THE DAILY EDGE (2 July 2018): Only Positives: Neutral Valuation and Rising EPS, So Far

U.S. Consumer Spending Moderated in May U.S. consumers only modestly boosted their spending in May despite improved incomes, as year-over-year inflation posted its largest increase in over six years.

Personal-consumption expenditures, a measure of household spending on everything from baseball bats to coffee machines, increased a seasonally adjusted 0.2% in May from the prior month, the Commerce Department said Friday. (…)

Personal income, reflecting Americans’ pretax earnings from salaries and other sources including investments, rose 0.4% in May, in line with economists’ expectations. (…)

April’s spending was revised to a 0.5% increase from an earlier 0.6% reading, while March spending was revised higher to 0.6%. (…)

The saving rate ticked higher in May to 3.2% from 3% in April, as incomes rose more than spending.

Notice how spending has outpaced income since 2015 (table from Haver Analytics):

Excess spending has been going on since December 2015:

At 29 months of spending more than earning, this is yet another record for the U.S. economy, driving the savings rate to a near record low. This indebted economy has no buffer to speak with right when the Fed is tightening and inflation is rising.

Implicit to such a very low average for the personal savings rate is the likelihood that 33% to 40% of U.S. households save an imperceptible, if any, amount of their after-tax income. When a financially stronger middle class provided a hospitable breeding ground for the persistently rapid consumer price inflation of 1972-1981, the personal savings rate averaged a much higher 11.4%. Yes, consumer price inflation may spurt higher every now and then, but today’s average American consumer may lack the financial wherewithal necessary for the establishment of stubbornly rapid price inflation. (Moody’s)

What are the odds that this will end well? Consumer spending was 64% of the economy prior to the 1990 recession, 67% prior to the last 2 recessions, 69% currently.

• No Savings? No Problem. These Companies Are Helping Home Buyers With Down Payments

(…) One startup, Loftium, will supply up to $50,000 for a down payment if the homebuyer agrees to rent out a room on Airbnb and share the income. A few organizations, like Unison Agreement Corp. and Landed Inc., offer “shared equity” contracts through which buyers get money for their down payments in exchange for pledging part of the home’s future value to investors like pension funds or foundations. And some banks, including Bank of America Corp. and Morgan Stanley , have programs through which young adults can get a mortgage with nothing down if their parents pledge investment assets as collateral. (…)

Inflation Gauge Hits Fed Target After Six-Year Run of Soft Prices An inflation measure watched closely by the Federal Reserve hit the central bank’s target for the first time in six years, a sign the growing economy is on healthier footing after a long run of slow growth.

(…) The Commerce Department’s price index for personal-consumption expenditures, excluding food and energy costs, rose 2% in May from a year earlier after running below that mark every month since April 2012. (…) The central bank also looks at a broader measure of inflation that includes food and energy costs. That measure was up 2.3% in May from a year earlier, the largest increase since March 2012, driven in part by higher gasoline prices. (…)

Tyson Foods Inc., the largest U.S. meat company by sales, figures rising freight rates will cost it $155 million in its current fiscal year. In response, it is raising prices for chicken, pork and beef, counting on consumers’ appetite to help the company negotiate with restaurants and retailers. (…)

General Mills Inc. has raised some prices in recent months and started selling smaller boxes of cereal at a higher price-per-ounce, thanks in part to higher freight and food commodity costs. (…)

“Our goal continues to be to pass the cost increases on to the marketplace,” Timothy Hassinger, chief executive of Lindsay Corp, which makes crop-irrigation systems, said on Thursday. “We’ve led the industry this year in the implementation of the steel surcharges. Our intention is to continue with this strategy.” (…)

On a 3-month annualized basis, core PCE inflation was +2.2% through May, down fro +2.4% in February but up from +1.9% in November and +1.4% in August. Last 2 months annualized: +2.3%, up from +2.0% the 2 months previous. It is thus more accurate to say that core PCE inflation is now +2.2%.

