Financial Review

A Perfect Gift

Sinclair Noe — June 3, 2015

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DOW + 64 = 18,076
SPX + 4 = 2114
NAS + 22 = 5099
10 YR YLD + .10 = 2.37%
OIL – 1.68 = 59.58
GOLD – 7.70 = 1186.00
SILV – .27 = 16.58

The U.S. trade deficit narrowed in April on a drop in imports. The Commerce Department said the trade gap narrowed to $40 billion from March’s revised deficit of $50 billion. The 26 percent drop in the April trade deficit was the largest decrease since early 2009 and reflects a surge in imports in March following the end of a West Coast ports labor dispute.

Service industries expanded in May at the slowest pace in 13 months. The Institute for Supply Management’s non-manufacturing index, which includes an array of industries from real estate to dining, declined to 55.7 from April’s 57.8. Readings above 50 signal expansion. Limited growth in orders reflects an American consumer who has been saving the extra cash from low gasoline prices and rising employment rather than spending it. Arts and entertainment, real-estate firms and rental companies led the list of the 15 non-manufacturing industries that reported growth in May. Mining, which includes oil extraction, contracted. An index of employment in service industries dropped to 55.3 in May from 56.7.

Payrolls processor ADP reports private employers added 201,000 jobs in May, the most since January. The ADP data came ahead of the U.S. Labor Department’s more comprehensive non-farm payrolls report on Friday, which includes both public and private-sector employment. It is estimated that the Friday Jobs Report will show 225,000 new jobs in May and the unemployment rate steady at 5.4%.

Meanwhile, the Labor Department has released details on the April jobs report. Payrolls grew in 50 U.S. metro areas with a population of 1 million or more in April compared with a year earlier. The biggest increase occurred in Silicon Valley’s San Jose metro area, where payrolls grew 6%. That was followed by the areas surrounding Orlando, Fla., where payrolls grew 4.3%, and Riverside, Calif., which saw 4.1% payroll growth. Employment in New Orleans was the only metro area without an increase; holding steady in April from a year ago. Austin, Texas had the lowest unemployment rate in April, at 3%, followed by Salt Lake City, Utah, at 3.1%. The Las Vegas area had the highest jobless rate at 7.1%. Metro Phoenix came in at 4.9%.

Two weeks before a FOMC policy meeting, the Fed publishes the Beige Book, an anecdotal assessment of the economy, named for its unassuming beige binding and page turning eloquence. Reports from the Federal Reserve’s 12 major regional district banks show a “generally optimistic” outlook for U.S. economic growth, which is “expected to continue at a modest to moderate pace in several districts.”

“Modest growth” was seen since the April 15 Beige Book publication in four Fed districts, while “moderate growth” was seen in three others. Dallas was the only district to report that its economic pace “slowed slightly.” Richmond and New York were the only districts in which consumer spending hadn’t picked up since April 15. And auto sales picked up everywhere except in New York and Cleveland. The Fed highlighted the effect of low gas prices in some of its districts, saying they had provided “a tailwind for consumer spending”; however that assessment has not yet been backed up by hard data. Employment levels were up slightly, with some districts reporting labor shortages.

The European Central Bank left interest rates unchanged at record lows. ECB president Mario Draghi said monetary policy stimulus is filtering through to the economy as planned, and he insisted the European Central Bank needs to see its bond buying through to the finish. Since the ECB started its $1.2 trillion quantitative easing program three months ago, inflation in the 19-nation euro area may have bottomed out. The inflation rate in the Eurozone was positive for the first time in six months in May, rising to 0.3 percent from zero. Draghi said:  “The recovery is on track exactly according to our projections.”

The fly in the European soup bowl could be Greece. The Greeks presented their proposal for a bailout; creditors presented a take-it-or-leave-it ultimatum in reponse; Greece threatened to miss a loan repayment to the IMF due on Friday if they can’t get a proposal they can live with. German Chancellor Angela Merkel stepped in to unblock the stalemate. Greek Prime Minister Alexis Tsipras is meeting today with European Commission President Jean-Claude Juncker.

OPEC is set to carry on pumping oil nearly flat-out for at least the next several months. OPEC is scheduled to meet Friday to determine production quotas and with oil prices having stabilized at around $65 a barrel there’s little appetite within OPEC to modify production limits or address Iran’s request to give it more room in the market as sanctions ease. OPEC officials will be meeting with executives from several major oil companies. Today, BP CEO Bob Dudley said he believes global oil supplies will continue to grow, putting downward pressure on prices.

