Financial Review

Countdown to Liftoff

Sinclair Noe — June 17, 2015

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DOW + 31 = 17,935
SPX + 4 = 2100
NAS + 9 = 5064
10 YR YLD – .01 = 2.31%
OIL – .22 = 59.75
GOLD + 3.60 = 1186.10
SILV + 11 = 16.22

The Fed has wrapped up its June FOMC meeting. No surprises. The economy is getting better, so they say. While the Fed says they have made “considerable progress” toward its goal of maximum employment, “the committee wants to see evidence of some further progress.” They are not hiking rates right now; they will probably hike rates in September, but don’t worry about the exact date because it will be so small and gradual you will hardly notice. That’s the quick version from the Fed.

Further wage and job gains could give Fed officials confidence that inflation, which has lingered below their 2 percent goal for three years, is likely to move higher. Growth is poised to pick up as consumers start spending a windfall from lower gasoline prices, even though that hasn’t happened yet. The economy is likely to expand at a 2.5 percent annual pace in the second quarter after shrinking 0.7 percent in the previous three months. Officials now expect the economy to grow this year between 1.8 percent and 2 percent.

Just a few months ago, in March, they had predicted growth of 2.3 percent to 2.7 percent. The contraction in the first quarter was caused in large part by temporary forces, including unusually severe winter weather and a slump in energy-industry investment brought on by lower oil prices. The Fed is aware of risks overseas, such as the slowdown in China and the danger of a Greek default. The FOMC statement has dropped explicit forward guidance and now they say rate decisions will be data dependent and will be made on a month to month basis.

And so we can conclude from this that the Fed will raise interest rates in September. Based on new economic forecasts we can anticipate two quarter-point rate rises this year but a shallower pace of increases in 2016. They maintained their projection that the benchmark rate would rise to 0.625 percent in 2015, while dropping it to 1.625 percent next year, just a little lower than their March median forecast of 1.875 percent.

The end of free money is in sight. Markets have been feeding from the Fed’s free money trough for about 7 years, and soon that will change. Money will still be cheap but not free. We know that monetary policy has been a key to market performance for the past 7 years; just overlay a chart of the Federal Reserve’s balance sheet on the S&P 500 and it is easy to see the relationship. The Fed’s influence on markets can be measured on a macro level or a micro level. On days when Yellen has spoken to markets, the stock market’s performance has typically been positive. According to analytics firm Kensho, after her last 19 speeches since becoming Fed chair, the S&P was positive 63 percent of the time with an average return of 0.24 percent. On the 10 days when the Yellen Fed issued a post meeting statement, the S&P was higher 60 percent of the time with a return of 0.19 percent. Today, the S&P was up 0.2 percent. So, how will the Fed’s moves affect the markets?

Well, free money has been a boon to debtors, and one of the biggest debtors is the government; as interest rates inch higher the government will have to pay out about $2.8 trillion more in interest over the next 10 years, according to the Congressional Budget Office. Higher interest rates will directly lead to larger budget deficits. One way to reduce the deficit is to bring in more revenue, and the best way to do that is to have more people working. If the Fed were to allow the unemployment rate to fall to 4.0 percent and remain at that level, it would lead to substantially higher tax revenue and reduced payments for unemployment benefits and other transfer programs. The cumulative difference over the 10- year budget horizon is nearly $1.9 trillion. There is still considerable debate about the positive effects of a Zero Interest Rate Policy on unemployment, but working on the idea that easy money results in more jobs, it feels like the Fed is hasty in its desire to raise rates; certainly in terms of demand growth from more workers, plus a boost in wages, plus the positive impact on the federal budget.

But it doesn’t look like the Fed will wait for 4% unemployment; and a Fed rate hike might actually hurt job seekers because a rate hike would result in a stronger dollar. Other central banks are cutting rates and expanding the money supply, weighing down their currencies. The Fed hikes, the dollar appreciates; at least that is the theory. In today’s press conference Yellen said the dollar has largely stabilized, and I suppose you could make that argument for a roller coaster that is no longer at its highest point, but the ride isn’t over just yet. A stronger dollar makes it tougher for companies to sell their goods overseas. A stronger dollar from the rate increase will boost U.S. demand for products from Asia and Europe, helping lift corporate profits in those regions; imports will be cheaper but that helps global stocks, not US multinationals.

