It has been said that the absence of booming conditions is responsible for this elongated cycle. If so, the Fed and all of us should get prepared because there are more and more signs that the U.S. economy is accelerating and near booming conditions. The huge +0.8% jump in May retail sales was broad and almost guarantees that inventories are getting depleted and more as we enter the third quarter and prepare for the important August-December period (back-to-school, Thanksgiving and Christmas).

Non-auto, ex-gasoline retail sales are up at a 6.6% annualized rate since March and the Commerce Dept. estimates that real retail sales have increased at a 6.3% annualized rate in the last 3 months after falling at a 3.7% annualized rate in the previous 3 months. Just a catch up or tax cuts spending to continue throughout the year?

Economic Outlook from Freight’s Perspective: Volume Strong, Pricing Even Stronger – Can It Get Any Better?

From both a volume and a pricing perspective, the U.S. freight economy is extraordinarily strong. The Cass Freight Shipments and Expenditures Indices are clearly signaling that the U.S. economy is ignoring all of the angst coming out of Washington D.C. about the potential of a trade war and all of the concerns coming out of Wall Street about the increased threat of inflation or the rise in interest rates. These indices are displaying accelerating strength on top of increasingly difficult comparisons.

Demand is exceeding capacity in most modes of transportation by a significant amount. In turn, pricing power has erupted in those modes to levels that continue to spark overall inflationary concerns in the broader economy. (…)

The current level of volume and pricing growth is signaling that the U.S. economy is not only growing, but that the level of growth is expanding. The 11.9% YoY increase in the May Cass Shipments Index is yet another data point confirming that the strength in the U.S. economy continues to accelerate. This level of percentage increase is usually only attained when emerging from a recession, not when comping against already strong statistics. (…)

That these percentage increases are so strong against tough comparisons explains why capacity is so constrained and realized pricing is so strong. (…)

Cass adds that its own stats combined with railroad stats reveal that strength is equally strong in the consumer economy and in the industrial economy. The strength in the latter is also seen in flatbed prices which, in May, were up 26.6% YoY on a spot basis and up 10.9% on a contract basis (excluding fuel surcharge, which was up 53.8%).

From a shipper’s perspective, these costs are getting out of hand with both Linehaul and Intermodal being up in the 9% YoY range in May with no signs of slowing.

  

U.S. Industrial Production Unexpectedly Declined in May

U.S. industrial production ended three straight months of growth in May with an unexpected decline due in part to a fire at a major Ford Motor Co. supplier.

Industrial output, a measure of everything produced by the nation’s factories, mines and utilities, slipped 0.1% in May from April in seasonally adjusted terms, the Federal Reserve said Friday. Economists surveyed by The Wall Street Journal had forecast a 0.2% increase.

The decline was led by a 0.7% fall in manufacturing output, “largely because truck assemblies were disrupted by a major fire at a parts supplier,” the Fed said. Production of autos and light trucks fell to a seasonally adjusted annual rate of 10.18 million units in May from 11.28 million units in April.

The fire, which occurred May 2 at a parts plant in Michigan operated by a unit of China’s Wanfeng Auto Holding Group, led Ford to idle production of flagship F-150 and Super Duty trucks for more than a week. Output has since resumed. (…)

Excluding motor vehicles and parts, U.S. manufacturing output declined by a more modest 0.2% from April. (…)

Compared with May 2017, overall industrial production was up 3.5%.

Hmmm…Easy to dismiss May with the fire at Ford’s plant. But:

• The Fed says that “Excluding motor vehicles and parts, factory output moved down 0.2 percent.” This means that Manufacturing output is up only 1.2% a.r. in the last 3 months.
• Construction Supplies are down 1.65 a.r. in the last 3 months.
• Mining (oil & gas) and Utilities are the only sectors with real output strength in recent months.

