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posted on 12 June 2017

Can Increased Investment Carry The Economy And The Market?

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Macro Tides Monthly Report 12 June 2017

U.S. Economy

The Commerce Department revised first quarter GDP from 0.7% to 1.2%, with most of the revision coming from business investment (1.34% vs. 1.12%) and consumer spending (0.44% vs. 0.23%). The uptick in business investment in the first quarter was certainly welcome after years of under investment.

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In the six recoveries since the 1969 recession, the recovery since June 2009 has been by far the weakest in terms of business investment. Despite the dearth of business investment, corporations have leveraged their balance sheets aggressively compared to the eight other expansions since 1953.

As a percent of revenue, corporate debt represents about 17% of revenue, 40% more than in the 1989-1990 and 1990-2001 expansions. Most of the increase in debt has come from stock buybacks.

Merger and acquisition activity has also surged during the last two years, while business investment has essentially flat lined. The increase in buybacks and M&A activity has been supportive of the stock market by shrinking the numbers of shares outstanding. But buybacks and M&A activity can’t replace the value of long term focused investment that provides a solid foundation for a company’s future growth.

The Federal Reserve’s Labor Market Conditions Index (LMCI) is a composite of 19 labor market data points. After peaking in December 2015, the LMCI softened until firming a bit in the first quarter of this year. Noting the dip in the LMCI in the November 2016 Macro Tides, I thought job growth was likely to moderate in coming months. During the past six months, monthly job growth has slowed. The 138,000 jobs created in May probably understates the strength of the labor market.

Job growth is being held back by the lack of qualified workers who have the skills needed. As the pace of technological change accelerates in coming years, this problem is only going to become larger. As a country, we need a modern day equivalent of the G.I. Bill which helped train and educate half of the 16 million veterans after World War II. President Trump could help more middle class Americans through a jobs training program in conjunction with corporations, than misguided tweets about unfairness in trade.

Job growth is being held back by a sharp decline in hiring by S&P 500 companies. Prior to the election, employment growth by S&P 500 companies was growing above 2% annually and higher than the 1.8% annual growth rate in nonfarm employment.

Since the election, hiring by S&P 500 companies has slowed markedly and is almost 2% below year ago levels. The last time S&P 500 employment growth was negative was in 2009, as the economy was contracting sharply in the wake of the financial crisis. The only logical explanation is that large companies are waiting until Trump’s pro-growth agenda becomes legislation. If true, employment growth will pick up nicely once S&P 500 companies determine the path to tax cuts is clear. Until then, job growth will remain muted.

Second quarter GDP is likely to get a boost from less inventory liquidation, which shaved -1.07% from Q1 GDP. If inventories remain unchanged, GDP in the second quarter would increase by 1.07%. Statistically, GDP would benefit but little organic growth would be added.

One area that may experience additional inventory liquidation is autos. Year over year auto sales continue to soften, which has bloated car dealers’ inventory. Car manufacturers have attempted to entice buyers with record discounts, but sales have failed to firm up.

In recent years aggressive lending helped boost vehicle sales, but delinquencies on auto loans have been grinding higher since mid-2014. According to Experian Automotive, in the first quarter non-prime auto loans were down -3.0%, sub-prime loan volume fell by -9.0%, and deep sub-prime lending was off by -7.0%. The fact that the auto loan delinquency rate has been rising during an economic recovery underscores just how low lending standards were.

As discussed in the November 2016 Macro Tides,

“Sub-prime auto loans were up 11% in 2015 and a stunning 124% since 2010, according to Equifax. The increase in lending standards by auto lenders will lower sales in coming months."

As forecast, lending standards were increased and sales have fallen. Whether auto lenders raise lending standards further is not a certainty, but they certainly won’t be lowering them anytime soon.

