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 (16 April 2018)

Travelling week.

Last week in SCARY FED, I expressed my surprise to learn that all FOMC voting members had a positive view for the U.S. economy and that there was no mention in the minutes about the possibility that consumer spending be much weaker than forecast given the historically low savings rate and rising interest rates.

Via Randall Forsyth in Barron’s:

BofA ML had anticipated that a third of the respondents to its “Word From Main Street” survey would spend the cash from the tax cuts. Instead, just 16% of respondents said they’d use the money for big-ticket purchases or day-to-day expenses, while 22% said they’d save the tax cuts, and 20% said they’d pay down debt. In other words, close to half of those polled plan to use the tax savings to shore up their personal balance sheets, although the bank suggested that people might be more responsible in surveys than in reality. (Some 20% said they didn’t get a tax cut, although the bank hypothesized that there might have been delays in getting the reductions or that the respondents didn’t notice them.)

Millennials (ages 22 to 37) said they’d be more likely to save the tax-cut money than Gen Xers (ages 38 to 53). Millennials also were less likely to use the windfall for daily spending and more likely to invest or pay down debt, most likely student loans. All of which suggests a “greater sense of responsibility than is often credited to this cohort,” the bank commented.

The fiscal picture is worse than it looks—and it looks bad

(…) Under current law, CBO projects that the debt—currently 77 percent as large as annual GDP—will rise to 96 percent of GDP by 2028. And that’s if Congress does nothing. If instead, Congress votes to extend expiring tax provisions—such as the many temporary tax cuts in the 2017 tax overhaul—and maintain spending levels enacted in the budget deal (which is called the “current policy” baseline), debt is projected to rise to 105 percent of GDP by 2028, the highest level ever except for one year during World War II (when it was 106 percent). (…)

Under both current law and current policy, Federal budget deficits are projected to rise over the course of the next decade and will continue to be large after 2028. Under current law, Federal deficits average 4.9 percent of GDP and exceed 5 percent of GDP by the end of the decade, higher than any time in the postwar period except one year in the early 1980s and right after the 2007-9 financial crisis and Great Recession.  Under current policy, Federal budget deficits are projected to average 5.9 percent of GDP over the decade and exceed 7 percent of GDP in 2028.  So, even by a conventional historical comparison of debt and deficits, the prospects look bad.

Here’s the worse part: The conventional comparison is misleading. The projected budget deficits in the coming decade are essentially “full-employment” deficits. (…)

In order to do an “apples to apples” comparison, we should compare our projected Federal budget deficits to full employment deficits.  From 1965-2017, full employment deficits averaged just 2.3 percent of GDP, far lower than either our current deficit or the ones projected for the future.

The fact that debt and deficits are rising under conditions of full employment suggests a deeper underlying fiscal problem.

CBO’s budget projections are a harsh reminder that the fiscal largesse that Congress and the Administration lavished on the country in the recent legislation is not a free lunch.

(…) Cowen Washington watcher Chris Krueger notes that nearly half of House GOP committee chairmen—10 of 21—are opting out of running for re-election. “There is no precedence for this. It is hard to numerically underscore how bearish this reality is for the tenuous 23-seat House Republican majority,” he writes in a research note. Even more retirements are possible, given that the deadlines by which candidates must file to run haven’t yet been reached in 19 states, he adds.

(…) Rising U.S. household debt is paced by credit-card delinquencies, and Chapter 11 bankruptcies grew 64% in March from a year ago, says the American Bankruptcy Institute. “The March number is concerning, as bankruptcies are seasonal, with peaks coming in April around tax season,” writes the Institutional Strategist newsletter. “April’s number could break records, with the bankruptcy virus spreading from brick-and-mortar failures to other industries.”

“What we are seeing are the telltale signs of the end of the credit cycle,” the newsletter continues. “The painful process of refinancing debt into the face of rising interest rates isn’t going to be compatible with many business models that have relied on a never-ending flow of cheap debt and virtually nonexistent interest expense.”

U.S. corporate debt stood at $6.2 trillion midway through last month, versus $2.5 trillion in December 2008. (…)

EARNINGS WATCH
S&P 500 Likely to Report Earnings Growth of 20% for Q1 2018

From Factset:

To date, 6% of the companies in the S&P 500 have reported actual results for Q1 2018. In terms of earnings, companies are reporting actual EPS above estimates (70%) at a rate that is equal to the 5-year average. In aggregate, companies are reporting earnings that are 5.6% above the estimates, which is above the 5-year average. In terms of sales, more companies (73%) are reporting actual sales above estimates compared to the 5-year average. In aggregate, companies are reporting sales that are 1.4% above estimates, which is also above the 5-year average.