Yet,

• 
  

  Empire State Manufacturing Index Continues to Strengthen

The Empire State Manufacturing Index of General Business Conditions rose to 25.0 during June, the highest level in eight months. (…) Haver Analytics calculates a seasonally adjusted index that is comparable to the ISM series. The calculated figure increased to 58.2, the highest level since March 2006. During the last ten years, the index has had a 69% correlation with the quarter-on-quarter change in real GDP.

Most of the components of the Empire State Survey improved this month. The new orders index rose to 21.3, the highest level since November. The shipments index similarly displayed strength with its rise to 23.5, the highest figure in six months. The unfilled orders measure also rose, but the delivery times series eased to 13.2 and indicated the quickest delivery speeds since February. The inventory index fell to a four-month low of 5.4.

INFLATION WATCH

June 2018: The New York Fed Staff UIG Measures

• The UIG derived from the “full data set” increased from a currently estimated 3.21% in April to 3.27% in May.
• The “prices-only” measure increased from 2.28% in April to 2.31% in May.
• The twelve-month change in the May CPI was +2.8%, a 0.3 percentage point increase from the April reading.

The UIG measures currently estimate trend CPI inflation to be approximately in the 2.3% to 3.3% range. There was a notable pickup in the twelve-month change in the CPI from 2.5% to 2.8%, with this series now in the middle of the range of the UIG estimates.

DoubleLine’s Jeffrey Gundlach showed this chart at John Mauldin’s SIC conference earlier this year. The UIG is now 3.2% and core CPI 2.24%.

Strong retail demand = low inventories = increased manufacturing demand = pricing power = higher wages = improved demand = bottlenecks = rising costs = rising prices … until the Fed has seen enough and stops the music.

• Bonuses Hit a Fresh High This Year. That May Not Be Great News for Workers

Private-sector bonuses that aren’t directly tied to a worker’s output reached 2.8% of employer pay and benefit costs in the first quarter. That’s the biggest share since the Labor Department started tracking the figure in 2008.

Bonuses started taking off four years ago. Businesses have been electing to give workers short-term payouts for retention and morale, rather than longer-term wage increases the economy had experienced in previous decades. “When you give wage increases to new workers you have to give it to your current workers, and it’s permanent,” said Lawrence Mischel, labor market economist  at the left-leaning Economic Policy Institute. (…)

A recent report by the Federal Reserve showed employers in the Atlanta Fed district were “increasing the proportion of employee compensation that is not permanent and can be withdrawn, if needed.” Meanwhile, a company in the Dallas Federal Reserve district offered large bonuses for trades, such as machinists and welders, who were willing to stay on the job for three years. (…)

China Delivers on Retaliatory Tariffs as Trade Feud Heats Up Beijing retaliated against planned U.S. tariffs on Chinese goods by targeting high-value American exports, bringing the world’s two biggest economies closer to an all-out trade war.

(…) In striking back at the U.S. action, China expanded the list of U.S. products that would be subject to tariffs to 659 types of goods, from some 106 types it originally disclosed in April. Most of the added goods on China’s retaliatory list are agricultural, seafood and energy products. President Donald Trump said earlier Friday that the U.S. would respond with more tariffs if China retaliated. (…)

• 
  

  Tariffs Hit U.S. Products from Chips to Cars

President Donald Trump’s plan to impose tariffs on about $50 billion of Chinese goods will force American semiconductor companies to pay duties on their own products because of the complexities of global supply chains, according to the Semiconductor Industry Association.

Most chips American companies import from China are designed in the U.S., and some of their components are made domestically before they are shipped to the Asian country for assembly, testing and packaging. The group called the tariffs “counterproductive.” (…)

An April study by Purdue University estimated that a 25% tariff on U.S. soybeans could cut American exports of the oilseed to China by 48% or more and wind up shrinking U.S. production by 11% to 15%.

“The one thing we don’t want to lose is China,” said Davie Stephens, vice president of the American Soybean Association, speaking from the cab of his tractor as he planted soybeans near Clinton, Ky. (…)

• China Warns U.S. Firms: Buckle Up While a trade battle between the U.S. and China would inflict pain on businesses and consumers in both countries, in the crosshairs, in particular, are multinationals with a mainland footprint.