I also discussed in the November Macro Tides how dependent the auto manufacturers had become on leasing:

“Since June 30, 2009, leasing grew from 13.5% of sales to a record 31.5% of sales in June 2016, according to Experian Automotive. In 2016, 3.1 million cars are expected to come off lease, an increase of 33% from 2015, according to NADA Used Car Guide. With so many used cars hitting used car lots, used car prices are down 3.6% through September 2016. Falling used car prices will pressure new car prices."

The flood of cars coming off a lease is expected to reach 4.5 million in 2018. The downward pressure on used car prices will remain high and continue to exert pressure on new car prices.

According to Experian Automotive, the average monthly payment on a new car in the first quarter was $509 and $303 a month for a used car. The gap of $206 in monthly payments between new and used cars has never been higher. As I wrote last November,

“The coming slowdown in car manufacturing will turn what had been a positive growth sector into a modest drag on GDP growth in coming quarters."

The table is set for the drag to become heavier.

The manufacturing Purchasing Managers Index has rolled over and begun to fall as the weakness in the auto sector spreads. New orders in May rose at the slowest pace since last September.

In May, the National S&P/Case-Shiller Home Price Index matched its 2006 high, while the 10-City Index was still 6.4% below its prior peak and the 20-City Index was off the 2006 high by 3.9%.

These indexes suggest most home values in the country have almost recovered their lost value, after plunging more than 20% to 30% after the 2006 peak. This is important since most homeowners need to wait until their home value has recovered enough, so they can make a profit after selling costs are deducted. This is one reason the inventory of homes for sale has remained low, despite the appreciation in home values since the 2012 bottom.

The S&P/Case-Shiller National Home Price Index has increased nearly 40% from the housing crash low in February 2012. The National Index though masks a great disparity between various cities. If you live in Dallas, your home is 35.5% above the prior peak and in Denver higher by 36.3%. But you’d be singing the blues, if you live in Phoenix or Las Vegas which are -27.3% and -33.9% below their peak.

Real estate research firm Trulia looked at the market value of each home in the country and compared it to its pre-housing crash peak. Trulia’s study found that only 34.1% of homes nationally had surpassed their previous highs. The difference between Trulia’s study and the S&P/Case-Shiller Indexes is that they give more weight to expensive homes than the individual home pricing in Trulia’s study. This suggests the inventory of homes for sale will remain low as homeowners around the country wait for the price of their home to recover.

As long as inventories remain low, upward pressure on home prices will continue. In 2006 home prices topped out a few months after the inventory of homes broke out above 5 months. The chart had formed a base between 4 and 5 months for years before it soared above 5 months in early 2006. Since 2012, the inventory of homes for sale has formed a base under 6 months. The recovery in home prices began when inventory fell below 6 months. Should home inventories ever climb above 6 months in coming months, home price appreciation will likely stall within a few months, as it did in 2006. Low inventory has played a significant role in the appreciation of home values in recent years. The problem is that home prices have increased far more than income growth. According to the Labor Department, incomes have only risen by 12% since 2012, but national home prices are up 40% from their 2012 nadir.

The affordability factor for first time home buyers, especially in “hot" markets, will increasingly be a hurdle. A new study by Genworth Mortgage Insurance estimates that since 2007, three million potential first-time home buyers were unable to buy a home due to three primary factors. Tighter lending standards in the wake of the financial crisis required larger down payments and income verification. Rising apartment rents made it tougher to save the necessary down payment. For many others, the burden of paying off student loans has been a hurdle prior generations didn’t have to deal with. In 2017, first time home buyers have represented 38% of the market, just below the historical average of 40%. This was possible as 78% of them took advantage of low down payment loans sponsored by Federal Housing Authority, which requires a down payment of just 3.5% and will loan money to those who have a credit score as low as 500. Now that first time buyers are back to the historic norm, it is hard to see where the incremental demand will come from to boost housing activity from current levels.

