Financial Review

Dark Clouds

Sinclair Noe — January 12, 2016

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DOW + 117 = 16,516
SPX + 15 = 4658
NAS + 47 = 4685
10 Y – .06 = 2.10%
OIL – .67 = 30.74
GOLD – 7.70  = 1087.50

The recent sell-off on Wall Street has some of the investment banks worried. For the past 7 years, JPMorgan Chase has seen every dip in the market as a buying opportunity. Now they are changing their tune and advising clients to sell any rally. A report from JPMorgan’s chief equity strategist cites several areas that are raising red flags, including: deteriorating technical indicators, expectations of anemic corporate earnings combined with the downward trajectory in U.S. manufacturing activity and a continued weakness in commodities, with oil dropping under $20 a barrel.

RBS, the Royal Bank of Scotland, says investors face a “cataclysmic year” where stock markets could fall by up to 20% and oil could slip as low as $10 a barrel. In a note to its clients the bank said: “Sell everything except high quality bonds. This is about return of capital, not return on capital. In a crowded hall, exit doors are small.” It said the current situation was reminiscent of 2008, when the collapse of the Lehman Brothers investment bank led to the global financial crisis. This time China could be the crisis point.

Goldman Sachs is warning that global stock markets may get worse. They remain neutral on stocks for now, but any further drops would create opportunities to invest. They prefer Europe to the US stock market because the European Central Bank is supporting the economy, and that’s poised to help the region’s companies to possibly achieve single digit earnings growth.

Standard & Poor’s says the outlook for corporate borrowers worldwide is the worst since the global financial crisis. The proportion of issuers facing a potential downgrade at the ratings company surpasses possible upgrades by the most since 2009. The gap also widened the most since the financial crisis in the past six months, S&P said. The corporate-debt outlook has darkened because of slower growth in China and a commodity rout that’s cut prices to the lowest since 1999. The slump has also driven corporate defaults to the highest since 2009.  S&P says there may be “significantly” more ratings downgrades than upgrades in 2016.

Lehmann, Livian, Fridson Advisors says the junk bond market is indicating a 44% chance of recession in the US within one year. They say, they aren’t making a forecast, just analysis of junk bond spreads over treasuries, now at 7.4%, which is not at recessionary levels of 10.19%, but indicates a 44% probability of recession. Jeffrey Gundlach, the co-founder of Doubleline Capital, sees a one-third chance of recession this year. Citigroup analysts say spread levels on the Markit CDX North America High Yield Index are pricing in an expected loss of 21.2 percent over a five-year period.

Now, that is a lot of negativity coming from the strategists and the big investment banks. You might expect at least some artificial optimism when the president of the Dallas Fed talks about oil. You’d expect some droplets of hope for that crucial industry in Texas. But when Dallas Fed President Robert Kaplan spoke on Monday, there was none, not for 2016, and most likely not for 2017 either, and maybe not even for 2018.

The wide-ranging speech included a blunt section on oil, the dismal future of the price of oil, the global and US causes for its continued collapse, and what it might mean for the Texas oil industry: “more bankruptcies, mergers and restructurings….”

But does all this negativity really mean the markets are collapsing, or is it a contrarian indicator? Is this a replay of last August, when we saw a nasty pullback, followed by a quick recovery, or is this the beginning of a recession that could drag down the markets and the economy? Of course we do not know, and the analysts do not know. What we do know is that there are risks in this market and those risks appear to be underpriced; on the flip side, these risks are now being identified. Another thing we know is that the Dow and the S&P are both trading below their 50 day and 200 day moving averages, so a downtrend is in place, at least for the moment.

We can also see what the analysts are seeing whenever we fill up the car. The price of oil is down 79% from the 20-year high hit in July 2008 at $145.29 which created record gasoline prices at the pump. Oil prices dropped under $30 a barrel today for the first time since 2003, dropping below a critical level of support: $30.28 a barrel, the financial crisis closing low on Tuesday, December 23, 2008.

The companies in the Standard & Poor’s 500 energy sector are expected to lose a collective $28.8 billion this calendar year, down from $95.4 billion in net income earned during 2008.  The analysis includes only the 36 S&P 500 energy companies that reported net income in 2008.