The blended (combines actual results for companies that have reported and estimated results for companies that have yet to report), year-over-year earnings growth rate for the first quarter is 17.3% today, which is slightly higher than the earnings growth rate of 17.0% last week. Positive earnings surprises reported by companies in the Financials sector were mainly responsible for the small increase in the earnings growth rate for the index during the past week.

The blended, year-over-year sales growth rate for the first quarter is 7.4% today, which is equal to the growth rate of 7.4% last week.

At this point in time, 5 companies in the index have issued EPS guidance for Q2 2018. Of these 5 companies, 2 have issued negative EPS guidance and 3 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 40% (2 out of 5), which is well below the 5-year average of 74%.

Will Booming Earnings Save the Bull Market? The biggest year for corporate earnings growth since 2010 promises relief for stalled stocks.

(…) “We’re looking ahead at six, maybe eight quarters of earnings momentum,” says John Lynch, chief investment strategist at LPL Financial, a broker-dealer serving independent financial advisors. “Companies are going to invest some of the extra cash from tax cuts, and consumers are going to spend.” (…)

The challenge for investors in the quarters ahead will be to discern core trends from short-term effects. Credit Suisse estimates that lower tax rates will add seven percentage points to growth in the first quarter. So if the Street is expecting 18% growth, the core trend is more like 11%. Energy has the highest expected earnings growth of any sector—79% for the first quarter. That’s enough to contribute about two percentage points to S&P 500 earnings growth. Some of that energy jackpot is owed to rising oil prices; Texas crude fetched $65 a barrel at the end of March, versus $51 a year earlier. So trim another percentage point or so, leaving core growth closer to 10%.

On the other hand, companies on average tend to beat expectations. Historically, that has added four percentage points to growth. It’s unclear what effect the sudden upward revisions of earnings estimates in January will have on companies’ ability to surprise to the upside now, but there is some early evidence that bodes well. Credit Suisse has tracked the results of companies that, because of oddball fiscal calendars or other factors, publish financial results ahead of the herd. Their upside surprises have been running twice as large as the historical average. Credit Suisse predicts a hefty 22% earnings increase for the first quarter. (…)

  • Big Gains at Banks Fail to Impress Lower taxes, a boost in lending income and a flurry of trading activity propelled profits higher at three of the U.S.’s biggest banks in the first quarter.

(…) Despite the strong earnings, investors sent shares lower on signs of tepid loan growth, particularly from businesses, and a lack of new earnings drivers after a run-up in valuations. (…)

Loan volume, especially for businesses, was on the rise at JPMorgan, Citigroup and PNC. But growth remained below levels of a few years ago. Bank executives said the tax overhaul passed late last year hasn’t yet had a pronounced effect on companies’ willingness to borrow.

At JPMorgan, total loans were up 4% from a year earlier but flat from the prior quarter. At Citigroup, they rose 7% from a year earlier but were up just 1% from the prior quarter.

“I think we have to recognize that tax reform is in its early stages,” Marianne Lake, JPMorgan’s finance chief, said on a call with reporters.

PNC CEO William Demchak said the lower tax rate may also crimp some areas of commercial lending. Companies will have more money on hand, which could reduce their need for bank loans, he added in an interview.

For the banks themselves, the tax overhaul is already flowing through to their bottom lines. JPMorgan reported an effective tax rate of 18% in the first quarter, down from 23% a year earlier. Citigroup’s effective tax rate fell to 24% from 31%, and Wells Fargo’s dropped to 19% from 27%. (…)

TECHNICALS WATCH

Lowry’s Research remains positive as its measures of breadth, Supply and Demand all suggest a healthy primary uptrend. “Through most of the correction subsequent to the Jan. 26th high, and especially over the past month, the market has shown signs of strength through improving breadth as well as a modest but steady expansion in Demand and contraction in Supply.  All in all, these signs of strength suggest an upside resolution to this correction and move to new bull market highs.”

While the last six U.S. recessions (back to 1969) were preceded by yield curve inversions, the six before that (back to 1937) were not! We explained this a few years back here.