And in an interesting twist, the leaders of six of Europe’s largest oil producers are calling for a plan to price greenhouse gas emissions, citing climate change as “a critical challenge for our world.” In a letter to the executive secretary of the United Nations Framework Convention on Climate Change and the president of the upcoming 2015 Paris Climate Conference, the CEOs of BP, Royal Dutch Shell, Statoil, Total, Eni, and BG Group focus on creating a framework for carbon pricing in countries that currently lack one, and then connecting that framework internationally.

The OECD, which has a history of cutting its growth outlooks, has done it again, reducing its global forecast due to lagging investment and risks, including a possible Greek default. Chief Economist Catherine Mann said that despite “monetary accommodation, less fiscal drag and a reduction in oil prices,” we’re not getting growth that is “matching the average of the past two decades.”  The OECD now expects the world economy to expand 3.1% in 2015, down from 3.7% predicted in October. Last year, the world economy grew 3.3%.

Several of FIFA’s big corporate sponsors including Coca-Cola, Visa, and Adidas said they welcomed the resignation of the soccer governing body’s president, Sepp Blatter, amid a wide-ranging corruption scandal, and urged the organization to enact swift reforms to restore its credibility. Of all the individuals and firms tied up in the scandal over bribery and corruption at FIFA, so far scrutiny has largely escaped KPMG. KPMG was the auditor for FIFA for the entire time under investigation, and it served as advisor for the Russia and Qatar official organizing committees when they prepared the winning bids that are now the target of corruption investigations in the U.S. and Switzerland.

Looking to expand its user base and rev up its revenue engine, Pinterest is planning to launch “buyable pins,” enabling users to buy items they see directly via Pinterest. Although Pinterest won’t take a cut of each transaction, merchants will have the option to pay for “promoted pins” – giving the company an important revenue source following its $11 billion valuation. Instagram has also announced a similar feature, permitting advertisers to add a button to encourage viewers to click through to their website.

The internet is the future of course, but online advertising has always been a fraction of the huge budgets spent on TV ads. That’s expected to change by 2019. PriceWaterhouseCoopers estimates that online advertising, which in 2014 brought in $49.45 billion in revenue in the US, will climb to $83.89 billion by 2019. That year will prove to be a major tipping point in advertising, with online ads overtaking television for the first time. Over this same period, TV advertising in the US will grow from $69.2 billion to $81.05 billion.

Wendy’s unveiled a new $1.4 billion share buyback, announced the closing of the sale of its bakery operations, reiterated guidance for 2015 and provided a longer-term outlook.

Avian flu has been the bane of American poultry farmers for months. Three deadly strains have forced them to kill off entire flocks of chickens, turkeys, and other birds to stop infection spreading, and to shut down facilities for costly disinfection procedures. Now consumers are going to start feeling the effects too. The price of wholesale consumer-grade eggs in the US reached an all-time high of $2.62 per dozen yesterday.

The nation’s population of egg-laying hens has been decimated. More than 30 million hens have been killed in Iowa alone, and it will be more than a year before egg production returns to normal across the country. On June 1, the fast-food chain Whataburger announced it will be limiting the hours that customers can order breakfast at its 800 restaurants in 14 states. Instead of serving breakfast taquitos and biscuit sandwiches with scrambled eggs 12 hours a day, Whataburger will offer them for four hours on weekday mornings and six hours on weekend mornings.

Takata will “rapidly” reduce its use of ammonium nitrate as an air bag propellant after it appeared “to be one of the factors” contributing to inflator ruptures; that was part of the testimony of Takata executive Kevin Kennedy before  a congressional subcommittee yesterday. However, Representative Michael Burgess, the Texas Republican who chaired the hearing, said he “couldn’t believe” what he was being told. “They are still making an air bag with ammonium nitrate as a propellant without a desiccant and they’re putting that in replacement and new vehicles.” Burgess said, “It almost seems like there should be a warning label stamped on the car.”