Take the situation at the S&P’s 500 biggest energy company, Exxon Mobil. The company is expected to report net income of $16.3 billion in calendar 2015, that’s down 64% from the $45.2 billion the company reported as net income in 2008. Still, it is a profit. Shares of Chesapeake Energy, an oil explorer, has seen its shares drop 94% from the day oil peaked back in 2008. The company is expected to post a loss of $13.1 billion for 2015, down from the $604 million profit it made in 2008. Or BP, which today announced it was cutting 4,000 jobs. An estimated 250,000 oil industry jobs have been lost worldwide since the price decline began.

Of course, you could just sell or avoid the energy sector, but the problem there is that some of these oil companies will default; not Exxon, but some of the smaller players. The defaults could be a big problem for the junk bond market; the junk bond market could be a big problem for the banks; the banks are always a problem; not just because they probably have a few bad bets on the oil patch, but because they leverage those bets with trillions of dollars of derivatives.

But just avoiding the oilpatch might not be enough; according to Bank of America’s High Yield credit strategist “on an unadjusted basis non-commodity earnings growth has been negative 2 of the last 4 quarters, representing the worst 4 quarter average earnings growth in a non-recessionary period since late 2000.”

The fourth quarter earnings reporting season is underway. Yesterday Alcoa kicked off earnings season, posting better than expected earnings and worse than expected revenue. Today Alcoa dropped just over 9%, to a 7-year low. Alcoa is down 28% over the past 9 sessions.

CSX reported after the closing bell today; the number 3 US railroad reported a lower quarterly net profit citing a drop in freight volumes, especially a 32 percent decline in the amount of coal hauled. Fourth-quarter net income was $466 million or 48 cents per share, 2 cents better than estimates, but down from $491 million or 49 cents per share a year earlier.

Still to come this week are Intel, JPMorgan, Wells Fargo, and Citigroup, among others.

The Labor Department’s Job Openings and Labor Turnover Survey, also known as the JOLT survey, showed 5.43 million job openings, up from 5.34 million in October. That’s still shy of the all-time high notched earlier in the year, but moving in the right direction. Even better, hires rose to 5.2 million from 5.17 million, and more people, 2.83 million, quit. That’s a sign of worker confidence in their job prospects.

The National Federation of Independent Business reported that its small-business optimism index edged up 0.4 points to a reading of 95.2. The readings have ranged between 94.1 and 98 in 2015. The percentage of small-business owners who expect real sales to improve rose by 9%, while those who expect better business conditions in the next six months slumped by 7%, which seems to be a contradiction.

The International Monetary Fund’s managing director Christine Lagarde says the Federal Reserve should wait to hike rates again until they see “clear evidence of firmer wage or price pressures.” Well, that didn’t stop the Fed in December… so. The Fed’s official inflation target, the PCE price index, rose at just 0.4% 12-month rate in November, well below the 2% official target.

Private-equity firm Apollo Global Management is said to be in advanced talks to buy Apollo Education (no relation) for about $1 billion. Apollo Education, operator of the for-profit University of Phoenix, had been in talks with a number of firms over a control-changing purchase.

McDonald’s could face pressure from the European Union after consumer groups in Italy filed fresh complaints. The company is accused of charging franchisees rents at excessive levels above market rates. McDonald’s is already one of the targets of an EU investigation into its tax arrangement with Luxembourg.

Last call for Internet Explorer.  Effective today, Microsoft has officially stopped supporting older versions of the web browser to encourage users to migrate to its new browser, Edge, instead. That could cause security and other issues for some companies.

The Powerball jackpot is now up to $1.5 billion, maybe more by tomorrow night’s drawing. If you take the lump sum and pay taxes, you would only get about one-third that amount, but don’t worry because you are not going to win. Probably. Your six numbers will not match, and your finances will stay put, minus $2. Most likely. Sorry. And good luck.