• Higher Oil Prices Will Cost the Average American Family $440 This Year

• Increase contradicts Trump’s claims and threatens to fuel pharma backlash

• 
  

  Inflation Is Here; What Will the Fed Do?

(…) With that goal met, the statement earlier this month by Fed Chairman Jerome Powell takes on more significance. At the news conference following the Fed’s rate increase, Mr. Powell said the Fed would move to cool things off “if inflation were to persistently run above” 2%, effectively quashing speculation that the bank would allow the economy to run a bit hot. (…)

Right now the Fed expects to raise rates two more times this year, and three times next. That means policy, by the Fed’s own measure, wouldn’t turn restrictive until the end of 2019. If the Fed needs to move faster, markets would be in for a surprise.

David Rosenberg:

• Kudlow Says White House Hopes Fed Will Raise Rates ‘Very Slowly’

• Why 10-Year Bond Yields Won’t Stay Above 3%

(…) Thomas Tzitzouris, head of fixed-income research at Strategas, doesn’t expect economic growth to fall apart in the near future. He does, however, blame the 10-year Treasury yield’s backup partly on the Federal Reserve, which he insists “continues to embark on a tightening path that the bond market does not believe is sustainable.” (…)

David Ader, chief macro strategist at Informa Financial Intelligence, points to the big yield disparities between Treasuries and comparable government credits overseas. Case in point: The 10-year Treasury was recently yielding some 2.5 more percentage points than its comparable German government bond. “That’s a compelling yield differential that comes into play, as well,” says Ader.

Over the past decade, the 10-year Treasury, on average, has traded at 90 basis points (0.9 percentage points) above the comparable Bund, according to FactSet. (…)

The 10-year Treasury’s real yield, which excludes inflation, has averaged 2.3% over the past 30 years, according to Nuveen’s Rodriguez. But it has had a much lower average—0.75%—over the past decade.

Rodriguez expects that it will average 1% to 1.5% in the coming years. “That, when combined with underlying core inflation near the Fed’s target of 2%, leads to an expected fair value of 3% to 3.5%” for the 10-year’s yield on a nominal basis, he says. That’s not too far from current levels. (…)

Hmmm…Prior to 2008, real yields have averaged much more than 2.3%. And the past decade was multiple QEs decade which the Fed is unwinding. And inflation is already above the Fed’s 2.0% target. Good luck with the 3-3.5% fair value.

Steve Blumenthal writes about investors’ dilemma, deciding who will prove right between Jeff Gundlach and Lacy Hunt:

One of the problems is that much of U.S. debt is financed with shorter-term paper.  So what happens when that debt needs to be refinanced?  Gundlach sees interest rates rising to 6% by 2020 or 2021.  That will pinch the pocket substantially.  My friend, Dr. Lacy Hunt, sees interest rates moving lower.  He believes that rising rates will quickly hurt the economy and drive us more quickly into recession.  He sees lower rates in recession.

I side with Blumenthal seeing higher rates in the short term, leading to a recession and, eventually, lower rates.

Debt’s the issue and debt dependency is pretty much everywhere.  The next recession will prove more challenging than the last two.  Those brought us 50+% equity market corrections.  Rising rates draw that date forward.  In recessions, all the bad stuff happens.  I suspect the next one will bring us equal or greater decline in both U.S. and global equities and a record corporate default wave.  I believe getting the recession timing right is critical.  So we watch and remain on guard for recession. (…)

There is clearly a Rising Risk of Global Recession (call it a 51.55% probability today). Do note the 90.73% probability when the Model reading moves above 70.  The temperature’s rising… Let’s keep watch. (…) more defense than offense until opportunity resets. (…)

SPEAKING OF YIELDS, HIGH YIELDS

A recent long-term Baa-grade industrial company bond yield spread of 198 bp that well exceeds its post September 2003 median of 178 bp reinforces the negative outlook for high-yield bonds. As inferred from the historical record, a 198 bp spread for the long-term Baa industrials has typically been associated with a 544 bp midpoint for the high-yield spread, which is much wider than the recent 370 bp. It was in 2007 that a well below trend high-yield spread was joined by a significantly above average Baa yield spread. Since late 1987, the high-yield bond spread shows a very strong correlation of 0.92 with the long-term Baa industrial company bond yield spread. (Moody’s)

Trump says Saudi king agreed to raise oil production up to 2 million barrels 

Really?

