U.S. Pending Home Sales Edge Higher in November
The National Association of Realtors (NAR) reported that pending home sales increased 0.2% (0.8% y/y) during November to an index level of 109.5 (2001=100). This followed their 3.5% jump in October. Sales were 3.6% below their recent peak in April 2016.
Sales changes were mixed by region in November. Those in the Northeast rose 4.1% (1.1% y/y) to an index level of 98.9, after edging up 0.5% in October. In the Midwest, they were up 0.4% (0.8% y/y) to 105.8, following October’s 2.4% advance. In contrast, sales slowed in the South by 0.4% (2.5% y/y) to 123.1, thus pausing after October’s 7.4% surge. And in the West, sales were down 1.8% (-2.3% y/y) to 100.4 after inching down 0.1% in October. The widely varying index levels themselves indicate that home sales trends are hardly standard across the country; sales in the South have historically been more vigorous than elsewhere, but relative strength otherwise shifts back and forth among the other regions.
WHAT COULD GO WRONG?
Robert Eisenbeis, Ph.D., Vice Chairman & Chief Monetary Economist, Cumberland Advisors
(…) What could go wrong? There are clearly plenty of possibilities. First, we are in uncharted waters when it comes to international central bank policy. A flood of liquidity has been created by that policy, and some assert that this liquidity has contributed to dampening volatility in virtually all key financial markets to historic lows. What the policy exit looks like is uncertain, and right now the Fed is rowing against the tide.
Uncertainty in the classical Frank Knight sense is the major concern. There is economic and central bank policy uncertainty and we simply have no way of assessing the probabilities of major shocks that loom on the horizon from a variety of sources. Positive economic growth in Europe and selected parts of Asia continues, but turmoil plagues Latin America including Argentina, Brazil and Venezuela. As for Africa, political unrest and civil wars are destroying more wealth than is being created. Unrest and war continue in the Arab Middle East, and the outcome of the Palestinian and Israeli situation is still far from clear. Then there is North Korea.
All of these uncertainties suggest that investment opportunities with lower risk remain centered on the US and Europe. However, there is an interesting dynamic at play even here when it comes to interest rates. With negative rates still in effect in Europe and the Fed’s continuing on its current path of gradually raising rates, it makes perfect sense for European banks to continue to hold reserves at the Fed at a continuingly widening spread to take advantage of the risk-free arbitrage that currently exists. This practice will put upward pressure on US exchange rates and also bid up Treasury prices on the margin to the extent that foreign banks buy Treasuries. When the ECB and Bank of Japan reverse course, much of this activity will unwind and act to tighten policy here in the US with no action taken by the Fed.
So, while there is room for optimism with respect to the US, cautious is the watchword going into 2018.
The yield curve is rapidly flattening as 2Y and 5Y rates jumped by 40-50% in the last 4 months. For the first time since 2011, TINA is not as powerful against uncertainty: investors have alternatives with both maturities now offering yields in the 2% range.
TINA is also losing strength considering that equity dividend yields, 1.8% on the S&P 500 Index, are now lower than the 1.9% yield on 2Y Treasuries, unseen since the Financial Crisis.
While U.S. interest rates are quickly rising, Moody’s observes that
Markets are fairly confident that nonfinancial-corporate leverage is about to peak and then move lower. Otherwise, how else can one justify expectations of a flat to lower default rate going forward? In terms of moving yearlong observations, the ratio of nonfinancial-corporate debt to pretax operating profits edged up to 696% in Q3-2017. Nevertheless, Moody’s Default Research Group expects a decline by the default rate from Q3-2017’s 3.5% to 2.4% by Q3-2018.
In previous cycles, the ratio of debt to operating profits kept rising after reaching current levels, in part because rates rose and/or profits peaked and dropped with subsequent recessions.
Thus, today’s seeming indifference to an elevated ratio of debt to operating earnings might be ascribed to expectations of an impending peak for the ratio of debt to core profits. The jumps by nonfinancial corporate leverage of 2000 and 2008 were largely the consequence of substantial contractions by corporate earnings. (…)
Moody’s net US High Yield Downgrades spiked during the 2015-2016’s bout of industrial commodity price deflation and subsequently declined to its current 2%, a level whihc has often been the cyclical low.
(…) Not only is the net high-yield downgrade ratio a useful leading indicator of the default rate, it is also a helpful coincident indicator of the high-yield bond spread. The net high-yield downgrade ratio now favors a 419 bp midpoint for a composite high-yield bond spread, which exceeds the recent actual high-yield spread of 365 bp. This difference of opinion implies that the high-yield spread predicts a lower default rate than do net high-yield downgrades.
It’s very much worth keeping an eye on high-yield credit rating changes, especially downgrades to the lowest rungs of the high-yield ratings’ ladder, or Caa3 or lower. Because the lowest high-yield credit ratings often accompany defaults, the relative incidence of downgrades to “Caa3 or lower” shows a very high correlation with the default rate.
More specifically, the moving yearlong ratio of the number of credit rating downgrades to “Caa3-or lower” to the number of high-yield issuers shows a very high correlation of 0.92 with the percent of high yield issuers defaulting during the past year, where the latter is commonly referred to as the high-yield default rate.