(…) Foreign-invested companies, including firms from Hong Kong and Taiwan, produce 43% of China’s exports, according to an analysis by the Conference Board, a New York think tank. The manufacturers among them notably make up 77% of China’s exports of information and communications technology—a sector highlighted by the Trump administration for new tariffs. (…)

While multinationals assess the potential impact from the escalation of trade tensions, makers of consumer electronics have been canvassing suppliers and, in the case of at least two personal-computer makers, inquiring about shifting some of production in China to the U.S. (…)

lready, some U.S. companies are facing increased regulatory scrutiny in China, according to Jacob Parker, vice president of China operations at the U.S.-China Business Council. For instance, he said, it takes longer for their products to clear Chinese customs; in other instances, Chinese regulators are putting advertisement slogans by U.S. firms under review. Some automobiles and farm products such as pork from the U.S. have piled up at ports. (…)

• Trade war could wipe out gains of GOP tax law, former top Trump economic adviser says

Oil’s Rally, Coupled With Strong Dollar, Causes Global Pain

(…) Fast-rising crude, on its own, has been pressuring global growth for months. Swiss bank UBS figures that today’s international crude price, around $75 a barrel, would boost global inflation by more than half a percentage point, compared with the $50 barrels the world enjoyed as recently as last year. (…)

Exacerbating the pain in many countries is a strengthening dollar. The WSJ Dollar Index, a measure of the dollar compared with a basket of 16 major currencies, has strengthened 6% since February.

In Europe, dollar strength against the euro has helped make crude today about 30% more expensive than when oil was at a low in February. (…)

• OPEC Discusses Output Hike of Up to 600,000 Barrels a Day Russia has proposed a larger hike, while Iran backs the status quo.

EARNINGS WATCH

Slower Profit Growth to Test Bull Market U.S. corporate earnings growth looks poised to slow from a blistering pace, posing a potential challenge to a stock market that is already contending with slower global-growth momentum and rising interest rates.

(…) Now, many analysts say the first quarter could represent a peak in profit growth. Earnings growth is expected at 19% in the second quarter, 21% in the third and 17% in the fourth, according to FactSet. Earnings are expected to grow only in the single- to low-double-digit range next year. (…)

Big deal!

Q2 is almost over and the earnings season will be in full swing in 3 weeks. Given the strong economic data so far, it is not surprising that corporate pre-announcements show no signs of bad news coming investors’ way in the summer months. Since the end of May, the number of positive pre-announcements is almost identical to negative pre-anns (+9 to 52 vs +11 to 71). Overall, the pre-announcement stats are better than last year at this time and only slightly worse than at the same time in Q1’18.

• How U.S. tax reform rewards companies that shift profit to tax havens

TECHNICALS WATCH

Climbing the wall of worry

Lowry’s Research analysis continues to provide very bullish readings:

• Its Operating Companies Only (OCO) Unweighted NY Price Index reached a new all-time high on Jun. 12th while the NASDAQ Comp. set a series of new all-time highs.
• These new highs in the price indexes were again confirmed by new highs in the Adv-Dec lines, “all suggesting price gains are being supported by a continued expansion in
  market breadth.”
• Lowry’s Selling Pressure index reaching another new low this week, while its Buying Power showed its most dynamic expansion since the rally to the Jan. 2018 market high, “suggesting a strengthening in the intermediate term trend in Demand.”

This EMA chart also remains very positive:

THE BULLISH VIEW

Evergreen/Gavekal’s Anatole Kaletsky has a contrarian bullish view that deals with many of the “known knowns” and “unknowns” expressed in SOLID EDGE, LOUSY ODDS. Worth reading in its entirety here.