GDP will rebound in the second quarter, but housing is not likely to strengthen much and auto sales are likely to slide. Business investment and hiring are on hold until President Trump’s agenda is enacted. Bank lending has fallen significantly since the election as corporations await more clarity about tax cuts and investment tax credits. The inability of Congress to move forward on health care and tax reform is causing a buildup in pent up demand that will be unleashed once Congress acts. Once the legislative hurdle is overcome, GDP could jump to over 3% as corporations resume hiring, lift wages for existing workers, and increase business investment. In this scenario, stocks could enjoy a blow off run, even if bond yields spike higher. In the next few months, the lack of legislative progress could make equity investors impatient and disappointed since the rebound in the second quarter is less than expected and the payoff of lower taxes is pushed further out on the horizon.

Federal Reserve

The Federal Reserve has been discussing the need to normalize rates for years, but has not acted when GDP growth created an opportunity to act. One opportunity occurred in 2014 when GDP accelerated to 4.0% and 5.0% in the second and third quarter. Some of this strength was due to a rebound from the decline of -1.2% in first quarter due to the effects of the Polar Vortex. By the time growth slowed to 2.3% in the fourth quarter, the opportunity had passed. At the September 2014 FOMC meeting, the 17 FOMC members projected the number of rate increases appropriate during 2015. Three of the 17 expected to increase rates twice, 11 thought there would be 3 increases, with 1 member projecting a single increase and 2 expecting no increases. Fourteen of the 17 members thought there would be at least two increases in 2015. The FOMC waited until December to increase rates, which was the first increase since 2006. The federal funds rate had been 0.12% for 8 years, before being increased to 0.37%.

Coming into 2016, and maybe in response to criticism for dragging their feet in 2015, the FOMC projected 4 rate hikes in 2016. Just as in 2015, the FOMC waited until the December meeting to increase rates for the first and only time in 2016. The lack of action was due in part to fluctuations in the domestic economy and temporary concerns about the global economy. More importantly, it reflected a mindset and bias of the majority of FOMC members to look for reasons NOT to increase rates. As the old saying suggests, if you look you shall find what you’re looking for, and the FOMC, led by Janet Yellen, found reasons not to act.

The bias to look for reasons not to act seems to have given way for the FOMC needing reasons why it should not increase rates. The FOMC will raise the federal funds rate for the second time in 2017 when they meet on June 14. This increase will occur against a back drop of slowing job growth, no measurable pick up from the 2.5% in annual wage growth, inflation slipping further below the Fed’s target of 2.0% in recent months, weakness in the auto sector which had previously been a contributor to growth, tepid growth in housing, and the dimming prospects of Trump’s growth oriented fiscal policies being passed in 2017.

The willingness to raise rates may be tested if China slows as expected, Europe’s growth trajectory fades in coming months, and growth in the U.S. slips back toward 2.0% in the second half of this year if no progress is forthcoming from Congress on Trump’s agenda. But if the FOMC needs reasons why it shouldn’t increase rates, financial markets may be unpleasantly surprised after years of the FOMC finding reasons not to act. The apparent shift in the FOMC’s bias has not been recognized, let alone acknowledged, by the financial markets, at least not yet.

China and Emerging Markets

As discussed in the May Macro Tides, China’s bank regulator has attempted to rein in the banks excessive use of short-term funding and has levied $27 billion in fines through April of 2017 on banks caught violating rules, compared to $40 million in all of 2016 and just $1 million in 2015. The efforts by the China Banking Regulatory Commission and interest rate increases by Peoples Bank of China (PBOC) have led banks to curtail lending to sectors with excess capacity, such as steel and property developers. Companies having more difficulty in getting bank loans, or unwilling to issue bonds due to high interest rates, have turned to Chinese trust firms.

According to data from the PBOC, new loans from trusts totaled $129.5 billion in the first four months of this year, nearly five times as much as in the first four months of 2016. According to Moody’s, trust loans made up 10% of China’s shadow banking system at the end of 2016. China’s shadow banking system has tripled since 2011, and was 87% of GDP at the end of 2016.