But higher rates and a stronger dollar won’t help all global stocks; emerging markets will likely be hurt. The Fed usually gives short change to emerging markets, but they may have reason to fret about something known as “spillback”. The term, coined by the International Monetary Fund, describes the threat to U.S. output from slumping import demand in emerging markets. As the Fed pushes borrowing costs higher, capital could flee developing countries, forcing them to cancel investment and settle for slower growth. That would be the spillover. But a buyers’ strike could rebound on U.S. exports of software, machines and services, undermining domestic recovery. That would be the spillback – and it could be quite significant. If you want strong growth in the US, you need emerging market buyers. Higher borrowing costs in emerging markets and a stronger dollar would further reduce U.S. exports, and the spillback risks of Fed monetary tightening are both real and large enough to cause serious concern.

Banks will like higher interest rates because they’ll be able to profit more from making loans. That, in turn could be bad news for mortgage rates, and by extension, the housing market. The good news on mortgage rates is that the Fed will move slowly, so rates will creep higher, not a quick rise. Insurance companies also like higher interest rates, because they invest customers’ premiums to be able to cover losses with the profits from those investments. If they can realize a higher yield on those investments, that goes directly to profits. Come on, you don’t think they’re going to lower the premiums.

Free money has been a boon for borrowers, and corporations have taken advantage. American corporations issued $757 billion in debt from January through May, a record volume 12 percent higher than during the first five months of last year. Companies have been borrowing at low rates and then buying back their own shares, or paying dividends, or buying up other companies. All that will dry up as the cost of money increases. Fed policymakers have expressed concern that an accommodative monetary policy has encouraged speculation in equity markets. With the prospect of higher rates, they are effectively calling for an end to financial engineering; think of buybacks and M&A as low hanging fruit. The stock market could still go higher but companies are going to have to work harder for their returns.

The Fed’s Zero Interest Rate Policy has been a nightmare for savers. Once upon a time money market funds paid almost 5%; that was 8 years ago. And don’t expect relief from the Fed any time soon. As the Fed begins tightening, yields on all short-term instruments won’t recalibrate higher, at least not soon. Right now, short-term Treasury bill rates are locked in just a smidgen above zero, and demand is strong, in part because financial institutions are required to have a little more of a liquid and safe cushion in the event of problems like 2008. Also, if rates move higher on the longer-maturity instruments, that means losses in price for bond funds or bond ETFs. Bond markets do not respond predictably to interest rate increases. There have only been a handful of tightening cycles in the Fed’s 100-year history, and on the whole, the differences have outweighed the similarities.

And there is concern that changes in financial markets since the crisis have reduced liquidity, or the ability of sellers to find buyers. The International Monetary Fund warned in its Global Financial Stability Report in April that central banks, by pumping money into markets, were concealing the decline of private participation in those markets. They concluded that: “Markets could be increasingly susceptible to episodes in which liquidity suddenly vanishes and volatility spikes.” And when liquidity dries up and volatility spikes, investors can run for the exits. That doesn’t necessarily mean a big sell-off or a crash; that might happen if the Fed surprised the markets, but this Fed seems content to telegraph every move and then move very slowly. Of course, we never know how markets will respond, and something like a Greek default or some other event could change the storyline very quickly, but the anticipated change is likely to be a more subtle shift from offense to defense.

A quick update on Greece; Prime Minister Alexis Tsipras said he’s ready to take responsibility for rejecting the terms of a deal on aid if creditors’ demands are unacceptable. Tsipras told reporters that without a satisfactory deal, he “will assume the responsibility to say ‘the big no’ to a continuation of the catastrophic policies for Greece.” Meanwhile, a Greek government committee has issued a report that determined public debt is illegal, and anti-austerity protestors are taking to the street in Athens. Negotiations between Greece and its creditors continue tomorrow in Luxembourg.

