FINANCIAL REVIEW

Work Hard and Invest in the Future

Sinclair Noe — November 17, 2014

DOW + 13 = 17,647
SPX + 1 = 2041
NAS – 17 = 4671
10 YR YLD + .02 = 2.34%
OIL – .37 = 75.45
GOLD – 2.00 = 1187.50
SILV – .18 = 16.24

Another day, another record on Wall Street. A record high close for the S&P 500. The Dow did not close above Thursday’s record close of 17,652.

The Dow Transports were down today, but Transportation stocks are the best performing names on the market over the past month. Since the market bottomed out on October 13th, the Dow Jones Transportation Average has soared an incredible 18%. So if you thought the S&P’s furious 11% rally has been a sight to behold, you clearly weren’t paying attention to the soaring plane, train and trucks.

Another Merger Monday; Halliburton agreed to buy Baker Hughes for about $34 billion. Actavis agreed to buy Allergan for $66 billion.

The Halliburton acquisition of Baker Hughes will unite 2 major oilfield services companies. Halliburton and Baker Hughes began discussions in mid-October; an interesting time as oil prices were falling, raising questions about the viability of expanding oil and gas exploration and development. The acquisition was on again, off again, and briefly turned hostile last week. The deal could still face regulatory scrutiny, even though Schlumberger is still the largest oilfield services company, bigger than a combined Halliburton/Baker Hughes. Halliburton has agreed to sell off businesses that generate up to $7.5 billion in revenue to appease the federal government.

Low oil prices tend to trigger consolidation, mainly because the big oil companies do not believe low oil prices will last, so they consider acquisitions as value plays. Buyers with cash to spend aren’t going to let the cheapest valuations in years pass them by and targets threatened by lower prices may become more willing sellers. So, the speculation ramped up with today’s announcement. Possible deals include General Electric going after National Oilwell Varco, and there is even speculation that someone might target BP. Some potential smaller targets include Oasis Petroleum, Pioneer Natural Resources, and Laredo Petroleum.

Allergan has agreed to sell to Actavis. The $66 billion deal, or $219 per share in cash and stock, ends months of speculation about a possible hostile takeover led by activist investor Bill Ackman, who had been working with Valeant Pharmaceuticals to court the Botox manufacturer. So, the Actavis deal would be the largest of the year; bigger than the $45 billion proposed acquisition of Time Warner Cable by Comcast; bigger than AT&T’s $48 billion purchase of DirecTV; and the third largest health care deal ever in the US. Combining Actavis and Allergan will create one of the 10 largest global drug makers, with about $23 billion in revenues expected next year.

Actavis was until recently based in Parsippany, N.J. But last year it agreed to acquire an Irish drug maker, Warner Chilcott, and relocate its headquarters abroad, striking one of the first big tax inversions. Actavis’s deal to move abroad and reduce its tax bill caught the attention of other drug companies, and set off a rush of similar deals. In September, the Treasury passed new rules to make it harder for companies to use inversions to skip town on taxes. But Actavis is like the cow that got out before the barn door was closed; Actavis completed its move overseas and is exempt from new inversion rules.

In economic news, industrial production fell a seasonally adjusted 0.1% in October, a bigger than expected drop and the second drop in the last three months. In October, manufacturing output rose 0.2%, but mining output dropped 0.9% and utilities output fell 0.7%. Capacity utilization fell to 78.9%. Oil and gas well drilling fell 0.8% in October, the first decline since February. Despite the drop, industrial production is up 4% over the last 12 months. Based on the recent weakness in manufacturing it is estimated that fourth quarter GDP may be running at about a 2% annual pace, down from 3.5% in the third quarter.
Separately, the Federal Reserve Bank of New York reported its Empire State manufacturing index rebounded a bit to 10.2 in November from 6.2 in October. The index had been up to 27.5 in September, so the readings over the last two months indicate a downshift in activity.

Last week was light on economic data; this week the big story will be Wednesday as the Federal Reserve FOMC releases minutes of the October 28-29 FOMC meeting, which was the meeting that ended Quantitative Easing 3. The minutes will be parsed for clues on labor markets, global weakness, a stronger dollar, and the inflation-deflation debate.