Trade Tensions Threaten U.S. Farm Belt, Trump’s Base The U.S. Farm Belt helped deliver Donald Trump to the White House, drawn to his promises to revive rural America and deregulate industry. Now, the president’s global trade offensive is threatening the livelihoods of many farmers.

(…) Disquiet among farmers grew in June as crop prices fell thanks to benevolent U.S. weather and additional duties expected from China on products like soybeans, for which it is the U.S.’s top customer. The total value of this year’s U.S. corn, soybean and wheat crops has dropped about $13 billion, or 10%, since the start of June, said Chris Hurt, an agricultural economist at Purdue University. (…)

Researchers at the University of Illinois and Ohio State University estimate that over four years, a 25% tariff on U.S. soybean imports by Beijing would result in an average 87% decline in income for a midsize Illinois grain farm. The loss would pressure farmland prices, they say, prompting a more than $500,000 decline in the farm’s net worth by 2021.

Farmers for Free Trade, an advocacy group, recently rolled out its third advertisement warning about the harmful consequences of trade fights for farmers. U.S. farm and agribusiness groups in June joined manufacturing, retail and technology organizations imploring Congress to step up oversight of the president’s actions. (…)

Still, many farmers say they support the Trump administration’s trade goals of modernizing Nafta, shrinking the U.S. trade deficit and combating what they see as unfair trade practices by China. They view the president’s approach as a negotiating tactic and hope it will bear fruit by fall, when farmers will harvest their crops. Some are prepared to sacrifice financially if the U.S. economy benefits in the long run. (…)

Trump: Auto Tariff Threats Are My Most Effective Weapons

(…) In discussing ongoing talks to renegotiate the North American Free Trade Agreement with Mexico and Canada, for example, the Republican president said in the Fox interview that “if they’re not fine, I’m going to tax their cars coming into America, and that’s the big one.”

“The European Union is possibly as bad as China just smaller, OK,” Mr. Trump said. “It’s terrible what they did to us. European Union—take a look at the car situation. They send a Mercedes in; we can’t send our cars in.”

Mr. Trump has repeatedly complained about Europe’s 10% tariff on car imports compared with the 2.5% imposed by the U.S., but he hasn’t mentioned the 25% tariff the U.S. imposes on imports of light trucks. (…)

The European Union is now warning of even greater pain for the U.S. should Mr. Trump follow though on cars. In a comment submitted to the administration Friday, the EU delegation to the U.S. said that it estimated that $294 billion dollars of U.S. exports—or 19% of last year’s U.S. exports—“could be subject to countermeasures” in response to car tariffs.

China on Sunday followed through on a pledge announced in May to cut tariffs on car imports to 15% from 25%. But in the weeks since that announcement China and the U.S. have edged closer to a full-scale trade war, and Beijing is preparing to raise tariffs on U.S. auto imports to 40% this Friday.

Rather than back down, Mr. Trump said he now wants to raise the stakes, by adding autos to the mix. The U.S. imported about $29 billion in steel in 2017, compared with about $192 billion in cars. The car industry makes up nearly a quarter of the country’s $500-billion-plus trade deficit. (…)

Mr. Trump in the Fox interview expressed confidence that he would persuade foreign car companies to build more in the U.S. and to export less.

“What’s going to really happen is there’s going to be no tax,” he said. “You know why? They’re going to build their cars in America. They’re going to make them here.” (…)

• 
  

  GM Says Tariffs on Auto Imports Could Drive Up Prices, Hit U.S. Jobs General Motors warned the Trump administration that tariffs on vehicle imports would hurt its competitiveness, cost U.S. jobs and result in “a smaller GM.”