Financial Review

Underwater

Sinclair Noe — June 12, 2015

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DOW – 140 = 17,898
SPX – 14 = 2094
NAS – 31 = 5051
10 YR YLD +. 01 = 2.39%
OIL – .74 = 60.03
GOLD – .70 = 1182.30
SILV – .07 = 16.06

The Trans Pacific Partnership trade deal hit a major roadblock today. The House rejected a key part of a package to fast-track the trade deal. The House voted today on two measures, both of which had to pass in order to send the legislation, which was already approved by the Senate, to the president. A bill to give the president fast-track authority to negotiate future trade deals was approved by a 219-211 vote. But another measure regarding funds to retrain workers failed, 126 to 302. Because the Senate had approved both measures, the failure of the retraining program prevented the package from advancing. The measure would give the Obama administration the ability to wrap up negotiations on the Trans-Pacific Partnership, a free-trade deal years in the making, and present a final agreement to Congress for expedited consideration and an up-or-down vote with no amendments.

In one of the more unusual coalitions of the Obama administration, the trade agenda found strong support with Republicans, while Democrats ended up blocking the measure. Democrats had repeatedly asked for the administration to make the trade deals public before seeking the fast-track power. Democrats also complained that the fast-track measure fails to protect workers, environmental standards and financial regulations, and does nothing to stop unfair currency manipulation. The failure does not necessarily mean an end to the battle. House Speaker John Boehner can bring the measures back if he can find a way to whip up more support.

New information reveals that more personnel records were hacked than previously reported during the federal cyber theft in December. Already considered one of the largest thefts of US government personnel data in history, investigators now estimate that it may include data on as many as 14 million people, more than triple the 4 million current and former government employees reported by the Office of Personnel Management last week. Officials are now weighing responses ranging from counter-intelligence initiatives to destroying the data in the intruders’ servers.

The producer price index increased 0.5 percent in May, the biggest one-month increase since September 2012. Prices at the wholesale level were pushed higher by a sharp jump in the cost of gasoline and a record increase in the price of eggs because of the avian flu. Core prices, which exclude energy and food, rose just 0.1 percent in May. Even with the advance in May, producer prices over the past 12 months are 1.1% lower.

Consumer confidence rose more than forecast in June. The University of Michigan preliminary consumer sentiment index increased to 94.6, from a final reading of 90.7 in May that was the lowest in six months. Consistent gains in the labor market are cited as a major reason for increased confidence, and likely helped underpin household spending, reflected in yesterday retail sales report which showed sales increased 1.2 percent last month.

Yesterday, there were reports that Greece might be nearing a deal on its debt problems. Then late yesterday the International Monetary Fund recalled its negotiating team from talks in Brussels, which might signal doom for any resolution. In response, Greece ruled out cutting pensions and demanded a debt restructuring. So, the battle lines are drawn, or redrawn, and next week EU officials will meet again in Luxembourg for a likely showdown, or it might be part of the game of chicken that both sides seem to be playing. The Greek tragedy could drag out for quite some time or it could come to a head at almost any time, and if a resolution is not found, there will almost certainly be a domino effect.

More bad news from the Eurozone today; Standard & Poor’s says Britain’s “economic policymaking could be at risk of being more exposed to party politics than we had previously anticipated.” The Credit rating agency says it is “similar to the situation in the U.S. in 2011.” Not exactly. The situation in Britain deals with a possible referendum vote on leaving the European Union in 2017. S&P lowered the outlook on the Britain’s AAA rating to “negative” from “stable.” That means there’s a one-in-three chance of a downgrade in the next two years. In its analysis, S&P said that PM Cameron’s pledge for a vote, made to placate elements of his Conservative Party, “represents a risk to growth prospects” for U.K. financial services, exports and the economy as a whole.

The number of borrowers who owe more on their home than it’s worth is falling, but there are still a number of borrowers who are deeply underwater. Zillow released its 2015 Q1 Negative Equity Report, which showed that negative equity fell in the first quarter of 2015 to 15.4% from 16.9% in the fourth quarter of 2014, and 18.8% during the same time period a year ago; negative equity peaked nationally at 31.4% in the first quarter of 2012. The rate of negative equity improved in all of the 35 largest housing markets in the first quarter of 2015. The rate of underwater homeowners is much higher among the homes with the least value. More than 25% of those who own the least valuable third of homes were upside down, compared to about 8% of the most valuable third of homes.

