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

LIBOR’S LABOR

Three-month LIBOR rates have more than doubled to 2.3% in the last year and have jumped seven fold in the last 30 months. According to Bloomberg, about $350 trillion of financial products and loans are linked to Libor, with a large chunk hinged to the dollar-based benchmark. In the past, spikes in LIBOR rates have coincided with peaks in business activity followed by sharply declining sales momentum. Meanwhile, the Fed has been raising its own benchmark and plans 2 or 3 more hikes this year.

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Rates are rising along the whole curve:

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Fiscal negligence, courtesy of world central banks!

The reality for anybody with floating rate debt and/or fixed rate debt maturing in coming years is skyrocketing interest expense over the next several years and the necessity to start planning for it:

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U.S. corporate debt to GDP is at a record level, exceeding levels previously reached during recessions. Corporate debt is now 25% of cash flow, higher than during the Financial Crisis as this chart from Ed Yardeni illustrates.

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High debt levels may be palatable when interest rates are abnormally low but can quickly become a burden when rates and serviceability are rising. Leverage does work both ways.

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Since 1992, debt leverage peaked at 2.2x during recessions. It is now 2.44x with 76% of borrowers levered more than 2.0x.

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We thus have record debt levels relative to revenues (GDP) and record leverage relative to cash flows nine years into the economic cycle and with record high profit margins. This when the Fed is tightening, labor capacity is stretched and the consumer, 70% of total demand, is squeezed by rising prices and record low savings rates. Maybe the word complacency should spell conplacency.

While economists and strategists continue to dismiss recession odds and statically calculate the effect of rising interest rates, corporate treasurers are actively discussing various scenarios for 2019-2022 with their CFO and COO, all of which showing sharply higher interest expense and potentially significant re-financing challenges amid the widely expected crowding out from the U.S. federal government and central banks’ normalization process (see WITH THE KING OF DEBT, CASH IS KING).

Treasurers are also pointing out that the recent tax reform is not friendly to interest expense on an after tax basis. A 100 bps increase in interest rates is really 122 bps with the new lower tax rate. From a debt servicing point of view, the tax bill is actually increasing an already high corporate leverage and the potential earnings bite from higher interest rates.

High yield default rates may be historically low at its current 2.0% but as Moody’s explains

each time the moving yearlong average of operating profits drops by 5% or deeper from its earlier maximum, the high-yield default rate eventually climbs up to at least 5%.

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While tax reform provides a one-time boost to 2018 after tax profits, trends in pretax results will dictate corporate behavior in coming quarters.

The current high indebtedness and leverage combined with sharply rising interest rates are not unnerving the debt market just yet but history shows that optimism (or complacency) rarely gets any better. Analysts rarely perform dynamic analysis incorporating rising interest rates and refinancing needs, matters rarely disclosed during corporate conference calls. The stealthy rise in financing costs goes unnoticed…until it really starts to bite and credit spreads widen rather swiftly.

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In the mean time, smart corporate executives are already beginning to adjust their business to the developing threats, curbing spending and maximizing cash flows, leading other less levered or less foresighted companies, eventually feeling the slowdown in revenues, to do the same. Employment slows or declines, spending budgets and capex plans are trimmed. Business sales start to wane, competition increases, operating margins are under pressure right when financial costs begin to rise. Dividend payouts are reviewed and stock buybacks reduced in order to protect cash and credit ratings.

This corporate dynamic explains why spikes in interest rates often lead a slowdown or a decline in corporate profits even absent a recession. The process is exacerbated by the now widespread corporate focus on quarterly results and profit margins,

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And if and when employment gets meaningfully impacted, consumer spending begins to wane as well, which is when monetary and fiscal flexibility can be very handy…Getting some flexibility in monetary policy is currently a prime target for the Fed but is several hikes away. Fiscal flexibility is nowhere in the minds of the current administration and Congress, quite the opposite.

THE DAILY EDGE (3 April 2018): Uncomfortable

U.S. Construction Spending Is Little Changed for Second Month

The value of construction put-in-place improved 0.1% (3.7% y/y) during February following unrevised stability in January. A 0.4% rise in building activity had been expected in the Action Economics Forecast Survey.

Private sector building activity increased 0.7% (3.8% y/y) after a 0.7% decline in January. Nonresidential construction improved 1.5% (1.3% y/y) and reversed January’s shortfall. Office construction strengthened 6.5 (3.0% y/y) and commercial construction rose 1.2% (7.4% y/y). (…)

The value of public sector building activity declined 2.1% (+3.7% y/y) and reversed the prior month’s increase. Highway and street construction, the largest component of public sector construction, eased 0.2% (-3.1% y/y).

