INFLATION WATCH
The San Francisco Fed’s tracking of the PCE deflator suggests that even PCE inflation has actually reached the magic 2% level:
This next chart illustrates the breadth of inflationary pressures. An increasing share of the basket is experiencing high inflation rates:
The following chart plots the evolution of the distribution of price increases in the monthly component data over the past year. The chart shows the percentage of components each month, weighted by their shares in total spending, for which prices grew between 0 and 2 percent (at an annual rate); between 2 and 3 percent; between 3 and 5 percent; between 5 and 10 percent; and more than 10 percent.
Meanwhile, in the pipeline:
The Industrial Materials Price Index from the Foundation for International Business and Economic Research (FIBER) rose 1.4% during the last four weeks (6.8% y/y) as factory sector production around the world continued to improve. The index level was at its highest point since August 2014.
Showing the greatest increase were prices in the miscellaneous group which improved 6.9% last month and 2.9% y/y. Within this group, framing lumber prices increased 8.1% last month and were up by one-quarter y/y. Prices for structural panels increased 12.7% m/m and rose by one-third y/y. Natural rubber costs gained 5.1% last month but still were off by one-third y/y. Prices in the textile group improved 0.2% last month and rose 1.8% y/y. Cotton prices strengthened 3.8% m/m, and by 7.4% y/y. Burlap prices fell 3.7% over the last four weeks, but rose 6.3% y/y.
Offsetting these gains were price declines in the metals sector which fell 1.8% during the last month, but improved 17.7% y/y. Weakness was led by a 2.6% one-month decline in aluminum prices. They increased 13.9% y/y. Copper scrap prices eased modestly last month, but gained 17.6% y/y. Steel scrap prices also fell 0.8% during the last four weeks, but rose 27.3% y/y). (…) Also easing were prices in the crude oil & benzene group by 2.1% last month (+5.0% y/y). (…)
Don’t hang your hat on this apparent slowdown as Haver Analytics’ Robert Brusca explains:
(…) Inflation is lower in January because the 0.6% increase in the PPI this year is smaller than the 1.3% gain in the PPI in January 2017. Looking ahead the EMU PPI rose in only one month over the six months from February through July 2017. In that one month (April), it rose month-to-month by 0.1%. The PPI fell in four of those six months and was unchanged in one other month.
That means that there is a stretch of months coming up in which if the PPI rises at all that will lead to an acceleration in year-on-year inflation. The PPI seems to be set up for a rough patch over the next six months unless oil prices move lower and help to persistently depress headline prices. (…)
The reality is that Eurozone PPI has been accelerating at a sharp 5.0% annualized rate in recent months:
This trend at the eurozone producer level is confirmed by the recent PMI surveys showing rising backlogs and delivery times:
While this is happening at the producers level, European consumers have been enjoying deflationary conditions: even though it is up 1.0% YoY in February, the core CPI in the euro area dropped a huge 1.7% MoM in January and has actually declined in 3 of the last 5 months for a total decline of 1.0% or 2.4% annualized. Somebody must be experiencing pretty weak margins in Europe.
A “ONCE IN A GENERATION” SHIFT?
Evergreen/Gavekal’s March 2 EVA discusses the possibility that we may be on the verge of a secular shift. Well worth reading entirely.
(…) For years, the incentive structure in China almost guaranteed overcapacity in pretty much everything. Then China would export this overcapacity, earn US dollars and re-invest the dollars into treasuries and so keep US (and global) interest rates low. More than a decade ago we dubbed this a “circle of manipulation” but is the characterization still apt? For starters, China is clearly no longer keen to re-invest excess dollars into treasuries, but is instead trying to make the renminbi a trade and reserve currency.
And, for seconds, it seems that the incentive structure in China may be shifting, so that too much output does not automatically get produced. (…)
So, let’s imagine that China (supply-side reforms and changed incentive structure), Korea (overvalued won) and Japan (finally looking out for shareholders) are no longer adding capacity hand over fist. Hence, if Northeast Asia isn’t adding capacity, who is? It isn’t the US, where corporates are busy buying back their shares, while private equity and venture capital firms scramble to fund the next “overcapacity-optimization” platform (Uber, Lyft, Airbnb…). It isn’t Europe either, where until recently, investment trends were rather pedestrian. So, if the conclusion is that no one is adding productive capacity, what should we expect? (…)
The first obvious consequence would be a rise in producer price inflation. Interestingly enough, this seems to be unfolding — at the very least, China, Japan and Korea have all stopped exporting deflation. (…)
Perhaps we would be willing to discard all of the above as sheer noise if it wasn’t for one uncomfortable recent development, namely the growing dichotomy between a falling US dollar and rising treasury yields. Doesn’t this tell us that something doesn’t “smell right”? (…)
Speaking of excess capacity:
THE “GOOD AND EASY TO WIN” WAR
U.S. Tariff Plan Spurs Global Jockeying President Trump plans to apply his steel and aluminum tariffs globally and won’t exempt allies such as Canada and Europe, a senior White House official said, an approach likely to intensify protests over the move.
