SWAN LAKE

Last November, I wrote about Cornerstone Macro’s strategist François Trahan who was very bullish on U.S. equities on the view that the U.S. economy can grown 3.0-3.5% annually for several years even with a weak Europe and a severely slowing China. The story was very appealing: the ROW being weak, the U.S. will benefit from low commodity prices and interest rates which will boost consumer expenditures and revive the housing market. In the background, the American manufacturing renaissance and the U.S. energy revolution, coupled with a strengthening dollar, will boost capex and employment while low inflation rates will restrain wage growth.

I argued in LONESOME COWBOY that economic scenarios are generally much smoother on paper than they end up being in the real world. Among my problems with Trahan’s scenario:

• The problems in Europe, Russia and China are not trivial. Things could even get worse. (…)
• How low will commodity prices go? What if oil prices drop to $60-70. What happens to Canada, Russia, the U.K., Brazil, the Middle East? Obviously nothing pretty. Globalization has magnified and speeded up the communicating vases. Sharply lower oil prices surely benefit consuming countries and global GDP but producing countries are not an isolated bunch suffering in silence in their corner, patiently waiting for the crisis to pass. Remember the eurocrisis?
• How high the dollar? How low the yen? How will other countries react, especially China and Korea? Currency wars and protectionism are not market friendly. Central banks are experimenting novel measures with many unknown consequences. (…)
• How about another LTCM, or euro bank crisis, or a China banking crisis? These unknown unknowns often pop up when major economic shocks occur.

In effect, the swans elegantly gliding on the calm surface of lake America are actually paddling furiously to keep advancing against many undercurrents. Some are also nearly totally immersed, searching for survival solutions, hoping to resurface in any color other than black.

On January 5, we learned that Cornerstone Macro turned bearish on U.S. equities, judging that the risk of economic contagion or international crisis has gotten too high:

“We see equities lower from here (yes we are bearish) and everything that goes with it …stronger dollar, lower bond yields and even lower commodity prices. In essence, we expect a good year for Main Street in the US but a volatile one for Wall Street,” write Francois Trahan, Michael Kantrowitz, and Emily Needell for Cornerstone Macro. “Investors should tread carefully as our highest conviction theme is the return of volatility”, says a new 29 page report obtained by ValueWalk.

The obvious international risks now are Europe, where deflation is a looming problem and the possibility of a Greek euro exit can’t be dismissed; Japan, where further weakening of the yen is having diminishing returns; and China, whose official growth numbers seem too high compared to leading indicators. If any of those economies stumbles, it could have a big impact on the US economy even if everything is going well domestically.

Trahan illustrates his fears with two sets of charts. The first shows how Japanese domestic equities are not responding positively to the most recent drop in the Yen.

 

Trahan then suggests that China GDP growth rate is actually well below the 7.5% target.

What really happened since mid-October?

• Brent collapsed another 40% from $85 to $50.
• The Euro lost another 10% to USD1.15.
• The Yen dropped another 10% against the USD.
• The Eurozone economy keeps teetering as Germany and Spain (!) help offset weaknesses in France and Italy.
• Grexit is back.
• China manufacturing PMI (Markit’s) has slipped below 50 in December reflecting weak domestic demand.

Pretty spooky indeed. Anything positive?

• Brent collapsed another 40% from $85 to $50.
• The Euro lost another 10% to USD1.15.
• The Yen dropped another 10% against the USD.
• Draghi seems to be about to win support for his own, closed-ended, QE.
• Abe got re-elected.
• China is clearly re-stimulating.
• U.S. GDP grew 5% in Q3.
• U.S. employment growth is accelerating.
• U.S. consumer spending is accelerating.
• U.S. mortgage rates dropped back to their May 2013 lows.

In effect, the oil collapse is turning into a $1 trillion (annualized) stimulus for the world’s largest economies: USA, China, Japan and Europe. It may not last a full year but $80 billion per month is not negligible while it lasts, especially if it helps change the momentum and get the wheels turning a bit faster.

