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Tuesday, January 26, 2016

Until After the Fact

Financial Review

Until After the Fact

DOW -208 = 15,885
SPX – 29 = 1877
NAS –  72 = 4518
10 Y – .03 = 2.02%
OIL -2.36 = 19.83
GOLD + 11.90 = 1108.90

Stocks in Asia rallied overnight, with the Topix index in Tokyo increasing 1.3 percent, China’s Shanghai Composite Index rising 0.8 percent and the MSCI Asia Pacific Index adding 1.2 percent. Despite gaining in early trading, shares in Europe turned lower. US stocks were down all day, but the selling got worse into the close.

Oil gave up some of its recent gains after Saudi Arabia said it is keeping up investments in energy products and data from China showed that diesel consumption dropped for a fourth consecutive month. Also, Iraq’s oil ministry told Reuters that the country had record output in December, producing as much as 4.13 million barrels a day. A senior Iraqi oil official said separately the country may raise output even further this year. After posting a 21% gain in just 3 days last week, West Texas Intermediate closed down 7.3%.

Following the lifting of economic sanctions and the release of billions of dollars’ worth of frozen Iranian assets, Tehran is ready for business: The country just struck a provisional deal to buy eight A380 superjumbos, while an agreement for 100 more planes from Airbus and Boeing could be completed this week. Over the weekend, China and Iran also mapped out a plan to broaden relations and expand bilateral trade up to $600 billion over the next decade.

Market-based expectations point to a 96 percent chance of the Federal Reserve maintaining rates unchanged at its meeting on Wednesday. In other words, there is also most zero chance of a rate hike, because the Fed knows they can’t surprise the markets right now.

The April FOMC meeting still has about a 30% chance of a rate hike. Investors will be scouring the statement released afterward for hints that the Fed is backing away from its base case of four quarter percentage-point rate increases in 2016.  Roughly $2.5 trillion of stock market value wiped out in the past three weeks could throw the Fed off its course of gradual interest rate hikes.

The dollar has appreciated by some 2 percent since the central bank last met on Dec. 16. Coming on top of a 11 percent increase in the year prior, the latest advance will curb already slowing economic growth and put downward pressure on an inflation rate that the Fed judges is too low as it is. The Fed doesn’t want to appear to kowtow to the markets, so look for the statement to mention something about how the Fed remains “data dependent”.

One year ago, analysts at Bank of America Merrill Lynch drew a parallel between the subprime mortgage crash and the drop in oil prices. Fast-forward to today and the analysts provide an update to their previous thesis. Here’s what they say:

“The pattern of the decline in the price of oil that began in mid-2014 is remarkably similar to the 2007-2009 pattern of the price decline of ABX, the credit derivative index that referenced subprime mortgages and, ultimately, the U.S. housing market. The ABX history suggests that oil will see more declines in the next couple of months and find a floor somewhere in the low 20s in the March-April time frame.

Both the duration of the decline (1.5+ years) and the scale of the decline are similar. Given that both housing and oil prices were fueled to spectacular heights in the two periods by massive credit expansion, it’s probably more than just coincidence that the respective “bubble” bursting patterns are so similar.

“Consider how things tend to work. Denial on what constitutes fair value is a big component of bubbles, on the part of both market participants and policymakers. When perceived “bubbles” burst, markets take their time in steadily shredding views of the perception of fundamental value, as prices move lower and lower. Along the way, many will cite “technical factors” as the cause of the decline, which in some way suggests the price decline may not be real when in fact it is all too real.

In the end, the technicals drive the fundamentals, as credit flees and borrowers go bust, and a feedback loop lower kicks in. Lower prices beget accelerated selling, as asset owners need to raise cash. It could be margin calls or it could be producer selling needs, it doesn’t really matter: the selling becomes inevitable and turns into forced selling.”

The point here is not that oil is necessarily the new subprime per se but that the recent action in the price of crude resembles nothing if not the bursting of a bubble and the sudden realization that the asset has been overvalued for too long.