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From Soybeans to Natural Gas, Investors Eye Threat of U.S. Tariff Retaliation
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EU Threatens Iconic U.S. Brands After Trump Opens Door to Trade War
Tariffs Could Ripple Through U.S. Economy
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Tariffs risk thousands of jobs, US manufacturers warn Fears that higher costs would make the country’s plants less competitive
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The Trade War’s Biggest Losers
(…) “The users of steel will be disadvantaged by the rise in the price of steel and potential retaliation,” they continue. Payrolls of steel and aluminum producers totaled 203,000 in January, compared with an estimated 6.5 million in industries that use steel, such as automobile production and construction.
They further cite the experience of the 30% steel tariffs imposed in 2002 by the George W. Bush administration, which boosted imported steel products by 14.3% and domestically produced ones by 10.7%. The tariff cost 200,000 jobs, according to a study by the Consuming Industries Trade Action Coalition, a group of steel-consuming industries, and were dropped a year later. (…)
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Trump Threatens to Impose Tariffs on European Vehicles Trade tensions heat up as president vows to penalize EU if it retaliates against U.S. metals duties
(…) “If the E.U. wants to further increase their already massive tariffs and barriers on U.S. companies doing business there, we will simply apply a Tax on their Cars which freely pour into the U.S.,” Mr. Trump wrote on Twitter from Palm Beach, Fla. “They make it impossible for our cars (and more) to sell there. Big trade imbalance!”
Imposing a tax on the imports of European cars would be more difficult than Mr. Trump’s tweet suggests. European auto makers employ thousands of workers in the U.S. and have factories in states including Alabama, South Carolina and Texas. BMW manufactures sport-utility vehicles in South Carolina and exports at least 70% of them to other countries. (…)
The U.S. imported $20.5 billion in German passenger cars in 2017. The U.S. charges tariffs of 2.5% on most cars from countries with which it doesn’t have a free-trade agreement, and 25% on pickup trucks. The EU has a tariff of 10% on car imports under WTO rules. (…)
The media are all out against trade wars which have no history of being good. We shall see how other countries actually react beyond their respective rhetoric often draped in their own protectionist behavior.
Investors thus have a lot to fear, especially since they can’t hide in the fixed income market, itself riled by inflation fears and rising bond supply.
Investors Bet Against Treasurys as Bond Market Anxiety Intensifies
(…) Signs of worry have proliferated recently. Futures markets show investors recently held the most bearish positioning on record in data going back to 2003. Bidding at February’s Treasury auctions declined as the supply of bonds rose. During the week ended Feb. 14, investors pulled the largest amount from fixed-income mutual funds and exchange-traded funds since just after the presidential election. And Treasury market volatility, as measured by Bank of America Merrill Lynch’s MOVE index, recently hit its highest level since April. (…)
The new Fed chairman’s comments that inflation pressures are strong and that fiscal policy is playing a supporting role in economic growth helped snap three days of gains for the 10-year note. (…)
Analysts also said the additional borrowing resulting from recent tax cuts could push yields higher. (…)
That was one my points in WITH THE KING OF DEBT, CASH IS KING.
- The Fiscal Times made things even scarier last Friday:
The Congressional Budget Office won’t release new budget projections that include the effects of the President Trump’s tax overhaul until April, but on Friday the deficit hawks at the Committee for a Responsible Federal Budget produced their own projections based on the CBO’s methods. The analysis shows annual deficits surpassing $1 trillion starting in 2019, three years earlier than previously expected, and the national debt growing larger than the economy in the next decade. In all, the tax cuts and spending deals are projected to increase the debt by $2.4 trillion over 10 years.