At the peak of the crisis, more than 15 million homeowners owed more on their mortgages than their homes were worth. Since then, foreclosures, short sales and rapidly rising home values freed nearly half of those homeowners, leaving 7.9 million homeowners upside down at the end of the first quarter; of those that are still underwater, over half or about 4 million owners, still owe 20% more than the value of their home, making it difficult for them to get out from under their mortgage.

For Phoenix, the negative equity rate in the first quarter was 19%, which works out to almost 147,000 homes in negative equity, and 56% of those owners were underwater by more than 20%. And 12.9% of underwater homeowners in Phoenix owe more than twice their home’s value to the bank. While home prices in Phoenix have recovered, according to Zillow valuations, prices are still down 26.9% from the peak.

Actually, it’s worse than that. Realistically, a homeowner needs roughly 20 percent equity in their home to afford the taxes and fees associated with listing and selling it and still have enough left over to afford a reasonable down payment on another home. When including these homeowners with less than 20 percent equity in their home, the national “effective” negative equity rate is 33 percent. Put another way, a third of all homeowners with a mortgage don’t have enough equity to list their home for sale and buy another. And while it’s great that the level of negative equity is falling, there are still so many homeowners underwater that it will likely be years before we get back to more normal levels of around 2% negative equity; and while we wait, many homeowners are stuck in their homes.

Next week the Federal Reserve FOMC will meet to determine monetary policy. No change is expected, although we will watch for any hint about when they plan to hike rates in the future. Also next week, the Fed will publish new quarterly forecasts, and all eyes are going to be on where they set the natural rate of employment; that’s the level of employment that is just strong enough to lift the economy without setting inflation on fire. Many people think the natural unemployment rate is about 5%. The current unemployment rate is 5.5%; so we are close. A new paper by Fed board staff shakes up this view by suggesting the number could be as low as 4.3%; the reason being that wages have not been keeping pace with hiring.

The bigger news next week will be Thursday, when Pope Francis will publish his much anticipated encyclical on the environment and climate change. An encyclical is a letter to followers, about 1.3 billion in this case.

An encyclical is not a scientific document, rather one that explores a particular issue in the light of Catholic social teaching. Yet the Pontifical Academy of Science has thoroughly investigated the research, producing its own documents on topics such as glacier retreat, and it is clear that we must take on board what the science is telling us. Francis will not approach the issue of ecology as a scientist (though he is a trained chemist) or as a politician (though he clearly has excellent political instincts). Rather, he will address his flock as a pastor, a teacher, theologian and spiritual guide. He will remind us that Creation is a gift from God, and that we have a moral responsibility to be responsible stewards. Creation in this instance means more than the ground we walk on and the air we breathe. It also means all of humanity, including the poorest, who are also the most vulnerable to climate change.

By tying climate action to the Christian mandate to aid the afflicted and give comfort to the needy, Pope Francis will be doing much more than merely acknowledging the severity of the problem. By virtue of his moral authority, the pope has the singular ability to mobilize people all over the globe to take whatever form of action they can. No other figure of our time can claim that degree of influence. The climate change narrative is about to change; no longer a debate about science or business; now it will be a moral issue, a religious issue; a simple matter or right or wrong. And with Pope Francis leading the charge, the climate change deniers and fossil fuel apologists will soon realize they haven’t got a prayer.

Tuesday, August 05, 2014 - Go Firgure

Financial Review with Sinclair Noe

DOW – 139 = 16,429
SPX – 18 = 1920
NAS – 31 = 4352
10 YR YLD - .01 = 2.48%
OIL - .86 = 97.43
GOLD + .40 = 1289.60
SILV - .39 = 19.84

We start with a couple of economic reports: The Institute for Supply Management’s services index rose to 58.7 last month, the highest level since December 2005, from 56.0 in June. A reading above 50 indicates expansion. Orders jumped to a 9 year high. A sub-index gauging services industry employment also rose as did order backlogs, but export order growth moderated.