Hedge-fund manager John Paulson is donating $400 million to Harvard University, the biggest gift in the school’s history. Harvard’s School of Financial Engineering and Applied Sciences will be renamed after Paulson. Paulson rose to fame and fortune in 2007 by using credit default swaps to bet against the subprime mortgage lending market, essentially a bet that mortgages would fail. That gamble paid off big. And while $400 million sounds like a large amount; it won’t make a big difference, not like donating the money where there is actual need. Harvard already has a $36.4 billion endowment, so really it was a perfect choice… for someone like Paulson.

Financial Review

Bad Things in the Midwest

Sinclair Noe — May 14, 2015

 

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DOW + 191 = 18,252
SPX + 22 = 2121.10
NAS + 69 = 5050
10 YR YLD – .04 = 2.24%
OIL – .77 = 59.73
GOLD + 6.30 = 1222.40
SILV + .35 = 17.55

The Standard & Poor’s 500 Index closed at an all-time high, taking out the previous closing high of 2117.69. The Dow is still about 36 points shy of its record closing high. The dollar is on track for its longest weekly losing streak since October 2013. The bond market rallied, just a little, which is at least a change from the past couple of weeks. The earnings season is winding down, and it was ugly, but it looks like there will be positive earnings growth coming from the first quarter numbers. The economic data has been tepid.

The number of Americans who applied for unemployment benefits in the first full week of May fell by 1,000 to 264,000. New claims have registered less than 270,000 for three straight weeks, only the second instance in which that’s happened since 1975. Continuing jobless claims, people already collecting benefits, were unchanged at 2.23 million in the week ended May 2.

Producer prices, or prices at the wholesale level, fell a seasonally adjusted 0.4% in April to mark the seventh decline in the last nine months, mainly because of lower gasoline and food costs. Core producer prices that exclude the volatile categories of food, energy and trade rose 0.1% last month; the increase was mainly due to higher prices for drugs. Over the past year overall producer prices have fallen a record 1.3% on an unadjusted basis. Yet the core rate has risen 0.7% in the same span.

U.S. corporate spending on capital projects could fall this year to the lowest level since 2011, with steep reductions by the energy industry and companies in other sectors cutting spending amidst broad concerns about global growth. Among the S&P sectors, only the materials and financials sectors expect to spend more in 2015 than they did last year. They’re not spending at a pace that would suggest a global recovery. According to data from Thomson Reuters, estimates from analysts show that total S&P 500 capex spending could dip to $641 billion in 2015 from actual spending of $718 billion for 2014, marking the lowest level since 2011.

And it’s not just businesses that are holding on to the purse strings; yesterday we had a report showing retail sales were flat last month. It was widely believed that lower oil prices would put extra money in shoppers’ wallets and they would rush out to spend. Oil prices remain more than 40% below the highs reached in mid-2014, which equates to a roughly $150 billion ‘tax cut’ to consumers.

One reason for the lack of spending might be middle class debt. According to the Federal Reserve, as of 2013, the average debt of middle-class families, those that fall within the middle three-fifths of the population by earnings, amounted to an estimated 122 percent of annual income. That’s down from 2010, but still higher than 2001. Consumers have been trying to save more because they realized that gas prices could go higher, and it is happening; consumers also realize that interest rates could go higher, and for a typical household, higher rates could spell disaster.

Futures contracts imply that traders see the fed funds rate at about 0.3 percent rate by December. That’s the lowest estimate of the year, and about half the forecast for the overnight lending benchmark that the Fed gave in March. Fed policymakers have been saying that a rate hike will probably happen this year, with the caveat that any move will be data dependent. The economic data looks soft right now but the Fed has another motivation for a rate hike: financial stability. With interest rates near zero, the Fed is limited in their ability to deal with financial instability. They don’t have many tools in their tool belt.

So the Fed says rate hike, the futures traders say no; and this is setting up for another market-wide tantrum. Former Fed Chairman Alan Greenspan, speaking yesterday, said: “Just remember we had the ‘taper tantrum.’ And we’re going to get another one.”

If for no other reason than a blind pig can find an occasional acorn, Greenspan is probably right about this; traders are almost certain to complain about higher rates, even if rates have been abnormally low for a very long time; which will then give them an excuse to trade with higher volatility. Higher volatility equates to bigger profits, or losses if they get it wrong. The start of a tightening cycle typically causes some rise in volatility, but rarely a bear market, provided the Fed doesn’t surprise the markets. The extent of the impact is likely to be influenced by two other conditions: changes in equity valuations and the direction of inflation.