Financial Review

How Low Did We Go

Sinclair Noe — March 9, 2015

 

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DOW + 138 = 17,995
SPX +8 = 2079
NAS + 15 = 4942
10 YR YLD – .05 = 2.20%
OIL – 26 = 50.00
GOLD – 1.80 = 1167.90
SILV – .20 = 15.83

“How Low Can Stocks Go?” That was the headline in the Wall Street Journal 6 years ago. The Dow was still slogging through 4 straight weeks of losses to close at 6547. The S&P 500 was at a 12 year low of 676. The Nasdaq Composite closed at 1268.

Not many people called it at the time. A few did. John Bogle called it 2 weeks early. Barack Obama called it 5 days early. Mark Haines called it one day late. Of course, after all four tires go flat you might not make the prediction that there will be a fifth flat tire. Nobody was really confident about a bottom until about the end of the year. The current bull market is the fourth-longest on record; it’s also the fourth strongest. When will the bull market end? No idea. I could call the end of the bull market every day, and one day I would be right but that would be a waste off time for all of us.

For now, we have a nice bounce from the sell-off on Friday. Friday we learned the economy added 295,000 jobs last month and the unemployment rate dropped to 5.5%, which should be good news, but the market is perverse, and it clearly demonstrated that it is afraid of the Fed raising interest rates. Back in 2008, the fed took emergency actions including setting a Zero Interest Rate Policy, which pushed investors into riskier and riskier assets by making the alternatives look less attractive. Remember, cash earns virtually nothing in the bank and bond yields are extremely low, so investors flocked to stocks. If and when the Fed actually raises rates, we can expect a full-fledged tantrum, or at least an 80% probability of a 5% or greater pullback.

The New York Times editorial board wrote an op-ed asking the Fed to delay rate hikes. The article outlined several reasons why the Fed should remain on hold, noting “wages have barely budged throughout the nearly six-year-old recovery” and “the labor market is not as healthy as those figures might suggest.”

You could make the case that we have seen excess when the population is willing to pay up to $10,000 for a watch with an 18 hour battery life. Which means that they are going to sell a boatload of them. The watch is basically like a smartphone, shrunk down to fit on your wrist; it has a phone, and apps, and such. This is not the first smartwatch; there are already versions from LG, Pebblewatch, Motorola, and Samsung; and they are selling well. About 10 million smartwatches shipped last year; about 40 million will ship this year.

The other announcements coming out of the big Apple event today: a new, lighter, skinnier Macbook; HBO is joining the Apple TV line-up; Apple said the iPhone was now the top smartphone in the world, having sold 700 million; Apple has tripled locations accepting Apple Pay to 700,000, including vending machines; and yes, you can Apple Pay with your Apple Watch.

Looking to stimulate the eurozone economy and avert the threat of deflation, the ECB began its €60B per month QE program today by buying German government bonds. The goal of the program is to drive up inflation, which has slipped into negative territory and has raised the specter of deflation, a broad decline in consumer prices that can eventually undercut corporate revenue. The European Central Bank has said bonds will be purchased on the open market — not directly from bond issuers, in part to avoid accusations that it is violating a ban on central bank financing of Eurozone governments. And it will wait several days before buying newly issued bonds to give financial markets time to determine a price.

QE does not spread across all the Eurozone. Greece was not invited to the party. The ECB is providing emergency aid to Greek banks, as long a they remain solvent and capitalized; they could pull the emergency lending at almost any time, and they might. The Greek government has not come up with details of a bailout plan, mainly because any bailout plan that would be acceptable to Germany would be catastrophic for Greece. Greek ministers floated the prospect of a referendum if their reforms are rejected. And so, each day the Greeks come up with a new story for why they haven’t put together a concrete proposal for bailouts. Scheherazade would be proud.

Credit rating agencies are changing the way they calculate credit scores. The three largest credit rating agencies (Equifax, Experian, and TransUnion) will be more proactive in resolving disputes over information contained in credit reports — a process federal watchdogs and consumer advocates have long decried as being stacked against individuals. Most changes will be implemented nationally and will kick in over the next six to 39 months.