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Why Consumer Spending Growth Is Slowing Banks are becoming more cautious lending to Americans despite a strong job market and rising incomes

(…) Credit-card lenders including Capital One and Synchrony Financial have confirmed that they tightened lending standards over the last two years in response to rising defaults or delinquencies. So, too, have auto lenders like Santander Consumer. (…)

This makes sense given the amount that consumers have borrowed in recent years. Data from the Federal Reserve Bank of New York show that aggregate household debt balances have risen for 14 straight quarters and at the end of last year exceeded their previous 2008 peak by $473 billion. (…)

Here’s a chart I show regularly:

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Manhattan Home Sales Plunge Most Since 2009

Sales of all condos and co-ops fell 25 percent in the first quarter from a year earlier to 2,180, according to a report Tuesday by appraiser Miller Samuel Inc. and brokerage Douglas Elliman Real Estate. It was the biggest annual decline since the second quarter of 2009, when Manhattan’s property market froze in the wake of Lehman Brothers Holdings Inc.’s bankruptcy filing and the global financial crisis that followed.

The drop in sales spanned from the highest reaches of the luxury market to workaday studios and one-bedrooms. Buyers, who have noticed that home prices are no longer climbing as sharply as they have been, are realizing they can afford to be picky. Rising borrowing costs and new federal limits on tax deductions for mortgage interest and state and local levies also are making homeownership more expensive, giving shoppers even more reasons to push back on a listing’s price — or walk away. (…)

Eurozone PMI at eight-month low amid broad-based growth slowdown

The final IHS Markit Eurozone Manufacturing PMI® posted 56.6 in March, unchanged from the earlier flash estimate and down further from December’s series-record high. The latest reading and the average over the first quarter as a whole (58.2) both remained indicative of solid growth nonetheless. (…)

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The further easing in the headline PMI mainly reflected slower growth of manufacturing production and incoming new business, both of which rose to the lowest extents since November 2016. Growth in new export business* (which is not a component of the headline PMI) slipped to a 15-month low.

The breadth of the upturns in output, new orders and new export business was as wide as their slowdowns during March, as all of the countries covered recorded sustained growth in each, albeit at slower rates than in recent months. In some Northern nations, this was partly driven by bad weather.

There were also signs that capacity constraints deriving from the recent growth spurt were impacting on production growth in March. Recent lengthening in suppliers’ delivery times has been among the greatest in the survey history, leading to widespread reports of raw material shortages and supply delays. This trend was especially noticeable in the Netherlands and Germany, both of which saw record lengthening in vendor lead times.

Backlogs of work at euro area manufacturers also increased during March, taking the current sequence of expansion to almost three years. Companies reacted to the sustained pressure on their capacity by raising employment. Jobs growth was signalled for the forty-third straight month, although the pace of increase eased to a seven-month low. (…)

Input price inflation remained marked in March, despite easing to a six-month low. Higher costs were driven, at least in part, by supply-chain constraints. Average selling prices also continued to rise at a solid clip, albeit the slowest in the year so far, as companies passed on the rise in purchasing costs. There were also reports that the ongoing upturn in demand was leading to improved pricing power.

BTW, the euro devalued by 35% vs the USD between 2008 and 2016. It lost 17% since.

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There is a broad-based tailing off of manufacturing PMIs in Asia in March. For the most part, the drops are not severe. But even where the queue percentile standings are relatively high, it is only because recent manufacturing activity levels in the region have been soft. (…)

TECHNICALS WATCH

CNN’s Fear & Greed Index:

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Momentum turns against Wall Street’s bull run Breach of a key technical level raises bigger questions for US equities

The bull is back sitting on its 200d m.a. this morning but he’s pretty uncomfortable…

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Good thing the 200d m.a. is still rising. Hopefully, the earnings season gets to a good start next week.

To make you more uncomfortable:

 

  

(…) Apple provides Intel with about 5 percent of its annual revenue, according to Bloomberg supply chain analysis. Intel shares dropped as much as 9.2 percent, the biggest intraday drop in more than two years, on the news. They were down 6.4 percent at $48.75 at 3:30 p.m. in New York. (…)

  • Zuckerberg says it will take ‘a few years’ to fix Facebook

Also uncomfortable: