THE DAILY EDGE (24 September 2018): Boom-Bust; Margins? Warning on Small Caps.

BOOM-BUST WATCH

Friday’s Flash PMIs from Markit should have investors worried:

• U.S.manufacturing is on a roll (“robust improvement in business conditions across the manufacturing sector”) as tariff protection measures are adding to an already strong demand environment (“stock building”, “strongly rising pre-production inventories”, “forward purchasing”). Yet “business sentiment has moderated to its lowest since March 2017” and manufacturing employment “expanded at the weakest pace for 13 months in September”. Manufacturers are worried.
• Services providers’ job creation “was the fastest since May 2015”, prompting Markit to predict “non-farm payroll growth topping 200,000 in September”. Yet, “the degree of positive sentiment was the lowest since December 2017”. Importantly, “some firms commented on intense cost pressures. This was also highlighted by a strong rise in input prices in September, while average prices charged by service providers increased at the fastest pace since the survey began in October 2009.”

On the one hand, manufacturing is booming but also struggling with actual and potential tariffs. Not the healthiest of booms.

On the other hand, the much bigger service sector is loudly complaining about accelerating wage pressures and pushing prices up in order to protect against “intense cost pressures”.

The Services PMI has dropped precipitously from 56.5 in June to 52.9 in September while service providers’ complaints have become more acute about the growing margin squeeze:

• July: “greater wage and transportation bills as driving the rise in cost burdens”;
• August: “larger cost burdens were partly passed on to clients through higher output charges. Delays receiving purchases and higher wage costs were commonly mentioned as placing strain on profit margins”;
• September: “intense cost pressures”.

INTENSE: “of extreme force, degree, or strength.”

If this is a prelude to what investors will be hearing from corporate conference calls during the coming Q3 earnings season…

Note also the apparent inflation signals from both the manufacturing and the service sectors with demand and price pressures coming from all sides: labour, transportation, tariffs, inventory accumulation, forward purchasing…

U.S. demand, boosted by tax cuts and increased government spending, is now augmented by corporate measures to cope with and/or protect against tariffs. The stronger demand environment allows for faster cost pass through but the accelerating build up in costs is evidently squeezing profit margins, particularly at service providers. Markit’s September Flash PMI made no specific mention of manufacturing margins but did signal weaker sentiment in spite of a booming business environment.

These charts end in August:

Dissecting the results from the various Fed districts, one finds that the stable spread lately (circled above) was essentially due to the Kansas City district data. All other districts reported trends suggesting further deterioration in margins during Q3.

NFIB surveys reveal the building pressures on small business labor costs…

…and their attempt at offsetting rising costs with actual and planned price increases…

…especially since small biz have no purchasing power nor economies of scale to delay or offset, not to mention Amazon.

EARNINGS WATCH: WARNING ON SMALL CAPS

Analysts remain upbeat on S&P 500 earnings as we approach the end of Q3:

But they have become much more cautious on smaller caps. If you subtract the above from the below, you get 480 non-500 companies with earnings revisions last week, 65% of which were negative revisions.

Ed Yardeni’s Net Earnings Revisions Index for S&P 600 companies was still positive at the end of August but the 3-m moving average has been declining and threatens to move into negative territory. Six of the 11 small cap sectors had negative NERI at the end of August. By contrast, only one S&P 500 sector had a negative NERI at the end of August.

The S&P 600 Index is down 2.2% in September vs +0.6% for the S&P 500 Index.

Lowry’s Research confirms the lag: its OCO (Operating Company Only) Small Cap Adv-Dec Line remains well below its Aug. 31st bull market high, contrary to large and mid-caps and most of its readings on small caps are deteriorating. Normally, the deterioration starts will small caps before moving to mid and large caps.  This process can take several months but in this world of ETF-dominated trading…

Tight Labor Market Fuels Worker Strikes Around U.S.

(…) In recent weeks, unionized hotel housekeepers in Chicago, distillery workers in Kentucky and crane operators in Seattle have all walked off the job to pressure employers for better pay and benefits.

Some 31,000 teachers in Los Angeles are threatening to strike, and union members atArcelorMittal SA and U.S. Steel Corp. have given the authority to strike if negotiations break down. (…)

“Now is the time to make sure we’re delivering,” said Christian Sweeney, deputy organizing director at the AFL-CIO. “If you’re not going to do it when there’s 4% unemployment, when is it going to happen?” (…)

A statewide teachers’ strike in West Virginia that started in February resulted in a 5% pay increase for teachers and changes to the state public employees’ insurance program, as well as increases for other state employees, more than state officials had previously offered. (…)

Earlier this month, the union representing crane operators in the Seattle area ended a 17-day strike after reaching a tentative agreement with a 17.8% increase in pay and benefits over three years. The union had rejected a 15% increase before it went on strike. (…)

In Michigan, highway construction projects across the state are stalled because the Michigan Infrastructure & Transportation Association, which represents contractors, has locked out heavy-equipment operators.