In a separate report, the Commerce Department said orders for manufactured goods increased 1.1% in June, more than reversing May's 0.6% decline. Orders for non-defense capital goods excluding aircraft hit a record high; this might indicate a renewal in business confidence and equipment spending plans. Factory orders rose across all categories, with bookings for electrical equipment, appliances and components recording their largest gain since November 2010. In another sign of strength, unfilled orders saw their largest rise in seven months.

So, a couple of good reports on the economy, and the stock market tumbles. Go figure.

The situation in Ukraine appears headed to a tipping point. Ukrainian forces have been pushing back against Russian backed separatists in eastern Ukraine. Meanwhile, Russia is massing troops on the border. Some 20,000 troops are now stationed about 50 kilometers from the border, closer than they had been stationed previously. In April, Russian President Vladimir Putin had briefly deployed about 40,000 troops at the border. The latest troops include Russian Elite forces, armored brigades, artillery and anti-aircraft units. Poland’s foreign minister thinks Russia is preparing to invade Ukraine; he didn’t flat out say an invasion was imminent, just that the Russians are getting ready.

Putin has ordered his government to prepare retaliatory measures against US and European economic sanctions imposed on Russia. We don’t know what Putin means by retaliatory measures. Russia may limit or ban flights over Siberia by European carriers bound for Asia as a response to sanctions levied against the country. Russia has also called for the UN Security Council to hold an emergency meeting on the humanitarian situation in Ukraine. It isn’t a humanitarian situation when the pro-Russian rebels shoot a plane full of civilians out of the sky, but it is a humanitarian situation when the rebels start getting their butts kicked.

One thing that hasn’t happened yet is a disruption in oil and gas supplies from Russia to Europe. Russia derives half its tax revenue from the oil sector; Europe relies on Russian supplies. As the weather changes and winter sets in, Europe’s resolve, which has already been soft, will weaken further. For now, energy prices are moving lower, despite violence in Eastern Europe, Libya, and Iraq. Global oil demand has been running below supply over the last few months, building up a glut of high quality crude oil in the West African, European and Asian markets. The US Energy Information Administration reported last week that gasoline supplies rose by 400,000 barrels at a time when market bulls hoped to see a reduction. Oil prices are at their lowest levels since February.

Yesterday we told you about the collapse of Portugal’s Banco Espirito Santo; today we report on the fallout. The French bank Credit Agricole held a 14% stake in Banco Espirito Santo and two seats on its board. Crédit Agricole's ties to the Portuguese group go back to 1986 when it helped the Espírito Santo Group set up Banco Internacional de Crédito. Over the years, the French bank raised its stake in the Portuguese group, as part of a larger international expansion plan in southern Europe.The French bankers say they never detected any “slip or difficulties” at Banco Espirito Santo. The collapse of the Portuguese bank nearly wiped out all the second quarter profits at the French bank.

Standard& Poors today announced that it was dropping its 10-year estimate of annual GDP growth in the US from 2.8% to 2.5%, which over a decade amounts to a pretty significant reduction. Why are they cutting the growth forecast? Here’s what S&P says: "Our review of the data, as well as a wealth of research on this matter, leads us to conclude that the current level of income inequality in the U.S. is dampening GDP growth, at a time when the world's biggest economy is struggling to recover from the Great Recession and the government is in need of funds to support an aging population... At extreme levels, income inequality can harm sustained economic growth over long periods. The U.S. is approaching that threshold...."

S&P analysts say it basically boils down to the idea that high levels of income inequality cause more affluent households to save more of their increasing income rather than spend it, and as that cash is withdrawn the economy slows. At the other end of the economic scale, as income declines, households go into debt to try to maintain their standard of living, a strategy that is simply unsustainable over time. And when the unsustainable ceases to be sustained, you get a breakdown, much like that of 2008. In fact, S&P notes, as income inequality increases, an economic system becomes more and more vulnerable to a boom-and-bust cycle. It cites research demonstrating that income distribution plays a much more important role in sustaining long-term economic growth than any other factor.