GM settles with activist investor, Harry Wilson. Wilson will give up his request for a seat on the automaker’s board, in exchange for the company agreeing to buy back $5 billion dollars’ worth of shares.

Also on the buyback bandwagon, Qualcomm announced $15 billion in buybacks. The company has about $31 billion in cash on hand, but might take on debt for the buyback, because debt is cheap these days. And apparently they have forgotten how to innovate.

Tesla has confirmed that it will cut jobs in China as it continues to grapple with slow sales in the world’s biggest car market. Tesla will eliminate 30% of its Chinese staff, or about 180 of its 600 employees. Tesla only sold 120 cars in China during January.

Documents released by a Brazilian court have now outlined the alleged use of Swiss bank accounts for the payment of bribes in the ever-widening Petrobras scandal. Brazilian prosecutors investigating the Petrobras scandal allege former company executives and politicians mostly from the ruling coalition government colluded with the energy group’s contractors to receive millions of dollars of bribes in exchange for business deals.

The Brazilian attorney-general’s office this week sought permission from the supreme court to investigate 54 people, most of them politicians. In Brazil, only the highest court can deal with criminal charges against sitting congressmen. The alleged use of Swiss bank accounts in the Petrobras case is fuelling efforts in Brasília to investigate accusations of tax avoidance by Brazilians at HSBC in Switzerland. This follows raids by prosecutors last month on HSBC’s offices in Geneva over allegations of tax evasion by wealthy clients of its Swiss private banking arm.

Gasoline rose 21 cents in the past two weeks, with the average hitting $2.54 a gallon, according to the Lundberg survey. Prices bottomed out Jan. 23, but they’re still nearly $1 lower than a year ago. Oil prices were up slightly today, 26 cents to $50 a barrel.  Goldman Sachs said it expected oil futures to stay low longer but noted that its earlier forecast for $40 oil may be too low.

OPEC’s top official said Sunday that the cartel’s decision to continue pumping crude in the face of collapsing prices is hurting the U.S. shale-oil industry and that a global pullback on investment could lead to a shortage that will push the market upward again. “Projects are being canceled. Investments are being revised. Costs are being squeezed.” Other top officials at the conference said they would maintain their response of continuing to pump in the face of collapsed prices caused in part by a glut of US shale oil.

Hedge funds cut bets on rising oil prices at the fastest pace since December 2012 as U.S. inventories expanded to the highest in more than three decades. Speculators pared their net-long position in West Texas Intermediate crude by 19 percent in the week ended March 3, U.S. Commodity Futures Trading Commission data show. Short wagers increased to a record for a second week. Oil producers are spending less, idling rigs and delaying wells to stem output that the government predicts will reach a four-decade high this year. That’s having little effect so far, with U.S. crude inventories expanding by 10.3 million barrels in the week ended Feb. 27, the most since 2001.The supply builds are astounding and we’re going to run out of places to put the stuff.

The United States has declared Venezuela a national security threat and ordered sanctions against seven officials from the oil-rich country in the worst bilateral diplomatic dispute since socialist President Nicolas Maduro took office in 2013. Declaring any country a threat to national security is the first step in starting a U.S. sanctions program.

Solar Impulse, an ultralight plane powered only by the sun’s rays, took off from Abu Dhabi this morning in an attempt to fly around the world without using fuel. The 21,000-mile flight is expected to take about 4 months.

Despite all thirty-one global banks passing the first round of the Fed’s stress test last Thursday, a tougher second round test this week, known as the Comprehensive Capital Analysis and Review (CCAR), will either approve or disapprove the lenders’ capital return plans. Last year, Citigroup became the only big U.S. bank to have its plans thrown out, with the Fed citing “insufficient” improvement in areas previously flagged. Other 2014 CCAR losers: Citizens, HSBC, and Santander.

Google has “assembled a team of engineers to build a version of the Android operating system to power virtual-reality applications,” sources told the WSJ.  Last year, Google launched Cardboard, a cheap prototype kit meant to get developers to start writing VR apps for Android.