We maintain that the 2008 recession was a once-in-a-generation credit super-cycle reset or balance-sheet recession. This type of recession results in a lower growth trajectory for decades afterword (secular stagnation) because a general leveraging attitude prior to it is replaced with a secular deleveraging attitude after.  

This type of recession is only comparable with two 20th century examples, the US Great Depression and Japan’s 1989 recession. In the aftermath of both, several recessions occurred without yield curve inversions. We posit that the economic stagnation following these larger recessions constricts the ability of the central bank to raise rates versus more normal recoveries (inventory-cycle recessions). Without the central bank as hawkish, business cycles occur without inversions. 

As a way to dismiss the post-depression era example, one could argue that the Federal Reserve was a different animal in the 30’s and 40’s than it is now because they didn’t formally set short-term interest rates, but it is hard to argue that the Bank of Japan has not been a modern central bank for the last 30 years. Use one or both examples, but the warning is the same. Don’t count on an early warning for a recession this time.

(Note: the 10yr and 5yr is used to represent the yield curve in Japan to get the most history. Other available series (for instance, the 2yr or BOJ target rate) only go back to the early 1990’s.)

Here’s the U.S. 10 minus 5 curve:

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THE DAILY EDGE (13 April 2018)

Pointing up Posted yesterday p.m.: SCARY FED
White House Plans to Escalate Trade Pressure on China The White House, confident that its hard-line strategy is succeeding, is planning to ratchet up the pressure on China by focusing on new tariffs and threatening to block Chinese technology investment in the U.S.

The additional moves come as President Donald Trump has told his senior aides to investigate the possibility of joining the Trans-Pacific Partnership, a move that would reverse a Trump campaign promise and further challenge China, which isn’t part of the trade pact.

For its part, China is looking to line up other countries against the U.S., Chinese officials said—especially in Europe, whose companies could benefit should China react to the stepped up pressure by retaliating against the U.S. Beijing has already responded to early volleys from Washington in the trade conflict with retaliatory tariffs of its own.

Administration officials familiar with the U.S. strategy say that the U.S. trade representative, as early as next week, will detail which products are on the list of $100 billion in Chinese goods subject to 25% import tariffs. The initial hit list of $50 billion in Chinese imports didn’t include some consumer staples such as clothing, mobile phones or shoes, to minimize consumer impact and limit domestic criticism. But trade experts say the sheer size of the expansion of the hit list makes the inclusion of consumer goods inevitable.

At the same time, the Treasury Department is crafting sharp prohibitions on Chinese investment in advanced U.S. technology, whether by acquisition, joint ventures, licensing or any other arrangement, according to a senior administration official. The agency is targeting China’s subsidization of domestic industries to turn them into so-called technology national champions, the official said.

The administration is debating whether to make the investment restrictions permanent, even if China changes its industrial policies, the official said. (…)

“China basically surrendered [with the Xi speech] and he [Trump] is probably going to put even more pressure on them before he accepts whatever their bottom line becomes,” said a person familiar with White House views. (…)

To try to limit domestic opposition to its tough line, the administration now is working on a program, which could cost billions of dollars, to compensate farmers suffering from Chinese retaliatory tariffs on U.S. crops. (…)

Here’s one via the WSJ:

The brewing U.S.-China trade war is compounding problems for companies that peddleused paper, milk jugs and metal. China is the top customer for the vast quantities of recyclable waste generated by the U.S., but the WSJ’s Bob Tita reports a 25% tariff on U.S. scrap aluminum and other recent Chinese restrictions on imported waste are sending the recycling industry into a tailspin. U.S exports of scrap plastic to China dropped 80% from October to January, and prices for mixed aluminum scrap dropped by about 15% over the past month, crumbling profit margins for processors and brokers that sell the material to China. Analysts say Chinese companies may end up buying more scrap aluminum from cheaper sources in Europe. In the U.S., some worry that trash collectors may simply toss recyclables in landfills if they can’t find other buyers.

U.S. Import Prices Are Unchanged

Nonpetroleum import prices ticked 0.1% higher (2.1% y/y) after two months of firm increase. Last 3 months: +4.4% annualized.

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TECHNICALS WATCH

Lowry’s Research warns of the low volume during the recent highly volatile sessions. “The market will likely need to show signs of significantly stronger Demand if a breakout from the recent trading range is to be sustained.”

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