Saturday, 22 February 2014

Credit - Crosswind

"The myth of unlimited production brings war in its train as inevitably as clouds announce a storm." - Albert Camus

Looking at the preliminary China Purchasing Managers' Index from HSBC/Markit for February falling to a seven-month low of 48.3 in conjunction with Japan's record trade deficit, France's disappointing PMI for services pointing towards lower growth ahead, and disappointing shipping data, made us think about using the analogy of the "crosswind" which is any wind that has a perpendicular component to the line or direction of travel. In aviation, as shown by the recent European storms, it does make landing and take-offs much more tricky. In similar fashion, all the recent economic developments as of late, such as China's tightening credit conditions, and continued Fed tapering, make it extremely tricky for the global economy at present times, and could have the potential effect of veering the global economy sharply towards a downturn and a deflationary environment.

Of course the Chinese crosswind is of two folds, on one hand China's deflating exercise is akin to a "controlled demolition" and will need to allow at some points some defaults to take place, on the other hand, it has to maintain sufficient credit conditions to ensure a certain level of growth for its economy.

As we wrote back in September 2011 in our conversation "Controlled demolition", as far as Europe and China are concerned, nothing has really changed in terms of the treatment of the on-going crisis:
"While Europe is busy with the demolition, we have China attempting deconstruction. In both case we have an attempt of controlled demolition, it is just a question of style." - Macronomics, 19th of September 2011.

We do hate sounding like a broken record, but the deflationary forces at play have been gathering strength we think as of late. Deflation risk is growing no doubt when one looks at the 5 year forward breakeven rate, which has been falling since the beginning of the year - graph source Bloomberg:
The Fed’s five-year, five-year forward break-even rate, fell to 2.23% last week, getting closer to the lowest since the central bank launched operation Twist back in September 2011. Back to the future? We wonder because every time over the past several years when inflation expectations have eased significantly stocks have declined and credit spreads widened meaningfully.

Because, if indeed the US economic recovery is genuine and the US has finally reached "escape velocity" as posited by Chicago Federal Reserve Bank President Charles Evans a year ago, then we wonder why (apart from the now famous "weather effect") US Family Housing Starts has been falling in conjunction with US Furniture sales, as well as the Baltic Dry Index as of late, pointing, we think to some important "crosswind" - graph source Bloomberg:
Since 2006:
- in yellow the Baltic Dry Index,
- in orange US Family Housing Starts
- in white US Furnitures Sales.

As we indicated in our January 2013 conversation "The link between consumer spending, housing, credit growth and shipping" :
"If there is a genuine recovery in housing driven by consumer confidence leading to consumer spending, one would expect a significant rebound in the Baltic Dry Index given that containerized traffic is dominated by the shipping of consumer products."

Any change in consumer spending trends is depending on a more pronounced housing market revival and will directly impact container traffic. In similar fashion, container shipping rates fell 4.8% recently, the first decline in 10 weeks as shown by the latest reading from the Drewry Hong-Kong/Los Angeles container rate benchmark - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark fell 4.8% to $1,986 in the week ended Feb. 19, the first decline in 10 weeks and the lowest rate since early January. Slack capacity continues to pressure prices, with rates 21.7% lower yoy and 21.2% below the July 2012 peak of $2,519. Carriers are expected to implement a $300 general rate increase on containers from Asia to the U.S., effective March 15." - source Bloomberg

 The container rate increased by $400 USD on the 15th of November already on all US destinations with no impact so far for the "recovery" desired by Private Equity busy investing in the shipping space as discussed back in our December conversation. What is of course of interest is an additional rate increase to counter the deflationary forces at plague still plaguing the shipping industry as a whole. As a reminder, Containership lines have announced 12 rate increases, totaling $5,250, on Asia-U.S. routes since the beginning of 2012.

The surge in the Baltic Dry Index before the start of the financial crisis was a clear indicator of cheap credit fuelling a bubble, which, like housing, eventually burst. In the chart below, you can notice the parabolic surge of the index in 2006 leading to the index peaking in May 2008  at 11,440;  with the index touching a low point of 680 in January 2012  -  Evolution of Baltic Dry Index from 1990 until today - source Bloomberg:
One thing for sure, it doesn't seem for now that the Baltic Dry Index has indeed reached "escape velocity" although, recently, one would have thought it did...Oh well. Yet another "crosswind" in the "recovery" scenario.

On top of continued "shipping woes", an additional "crosswind" we are seeing is Citigroup Inc.’s U.S. Economic Surprise Index, which measures data against analysts’ expectations, fell to minus four on the 19th of February, from 73 on January 15, suggesting that economic reports are increasingly missing forecasts.