(…) Is it possible that the political risks are by now so thoroughly understood and absorbed by the markets that politics will create risk-on buying opportunities, rather than
reasons for further caution? (…)

In sum, although global trade relations are unlikely to improve as long as Trump is in the White House, the probability of trade wars escalating much beyond their present intensity seems to be quite low. And past experience of tariffs, export limits and other protectionist measures applied to specific sectors such as metals and agriculture suggests limited damage to the world economy from the present scale of the trade wars. Moreover, insofar as US tariffs do cause real damage, this will mainly be felt in the US. Tariffs are equivalent to a tax hike on US businesses and consumers and will also add to US inflation. In Europe, by contrast, US protectionism should promote a healthy shift in demand from exports to domestic consumption. And in China, efforts by Washington to prevent technology transfer or slow innovation will simply encourage even more government investment and subsidies in the sectors subject to US pressure.

(…) if we look around the world and compare the likely political challenges with the risks now discounted in financial markets, the gap between expectations and reality does not seem particularly daunting. Assuming that the economic fundamentals of growth, inflation and monetary policy remain pretty favorable around the world, which still seems to be the case, the recent panics over politics in financial markets seem more like a climax or a false alarm than the beginning of a systemic crisis.

In short, the markets may have reached “peak politics” and we could find in the months ahead that political risks have been almost fully discounted. The chaos in Italy means investors rotating out of US assets should favor emerging markets over Europe, which will probably suffer more financial volatility in the next few months than most developing economies. On balance, however, this seems like a good time to “buy the dip” in non-US assets, just as “buy the dip” was a good decision to make on Wall Street and the US dollar two months ago.

The only major risk not really addressed by Kaletsky is his 3rd macroeconomic risk: “Inflation accelerates or the bond market panics because the Fed is behind the curve of rising inflation.”

This scenario is gaining credibility almost daily.

Paul Tudor Jones is obviously worth listening to (click on image)…

…but Steve Blumenthal offers a short written summary here, even more summarized in these bullet points:

• I am currently as light on my positions as I’ve ever been.  I can’t remember how many years it has been since I’ve been this light.  Meaning I don’t have a lot of macro positions on right now because I think the reward-risk on a large variety of things is diminished at this particular point in time.  I like to have significant leveraged positions when I think there is an imminent price move directly ahead.
• it’s probably a fault of mine just because I think interest rates are going up or I think the dollar is going to go higher. 
• I have a sense that the third and fourth quarter are going to be phenomenal trading times.  I have a feeling we are going to go into a summer lull.
• I think we’ll see rates move significantly higher beginning late third quarter early fourth quarter and it will be interesting because I think the stock market also has the ability to go a lot higher at the end of the year.
• I think you’ll see rates go up and stocks go up in tandem at the end of the year.  If you asked me to think of similar time periods, I’d say 1987 in the U.S., I’m not saying we are going to have a crash.  It was a time when you had a budget deficit and you had stocks and rates going up together for a period of time. 1999 in the U.S. also jumps to my mind where things got crazy at the end of the year. 1989 in Japan: they had strong fiscal and monetary pulses that worked their way through the stock market… So I can see things getting crazy and particularly at year-end after the mid-term elections.  Yeah, I can see things getting crazy to the upside.”
• I think this is going to end with a lot higher prices which will force the Fed to shut it off.  And yes, the reason I’ve picked a couple of those years is that when you look at the valuation of the stock market relative to GDP, we are at levels that historically lead to some type of economic contraction.  It’s an old story… we’ll probably play it again.
• Rates have got to go up enough to either shut the economy down and overwhelm those buybacks or make it economically less viable for companies to issue debt and buyback stock.  It’s real simple.

Real simple!

CHART OF THE CYCLE:

• Crunch time nears for highly leveraged US companies Groups with lower debt and higher capital set to outperform

PERVERSE INDEXING

Very important piece of knowledge from Barron’s Randall Forsyth:

(…) Bond index funds also use capitalization weighting. But instead of reflecting the market’s assessment of their assets’ value, they are weighted according to the size of their debt. Ironic result: The more a company or country borrows, the more of their paper bond-index investors must buy.