The analysis lays out two different possible paths, one based on a current law, in which some personal tax cuts are phased out after 2025, and another based on the assumption that the personal tax cuts will be extended and that recent spending increases defined in the Bipartisan Budget Act continue. The second scenario, which CRFB refers to as “more realistic policy assumptions” and many policy experts see as likely, produces the most dramatic increases in debt and deficits. (…)
This next chart, via John Mauldin, should get your attention after you look at the horizontal axis:
There is no “slight” releveraging! The U.S. is currently as deep in debt in relation to its GDP as it was DURING the economic depression of the early 1930s AFTER real GDP had collapsed 26% in 4 years.
The U.S. federal debt exploded after the 2008 financial crisis and nothing has been done to restore the ratios and prepare for the next downturn. During the next several years, the Federal Government debt will explode again by 20-30% of GDP!
Corporate executives have no lessons to give the Dems nor the GOP on fiscal responsibility. Corporate debt in the U.S. has doubled to $6.1T since 2007, rising 65% since 2010. According to Morningstar/CPMS data, the median debt to equity ratio of the 2,195 companies in its database currently stands at 61%, up from 32% in Q1’2007. S&P 500 companies are even worse with a D/E ratio of 87%, up from 70% in 2013.
Consider that the tax reform actually magnifies the cost of debt in two ways: the lower effective tax rate boosts the after tax cost of debt for all borrowers and the new limit for interest expense deduction at 30% of EBITDA (EBIT in 2022) makes it even more onerous for the most indebted companies.
In November 2017, a Fed analysis of the corporate debt market revealed that 25% of corporate bonds and 66% of corporate loans would mature before the end of 2020.
The increase in the federal funds rate from 1-1/4 percent to 3 percent by 2019 as implied by the projections in the June 2017 Summary of Economic Projections would translate into an increase in interest payments of $2 billion in 2017, $15 billion in 2018, and $37 billion in 2019, relative to a scenario in which the federal funds rate remains at 1-1/4 percent. The increase implies that the aggregate interest coverage ratio–the ratio of earnings before interest and taxes (EBIT) to interest expenses on bonds and loans–for the U.S. nonfinancial sector will decline in 2019 from 4.6 in a scenario in which rates remain at current levels to 4.1 in a scenario in which rates evolve according to the SEP.
The Fed analysts assumed that the LIBOR floating rate debt would be renewed at rates that would follow the fed funds rate, i.e. +70 bps in 2018, and +90 bp in 2019 The reality, so far, is that 3m LIBOR rates have already risen by 65 bps to 2.0%, a 50% jump, while the Fed funds rate has only advanced by 25bps (+20%). With respect to corporate bonds, the analysts simply assumed that the maturing bonds would be rolled over at a coupon rate equal to current market yields plus the projected cumulative federal funds rate hike at the time of rollover. This assumption will also likely prove optimistic. In just the last 3 months, 5Y and 10Y rates have also gone up 70 bps (+30-35%). And the FOMC members are debating whether they should hike 3 or 4 times in 2018 alone!
The Fed’s static analysis misses several important facts:
- Market rates can significantly diverge from managed rates. This is already happening.
- The tax reform and the recent budget will certainly increase the supply of bonds in coming years, pushing rates up.
- Bond spreads will likely widen.
- Generally rising interest rates will likely slow economic growth, putting pressure in EBIT.
All this to say that corporate interest coverage is likely to get significantly worse than the 4.1x assumed in the Fed’s November analysis. I would not be surprised if the coverage ratio gets below 4.0 in 2018 and below 3.5 in 2019.
David Rosenberg has his own angle:
The race is thus on between earnings growth, inflation and interest rates.
EARNINGS WATCH
To date, 97% of the companies in the S&P 500 have reported actual results for Q4 2017. In terms of earnings, more companies are reporting actual EPS above estimates (74%) compared to the 5-year average. In aggregate, companies are reporting earnings that are 4.4% above the estimates, which is also above the 5-year average. In terms of sales, more companies (77%) are reporting actual sales above estimates compared to the 5-year average. If 77% is the final number for the quarter, it will mark the highest percentage of S&P 500 companies reporting positive sales surprises since FactSet began tracking this metric in Q3 2008. In aggregate, companies are reporting sales that are 1.5% above estimates, which is also above the 5-year average.