We have indeed been sitting in the deflationary camp for a while and when it comes to assessing the risk of deflation, we think the Fed might be again behind the curve as indicated in Simon Kennedy's Bloomberg article from the 21st of February entitled "Deflation Risk Growing in Wells Fargo Model":
"The U.S. economy may prove more prone to deflation than the Federal Reserve acknowledges and that may present a reason to keep monetary policy loose, according to a model created by Wells Fargo Securities LLC.
Deflationary pressures have been “relatively high” since January 2010 and now have a 66 percent chance of prevailing in the U.S., according to Charlotte, North Carolina-based economists John Silvia, Azhar Iqbal and Blaire Zachary. Their calculations include factors such as the personal consumption expenditures price deflator, unemployment rate and the Fed’s inflation target.
The model is “useful for policy makers, investors and consumers who can attach a probability with each more-likely scenario of future price trends: inflationary, deflationary or price stability,” the economists said in a Feb. 17 report.
They say that such a persistently higher probability can highlight a looming threat. In the 1980s, for example, the model would have pointed to the risks of higher inflation, which did mark that decade.
“The recent year’s surge in the deflationary pressure probabilities may offer a justification for the highly accommodative monetary policy,” the authors said in the report.
The Wells Fargo model is more worrying than one created by the Federal Reserve Bank of Atlanta, which is based on the market for Treasury inflation-protected securities. As of Feb. 14, that gauge said the probability of deflation was steady at zero.
Central bankers so far don’t sound worried by a deflation threat. Fed Chair Janet Yellen told lawmakers on Feb. 11 that some of the recent softness in prices “reflects factors that seem likely to prove transitory.”" - source Bloomberg.

We have long argued that what we have been fearful of when it comes to the meteoric rise of the S&P 500 in recent years was "peak earnings", of course what has been justifying more and more "lofty" valuations, has been the growing recourse to buybacks which has been very successful indeed in "boosting" US stock prices overall as displayed in the below graph from Bloomberg showing the impact of multiple expansion. 

For illustrative purposes, we have been plotting the growing divergence between the S&P 500 and trailing PE since January 2012 - graph source Bloomberg:

Buybacks have indeed counted more in recent years for US stocks returns than dividends as illustrated by Bloomberg's recent Chart of the Day from the 19th of February:
"Share repurchases may do more to explain gains in U.S. stocks during the past five years than dividends increases, according to Sean Darby, Jefferies Group Inc.’s chief global equity strategist.
As the CHART OF THE DAY shows, the Standard & Poor’s 500 Buyback Index has advanced further in the current bull market than either the S&P 500 Dividend Aristocrats Index or the S&P 500 itself. The comparisons are based on total returns, which account for dividend payments.
Repurchases have left stock investors with “an ever decreasing pool of opportunities,” Darby wrote yesterday in a report. They help explain why share prices have risen relative to earnings, the Hong Kong-based strategist added.
The S&P 500 was valued at 17 times profit as of yesterday, according to data compiled by Bloomberg. The ratio increased from 13.5 at the end of March 2009, the month when the bull market started.
Growth in mergers and acquisitions, inflows of funds into U.S. stocks and “limited equity issuance” also contributed to the higher price-earnings ratio, Darby wrote. He cited S&P 500 data showing more common and preferred shares were repurchased than issued last year for the ninth year in a row.
The buyback index tracks the 100 companies in the S&P 500 whose spending on repurchases in the previous 12 months was the highest percentage of their market value when the period began. The dividend index is comprised of 54 companies that increased payouts annually for at least 25 years." - source Bloomberg.

In similar fashion, low quality stocks overall have more benefited from the liquidity FED/ZIRP induced rally that quality paying dividend stocks overall since March 2009 - graph source Bloomberg:

But when it comes to our concerns with "peak earnings" and US inflation, we have indeed looked at the relationship between both the S&P 500 Ebitda since 2008 and the US CPI - graph source Bloomberg:
If indeed inflation is trending down and deflationary forces are still acting as strong "crosswinds", then again there is a rising risk for some "unforeseen" (by the Fed) adjustments we think.

On a final note, another "crosswind" for earnings in particular and stocks in general, is coming from Emerging Markets' woes, given the withdrawal of liquidity by the Fed will no doubt curb somewhat global growth as displayed in Bloomberg's Chart of the Day from the 11th of February:
"Declines in emerging-market currencies are a signal that stocks worldwide will extend this year’s drop because cuts in Federal Reserve stimulus will curb growth, said Gautam Batra of Signia Wealth Ltd.
As the CHART OF THE DAY shows, the MSCI All-Country World Index and a Bloomberg gauge of 20 emerging-market currencies moved in tandem from 1999 to 2012. The two measures then diverged and widened to a record on Jan. 22. Since then, equities have dropped 2 percent, more than the 0.3 percent decline for the currencies.
Weakness in emerging-market currencies will hurt profit at global companies, which are increasingly dependent on those nations, according to Batra, managing director and investment strategist at Signia in London. Almost 53 percent of U.S. trade came from developing countries in 2012, up from 39 percent in 2002, data compiled by Bloomberg show. For the European Union, the proportion rose to 28 percent from 18 percent.
“We will absolutely recalibrate between stocks and emerging-market currencies,” Batra said in a telephone interview. His firm manages 2.2 billion pounds ($3.6 billion).
“The potential for a negative feedback loop from the emerging markets to the developed markets is huge.”
The gauge of emerging-markets currencies fell 3 percent last month, extending last year’s 7.1 percent decline. That helped send worldwide shares down 4.1 percent in January as the Fed’s decision to press on with bond-buying reductions spurred concern the economic expansion may falter. Equities jumped 20 percent in 2013, their biggest annual gain since 2009." - source Bloomberg

So don't jump to fast on the "Great Rotation" bandwagon from bonds to stocks...

"It's a fool's paradise. We're basically printing money to keep everybody happy in the short term" - Steve Miller, Chairman of American International Group, 12th of February 2012 on Bloomberg TV.

Stay tuned!

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