Recently, Moody’s Investor Service lowered China’s debt rating for the first time since 1989. Moody’s noted that in recent years China’s GDP has grown between 6.5% and 7.0%, but the country’s debt has increased by 15% a year. This has caused China’s debt to GDP ratio to soar to more than 250% of GDP. Moody’s said,

“We expect China’s growth potential to decline to close to 5% over the next five years."

If China’s GDP slows from 6.9% (Q1 2017) to 5%, a decline of 40%, corporations will find it difficult to service their debt. A slowing of this magnitude would expose China’s banks to a significant increase in non-performing loans. As Fitch ratings noted recently,

“China’s recent economic growth trajectory has been accompanied by a buildup of imbalances that poses risks to its basic economic financial stability."

As discussed in the May Macro Tides, excess liquidity in China turned lower in the first quarter, which suggested China’s economy and property market were likely to slow in coming months. In April, retail sales, auto sales, and mobile phone production all slowed modestly. Housing prices increased half as fast in April as in March in tier one city’s. Growth in medium and long-term lending to households slowed for the second month in a row in April. And China’s Caixin Manufacturing Purchasing Managers Index dropped to 49.6 in May, which indicates an outright contraction.

The decline in commodity prices discussed in the May commentary has become broad enough to cause the global Purchasing Managers Price Index (PMI) to roll over and begin to fall sharply. The last peak in the Global PMI Price Indicator in 2011 was followed by a bear market decline in emerging market equities, as measured by the Emerging Market ETF EEM.

Between May 2011 and October 2011, EEM plunged 33.7%. This decline received a big assist from a 19% decline in the S&P 500 as the U.S.’s credit rating was lowered. It is unlikely this large of a decline in emerging market equities will unfold in coming months. However, emerging markets have attracted a huge inflow of money and almost everyone is recommending them.

Emerging economies are expected to grow faster than advanced economies in coming years, and no doubt they will. The risk is that a slowdown in China could curtail some of the rampant enthusiasm for emerging market stocks and lead to a quick shakeout of 10% in EEM from its recent high of $42.00 (black horizontal trend line on chart).

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The Dollar has declined 7% since peaking in January, which has provided a nice tailwind for EM currencies and EM equities.

The Dollar’s tailwind could become a headwind soon. The decline in the Dollar has dampened bullish sentiment so much so that it’s hard to find anyone who thinks the Dollar could rally. Technically, the Dollar is oversold and the recent price low was not confirmed by the Dollar’s RSI. This divergence suggests selling pressure in the Dollar has begun to wane, which is often a precursor to a rally. Over the next few months, the Dollar has the potential to recoup 3% to 4% of the 7% decline since January. In the May 22 Weekly Technical Review I thought the dollar had more downside. “The Dollar broke down on May 16 and could drop to 96.38. That is where the current decline would equal the initial decline of 4.96 points from the January high of 103.82 to 98.86." The dollar traded as low as 96.45 on June 7 before reversing higher, so the odds favor that the expected trading low in the dollar is in place. The majority of EM currencies are likely to pull back, which might provide another reason for a correction in emerging market equities.

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The European Central Bank (ECB) met on June 8 and decided to leave policy unchanged, so the ECB will continue its $60 billion in monthly purchases of European bonds. The ECB’s balance sheet will continue to expand which will continue to keep sovereign bond yields low throughout Europe.

This is important since one of the factors that are likely to trigger higher Treasury bond yields in the U.S. is an increase in European bond yields. Specifically, if the yield on the 10-year German Bund closes above 0.50%, the Bund yield could quickly rise to 0.9% to 1.0%. An increase of this magnitude would certainly cause Treasury yields to rise. A decision by the ECB to reduce the amount of its monthly bond purchases could be a trigger for yields to rise throughout Europe. A decision to reduce the ECB’s Quantitative Easing program may not occur until the fourth quarter based on Mario Draghi’s assessment:

“We need to be patient. A very substantial degree of stimulus is still needed."