The blended (combines actual results for companies that have reported and estimated results for companies that have yet to report) earnings growth rate for the fourth quarter is 14.8% today, which is slightly below the earnings growth rate of 14.9% last week.(…) The blended sales growth rate for the fourth quarter is 8.2% today, which is equal to growth rate of 8.2% last week. (…)
If the Energy sector were excluded, the blended earnings growth rate for the remaining ten sectors would decrease to 13.1% from 14.8%.
During the first two months of the first quarter, analysts increased earnings estimates for companies in the S&P 500 for the quarter. The Q1 bottom-up EPS estimate rose by 5.7% (to $36.32 from $34.37) during this period.
On average, the bottom-up EPS estimate usually decreases during the first two months of a quarter. During the past year (4 quarters), the bottom-up EPS estimate has recorded an average decline of 1.8% during the first two months of a quarter. During the past five years (20 quarters), the bottom-up EPS estimate has recorded an average decline of 3.1% during the first two months of a quarter. During the past ten years, (40 quarters), the bottom-up EPS estimate has recorded an average decline of 4.0% during the first two months of a quarter.
In fact, the first quarter of 2018 marked the largest increase in the bottom-up EPS estimate over the first two months of a quarter since FactSet began tracking the quarterly bottom-up EPS estimate in Q2 2002. The previous record for the largest increase in the bottom-up EPS estimate was 4.4%, which occurred during the first two months (October through November) of Q4 2009.
Analysts have not only increased EPS estimates for the first quarter, but also for the full year. The CY 2018 bottom-up EPS estimate increased by 7.3% (to $157.97 from $147.24) from December 31 through February 28. This is the largest increase in the annual EPS estimate for the index over the first two months of the year since FactSet began tracking the annual bottom-up EPS estimate in 1996.
Thomson Reuters’ tally shows that 53 companies have pre-announced positively for Q1’18, up big time from 30 and 39 in Q1’17 and Q4’17 respectively. Sixty-four have pre-announced negatively, down from 73 and 66 respectively.
Trailing EPS are now $133.15 per TR and are set to exceed $138 after Q1’18 and are expected to total $158 for the full year, a highly unusual 19% leap so far in the cycle, nearly half owing to the tax reform which impacts companies and sectors quite unevenly:
TECHNICALS WATCH
Lowry’s Research remains bullish seeing no evidence of weakening Buying Power and/or rising Selling Pressure. However, LR says that the two 90% Downside Days recorded on Feb. 2nd and Feb. 5th need to be reversed with “at least one 90% Upside Day, signaling that buyers are rushing to get back into the continuing bull market.”
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DIP BUYERS?
Steve Blumenthal shares interesting insights given the increased volatility:
(…) No doubt there is a clear bull case for why buybacks could prove the savior, rather than the Achilles’ heel of U.S. equity markets this year. With the new tax law reducing liabilities and incentivizing repatriation, buybacks are already on record pace — $171 billion worth have been announced so far in 2018, more than double the amount disclosed by mid-February 2017. If a tax-bill-fueled buyback bonanza can effectively “buy the dips”, market tranquility can be protected, preventing a large-scale unwinding of low-volatility-pegged strategies.
However, this optimism neglects the threats facing the buyback-industrial-complex. A political backlash against buybacks is intensifying as the tax bill manifests — since passage, total buybacks announced exceed worker bonuses and raises by roughly 63x. Yet, even if political concern doesn’t materialize into action, a more systemic problem remains: rising interest rates combined with the toxic mix of corporate inequality and debt.
According to an IMF estimate from last spring: “Large U.S. corporations have experienced a negative net equity issuance of $3 trillion since 2009 due to share buybacks.” U.S. corporate debt — piled on by both strong and weak hands — sits at an all-time high of $13.7 trillion. Meanwhile, the tax bill will disproportionately benefit the strong hands — for one, the richest 10% of companies control 80% of the $1 trillion offshore cash hoard. Begging the pressing question: As the cost of debt goes up, can the buyback spending of the strong offset the turbulence caused by the weak?
Buybacks have been essential fuel for the low-volatility regime, enabling steady equity appreciation and in turn, the rules-based strategies pegged to that tranquility. Now, as volatility returns to equity markets, buybacks will likely prove key to understanding and anticipating the threat of a high-volatility crash.