This week’s economic calendar will also include reports on homebuilders’ sentiment and home sales. Tomorrow we’ll look at inflation on the wholesale level with the Producer Price index. Lower oil prices will likely play a big role in tomorrow’s report. Wholesale gasoline prices were down 11% in October, which could knock 0.6 to 0.8 percentage points from the headline inflation number. In September, weakness in miscellaneous service prices drove a 0.1% decline. The Consumer Price Index, which measures inflation at the retail level, will be released on Thursday, and again energy prices will be an important component. Best guess is that inflation is running at a 1.8% annualized rate according to the CPI.

The general feeling seems to be that oil prices will rise. OPEC holds a meeting November 27 in Austria, and there will certainly be discussion about cutting production and supply. A decrease in global demand and the boom in US shale have pushed prices down more than 25% since June, but OPEC’s 12 member countries are not unanimous on production cuts. Last week, Kuwait’s oil minister said he didn’t think there would be a reduction in output. Over the weekend, Kuwait’s cabinet and Supreme Petroleum Council held a meeting to consider options to halt the slide in prices. It’s a sign the nation is becoming increasingly concerned. The Saudis have said they could live with lower prices, and they don’t want to lose market share if they do agree to a cut, so they won’t try to cut back production on their own, but if other nations agree to a production cut, the Saudis will probably go along.

Another question OPEC will have to consider is global demand, specifically in light of the economic weakness in Europe, announced last week and the news from Japan today. Japan Is In Recession. Unexpectedly poor GDP data confirmed Japan has been in recession, with a 1.6% rate of contraction in the third quarter when a 2.2% rate of growth was expected; this followed a 7.3% rate of decline in second quarter.

The Central Bank of Japan and Prime Minister Shinzo Abe has thrown everything but the kitchen sink at the Japanese economy. The problem is that certain parts of the government got worried, and decided they could not live with the debt, and they needed to raise taxes, which turned out to be a terrible idea. Japan was expected to hike tax rates for the second time this year. Given that the first tax hike has been blamed for this year’s economic woes that second hike is likely to be delayed. And it is now recognized that a Valued Added Tax, or VAT increase was the cause of the recession. Japan also tipped into a recession after a 1997 consumption-levy rise, leading to the fall of the government of the day. Today’s report comes two days before the Bank of Japan’s next policy meeting. Governor Haruhiko Kuroda last month led a divided board to expand what was already an unprecedentedly large monetary-stimulus program.

The unexpected shrinkage of the Japanese economy sent Japan’s major stock index, the Nikkei, tumbling 2.9%. The yen tumbled to a 117.05 per dollar, the lowest level since October 2007. Markets were down in Europe, and it was expected US markets would tumble on the news, but it didn’t really happen.

This is the sixth time in the past 20 years that Japan has dropped into recession and you might think there are a few things we could learn from the Japanese experiment. First, Japan’s famously stagnant economy may not be all that unique, and if it can happen to Japan, it can happen anywhere.

When the asset-price bubble first burst in Japan in the early 1990s, they did not pursue an aggressive fiscal stimulus program and they did not force banks to quickly recognize losses and recapitalize. Instead, Japan’s ill-timed effort to balance its budget with a consumption-tax increase in 1997 sent the economy into recession, and a paralyzed banking sector contributed to an extended period of stagnation that has done much more to worsen the debt burden than well-targeted government spending would have.

Japan’s problems in the 1990s look a lot like the problems facing the Eurozone today: undercapitalized banks, lethargic business lending, and rolling recessions that turn into extended periods of stagnation.

By the way, the 2-day summit of the G-20 wrapped up in Australia, and like most G-20 meetings, it was not very productive. It will likely be remembered for Vlad Putin’s boorish behavior, but there were a few things that might count as accomplishments. The G-20 managed to sign off on anti-tax-evasion measures and on anti-corruption guidelines. One of the biggest accomplishments might be agreement by leaders to boost their economies by a collective $2 trillion by 2018. IMF Managing Director Christine Lagarde told the leaders that in order to avoid the “new mediocre” of low growth, low inflation, high unemployment and high debt, all tools should be used at all levels.

The G-20 plan to boost global growth is long on ambition but short on specifics. The mostly structural policy commitments spelled out in each country’s individual growth strategy include China’s plan to accelerate construction of 4G mobile communications networks, a $417 million industry skills fund in Australia and 165,000 affordable homes in the U.K. over four years. So the plan to avoid stagnant economies is to invest in housing, education, and infrastructure. Now, whether any of this comes to pass remains to be seen, but really this economics stuff is pretty simple. Work hard and invest in the future.