(…) Both GM and Toyota warned that U.S. consumers would bear the brunt of increased costs. Toyota said its Camry sedan, built in Kentucky, is made with about 30% foreign parts. Tariffs could tack on $1,800 in costs to the car, which has a base price of about $23,600, Toyota said in its comments to the Commerce Department. (…)

The Alliance of Automobile Manufacturers, the industry’s chief lobbying group in Washington, said this week that a 25% import tariff would increase the average price of an imported vehicle by $5,800, “a tax of nearly $45 billion” on U.S. consumers.

About 7.9 million of the 17.2 million vehicles sold in the U.S. last year were imported, according to LMC. (…)

In a statement, Commerce Secretary Wilbur Ross said his department has fielded about 2,500 comments on the tariff investigation, with public hearings set for July 19 and 20. The input “will enable us to make our best informed recommendation to the President,” he said.

• Trump says auto tariff probe will be completed in three-four weeks

• Largest U.S. business group attacks Trump on tariffs

(…) “The administration is threatening to undermine the economic progress it worked so hard to achieve,” said Chamber President Tom Donohue in a statement to Reuters. “We should seek free and fair trade, but this is just not the way to do it.” (…)

• Tariffs Aren’t China’s Strongest Weapon Against the U.S.

(…) As Beijing works out how to retaliate against the Trump administration’s trade policies, it can draw on a long tradition of bureaucratic obstruction. The biggest loser will probably be American multinationals in China. Those that sell easily replaceable goods and services could lose market share in a hurry. (…)

Chinese leader Xi Jinping recently hinted that European and Asian conglomerates might soon find themselves benefiting as China punches back against the U.S. (…)

it might suddenly become inadvisable for employees at state-owned or important private businesses to drive American cars, flaunt new iPhones or take holidays in the states as officials heed Mr. Xi’s words. U.S. auto sales in China look likely to come under particular pressure—a big problem for companies like General Motors, which now sells more vehicles through its China joint ventures than in the U.S. The travel sector could suffer too: Chinese people spent $18 billion on U.S. travel in 2016, about twice as much as Japanese visitors.

Consumer goods and entertainment also look vulnerable. Starbucks ’ aggressive expansion plans in China could face renewed obstacles. Hollywood could find China’s notorious summer “blackout” periods for foreign films extended. (…)

China Factory Gauge Slips in June as Trade War Dampens Outlook

The manufacturing purchasing managers index stood at 51.5 in June, versus 51.9 in May, and the forecast of 51.6 in a Bloomberg survey of economists. The non-manufacturing PMI, covering services and construction, rose to 55, the statistics bureau said Saturday, compared with 54.9 in May. (…)

A sub-index of new export orders fell to 49.8 from 51.2, signaling weakening demand from other countries. Gauges for new orders and the backlog of orders also dropped. (…)

• China’s Rebound Gone Within a Day With Even Biggest Stocks Crumbling The list of negatives facing the $6.6 trillion stock market is growing.

• 
  

  China plans income tax cut to boost consumption 

  Workers earning less than $45,000 a year to gain most from across-the-board reduction

Note: Global PMIs will be posted tomorrow.

Canada’s Economy Shows Surprise Strength With April GDP Gain

Gross domestic product expanded 0.1 percent from the prior month, Statistics Canada reported Friday in Ottawa. Economists had been expecting a flat reading due to the impact of poor weather conditions in April and following a disappointing run of economic data for the month.

The economy now is on track for growth to accelerate — at least in the second quarter — to beyond 2 percent, which should reinforce expectations the Bank of Canada will proceed with interest-rate increases in the second half of this year. The report marks a third consecutive month of gains — including strong advances of 0.3 percent and 0.4 percent in March and February. (…)

EARNINGS WATCH

Overall, the estimated earnings growth rate for Q2 2018 of 20.0% today is above the estimated earnings growth rate of 18.9% at the start of the quarter (March 31). Five sectors have recorded an increase in expected earnings growth since the beginning of the quarter due to upward revisions to earnings estimates, led by the Energy, Materials, and Information Technology sectors. On the other hand, five sectors have a recorded a decrease in expected earnings growth due to downward revisions to earnings estimates, led by the Consumer Staples sector. One sector (Real Estate) has recorded no change in FFO growth (5.7%) since March 31.