Reinforcing Draghi’s view is the recent decline in inflation from near the ECB’s target of 2.0% to 1.4% in April. The ECB also cut its forecast for future inflation to 1.5% in 2017, 1.3% in 2018, and 1.6% in 2019. The core rate of inflation was only .9% in April. Although bank lending to businesses and households is up just over 2% and improving, it is way below the levels of lending in 2007. In 2007, bank lending to businesses was growing close to 15% and household lending was up more than 8%.

First quarter year over year GDP was revised up from 1.7% to 1.9%, and quarterly annualized GDP to 2.3% from 2.1%. Equity markets throughout Europe have outperformed the S&P 500, especially after the French election proved a non-event. With the economy improving, elections in the Netherlands and France in the rear view mirror, investor confidence has soared.

The Euro Area Sentix Investor Confidence index rose to its highest level since 2007. As an avowed contrarian, I view this as an indication that European equity markets are vulnerable to a 4% to 7% correction soon.

The decline in the Dollar has been a boon to the Euro, which has rallied from a January low of 1.043 to a high of almost 1.130 again of 8.2%. This rally has not gone unnoticed by currency traders. In January, as the Euro was making its low, large speculators had a fairly large short position in anticipation of the Euro declining further. As the Euro rallied, large speculators were forced to cut losses on their short position by buying Euros. Their buying and buying spurred by the improving European economy and the elections going well, is why the Euro has rallied more than 8% versus the dollar in less than 6 months.

Large speculators are now holding their largest long position since 2014 and 2011. Since large speculators are trend followers, they are usually caught being too long at tops and too short at bottoms. After peaking in May 2014, the Euro dropped 25.2% by March 2015. After peaking in May 2011, the Euro subsequently fell 19.4% before bottoming in July 2012. History suggests the Euro could be vulnerable to a meaningful correction in the next six to twelve months at a minimum.

A decline in the Euro could be a trigger for international investors to take profits in European equity markets, since European equities have performed better than the S&P 500 so far in 2017.

European stocks have been trumpeted as being cheaper than U.S. stocks, which are seen as being expensive. This story line received even more traction after European GDP was up 2.0% in the first quarter compared to only 1.2% in the U.S. According to MSCI, as of June 1 the forward Price/Earnings ratio for U.S. stocks was 17.8 and 14.6 for European equities.

The MSCI EMU index covers 85% of the large and midcap stocks in 10 European countries. Based on this metric European equities appear to be selling at an 18% discount to the U.S.

The valuation thesis has been touted as a primary reason why financial advisors and investors have been told to overweight their allocation to European equities. This discount may not be as large as it appears based on historical valuations.

The average discount since Thomson Reuters IBES data began in the mid 1980’s has been 2 points to the U.S.’s price/earnings ratio. There have been good reasons for this discount over time. Although the EU’s GDP was up more in the first quarter, during the last 5, 10, and 15 years, average GDP growth in the EU has been slower than in the U.S.

Labor laws in the EU are far more stringent and make it far more difficult for companies to lay off workers. Labor flexibility in the U.S. makes it far easier for U.S. companies to respond quickly to changing economic conditions.

Part of the current discount in the EMU index is due to European banks which are still not as strong as banks in the U.S. In total, EU banks have almost $1 trillion in nonperforming loans with more than $300 billion concentrated in Italian banks. If the current discount is adjusted for the historical 2 point discount in the P/E ratio for European stocks, the 18% discount compared to U.S. stocks shrinks to 6.7%. After the Euro peaked in 2011, European stocks fell 33%, exacerbated by the 19% fall in the S&P 500, and by more than 15% after the Euro peak in 2014. In the current environment, a decline of 7% to 10% seems reasonable.

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