This is a gigantic displacement of money from oil producers, mainly MENA countries and Russia, to consumers, mainly in OECD, and it is obviously generating economic waves. However, few important producing countries will meaningfully reduce their expenditures as a result. They will likely use their enormous reserves or borrow to maintain their economy and, importantly, social order. There will be casualties (e.g. Venezuela) but likely no contagious cataclysm.

In all, volatility is certainly back, no surprise, except perhaps to the Cornerstone Macro fellows. But the world is not going to fall apart. In fact, anybody who was worried about Europe, China and Japan should now be less worried.

China is critical in the overall assessment because it now accounts for 30% of world growth compared with 15% for the U.S., 5% for the Eurozone and 3% for Japan. China seems to be intent of taking care of itself. Within the last 2 months, it has accelerated 300 infrastructure projects ($1.1T), it has eased bank lending rules and cut interest rates and bank loan reserve requirements. Importantly, the current leadership has shown a willingness to promote public-private partnerships in investment projects to support funding needs. This should help improve the overall quality and effectiveness of capital spending in China and ease concerns about China’s indebtedness.

• Electricity consumption is perhaps one of the most reliable official Chinese stat. It grew 4.2% YoY in December, up from +3.3% in November and +3.1% in October.
• CEBM Research, which conducts its own surveys, wrote a hopeful note on China’s important economy-leading housing sector on January 5:

Property was the only sector that delivered solid growth, with sales momentum continuing to strengthen, especially in tier-one cities. However, strong property sales have yet to translate into investment and new starts, as property developers are more concerned with inventory reduction for the time being. Against this backdrop, inventory is declining while asking prices for both new housing and second-hand housing continued to increase in tier-one cities. Moreover, some banks expanded the scope of preferential mortgage policies and offered more favorable discount rates in December, which is expected to further boost property transactions going forward.

• HSBC’s China manufacturing PMI dipped below 50 in December:

The weaker PMI reading was partly a result of a renewed fall in new business volumes placed at Chinese manufacturers in December. Though only slight, it was the first reduction in new orders since April. Data suggested that the decline was largely driven by softer domestic demand, as new export work rose for the eighth month in a row and at a slightly quicker rate than in November.

If China’s housing sector can find a new breadth, the domestic economy will contribute to GDP growth and help prevent a significant growth slowdown. It seems doubtful that the Chinese dragon has suddenly morphed into a lame duck, let alone a black swan. Keep in mind that China is one of the main beneficiary from lower oil prices. Note that vehicle sales rose 15.3% MoM (SA) in December, up 12.9% YoY. Sales for the whole of 2014 were up 6.8%.

Europe remains the sick duck on the lake but the lower Euro and Super Mario are coming to the rescue adding to the positive impact from lower energy costs. Markit sums up the EU manufacturing sector:

The average PMI reading over the final quarter as a whole (50.4) puts the manufacturing sector on course for its worst growth outcome since the current recovery started in Q3 2013. The quarterly averages for the output and new orders indices are similarly the weakest during that sequence.

December saw the slowest output growth during the current one-and-a-half year period of sustained expansion. However, there was a mild improvement in new order inflows, which rose slightly for the first time in four months. Although domestic market conditions remained lacklustre, the trend in new export business provided a positive contribution to total order books. The growth rate of new export orders rose to a three-month high.

The eurozone service sector remained on a soft track at the end of 2014 but growth of business activity and new orders was recorded, with trends in both improving on those signalled in November. 

Meanwhile, the U.S. economy keeps chugging along at rates that suggest sustained expansion without overheating. American consumers greatly benefit from lower energy prices.

U.S. consumers purchase about 140 billion gallons of gas annually, so a $1.00 drop in gasoline is a net savings of $140 billion (or about 1% of gross domestic product [GDP]). Each household that has been spending about $2,500 per year on gasoline (roughly the national average) will see a drop of perhaps $600 annually, based on U.S. Energy Information Administration (EIA) forecasts. For someone making the median income in the United States (about $52,000), that’s almost an extra week’s paycheck.