McDonald’s is pursuing an 18-month effort to turn its business around. In July, it announced it would reposition the brand through better value, service, marketing, and menu options. Now, about a third of the way through its turnaround plan, the effort has focused heavily on marketing and has yet to pay off as same-store sales continue to slide. MCD  reported a 4 percent decline in domestic same-store sales (sales at stores open at least 13 months) for February and a 1.7 percent decline globally. It blamed aggressive competition. While U.S. same-store sales in December and January were up, it appears now that most of this bump probably resulted from better weather than last year’s. Maybe they should consider changing the slogan from “the fast food joint that made America fat.”

Friday, May 30, 2014 - Record Highs, Bonds, Coal Mines

Financial Review with Sinclair Noe

DOW + 18 = 16,717
SPX + 3 = 1923 (another record)
NAS – 5 = 4242 (not a record)
10 YR YLD + .01 = 2.45%
OIL - .71 =  102.87
GOLD – 4.60 = 1252.30
SILV - .23 = 18.91

For the week, the Dow rose 0.7%, the S&P 500 gained 1.2% and the Nasdaq added 1.4%. For the month of May, the Dow gained 0.8%, the S&P 500 rose 2.1% and the Nasdaq climbed 3.1%. Meanwhile, if you are looking for action, the bond market is the place; the yield on the 10 year note has dropped from 2.65% to 2.45% this month.

Nearly everyone is looking for an explanation as to why longer-term interest rates continue to fall in the face of reduced Fed support and what is being hyped as better economic data. This wasn’t supposed to happen. The Federal Reserve has been propping up Treasury bond prices, and suppressing yields, for the past several years by buying large quantities of bonds each month in an effort to increase investment and consumption, and force investors into riskier assets. To some extent, the Fed’s QE purchases have worked; ultra-low interest rates have supported housing price increases and have led to skyrocketing stock prices.  Household net worth has increased by $25 trillion from the financial-crisis lows in the first quarter of 2009.  However, these gains in net worth have overwhelmingly accrued to the well-to-do while low- to moderate-income folks continue to suffer from poor employment opportunities, stagnant incomes, inadequate retirement savings, and rising costs for everything from food and energy to health care and education.  In other words, the economy hasn’t really improved but the Fed may have created financial asset bubbles.

Last December the Fed began winding down its large scale asset purchases by tapering, or incrementally reducing the amount of purchases over a scheduled period of a year or so. Back in December the Fed was buying $85 billion a month in mortgage backed securities and treasuries; they have now cut that to just $45 billion a month, and by the end of the year they anticipate they will end the large scale asset purchases. This means that demand for treasuries and MBS has, or should have dropped significantly. If there is less demand and the supply stays the same, then prices should fall and bond yields should be moving higher. The exact opposite has been happening; long term bond prices have increased and bond yields have been falling; and the timing of this increase in prices and drop in yields coincides with the start of the Fed taper.

Is there something wrong with the supply/demand equation? Is there invisible demand out there? Well, treasuries are considered a safe haven investment, and if we saw volatility in the stock market, we might expect a move to the safe haven of treasuries. Right now the CBOE Volatility Index known as the VIX, is down. As the 10-year yield touches the 2.4% level, its lowest in nearly a year, the VIX is hovering around 11.5, near its lowest levels since before the financial crisis.

The VIX measures volatility in the US market, so maybe we need to broaden out horizons. Europe is experiencing low-flation, and in some Euro countries the low-flation has turned to deflation; as a consequence, the rates in Europe are very low: German 10 year bonds yield 1.36%, France yields 1.75%, Spain 10 year notes yield 2.86%. In a global market there is something wrong with pricing. Why is the US bond yield higher than the French bond yield? That does not compute.

Of course, one explanation is that foreign investors are looking for a place to park money and if you can get a better yield on US treasuries compared to French bonds, it just makes sense that you wouldn’t buy the French bonds; add in the idea that buying US treasuries serves as an effective hedge against home currency depreciation and treasuries should be attracting money that might be held in emerging market economies.

