SYNCHRONIZED ACCELERATION?
The global economy is on the mend. Measures of current activity are rebounding, as are a variety of leading economic indicators.
Investors have taken notice: Market-based inflation expectations have risen, as have growth-sensitive commodity prices. Earnings growth expectations have surged, rising in the U.S. to nearly the highest level in a decade. Cyclical stocks have also bounced back, after having lagged the overall market for five years.
We agree with the market’s positive re-rating of global growth prospects, but worry that undue pessimism is starting to give way to excessive optimism. Two potential developments in particular could end up giving investors pause: a slowing of China’s economy later this year and the possibility that U.S. fiscal policy will end up being less stimulative than expected.
We believe that China is key to the global reflation story playing out for longer. Our new China GPS economic indicator helps explain why. It’s the latest in our suite of GPS indicators intended to give a forward view on growth expectations, which tend to drive financial markets, and it implies a positive outlook for China’s near-term growth outlook.
Over the past five months, our broader G7 GPS indicator has consistently signaled a brighter economic outlook than the consensus view of economists—just as global reflation has become a more dominant theme in the markets—suggesting more scope for upgrades. A better-synchronized global recovery is making the current bout of economic reflation more self-reinforcing, with China’s recovery and Europe’s surprising pickup now feeding through.
With the China GPS, we created a similar gauge of the three-month growth horizon but focused on the Caixin/Markit composite PMI. As the chart below makes clear, China has staged a sharp recovery over the past year after the 2015 slowdown. The GPS suggests that China’s composite PMI can climb further from current levels, with the momentum of this upswing showing no signs of fading yet. We expect a steady expansion ahead in China, with room for upside surprises. (…)
There are certainly risks to China’s growth outlook, including the country’s recent debt binge. However, we see debt as a slow-burning problem. (…)
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Confirming charts from World Economics:
OECD China Composite Leading Indicator ‘Li Keqiang’ Index
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China mulls radical output cuts, port coal ban in war on smog – document China is considering forcing steel and aluminum producers to cut more output, banning coal in one of the country’s top ports and shutting some fertilizer and drug plants as Beijing intensifies its war on smog, a draft policy document shows. -
Boom-Bust Barometer Making All-Time Highs
The Boom-Bust Barometer (made famous by Dr. Ed Yardeni) is a simple, but effective, way of avoiding large drawdowns in the stock market. This indicator is calculated by taking the CRB Raw Industrial Price Index divided by initial unemployment claims. The theory goes that if commodity prices are rising and unemployment claims are falling (thus the indicator is increasing), then economic activity is on sound footing. As you can see in the charts below, the indicator is currently making all-time highs. Additionally, you can see that the Boom-Bust Barometer has had a very high positive correlation to various stock indexes going all the way back to 1966 in some cases. When it is increasing as it currently is, it is very rare to see a major correction in stock prices. (…)
Ed Yardeni has refined his indicator adding Bloomberg’s Consumer Comfort Index to his Boom-Bust Barometer:
EARNINGS WATCH
Factset’s weekly summary on S&P 500 companies:
Overall, 71% of the companies in the S&P 500 have reported earnings to date for the fourth quarter. Of these companies, 67% have reported actual EPS above the mean EPS estimate, 11% have reported actual EPS equal to the mean EPS estimate, and 22% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate is below the 1-year (71%) average, but equal to the 5-year (67%) average.
In aggregate, companies are reporting earnings that are 3.5% above expectations. This surprise percentage is below the 1-year (+4.4%) average and below the 5-year (+4.2%) average.
In terms of revenues, 52% of companies have reported actual sales above estimated sales and 48% have reported actual sales below estimated sales. The percentage of companies reporting sales above estimates is equal to the 1-year average (52%) but below the 5-year average (53%).
In aggregate, companies are reporting sales that are 0.5% above expectations. This surprise percentage is above the 1-year (+0.1%) average, but equal to the 5-year (+0.5%) average.
The blended earnings growth rate for the fourth quarter is 5.0% this week, which is slightly lower than the earnings growth rate of 5.1% last week., but higher than the estimate of 3.1% at the end of the fourth quarter (December 31).