Because of the upward revisions to sales estimates, the estimated year-over-year sales growth rate for Q2 2018 has increased from 7.9% on March 31 to 8.8% today.

In a typical quarter, analysts usually reduce earnings estimates. Over the past five years (20 quarters), earnings estimates have fallen by 3.4% on average during a quarter. Over the past ten years, (40 quarters), earnings estimates have fallen by 5.0% on average during a quarter. Over the past fifteen years, (60 quarters), earnings estimates have fallen by 3.9% on average during a quarter. (Factset)

Thomson Reuters’ tally reveals no significant deterioration in corporate guidance as of June 28.

According to RBC, tax reform will boost earnings 6% and account for about 37% of this year’s EPS growth rate for S&P 500 companies. Buybacks will add 2.2%. RBC assumes no increase in EBIT margins this year and next. Curiously, they see no negative impact from rising interest rates this year and next.

The restaurant business looks set for a meaningful erosion in operating margins however.

Moody’s sees other factors threatening margins going forward:

Given the global complexities of modern supply-chain management, a surprisingly large number of U.S.-based businesses may delay capital spending and staffing plans until trade-related uncertainties are sufficiently resolved. As it now stands, tariff-driven increases in material costs have compelled some companies to rein in employee compensation for the purpose of protecting profit margins. In addition, higher materials costs have been weighing on the credit quality of some manufacturers that use steel intensively.

Tariffs explain why year-to-date advances of 40% for the spot price of steel and 21% for the most actively traded lumber futures contract are so much greater than the accompanying 0.5% dip by Moody’s industrial metals price index (which excludes steel’s price). To the degree tariffs increase the costs of materials and inventories, businesses will tighten their control of other costs, the most prominent being employee compensation. (…)

Not to be overlooked is how the $521 billion of U.S. merchandise imports from China during the 12-months-ended April 2018 far exceeded the comparably measured $133 billion of U.S. merchandise exports to China. Worth mentioning is how that imbalance includes billions of dollars of goods that are manufactured in China for U.S.-domiciled businesses. China is unrivaled as far as being a manufacturing platform for companies based in advanced economies. Thus, many American businesses and shareholders are vulnerable to tariffs imposed on imports from China. (…)

The recent strengthening of the dollar against a broad array of currencies from both advanced economies and emerging market countries will reduce (i) the global price competitiveness of goods and services produced in the U.S. and (ii) the dollar value of foreign-currency denominated earnings from abroad. (…)

If other central banks pursue policies that facilitate dollar appreciation, the Fed may have no choice but to stretch out its planned normalization of U.S. monetary policy. (…)

Very late in the cycle, potential trade wars, the Fed hiking rates on a highly indebted world boosting the USD in the process, all very good reasons not to bet too much on forward earnings…

Trailing EPS are now $140.12. Pro forma tax reform, trailing EPS are about $146.50 and are set to reach $150.50 after Q2 if current estimates are met.

On that basis, the Rule of 20 P/E is 20.1 after Q2.

Why Stocks Are Losing Out to Cash

(…) But TINA is getting dumped by investors who, according to Bianco Research’s Ben Breitholtz, are having a “new love affair with cash.” Not literally the folding green stuff, but supersafe, ultraliquid investments. Exchange-traded funds investing in short-term government securities recently have been attracting 33 cents out of every dollar going into ETFs of all asset categories, he wrote on the Bianco website early in the week.

That’s confirmed by the stampede into Treasury bills by the Thundering Herd, according to Bank of America Merrill Lynch’s global investment strategy team led by Michael Hartnett, as the firm’s clients ramp up their holdings of the safest, most liquid investment on the planet. As noted here last week, short-term T-bills provide nearly the same yield as dividends on the S&P 500, which may be why TINA seems a bit fey these days.