For now, inflation remains moderate but that can change; and one big factor will be energy prices. The fact that equity multiples have been rising suggests that markets are at greater risk for at least a modest correction; not a crash but enough to get your attention. And when we talk about rising multiples, we generally think of momentum stocks, and the usual suspects in this area would be biotech and social media stocks. The flip side to this line of thinking is that stocks climb a wall of worry. Momentum stocks typically represent areas of growth in an otherwise stagnant economy.

For now, volatility remains at low levels, the VIX, or volatility index is trading just under 13, almost half the level from back in December. It kind of feels like the calm before the storm.

Bad things are happening in the Midwest.

Deadly avian flu viruses have affected more than 33 million turkeys, chickens and ducks in more than a dozen states since December. On Tuesday, agriculture officials confirmed that the bird flu outbreak that has spread throughout the Midwest for months had reached Nebraska, making it the 16th state affected. Today, South Dakota reported its first possible infection on a chicken farm with 1.3 million birds in the eastern part of the state. The Iowa Poultry Association says there is no food safety risk for consumers. Chickens, turkeys and other poultry infected with bird flu will be destroyed and will not enter the food supply. Still, Iowa Governor Terry Branstad declared a state of emergency on May 1 due to the avian influenza outbreak. The virus may pose no risk to humans, but it is already having an impact on prices at the grocery store.

Iowa, where one in every five eggs consumed in the country is laid, has been the hardest hit: More than 40 percent of its egg-laying hens are dead or dying. For now at least, the biggest impact of the virus is on egg prices. It is estimated that prices will rise 1.6% for every million chickens destroyed. About 90 percent of the more than 25 million chickens that are being destroyed in Iowa produced liquid eggs, and already the wholesale price for those eggs nationwide has nearly doubled from late April. Liquid eggs are used in everything from mayonnaise to cake mix and are a major product of Iowa’s poultry industry.

According to the Associated Press, the price of a carton of eggs at supermarkets has increased 17% over the last month, hitting an average of $1.39. Bulk prices paid for eggs by cake mix and mayonnaise manufacturers, meanwhile, have spiked 63% over the past two-and-a-half weeks. Turkey prices are up as well, with breast meat at delis rising 10% since mid-April. So far, chicken prices appear to be unaffected.

Certainly the avian flu affects chicken farmers but from there it ripples through the Midwestern economy to the support businesses, ranging from bank lenders and insurers to trucking operations, feed mills and farmers. It hasn’t hit corn and soybean farmers yet, but it means a smaller market for part of their crops.

Next stop:
Chicago,
“Hog butcher for the world,
Tool maker, stacker of wheat,
Player with railroads and the nation’s freight handler;
Stormy, husky, brawling,
City of the big shoulders.
They tell me you are wicked and I believe them.”
City of Junk.

Moody’s Investors Service dropped two other hammers on Chicago taxpayers today, downgrading debt on both Chicago Public Schools and the Chicago Park District to junk levels. For the schools this will apply to $6.2 billion in general obligation debt.

The action won’t necessarily prevent CPS from borrowing more. But it will make that more costly, and comes at a particularly sensitive time, as the district seeks to renegotiate hundreds of millions of dollars in currently-losing swaps contracts. Beyond that, the district faces a deficit of well over $1 billion in its budget for the school year that begins on July 1, and is in negotiations with the Chicago Teachers Union, which says the current financial woes are “manufactured.”

At the parks, $616 million in outstanding general obligation debt is affected. Yesterday, Moody’s downgraded the city’s credit rating to junk status. Moody’s said Chicago’s options for curbing its $20 billion unfunded pension liability “have narrowed considerably” after last week’s Illinois Supreme Court ruling invalidated a state pension reform law. Moody’s said spending cuts and tax increases may be needed, regardless of how the court rules. The state could force the city to pay retirees directly, possibly leading to another rating cut. Moody’s on Tuesday also cut ratings on Chicago’s sales tax, motor fuel tax, and water and sewer revenue bonds.

Cities don’t get to play by regular bankruptcy rules. Cities don’t really have the choice of liquidating and going out of business. So when they can’t keep up with pensions, payrolls, services, and other obligations, they get temporary bankruptcy protection under Chapter 9. But they know that sooner or later they need to come up with a plausible matching-ends-with-means plan for coming out of bankruptcy. How will this all play out? I don’t know. But I’m guessing there might be a new nickname for Chi-town. City of big haircuts.