The blended revenue growth rate for Q4 2016 is 5.0%.
At this point in time, 82 companies in the index have issued EPS guidance for Q1 2017. Of these 82 companies, 57 have issued negative EPS guidance and 25 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 70%, which is below the 5-year average of 74%.
Thomson Reuters IBES guidance tally:
Bespoke looks at all NYSE companies:
While guidance keeps getting worse and worse as earnings season progresses, the backward-looking earnings and revenue beat rates continue to come in strong. So far this earnings season, 65% of companies that have reported have beaten consensus analyst earnings per share estimates. (…)
For top-line revenues, 57% of companies have beaten estimates this season. While not as strong as the bottom-line EPS beat rate, a revenue beat rate of 57% would be good enough for the strongest reading since Q4 2014.
(Bespoke)
Early on this earnings season, companies were raising guidance at a higher rate than they were lowering guidance. But over the last two weeks, guidance has gotten worse and worse, and at this point the number of companies that have lowered guidance far exceeds the number of companies that have raised guidance. Below is a look at the quarterly spread between the percentage of companies raising guidance minus lowering guidance going back to 2001. As shown, the current reading of -3.1 percentage points would be the weakest seen in a year.
(Bespoke)
Yet, nothing really out of the ordinary. As usual, analysts are revising their estimates down…
…but not so much for the whole of 2017…
…although Q1 just took a nosedive:
TO BE WATCHED:
Global auto sector booms, but also struggles with higher costs
(…) IHS Markit’s sector PMI data show worldwide auto industry production rising at its fastest rate in just over six years in recent months, with production surging again in January amid strong order book growth.
Inflows of new orders into the autos and parts sector rose at the start of the year at the fastest rate since early 2011; a period when post-recession incentives were boosting car sales globally. (…)
With backlogs of uncompleted orders rising in January to the greatest extent since November 2013, the survey data also suggest that auto sector firms continue to lack capacity to meet current demand, in turn raising the prospect of further recruitment by the industry in coming months.
There are signs that capacity shortages are also appearing in auto sector supply chains. The auto sector PMI survey’s Suppliers’ Delivery Times Index signalled the most severe lengthening of lead-times for over three years, as auto suppliers increasingly struggled to meet demand without incurring delays. Purchasing activity at auto companies is running at its highest for seven years.
The sector has also ramped-up its inventory building, with January seeing one of the largest monthly increases in pre-production inventories since the global financial crisis.
The increased number of bottlenecks and delays in auto supply chains are also helping suppliers push through price hikes, as end producers are willing to pay premiums to ensure supply. Incidences of suppliers offering discounts to boost sales have also fallen as demand has picked up.
At the same time, higher global commodity prices, notably for oil, energy and metals, is also pushing up auto production costs. The PMI data have shown auto sector input costs rising in recent months at the fastest rate for almost six years.
Selling costs are also rising, but at a much reduced rate compared to input costs. The differential between selling price and input cost inflation has consequently indicated the greatest squeeze on auto company operating margins since early-2011 in recent months.
The extent to which auto sector margins are being squeezed is also significantly greater than the average for all manufacturing.
The current strength of global car sales bodes well for corporate profits, but the extent to which margins are under pressure is a concern. Coming months will reveal whether producers seek to push through higher prices in order to offset the increase in costs, or whether cost pressures will abate.
Sources for charts: IHS Markit, JPMorgan, FTSE.
Let’s take this analysis further looking at the U.S. industry:
- New car prices have been flat for nearly 2 years while used car prices dropped 6%. Soft used car prices are expected to continue given the expected “tsunami” of cars getting off leases in the next 2 years:
- Import prices are declining thanks to the strong dollar:
- Domestic production is waning against high inventories, peaking demand and rising competition from imports:
- Declining production, weak pricing, rising costs…Can tax reform, including a border tax, save the industry?
- But wait! Trump’s reforms could bring other problems as Holman Jenkins writes in the WSJ:
(…) With their fuel-economy mandates introduced in the 1970s, legislators forced the Detroit auto makers to pit their weakness in cheap, smaller vehicles directly against Japanese strength. Instead of letting the Big Three behave as sensible businesses do and concentrate on product lines they can produce profitably, Congress mandated that they build cars that made no sense to build.