Although the issue of income inequality is often addressed in moral terms, S&P concludes, at its foundation it is really an economic issue, saying: "A rising tide lifts all boats … but a lifeboat carrying a few, surrounded by many treading water, risks capsizing."

Earnings reporting season:

Retailer Target cut its second quarter earnings estimates due to higher promotions and more discounting; they also lost about $148 million related to that data breach, where hackers gained access to customer credit card info; that’s a small number compared to total sales at Target, but it apparently proved a costly distraction. Morgan Stanley reduced its second quarter earnings by 2 cents per share due to increased legal settlements. Disney posted better than expected earnings; shares moved just a smidge higher in after-hours trading. Cablevision cut back on its promotions and subscriber losses doubled in the second quarter. First Solar posted profits that missed estimates by a wide margin; they blamed project delays. Groupon fell in after-hours trading after posting a second quarter loss nearly triple the loss from a year ago. Zillow announced a second quarter loss, even as revenue increased; and they raised their full year revenue outlook. This was Zillow’s first quarterly report since they announced a $3.5 billion deal to acquire rival Trulia.

Time Warner and Fox both report earnings tomorrow, but the big news came today. Fox withdrew its offer for Time Warner. Game over. When Fox made the hostile bid, its stock dropped and Time’s stock soared; meanwhile Time’s board and management opposed the takeover and refused to discuss the offer. Now that Murdoch has dangled a huge windfall in front of Time Warner shareholders, only to take it away, one imagines that some of those shareholders may soon be venting their frustration to Time Warner's board and management.

Several America corporations have found a loophole in the tax code, which allows for a company to acquire a partial interest in a foreign company, and then change the address of its headquarters in order to evade US taxes; it’s called an inversion. There have been 22 such deals since 2011, most have been in the pharmaceutical industry, where overseas sales generate significant income that cannot be brought back to the US without suffering a major tax hit; but there have also been inversion deals in the media, consumer and manufacturing sectors. Some of those deals have collapsed, amid disputes over price and political scrutiny.

Walgreens was next on the list; closing in on a deal to buy the 55% of British pharmacy retailer, Alliance Boots; Walgreens already owns 45% of Alliance Boots. Walgreens will buy out Alliance Boots, but it won’t move its corporate headquarters abroad and it will not change its corporate citizenship to a lower tax country. They say they won’t do the inversion move because they would have had to renegotiate an existing agreement, and Alliance Boots wasn’t willing. There may also have been some political pressure.  President Obama has denounced tax inversions as unpatriotic and has urged Congress to stop them; which is like asking a Kleenex to stop a freight train. So, now the Treasury Department says there may be an executive order to provide a partial administrative fix, you know, until Congress gets back from its 5 week vacation.

As Ebola spreads, pharmaceutical giants are sitting this one out. That's mainly because treating a disease that affects a relatively small number of people who typically don’t have a lot of money doesn’t offer a great return on investment. It's unclear how much profit it would take to get Big Pharma interested in finding an Ebola cure, but right now such a project could well be a money-loser. Instead, small biotech firms, academics and government agencies are leading the search for an Ebola cure. And in a twist of fate, they may have found a way to treat the virus: tobacco.

A tiny San Diego-based company provided an experimental Ebola treatment for two Americans infected with the deadly virus in Liberia. The biotechnology drug, produced with tobacco plants, appears to be working. Mapp Biopharmaceutical produced an experimental drug called ZMapp, an antibody that had been tested only on infected animals; now it’s been given to human patients, and it seems to make a big difference. The antibody work came out of research projects funded more than a decade ago by the U.S. Army to develop treatments and vaccines against potential bio-warfare agents, such as the Ebola virus.

The tobacco plant production system was developed because it was a method that could produce antibodies rapidly in the event of an emergency. To produce therapeutic proteins inside a tobacco plant, genes for the desired antibodies are fused to genes for a natural tobacco virus. The tobacco plants are then infected with this new artificial virus. The infection results in the production of antibodies inside the plant. The plant is eventually ground up and the antibody is extracted. The whole process takes a matter of weeks.