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 May 2018)

Economic Outlook from Freight’s Perspective Volume Strong, Pricing Even Stronger – Capacity Still Tight but Less Tight

Both the Shipments and Expenditures Indexes extended their run into positive territory. They are still displaying accelerating strength on top of increasingly difficult comparisons, but while capacity is tight it is slightly less tight. That said, demand is still exceeding capacity in most modes by a significant amount. In turn, pricing power has erupted in those modes to levels that 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 level of growth is expanding. The 10.2% YoY increase in the April 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.

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(…) the DAT Flatbed Barometer is indicating that the U.S. Industrial economy is alive and well and accelerating. So it shouldn’t come as a big surprise that spot rates in the flatbed segment:
 have exceeded contract rates since September 2017;
in April YoY, were up 26.0% on a spot basis and up 12.5% on a contract basis (not including the fuel surcharge, which was up 42.3%).

When viewed on a nominal basis, the chemical carload volume looks equally bullish for U.S. Industrial Production.

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The latest data point shows total intermodal pricing (all-in intermodal costs) rose 6.6% YoY in April. The index is now at 141.9, just shy of the all-time high of 143.2 established in March. April marked the nineteenth consecutive month of increases, and brings the three-month moving average up to 5.9%. “Tight truckload capacity and higher diesel prices are creating incremental demand and pricing power for domestic intermodal,” stated Donald Broughton, analyst and commentator for the Cass indexes.

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CHINA SLOWING

Source: World Economics (via The Daily Shot)

A firm controlled by a city government in China’s Inner Mongolia region has failed to make interest and principal payments on nearly 4 billion yuan ($629 million) in off-balance sheet loans, two sources with direct knowledge of the matter said. (…)

Xilinhot Geipaishui Co, a local government financing vehicle (LGFV) controlled by the city of Xilinhot, has failed to repay loans from more than 20 mostly state-run leasing firms, said the sources, who were from two of the leasing companies involved. (…)

The Finance Ministry said Tuesday the levy will be lowered effective July 1 from the current 25 percent that has been in place for more than a decade, boosting shares of automakers from India to Europe. (…)

High five The shift is significant more for its optics than its potential impact given imported cars made up only about 4.2 percent of the country’s 28.9 million in automobile sales last year. (…)

Like all U.S. manufacturers have JVs in China.

Most indicated that they wouldn’t make much use of the rule change because of the massive investments they’ve already made in shared local production.

EARNINGS WATCH

With 468 reports in, the beat rate stands at 79% and the surprise factor is +6.7% (+1.1% on revenues). Blended EPS are seen up 26.2% (24.2% ex-Energy) on a 8.2% revenue growth rate  (+7.8% ex-Energy).

This 7.8% revenue growth rate is amazing, having accelerated constantly since +4.1% in Q2’17 to almost double in a year during which nominal GDP growth went from +4.0% YoY to +4.7% and Business Sales from +6.6% to +6.0%. A weaker USD helped Q1’18 revenues but we must admit that corporate America is doing pretty well overall. Eight of the S&P 500 ten non-Energy sectors have seen their revenue growth rates accelerate in each of the last 3 quarters (7 in the last 4 quarters).

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By comparison, revenues for the 385 STOXX 600 companies that have reported so far declined 0.8% in Q1’18 as only Energy (+9.3%) and Consumer Cyclicals (+0.5%) showed positive revenue growth.

Trailing EPS are now $140.23. Pro forma tax reform for the last 12 months: $146.60 assuming 7% average accretion. If Q2 results meet current expectations for 20.0% growth, trailing pro forma EPS will exceed $151 after Q2.

Pointing up Pre-announcements for Q2 have been less positive in the last week as 3 companies positively pre-announced against 8 negative pre-ann’s. As of yesterday, pre-ann’s are 37/52 pos/neg, better than last year at the same time (39/69) but somewhat less upbeat that during Q1’18 at the same time (46/57).

In truth, costs are rising almost across the board and risks of negative surprises on profit margins are increasing. This cycle is getting pretty elongated and there is no doubt that resource utilization is getting stretched. The fact that companies seem better able to pass their rising costs on to clients is not all that positive. One, this is a zero-sum game. Two, demand can slow down much faster than costs pressures. Hence the need to watch revenue growth.

(…) European profitability has taken a hit from a roughly 15% gain in the euro between the start of 2017 and 2018. Companies in the Stoxx Europe 600 generate about half of their revenues outside of Europe and a stronger local currency cuts into the earnings of multinationals. (…)

Since the peak of the last profit cycle, roughly a decade ago, the gap in earnings between the U.S. and Europe has grown to 70%, said Ms. Olney. But removing the technology and financial sectors from the equation shrinks the gap to 27%, she found. European banks have lagged behind the U.S. over that period as the region struggled to recover from a debt crisis and ultralow interest rates cut into their profitability. (…)

Costs are also rising in the EU while revenue growth is much slower. And Brexit. And Italy, yaddi yaddi yadda…

GLOBAL WAVE PEAK

The Merrill Lynch’s Global Wave indicator has peaked, suggesting that the growth cycle could be ending. (The Daily Shot)

Source: BofA Merrill Lynch Global Research

EMERGING SUBMERGING

This is a bigger risk for now (EMERGING SUBMERGING):

Source: Oxford Economics (via The Daily Shot)

An Immigration Debate Distinct From Economic Realities There is a good case that America’s economy has never needed immigrant labor more than it does now. The long-term demographic trends also suggest immigration can be more helpful than harmful. Yet the climate is more hostile toward immigrants and immigration than at any time in recent memory, Gerald F. Seib writes.