Hartnett & Co. also note that equity funds suffered their second-biggest weekly outflow, some $29.7 billion, last week. Since the beginning of the year, there has been a big turnaround in flows into equities. From a gusher of $103 billion in the first five weeks of 2018, when stocks seemed on an unstoppable ascent, the inflows slowed to $31 billion over the next five months, before reversing to a $50 billion outflow in the most recent five days. (…)

Buybacks Set Record, Led by Apple S&P 500 companies bought back $189 billion of shares in the first quarter, topping a record set in 2007.

In all, S&P 500 companies repurchased $189.1 billion of shares in the first quarter, surpassing the previous record, set in the third quarter of 2007, by nearly 10%, according to S&P Dow Jones Indices.

However, Howard Silverblatt, senior index analyst at the firm, pointed out that first-quarter activity was pretty top heavy. The 20 companies in the index that bought back the most stock accounted for nearly half of all the repurchases. (…)

But who is surprised after tax reform? (charts from Ed Yardeni)

Buybacks are not having as much torque on equity prices as buyback yield (the dollar value of share repurchases relative to market cap) has declined (chart from RBC).

Hot M&A Market Is on Pace for Record If the current pace of deals continues, there will be $4.8 trillion worth of mergers and acquisitions in 2018, more than the record set in 2007.

IPO Market Posts Blistering First Half So far this year, 120 companies have used initial public offerings to raise $35.2 billion on U.S. exchanges—the highest volume since 2012.

TECHNICALS WATCH

Lowry’s Research maintains that, even though even the strongest bull markets are subject to periodic short-term corrections, “the market continues to exhibit all the hallmarks of a broad-based primary uptrend supported by long-term trends of expanding Demand and contracting Supply.” As of the June 27th sell-off, Lowry’s Buying Power was 4 points above and Selling Pressure 2 points below their May 29th levels. “Significant market declines typically don’t include expanding Demand and contracting Supply.”

• THE SITTING BULL

The S&P 500 Index is back sitting on its 200dma, which remains in an uptrend as this Ed Yardeni chart illustrates:

Some sectors show pretty worrying trends however:

  

  

The $2 Trillion Challenge Facing Emerging Markets In Asia’s emerging markets, among the biggest issuers of dollar bonds, yields are now at their highest in nearly five years

(…) The average yield on dollar-denominated bonds in emerging markets globally has risen to 4.7%, up from 3.7% at the beginning of the year, according to Bloomberg Barclays index data. Bond yields rise as their prices fall. In Asia’s emerging markets, among the biggest issuers of dollar bonds, yields are now at their highest in nearly five years.

That is a significant rise in the cost of funding for developing countries, which have $2 trillion in outstanding dollar-denominated bonds—a figure that has tripled in the past 10 years—according to the Bank for International Settlements. (…)

China’s main stock benchmark entered a bear market this week, having declined 20% from January highs, while the yuan dropped 1.4% against the dollar. (…)

The International Monetary Fund estimates the effect of U.S. rate increases and bond sales this year and next year could reduce inflows into emerging markets by about $70 billion—a turnaround from the $260 billion it reckons has flowed into those economies since 2010 as a result of the Fed’s earlier policies. (…)

Bottom fishing EM debt? (AN EMERGING OPPORTUNITY?)

Facebook, Google Aren’t Tech Stocks? What That Means for Investors Facebook and Google parent Alphabet Inc. will soon shift out of the highflying tech sector of the S&P 500. The change means that funds will be realigning billions of dollars in holdings.

Facebook Inc. and Google parent Alphabet Inc. GOOGL 0.21% are expected to say goodbye in September to the highflying tech sector of the S&P 500. They will join a new communications-services group that will also house media giants such as Netflix Inc. andComcast Corp. CMCSA 0.55% that now reside in the consumer-discretionary group.

This is far more than mere housekeeping on the part of an index provider. The revisions mean that funds tracking the current telecom, tech and consumer-discretionary sectors will be forced to trade billions of dollars of shares to realign their holdings before the moves become effective Sept. 28. (…)