The past two weeks have offered a clear illustration of the importance of buybacks to the low-volatility regime. Not surprisingly, the “VIX tantrum” corresponded to the tail end of the buyback blackout period (the SEC forbids buybacks during quarterly reporting to control insider trading). Since 2009, the largest equity drawdowns — August 2015, January to February 2016, and two weeks ago — all occurred in or right after the share buyback blackout period. Even less surprising, corporations stepped in after February 5, 2018, bought the dip, and suppressed volatility. Goldman Sachs’ unit that executes share buybacks for clients had its busiest week ever, seeing roughly 4.5x its average daily volume over 2017. (…)
However, the topline numbers neglect the severe inequality within the corporate ecosystem. As of 2015, just 30 firms accounted for half the profits of all publicly-listed U.S. companies, down from 109 in 1979. Only through cheap debt accumulation have laggards been able to afford the buybacks necessary to keep stock appreciation stable. As the IMF warned last year, 22% of U.S. corporations are at risk of default if interest rates rise.
The tax bill may exacerbate, rather than relieve this threat. Moody’s concluded in a report earlier this year: “Low-rated or cyclical companies could see more of their income become taxable as their financial performance deteriorates and their interest expense to EBITDA/EBIT rises meaningfully above the 30% threshold.” ValueWalk summed up Moody’s analysis further: “High quality companies will benefit but low-quality levered companies could get hit hard.”
The short term could survive this threat. As leaders convert their tax-bill windfall into buybacks, laggards may face escalating market and shareholder pressure to keep pace. The past decade plus has provided countless examples of inopportune, if not reckless buybacks. From GE between 2005 and 2007 to Glencore in 2014 and American Airlines since its 2011 bankruptcy, corporate C-suites have time and again prioritized the short-term benefits of buybacks over medium- to long-term debt-management. (…)
China Turns Fiscal Screws While Maintaining 6.5% Red Line on GDP
The deficit target — released Monday as Premier Li Keqiang delivered his annual report to the National People’s Congress in Beijing — was lowered to 2.6 percent of gross domestic product from 3 percent in the past two years. The 6.5 percent goal is consistent with President Xi Jinping’s promise to deliver a “moderately prosperous” society by 2020.
Policy makers dropped a target for M2 money supply growth, saying it’s expected to expand at similar pace to last year. Authorities reiterated prior language saying prudent monetary policy will remain neutral this year and that they’ll ensure liquidity at a reasonable and stable level. (…)
Other key economic objectives included:
- Retail sales growth of about 10 percent
- Consumer prices will rise about 3 percent, the same as last year’s ceiling
- Creation of 11 million new urban jobs, the same as last year
- Yuan exchange rate to remain stable at an equilibrium level
(…) Other 2018 objectives included:
- Cut energy use per unit of GDP by more than 3 percent, versus 3.4 percent goal in 2017
- Steadily push forward legislation for a property tax
- Keep registered urban unemployment rate under 4.5 percent, unchanged from 2017
- Cut about 30 million tons of steel capacity, compared with 50 million ton goal last year
- Defense spending is expected to rise 8.1 percent, the quickest pace in three years
The WSJ catches on something I posted about last week.
Credit-Card Losses Surge at Small Banks Small banks have been fighting for a bigger piece of the credit-card market in search of higher returns. Now, they’re contending with rising losses.
(…) Their charge-off rate, or the share of outstanding card balances written off as a loss after consumers failed to pay, hit 7.2% in the fourth quarter, up from 4.5% a year ago, according to Federal Reserve data. (…)
While overall card losses are still relatively low—below the historical average of the last 30 years, for instance — they’ve been slowly climbing in the last two years.
But they’ve especially surged at smaller banks, those outside the 100 largest by assets that have less than around $10.4 billion in assets. There, the average charge-off rate is near an eight-year high, while the 3.5% loss rate at large banks remains well below the 10.6% seen in 2010. (…)
While the hundreds of smaller U.S. banks that offer credit cards account for just around 2% of outstanding credit-card debt, according to a measure by S&P Global Market Intelligence, some investors view that debt as a window into the financial health of the middle-and-lower-income consumer. (…)
Large banks’ outlook for card borrowers has soured a bit, too. Half of large banks surveyed in the Federal Reserve’s senior loan officer survey for January said they expect delinquencies and charge-offs on their credit card loans to worsen this year. That is up from 37% a year earlier and 10% in January 2015. (…)
China cites ‘grassroots’ demand to scrap term limits Rubber-stamp parliament justifies move allowing Xi to stay on as president for life
‘I think it’s great. Maybe we’ll give that a shot some day’