And the total does not include home heating costs, where additional savings are captured, as the decline came just ahead of the coldest winter months (the sharp drop in natural gas prices is also helping). Depending on your assumptions, savings for the average American from lower energy prices could reasonably be estimated at over $1,000 per year, which for many, is like getting a raise. (LPL Financial)

Historically, Americans have spent the windfall. If they perceive that oil prices will remain low for an extended period, consumers will reconsider their monthly budgets. This will particularly impact younger Americans who will find room for new monthly instalments on cars and/or new homes, providing unexpected additional life to the auto sector and a much needed boost to the lagging housing industry.

Deflation fears should diminish given the enormous demand stimulation created by lower energy prices. The latest inflation numbers from the EU and the U.S. are important to that effect. U.S. core prices, unchanged MoM in December, rose at a 1.2% annual rate in Q4’14 but the median CPI, up 0.2% MoM in December, rose at a 2.0% annual rate in Q4 after rising at a 1.2% annual rate in Q3. The Cleveland Fed’s daily nowcasts suggest that total CPI could drop 0.6% MoM in January but core CPI is edging up 0.14% as of Jan.15. Total CPI could thus turn negative YoY in January (-0.1%) but core CPI would remain in the +1.7% range.

In Europe, the media made a big fuss on December CPI across the European Union’s 28 members falling for the first time since records began in 1997. They made no fuss from the fact that, ex-energy, annual inflation was steady at +0.6% YoY in December and up 0.3% MoM even with a weak economy.

Energy deflation is good for the economy. Past periods of declining oil prices haven’t dragged core prices down. In 1986 and 1987, falling energy prices sent headline inflation lower but core prices remained steady, a pattern repeated in the late 1990s and again in the early 2000s.

A contagion risk lies among oil producing countries such as Russia and Venezuela. Russia and Venezuela are already in recession and things will get a lot worse. Venezuela is a weak chick in this game of chickens but Russia is a strong and combative rooster.

Russia’s problem is less with the oil price decline given that the ruble has sunk 40% since June, enabling the government to continue to collect enough oil taxes to cover pensions and other budget obligations, but with Western sanctions which severely limit Russia’s access to global capital markets.

Perversely, since exports are now its only source of hard currency, Russia cannot really afford to reduce its oil exports. In fact, to the extent that the nascent recession reduces domestic oil consumption, Russian exports of oil and oil products could actually increase during 2015. Yet, Russian cuts were clearly required by the Saudis last November.

The reality is that Saudi Arabia cannot win this game other than reducing the pace of future Irak oil output. If demand does not recover enough, supply will rebalance the markets by mid-year, before any meaningful contagious casualties emerge (see Facts & Trends: “Buy Low” Time For Oil)..

To be sure, Cornerstone Macro’s fears of contagion(s) are not without justification. Black swans and other weak and sick ducks abound on the lake. Sudden collapses in important commodities or currencies such as oil, copper or the Swiss Franc can turn many apparently healthy fowls into foul meat, potentially poisoning the whole lake. This Punch Line article lists quite a large number of swans of various colors.

These fears and the complexity of all the possible interactions call for prudence in equity investments but do not justify a fully bearish position.

At current levels, the S&P 500 Index is selling at 17.4x trailing EPS after Q4’14 ($115.82e). This is a hefty 27% premium over its 13.7 median and average since 1927, 1953 and 1983.  This is not a cheap market in absolute terms.

Under the Rule of 20, with core inflation at 1.5%, fair P/E is 18.5x or 2142 for the S&P 500 Index. This 6% upside is nothing to write home about but it is also not terrible in the current low rates environment, also considering that the 200-day moving average stands at 1968, only 2.6% lower, and is still rising.

Given that earnings ex-energy continue to rise at a decent 5-10% rate (see NEW$ & VIEW$) and that energy stocks are near their lows (Facts & Trends: “Buy Low” Time For Oil), it seems a good bet to stay at the table and see how things evolve in coming months.

This is a game of probabilities since nobody can pretend to know the future. The Rule of 20 chart above indicates that equity valuations, though not cheap, remain within the “lower risk” area. This simply means that, from a valuation standpoint, equities offer more upside than downside at current levels using trailing earnings and current inflation numbers. LPL Financial looks at equity probabilities using the economic picture…

…which is not bad at all in the USA…

…and improving:

In all, this equity market does not seem ready to deliver its swan song.