The American birthrate has slowed dramatically, with the number of babies born in the U.S. last year hitting a 30-year low. At the same time, Alaska fisheries, New Hampshire restaurants and Maryland crab processors all say they are critically short of workers. Farmers say they need thousands more workers, and some production is moving overseas for lack of labor. There are 6.6 million job openings in the U.S., which means that, for the first time in history, there are enough openings to provide a job for every unemployed person in the country.

Meantime, the House of Representatives virtually ground to a halt last Friday because some Republican lawmakers are demanding a vote on a bill that would lower legal—not illegal, but legal—immigration. (…)

Fifth Third Signals Resurgence of Banker Confidence Bank’s deal to acquire a small Chicago lender shows that banking sector is back in growth mode

(…) A bill that passed the Senate and may soon pass the House would raise the threshold for annual stress testing by the Federal Reserve from $50 billion to $250 billion of total assets. This is expected to spur more mergers between banks slightly below the $50 billion threshold. (…)

MB Financial Chief Executive Mitchell Feiger stressed on the call that greater scale is important for being able to invest in technology and compete against national giants. User-friendly online and mobile platforms are increasingly valuable in the race to attract deposits, putting smaller banks with more modest technology budgets at a significant disadvantage. (…)

EMERGING SUBMERGING

I do not invest in emerging markets. Too many moving parts (earnings, accounting, disclosure, forex, politics,…) with unlimited potential grey and black swans from so many corners. It is almost impossible to correctly value emerging markets and adequately measure risk vs reward. Last 15 years: much volatility (risk) with zero overall growth (reward). Only for traders who can be repeatedly smart (lucky?). Key word is repeatedly. Poor odds for me! North American equity markets provide a large enough playground that I can better understand and value. Despite what they say, diversification is not necessarily risk/return positive.

VWO

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From time to time, an emerging markets crisis rocks all other markets for a while. The root causes are generally the same: rapid increases in U.S. interest rates and the U.S. dollar.

Jerome Powell explained the links between U.S. monetary policy, the USD and emerging economies and markets in a speech to the Institute of International Finance in October 2017. That was before he became Fed Chairman.

But in a May 7, 2018 speech to an IMF conference, the new Fed Chairman felt the need to tell the world that U.S. monetary policy isn’t the major cause for EM crisis.

There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.

But Powell added these warnings given that Fed policy was for scheduled rate hikes well into 2019:

I do not dismiss the prospective risks emanating from global policy normalization. Some investors and institutions may not be well positioned for a rise in interest rates, even one that markets broadly anticipate.

Risk sentiment will bear close watching as normalization proceeds around the world.

Global policy normalization is central banker current wording for scheduled multi-year rate increases. You have been warned.

What Powell is referring to with “risk sentiment” is the highly sensitive risk-on/risk-off trigger on emerging debt and equity markets that effectively dictates capital flows so important for dollar-indebted EM countries and companies.

In previous EM crisis, developed world banks were the lenders to EM countries. This time around, the lenders are mainly bond investors and the borrowers a mix of EM corporates, small to very large, and, to a lesser extent, sovereigns.

In previous crisis, the epicenter was relatively limited to one or a few countries like Mexico in 1982, Thailand and Malaysia in 1997. Redirected capital flows made the crisis global but the economic damages were limited in time and scope. This time around, the visible problems are in Turkey, Argentina and Venezuela but heavily dollar-indebted corporations, spread across the world, are silently suffering the pain of being slowly strangled but rising rates and the strong USD. Eventually, the strangled groundhogs will suddenly emerge from their increasingly uncomfortable undergrounds in need of financial air or simply declare bankruptcy.

In previous crisis, the risk-off trades were in equities and the debt instruments of specific countries and banks. This time around, the risk-off trades will combine both equities and EM bond funds, creating a lot more additional pressures on the weak currencies and further boosting the USD, amplifying the problem in the process. ETF investors will want to rush to the exits, only to find very narrow exit doors with few buyers on the other side? This time around, the next EM crisis will also be a liquidity crisis that will likely impact all asset classes in both emerging and developed markets.

Data from the Institute of International Finance show that EM ex-China debt has almost doubled to $27T since 2007 while China’s has been multiplied 6 times to $36T.

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Corporate borrowings have ballooned across the world while central banks drove interest rates through the floor.

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U.S. interest rates are now going in the wrong way for these unprepared borrowers. The Fed has set the path straight up for short term rates, from nearly zero in 2015 to their current 1.75% on their way to 2.9% at the end of 2019 per the most recent Fed dot plot. Longer term rates are feeling the upward pressure while also lifted by rising inflation and inflation expectations. Ten-year Treasury yields bottomed in 2016 at 1.4% and have since gone up 170 bps even though still offering a historically low 0.6% real yield.

With more than $3T in EM debt maturing between now and the end of 2019, refinancing will necessarily cost between 300 and 500 bps more on fixed rate debt alone, a whopping $120 billion jump in annual interest costs on fixed rate debt. Some 50% will be absorbed by the non-financial corporate sector.

This, without taking into account the damage inflicted by the rising USD.

Foreign investors have increasingly bought domestic-currency bonds, seeking both credit and currency gains. If investor appetite for EM risk reverses, issuers may face refinancing challenges even in their home markets, while capital outflows could put pressure on exchange rates or foreign exchange reserves. (Fitch)

Add rising oil prices and you get something close to a perfect storm. It will likely start in the EM world but interest rates and oil prices are rising across the developed world as well where non-financial corporates are also highly indebted.

Groundhog days ahead! Watch your step.