Then Congress intervened again to make sure the Big Three couldn’t at least shift small-car production offshore, to take advantage of cheaper nonunion labor to match the cost advantage of the foreign makers. The fuel-economy rules were structured so that only small cars made in domestic, high-cost United Auto Workers factories count as offsets to the fuel-hungry larger vehicles and pickups that were the Big Three’s bread and butter.
John Dingell, former congressman from the UAW, er, Michigan, was the longtime author and guardian of this provision. He knew exactly what he was doing, though probably not five other congressmen, out of 435, have ever understood their role in foisting a deranged, uneconomic business model on the homegrown U.S. auto makers.
We mention this because it is impossible to exaggerate how brainless and mostly unintended are the consequences that Washington’s growing bureaucratization inflicts on the U.S. economy. When the crisis came in 2008, it is remarkable how little it changed the underlying dispensation. General Motors and Chrysler were allowed to dump their obligations to bondholders, but everything else remained the same. They are still subservient to a UAW labor monopoly, however temporarily chastened by its flirtation with disaster. Foreign transplants in the southern U.S. states still enjoy a free labor market that the Big Three are denied. The fuel-economy rules have only grown more perverse and Rube Goldbergesque, though they do contain a few sly advantages for Detroit’s pickup and SUV business.
Only one substantial change has come along to make this crazy arrangement a mite more sustainable. That’s the North American Free Trade Agreement’s gradual authorization of U.S. auto production in Mexico without running afoul of what was variously known as the “two fleets” or “anti-backsliding” rule—the Dingell mandate that forced them to lose large amounts of money building small cars in UAW-staffed domestic factories.
Which brings us to an irony: Judging by his tweets, Donald Trump now means to yank this Mexican life preserver away. He wants to be the new John Dingell, requiring the Big Three to build their EPA-mandated, money-losing small vehicles in U.S. plants. Plus ça change, the French would say.
Magical Mystery Tax Plan While tax reform is definitely coming, a final bill is still a long way off, and a 2017 effective date is looking less likely.
(…) Whatever the details, the president’s tax proposals face “a very long slog” on Capitol Hill, observes Greg Valliere, chief strategist at Horizon Investments. The House may move quickly, despite possible quibbles over the price tag, but “the problem, as usual, will be in the glacial Senate.”
Orrin Hatch, the octogenarian Finance Committee chairman, “has made it clear that there are huge unresolved issues,” says Valliere, including the BAT, debt deductibility, caps on individual exemptions, and abolishing the estate tax. While tax reform is definitely coming, a final bill is still a long way off, and a 2017 effective date is looking less likely, he concludes. (…)
Amazon warns that trade protectionism could hurt business Amazon.com Inc warned on Friday that government actions to bolster domestic companies against foreign competition could hurt its business, in a possible reference to U.S. President Donald Trump’s “America First” agenda.
SENTIMENT WATCH
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US stocks hit records in ‘grand slam’ for markets Small-cap stocks catch up with larger brethren as four main barometers shine
The four main US stock barometers all logged record closing highs on Friday, marking the first grand slam in two months as small capitalisation stocks have caught up to their larger brethren. (…)
Earnings for small-cap groups as a whole have fallen by about 1 per cent from the previous year in the fourth quarter, compared with growth of 6 per cent for large-caps, according to Bank of America Merrill Lynch strategist Dan Suzuki. - Small-caps have also taken-on debt at four-times the rate of earnings growth since 2008 and their ratio of borrowing-to-profits is near all-time highs.
- A measure that incentivises exports and penalises imports, and one that would stop companies from deducting loan interest from income, might also be bearish for small-caps.
Source: @bespokeinvest (via The Daily Shot)
We have constructed a ‘Complacency-Anxiety’ Indicator (CAI), using a number of variables that gauge investor positioning, sentiment and risk on/off biases (see chart). The CAI is at its highest level ever, signaling extreme confidence/conviction in the outlook for equities.