(…) For now, the latest thinning of Caa-grade bond spreads suggests that the market believes the latest increase in default-prone downgrades will be short-lived. (…)
Making the recent narrowing by Caa spreads all the more remarkable is how recent tax reform legislation weighs most heavily on Caa-rated issuers. According to Moody’s Investors Services, the combined benefits of a lower corporate income tax rate and the full and immediate deductibility of capital spending will exceed the costs of less than full deductibility of business interest expense “for all but a handful of U.S. investment-grade nonfinancial companies”.
However, the loss of the full deductibility of interest expense leaves an estimated 26% of U.S. high-yield issuers worse off despite both a lower corporate income tax rate and the more favorable tax treatment of capital expenditures. In addition, the share of high-yield companies that are worse off soars as the high yield credit rating moves lower.
For example, the percent of issuers made worse off jumps from 7% at the Ba rating to 27% for B2-rated issuers and, then, to 50% for B3-grade issuers. Finally, more than 75% of issuers rated Caa1 or lower will be worse off because of the loss of the full deductibility of interest expense. The high-yield market must be careful not to underestimate the risks now implicit to any unexpected broad-based contraction of operating profits.
And interest rates have just begun their upward journey…
But, the optimists say, tax reform will boost the economy and profits. David Rosenberg did the math, calculating that the $80B of expected incremental gain to nominal GDP and the $140B in additional profits dwarf against the $420B withdrawal of monetary support from the Fed in 2018. And if the Fed just raises rates twice (most economists expect 3-4 hikes), this would add an additional $100B drag out of nominal GDP.
Goldman expects $5 billion hit to quarterly earnings due to new tax law
Around two-thirds of the $5 billion decrease is due to repatriation tax, Goldman said in a statement with the U.S. Securities and Exchange Commission.
The remainder includes the effects of the implementation of the territorial tax system and the re-measurement of U.S. deferred tax assets at lower enacted corporate tax rates. Expect a tsunami of such announcements in January. Also expect chaos in earnings data as each aggregator applies its own approach in the treatment of “non-operating” and “non-recurring” items.
U.S. Investor Optimism Still Riding High
U.S. investor optimism has remained strong in the fourth quarter, with investors mostly upbeat about the 12-month outlook for the economy, the stock market, unemployment and their personal finances. This is reflected in the Wells Fargo/Gallup Investor and Retirement Optimism Index, which hit +140 in the fourth-quarter poll. While similar to the +138 recorded in the third quarter, it is up from +96 a year ago and is technically the highest since September 2000, when it was +147.
But the average hides the great American divide:
Republicans’ score on the index jumped from -9 in the third quarter of 2016 to +145 in the fourth quarter of that same year — a three-month period spanning the 2016 election. It has since edged up further to +220. Meanwhile, Democrats’ index score plummeted from +166 to +32 a year ago — but has since improved, now registering +56.
Bullish Sentiment: Start of a New Streak?
(Bespoke)
SoftBank-led group to acquire $9bn stake in Uber Shareholders agree to sell 17% of car-booking company at a discount
(…) The investment by the SoftBank-led consortium is comprised of two tranches. The consortium will buy about $1.25bn of new Uber shares at the same price as the company’s most recent fundraising round, which valued it at $70bn. The group will also buy a second, larger tranche of discounted shares from Uber’s existing shareholders, at price of $32.93 per share, which is a 30 per cent discount to Uber’s previous fundraising. (…) About 15 per cent of Uber’s shares will change hands in the tender offer, which was oversubscribed, said people familiar with the process. (…)
In effect, SoftBank is buying a 17.5% stake in Uber, with 2 board seats, for $9B, valuing Uber at $51.4B, nearly 27% below the most recent valuation. As a reminder, on August 23, 2017:
(…) Three of the investors, Vanguard Group, Principal Funds and Hartford Funds, all marked down their shares by 15 percent to $41.46 a share for the quarter ended June 30, according to the fund companies’ latest disclosure documents, the Journal reported.
A fourth investor, T. Rowe Price Group, cut the estimated price of its Uber shares by about 12 percent to $42.70. Another investor, Fidelity Investments, maintained its estimate of $48.77 as of June 30, WSJ said. (…)
Looks like markdowns between 20% and 32% should be necessary at year-end.
But wait! SoftBank’s direct $1.25B investment could be used to keep the valuation at $69B since this is the latest value from fund raising. 
FYI:
Uber Technologies Inc.’s net loss widened to $1.46 billion in the third quarter, according to people with knowledge of the matter, as the ride-hailing leader struggled to fend off competition, legal challenges and regulatory scrutiny. (…)
Uber told stockholders that gross bookings, the key yardstick of demand for ride services, rose 11 percent to $9.71 billion in the period that ended in September, compared with $8.74 billion in the second quarter, said the people. Net revenue grew 21 percent to $2.01 billion in the third quarter from $1.66 billion.
But losses, which had been narrowing in previous quarters, reversed course. The net loss increased 38 percent from the second quarter, when it was $1.06 billion. (…)