the moderations in order book growth and business confidence show some worrying signs of vulnerability.

(…) But perhaps more fundamental to the longer-term inflationary picture is ongoing upward pressure on salaries and wages, which continue to be pushed higher by an improving job market.

OPEC, partners discuss oil supply cut of up to 1.4 million bpd: sources  OPEC and its partners are discussing a proposal to cut oil output by up to 1.4 million barrels per day (bpd) for 2019, three sources familiar with the issue said, a larger reduction than previously thought to avert a price-sapping oversupply.
U.S. Budget Deficit Widened in October, Treasury Says The federal government started its new fiscal year much as it ended the last one—with spending up and revenues lagging behind the broader economy.
Panel Warns China Tech Prowess Threatens U.S. Report finds China’s dominance of networking-equipment manufacturing threatens 5G wireless infrastructure

In a new report, the U.S.-China Economic and Security Review Commission found Chinese dominance of networking-equipment manufacturing threatens the security of U.S. fifth-generation, or 5G, wireless infrastructure. The panel cited Chinese telecommunications giants Huawei Technologies Co. and ZTE Corp. in particular.

In addition, China’s position as the world’s largest manufacturer of internet-connected household devices creates “numerous points of vulnerability for intelligence collection, cyberattacks, industrial control, or censorship,” said the panel, which includes appointees by Senate and House leaders of both parties.

Beijing has denied interfering in U.S. affairs and says much of U.S. policy toward China is an inappropriate attempt to contain its rise.

While many policy makers historically considered the commission’s recommendations to be aggressive, they are increasingly being viewed as mainstream as U.S. officials’ attitudes toward Beijing harden. (…)

EARNINGS WATCH

With 454 companies in, the beat rate is 78% and the beat factor a record +6.6%:

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The blended growth rate is now seen at 28.0% (24.6% ex-Energy), from 21.6% on Oct.1. Q4 estimates are at 17.8%, from 20.1% on Oct. 1 while full year 2019 earnings are expected to rise 8.8% (10.2%).

Today’s CPI continued the decline in inflation since the summer which should help equity valuations and interest rates.

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Amid these exceptionally strong S&P 500 earnings, investors are scrutinizing the future in search of signs of earnings peaks. It won’t find it in Q4’18 but as we move into 2019, growth becomes much slower past the tax reform.Analysts are now seeing Q1’19 earnings up 7.4% and full year 2019 up 8.8%. Nothing wrong with such growth rates in the 11th year of a cycle (!) but the margin of safety has narrowed considerably.

I have documented the increasing downward revisions on small caps earnings since the summer months. Recent conference calls have made people even more nervous:

Source: BofA Merrill Lynch Global Research (via The Daily Shot)

  • And here is the ratio of mentions of “better” or “stronger” vs. “worse” or “weaker” on earnings calls.

Source: BofA Merrill Lynch Global Research

Obviously, using “better” or “stronger” after this year will be pretty heroic, be it on the economy, corporate revenues or profits and profit margins.

Yes, earnings growth has peaked this quarter. But there is no evidence of an earnings peak yet.

Blackstone’s Byron Wien:

The high level of debt throughout the economic system has continuously worried investors, but low interest rates and strong growth have diminished the importance of this factor. (…) Corporate debt is off its peak, but still high. Because of tax cuts and additional spending, the U.S. budget deficit is increasing from $700 billion to $1 trillion. All this is happening while the Federal Reserve is raising short-term interest rates and shrinking its balance sheet. If rates continue to rise, the cost of servicing debt will increase at the same time that liquidity in the system is decreasing.

As the Federal Reserve buys fewer Treasurys in pursuit of “normalization,” Japan and China will also be participating less vigorously in Treasury auctions because of tariff issues. This is not good for the outlook for equities. Of all the factors influencing the market, this could turn out to be the most important. For the market to move higher, it will be dependent on earnings to overcome the impact of shrinking liquidity. (…)

No market can move higher without leadership, and a small group of technology stocks have certainly been the outstanding performers in the market before the sell-off began. The so-called FAANG stocks, Facebook, Apple, Amazon, Netflix and Google (Alphabet) had returned 38% annually since 2014. These stocks have been hit hard in the recent decline. At this point, technology stocks appear more reasonably priced than in 2000. Then, tech was selling at a 200% premium to the general market; today the premium is 30%, according to Barron’s. (…)

The February and October market corrections reflect the volatility risk stemming from the proliferation of passive and computer-driven programs. One such strategy, Risk Parity, popularized by firms like Bridgewater and AQR, has amassed over $400 billion in AUM. This approach makes allocations based on risk, rather than traditional stock and bond weightings. When volatility in one asset class increases, the portfolio is shifted to less volatile assets in order to maintain optimal risk levels, typically without much human intervention.

Similarly, recent research suggests that 60%–90% of daily equity trading is now performed by algorithmic trading, up from 25% in 2004. Meanwhile, passive exchange-traded funds have directed trillions of dollars into equity markets since 2009, and the percent of the U.S. equity market share captured by passive strategies has increased from 26% at the start of 2009 to 47% as of 3Q’18. All of these trends are likely to increase volatility moving forward. One result is to discourage investors who base decisions on fundamentals like earnings, but feel that the market is being controlled by professionally run, computer-based forces which they do not understand and, in some cases, fear.

Taking all of these factors into account, I believe we are going through a necessary correction prior to the next upleg, which should occur after the mid-term election, regardless as to whether the Democrats take control of the House of Representatives or not. Earnings will continue to drive the market and the prospects for earnings growth in the U.S. for 2019 remain strong in spite of what is happening elsewhere in the world.

Relevant chart from Ed Yardeni:

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Trump Mocks France for World War Losses

After a fractious visit to Paris over the weekend, Trump returned to the theme of a European army to defend the continent’s interests and took renewed offence.

Trump’s tweet:

Emmanuel Macron suggests building its own army to protect Europe against the U.S., China and Russia. But it was Germany in World Wars One & Two – How did that work out for France? They were starting to learn German in Paris before the U.S. came along. Pay for NATO or not!

Trump’s tweet is twisting the facts but who’s surprised?

Trump likely never read Dale Carnegie’s book “How to Win Friends”. He also likely did not read much about U.S. history. Without the French army which, under Lafayette, Rochambeau and de Grasse, defeated the British in 1781 in the Battle of the Chesapeake and the Siege of Yorktown leading to the surrender by Cornwallis on October 19, 1781, Trump would likely drink tea, eat fish and chips and plum pudding and be currently negotiating Brexit rather than fighting China.

France almost got bankrupt financing the American revolution. A minimum of respect would be appropriate.