Meanwhile, the economists at Moody’s Capital Markets Research weigh in; they say, if you want to know where equities are going, look at junk bonds. Specifically, look at the spread in yield between junk bonds and Treasuries. That spread has been widening sharply. And look at the Expected Default Frequency (EDF), a measure of the probability that a company will default over the next 12 months. It has been soaring.

Moody’s Expected Default Frequency began spiking last summer and has nearly doubled since then to 8%, the highest since 2009. The average spread between high-yield bonds and Treasuries has widened to 813 basis points (8.13 percentage points). But at the lower end of the junk-bond spectrum (rated CCC and below), the yield spread is a red-hot 18.4 percentage points.

Here’s why the spread matters: A wider-than 800 basis-point high-yield spread reflects elevated risk aversion that will reduce capital formation and spending by non-investment-grade businesses. In addition, ultra-wide bond yield spreads favor a continuation of equity market volatility that should sap the confidence of businesses and consumers. How bad is it? That’s the scary part, they say we won’t know until after the fact.

California Insurance Commissioner Dave Jones is urging insurers to voluntarily divest from thermal coal, citing the risks of climate change and the danger of losses on assets backing policyholder obligations. California is the sixth-largest insurance marketplace in the world, and this is the first time a state insurance regulator has called for the divestment of such assets. The commissioner is also requiring insurers to annually disclose their carbon-based investments, including holdings in oil, gas and coal.

McDonald’s reported fourth-quarter profit and sales that beat expectations.  US same store sales were up 5.7% in the fourth quarter. Same-store sales across all regions rose 5% from a year earlier. The big reason for the turnaround is that customers are eating up the all-day breakfast menu.

Halliburton reported a fourth-quarter net loss of $28 million, or 3 cents a share, compared with $901 million, or $1.06 share a year earlier. Halliburton also said it expanded its list of assets to sell as it tries to convince antitrust authorities around the world that its purchase of rival Baker Hughes won’t impede competition. The cash and stock deal was valued at $34.6 billion when it was announced near the end of 2014, just as oil prices had begun their downward spiral. Shares of both companies have dropped more than 30 percent since then.

This week’s quarterly earnings announcements will include results from three of the tech sector’s most important companies: Apple reports on Tuesday, Microsoft and Amazon report on Thursday.

Alphabet has agreed to pay $185 million in a back-tax settlement with U.K. authorities, setting off a hostile response from opposition politicians questioning the government’s handling of the case. According to a panel in 2013, Google paid just $16 million in U.K. corporate tax from 2006 to 2011 on $18 billion of revenue. Separately, Apple is facing a European tax investigation that could force the iPhone maker to pay more than $8 billion in back taxes.

Johnson Controls and Tyco International have announced plans to merge, in a deal that values the combined company at $40 billion. Both firms have recently fallen on hard times – Johnson has dropped more than 20% over the past year, while Tyco is down more than 25%. The new company will change its headquarters to Ireland for tax purposes.  Tyco was one of the first big U.S. industrial companies in seeking tax relief by moving its legal residence offshore. The company moved its headquarters to Bermuda from New Hampshire in 2007, then to Switzerland in 2009, and to Ireland in 2014.

Siemens has agreed to buy CD-adapco, a privately held U.S. engineering software firm, for close to $1B in cash. The acquisition comes ahead of Siemens’ annual shareholders meeting on Tuesday.

Twitter CEO Jack Dorsey tweeted late Sunday night that 4 senior Twitter executives are leaving the media company, the biggest leadership changes since Dorsey returned as chief executive as he struggles to revive the company’s growth. Twitter’s stock has fallen nearly 50 percent since Dorsey’s return last year and is now trading below its IPO price.

U.S. health inspectors have found serious deficiencies at Theranos’ northern California laboratory that, if not fixed, could see the lab suspended from the Medicare program. Regulators did not detail the problems, but results of the inspection are expected to be made public soon. The findings could also lead Walgreens to take an even harder look at what remains of its partnership with Theranos.

Takata shares tumbled 10% in Tokyo overnight, hitting their lowest level since 2009, after U.S. regulators said recalls involving the company’s air bags would expand by around 5 million vehicles. Takata executives are also meeting automakers this week to discuss the company’s financial condition, including how to split recall-related costs that could climb into the billions of dollars.

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