Fitch: The Trump Administration Poses Risks to Global Sovereigns
(…) In Fitch’s view, the present balance of risks points toward a less benign global outcome. The Administration has abandoned the Trans-Pacific Partnership, confirmed a pending renegotiation of the North American Free Trade Agreement, rebuked US companies that invest abroad, while threatening financial penalties for companies that do so, and accused a number of countries of manipulating exchange rates to the US’s disadvantage. The full impact of these initiatives will not be known for some time, and will depend on iterative exchanges among multiple parties and unforeseen additional developments. In short, a lot can change, but the aggressive tone of some Administration rhetoric does not portend an easy period of negotiation ahead, nor does it suggest there is much scope for compromise.
Sovereigns most at risk from adverse changes to their credit fundamentals are those with close economic and financial ties with the US that come under scrutiny due to either existing financial imbalances or perceptions of unfair frameworks or practices that govern their bilateral relations. Canada, China, Germany, Japan and Mexico have been identified explicitly by the Administration as having trade arrangements or exchange rate policies that warrant attention, but the list is unlikely to end there. Our revision of the Outlook on Mexico’s ‘BBB+’ sovereign rating to Negative in December partly reflected increased economic uncertainty and asset price volatility following the US election.
The integrative aspects of global supply chains, particularly in manufactured goods, means actions taken by the US that limit trade flows with one country will have cascading effects on others. Regional value chains are especially well developed in East Asia, focused on China, and Central Europe, focused on Germany.Tighter immigration controls and possible deportations could have meaningful effects on remittance flows, as the US has the world’s largest immigrant population. World Bank data confirm that the US and Mexico share the world’s top migration corridor and have the largest bilateral remittance flows. Relative to GDP, remittances are even larger for Honduras, El Salvador, Guatemala and Nicaragua, all of which receive most inflows from the US.
Countries hosting US direct investment, at least part of which has financed export industries focused back on the US, are at risk of being singled out for punitive trade measures. The list of these countries is potentially long, since US-based entities account for nearly one-quarter of the stock of global foreign direct investment. Countries with the highest stock of US investment in manufacturing are Canada, the UK, Netherlands, Mexico, Germany, China and Brazil.
Fitch: Deregulation on Horizon for US Financial Institutions
Fitch believes that the Financial Choice Act (FCA), proposed by House Financial Service Committee Chairman Representative Jeb Hensarling, R-TX, in 2016, may serve as a blueprint for some of the changes ahead. The FCA is broad in scope and includes proposals to change FI activities, modify and potentially reduce financial regulators’ authority, limit regulatory burdens for certain FIs, add greater congressional oversight of regulators and propose reform to market infrastructure.
In determining the potential impact of such regulatory changes, both the direct impact of the change and the responses from individual banks will be key in determining the ultimate issuer credit effect. The extent to which the reforms could lead to a reduction or changes to the quality of capital and/or liquidity, or weaken governance, will be particularly important for ratings over time.
Several parts of the FCA target regulatory relief for strongly capitalized and well-managed banks, such as a proposal to exempt banks from many regulations should they exceed a 10% or higher financial leverage ratio. Smaller banks meeting the requirements would most likely benefit. For large global systemically important banks, Fitch estimates that the $400 billion in incremental Tier I capital necessary to achieve the minimum leverage ratio – the calculation would likely be similar to the Basel III supplementary leverage ratio – would outweigh any potential cost benefits of regulatory relief.
Limiting regulatory authority is another key plank of the FCA. The most significant change for the markets would be the proposed restructuring of the Federal Reserve, including how it sets interest rates, as well as its authority as a central bank. The proposed rule also calls for restructuring the Consumer Financial Protection Bureau (CFPB), adding congressional review of financial agency rulemaking and subjecting agencies’ rulemaking to judicial review, among others.
Overall, Fitch believes that such reviews could hamper agencies’ effectiveness and significantly impede their ability to issue new rules, which could have an overall negative effect on the system. Fitch believes that restructuring the CFPB with a Consumer Financial Opportunity Commission, as stipulated in the FCA, would lower compliance costs and reduce potential fines for consumer finance, but lead to weakening control frameworks.
Trump’s Economic Cabinet Is Mostly Bare. This Man Fills the Void.
TREAT YOURSELF
Good stuff from Grant Williams: https://youtu.be/GEwuGHFF7qE