In general, if economic growth is expected to accelerate, interest rates should rise as well.  The reason for this is fairly straightforward.  Increased demand for goods and services should lead to price increases.  Inflation is one component of "nominal" interest rates.  The other component is called the "real" rate of interest, and it is determined by the demand for money.  As economic growth accelerates, the demand for money should increase as people become more confident in making spending and investment decisions.  Therefore, higher inflation expectations and higher demand for money should lead to higher interest rates in a strengthening economy; but they haven't. Perhaps the weak economy of the Eurozone is holding back rates in the US, or maybe the US economy isn’t as strong as we imagine.

Another consideration has us going back to the supply-demand equation; if supply dries up faster than demand dries up, then that would push prices higher. Remember that the federal deficit has been trimmed to the lowest levels in about 13 years and that means the government isn’t issuing as much new debt. And the housing market has slowed and that means there should be less in the way of mortgage backed securities.

That was certainly the case for the first quarter; the US economy shrank. And there are no real signs of inflation in the US, or at least we didn’t see inflation for quite some time. That may be changing; the April CPI and PPI showed a minor pop in prices; the low interest rate environment has boosted financial asset prices, so stocks and housing prices have moved higher; food prices are also higher but they tend to be overlooked as a weather related aberration, although I doubt that is temporary; the labor market is still weak and despite the unemployment rate dropping to 6.3% there is tremendous slack and little participation and there doesn’t seem to be any wage inflation. The Fed might claim the economy is getting stronger and the Fed might not consider deflation to be a problem, but the bond market seems to be saying the recovery is sick. At least for the Main Street economy.

Further proof today showing American shoppers dialed it back in April. Household purchases fell 0.1%, the first decrease in a year, and following a 1% gain in March; that was the bounce back from the pent up demand of the frozen winter. After adjusting the figure to account for inflation, the news was worse; spending dropped by the most since September 2009 as income growth cooled. Incomes advanced just 0.3% in April, and without pay gains, consumers lack confidence. Consumer sentiment dropped from 84.1 in April to 81.9 in May. What we’re seeing is the failure of trickledown. The stock market may be strong, the well-off may be better off, but it doesn’t trickle down. The economy is never going to recovery without broad based demand, and that will only happen when the labor market gets strong, until then, the Fed is pushing on a string with QE and the Zero Interest Rate Policy.

There are many possible reasons behind the move in bonds, but a big part still has to do with the economy, even with all the subplots of the international markets and the inflation-deflation debate, we get back to the idea that the economy is weak, and the recovery is uneven. The first quarter GDP contraction was certainly weather related but that doesn’t mean the economy will bounce like a quarter on a trampoline. Second quarter GDP should be positive but probably not sizzling hot. I don’t buy that story, and apparently the bond market isn’t buying it either.

Next week’s economic calendar includes the ISM surveys of business activity in the manufacturing and services sector. What will be important to the outlook is what the surveys say about employment, export prospects and inventories. On Wednesday the Fed will release its Beige Book of regional economic reports. The next Fed FOMC meeting is June 17-18. Next Friday is the monthly jobs report; the unemployment rate, the headline number is at 6.3%, but that’s based on a participation rate at 62.8%. If the participation rate moves higher, look for the unemployment rate to jump.

Another big event next week, President Obama on Monday will unveil a plan to cut carbon pollution from power plants and promote cap-and-trade, undertaking the most significant action on climate change in American history. The proposed regulations could cut carbon pollution by as much as 25% from about 1,600 power plants in operation today. Power plants are the country's single biggest source of carbon pollution; responsible for up to 40% of the country's emissions.

The rules, which were drafted by the Environmental Protection Agency and are under review by the White House, are expected to put America on course to meet its international climate goal, and put US diplomats in a better position to leverage climate commitments from big polluters such as China and India. The plan is certain to result in political backlash with critics making doomsday claims about the costs of cutting carbon. Coal mining companies, power plant operators and others are already lining up for legal challenges to the executive action, claiming the approach oversteps the EPA’s authority.