Mike Nystrom, a spokesman for the contractors association, said the operating engineers’ union has turned down a 14.4% increase in total compensation. “They self-authored a contract and have put in it everything they’ve ever hoped for and wanted,” Mr. Nystrom said. (…)

China Says It Won’t Hold Trade Talks Unless Trump Stops Threats The latest round of U.S. duties took effect just after midnight Washington time.

U.S. farmers say Trump’s $12-billion China-tariff bailout not enough, may affect their mid-term votes

Caterpillar leans on old playbook to cope with Trump tariffs Six months into the U.S. tariffs on imported aluminum and steel, Caterpillar Inc is finding that one of the best ways it can protect profits is a cost cutting strategy that is more than two years old.

(…) CAT is producing more loaders here with 30 percent fewer people on the factory floor than in the past, the company told Reuters.

It has redesigned all new machines it makes with over 20 percent fewer parts, cutting back on the consumption of steel which brings down the cost, Tony Fassino, vice president at Caterpillar’s building construction products, said after a factory tour in Clayton. (…)

Trump’s Overconfidence May Bring ‘Major Miscalculation’: JPMorgan

(…) The worry is that “U.S. economic and equity market resilience despite tariffs will embolden the President on all geopolitical fronts — autos, Nafta and particularly Iran — and thus risk a major miscalculation from sanctions that are tough to calibrate,” strategists led by John Normand wrote in a note Sept. 21. (…)

JPMorgan also is starting to factor into its strategy a growing potential for a “Phase III” of the U.S.-China trade war next year affecting all Chinese imports. That could, the strategists say, lead to weaker Chinese growth and hit the commodities complex — not to mention U.S. stocks.

“For U.S. equities, 25% tariffs on all imports from China could take $8 off consensus 2019 EPS projections of $179 and reduce next year’s EPS growth from 10% to 5% year-on-year,” the note said, citing a Sept. 12 report from JPMorgan strategists led by Dubravko Lakos-Bujas. The $179 refers to average Wall Street estimates for the S&P 500. (…)

AMERICA CURSED

• Harley Is Winning in Europe—Without a Trade War

(…) With sales in the U.S. falling, the European market has become so important to Harley that the company is willing to invoke Trump’s wrath, announcing a few months ago it would shift manufacturing abroad to skirt retaliatory tariffs enacted in the president’s trade war over steel and aluminum shipments. The European Union is imposing a 25 percent tariff on U.S. motorcycle imports in response to Trump. 

Harley’s success in Europe is evidence that American companies can compete and even flourish there, without a trade war—if the products are good enough. The company built a strong network of dealerships and made some adjustments to the products to suit European tastes: slimmer bikes, special customization options and even wifi on board.

Harley’s approach—catering to local tastes with a distinctly American product—couldn’t be more different than Cadillac and Chrysler, which haven’t developed cars with Europeans in mind, said Felix Khunert, an auto analyst with PwC in Germany. (…)

Oil climbs to 4-year high close to $81 a barrel Producers boost prices by deciding against output increases sought by Trump

Canadian Inflation Slows Even as Core Price Measures Quicken

The consumer price index recorded an annual pace of 2.8 percent during the month, in line with economist expectations, Statistics Canada said Friday in Ottawa. It had hit 3 percent in July on the back of higher gasoline prices. Core measures of inflation ticked up to an average of 2.1 percent, the fastest since February 2012. (…)

Loose Leveraged Lending Is Storing Up Economic Trouble, BIS Says

(…) The total of leveraged loans and high-yield bonds outstanding in Europe and the U.S. has doubled to about $2.65 trillion since the financial crisis, according to the Basel, Switzerland-based BIS, known as the central bank for central banks. While high-yield bonds still account for more than half the tally, growth in lending to risky companies has outpaced sales of those securities, and leveraged loans now account for almost 45 percent of the market.

Distress among indebted borrowers “may affect not only investors holding these loans, but also the broader economy,” economist Tirupam Goel wrote in the BIS’s Quarterly Report. (…)

Almost 80 percent of newly issued loans are now covenant lite, compared with less than 25 percent in 2006 and 2007, according to Moody’s. (…)

The BIS report identified other concerns, including the prospect of fire sales by loan funds if ratings downgrades push some of their investments into junk. Diamond said there’s potential for such leveraged mutual funds to cause havoc.