So, for the big bond indexes, that would mean governments predominate. (…) Globally, that means that the governments most deeply in hock get the biggest weights. Italy is important to the bond markets because it is the world’s third-largest debtor, even though its gross domestic product is only the world’s eighth biggest, behind India and just ahead of Brazil.

In the U.S. corporate bond market, the biggest borrowers get the top weighting. So, in the $32 billion iShares iBoxx $ Investment Grade Corporate Bond ETF (known far better by its ticker, LQD, than its mouthful of a name), most of the biggest nonfinancial names have one thing in common: They have issued billions in debt to fund megadeals.

(…) In LQD’s portfolio, AT&T debt accounted for 2.59%, the same as the weighting of rival telecom Verizon Communications (VZ), which borrowed heavily to acquire Vodafone Group’s (VOD) former stake in its wireless unit. (…) Anheuser-Busch InBev (BUD) accounts for 2.24% of LQD as the result of rolling up most of the major brands of suds around the world. CVS Health (CVS) comprises 1.82% of LQD, ahead of its proposed $69 billion deal to buy health insurer Aetna (AET). Then there’s Comcast’s (CMCSA) 1.49% weight in LQD, but that’s before its proposed $65 billion bid for 21st Century Fox (FOXA), which our colleague Tiernan Ray writes would create a “debt beast,” topped only by AT&T after the Time Warner deal, with an estimated $170 billion of debt, should it win the bidding war with Walt Disney (DIS) for the Fox properties. (Fox and Dow Jones, the publisher of Barron’s, share common ownership.) (…)

On that score, Gimme Credit, the very independent corporate credit research outfit, last week reiterated its negative stance on AT&T’s notes maturing in 2027, given the increase in leverage following the Time Warner acquisition. That’s contrary to what index-tracking portfolios must do, which is to take on more AT&T paper as the telecom issues it.

The basis of index investing is agnosticism, that you don’t know more about a company than the collective wisdom of the market does. Moreover, modern portfolio theory holds that the capital structure—how much is debt versus equity—doesn’t affect the value of a corporation. Yet the value of a company’s debt is determined mainly by management’s decisions on borrowing. The practice of weighting corporate bond indexes according to a company’s debt provides an additional incentive for firms to go into hock.

INTERESTING STUFF!

• AT&T’s Ambitious Plan to Take On Facebook and Google for Ad Dollars Telecom giant aims to ramp up targeted ads considerably; weighs automated marketplace

(…) AT&T currently has two minutes of ad space per TV hour to sell on satellite service DirecTV. Time Warner’s Turner cable channels, which include CNN, TNT and TBS, will give it about 14 more minutes per hour.

That means it could replace a broad national pharmaceutical ad on TBS’s “Conan,” so that a young family in New Jersey viewing the late-night show would see a baby diaper ad while a young single person nearby would see a sports car ad. Data from AT&T’s wireless subscribers—including their usage habits, purchase habits and location—will help target ads and determine if they prompted someone to buy something or go somewhere. (…)

There are some major issues that could derail these plans. AT&T’s pay-TV operations, which also include its fiber-optic and video-streaming services, reach only part of the country, about 25 million households, and the company would likely need to strike agreements with other distributors in order to sell targeted TV advertising nationally, ad and media executives say. (…)

AT&T also has weighed selling ads through an automated marketplace, and even creating a broader consortium that could sell ad space for networks other than those it now owns, according to people familiar with the matter. OpenAP, a similar industry initiative already being developed, involves Turner, Viacom Inc., 21st Century Fox , and Comcast Corp.’s NBCUniversal. (…)

• AT&T, Time Warner, and the Need for Neutrality

• Google Invests $550 Million in Chinese Online Shopping Site JD.com Google’s $550 million investment in JD.com will deepen its ties with China and strengthen its foothold in online shopping.