“The borrowing that they do is usually from a bank,” he said in an interview. “They buy a loan from a bank, they borrow money from the bank to buy the loan from the bank — not necessarily the same bank. So the risk would ultimately get back to bank balance sheets.”

SENTIMENT WATCH

Bull Market Charges On, Even Without Tech The Dow industrials and S&P 500 are at all-time highs, while the S&P tech sector is on course for its worst months since March

REPATRIATION

U.S. corporations repatriated some $225 billion in the initial quarter, which slowed to $105 billion in the second. Based on JPMorgan strategists’ estimate of $400 billion to $500 billion being repatriated in all of 2018, the $330 billion first-half inflows represent the lion’s share for the year. They further estimate that $270 billion of that already has been deployed, with a little less than half, $124 billion, being used for stock buybacks, and $133 billion earmarked for debt reduction. A grand total of $13 billion, or 5%, funded capital expenditures.

All of which suggests that financial engineering remains one of the marvels of this market. (Barron’s)

The main and most important “marvel” for equities is called “profits”. Q1: +26.6%; Q2: +25.0%; Q3e: +21.7%; Q4e: +20.3%.

Trailing EPS are now $148.58 which become $153 if we pro forma for 12 months of tax reform using 7% average accretion. Equities remain slightly overvalued (7%) on the Rule of 20 scale but the Rule of 20 Fair Value (yellow line) keeps rising given the strong EPS and the recent slowdown in inflation.

Once again from JP Morgan: “For U.S. equities, 25% tariffs on all imports from China could take $8 off consensus 2019 EPS projections of $179”.

Buybacks Lift Corporate Earnings Companies’ record stock repurchases this year are causing profits to appear stronger and fueling the stock market’s record run

(…) S&P 500 companies bought back a record $189 billion of their own shares in the first quarter, and a similar number—if not more—is expected for the second quarter, according to S&P Dow Jones Indices. By contrast, S&P 500 buybacks totaled no more than $137 billion in any of the six quarters before the tax overhaul. (…)

The per-share earnings increases generated by stock buybacks are low quality, inflating results without underlying substance, said Gregory Milano, chief executive of Fortuna Advisors, a financial consulting firm that has examined buyback trends. “It has less value.” (…)

Hmmm…not necessarily less value. One, the share reduction is not temporary. Two, when done responsibly at reasonable valuation using excess cash, it makes sense. Nobody should be surprised of heavy buybacks during a year of tax cuts and cash repatriation.

The impact of buybacks will be increasing in coming quarters. Fewer shares outstanding will boost EPS by 2.2% and 2.6% in Q3 and Q4 respectively (+1.2% in Q1 and +2.0% in Q2). It could culminate at +3.4% in Q1’19 based on current numbers.

CHART FOR YOU

These two lines will eventually meet again:

Wall Street’s Marijuana Madness: ‘It’s Like the Internet in 1997’ Entrepreneurs and investors are rushing headlong into the nascent legal marijuana industry, fueling a stock craze reminiscent of the late 1990s dot-com bubble and the recent bitcoin mania.

(…) Canada has become a hotbed for the cannabis industry because it is one of only two countries, along with Uruguay, that has legalized recreational marijuana use. Starting Oct. 17, Canadians will be able to buy pot from licensed vendors across the country. In the U.S., the use, sale or possession of marijuana is illegal under federal law, though 30 states permit medical use and nine states allow recreational use. (…)

There are more than 120 marijuana companies listed on Canadian stock exchanges, but the sector is dominated by five companies, whose total market value has catapulted from less than $4 billion to nearly $40 billion in the past year. (…)

Investors took notice last year when Constellation Brands Inc., whose stable of products includes Corona and Modelo beer, sank nearly $200 million into Canopy Growth Corp. CGC -5.00% , one of Canada’s biggest marijuana growers. In August, the beverage group raised its bet on Canopy, investing an additional $4 billion. Constellation’s president, Bill Newlands, told investors recently that the company is expanding into cannabis products through Canopy because it believes more countries will open their doors to medicinal or recreational sales, and the global market “could be a $200 billion business in very short order.” (…)

Jesse Pytlak, a Toronto analyst with Cormark Securities, estimates cannabis stocks are currently valued at more than 10 times the C$5 billion to C$9 billion market expected to emerge in Canada by consulting firm Deloitte after legal recreational sales begin. He warned investors are prematurely deciding which companies will dominate a new market before a single ounce of recreational pot is legally sold in Canada. (…)

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