Financial Review

Inflation and a High Pressure Economy

Sinclair Noe — October 19, 2016

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DOW + 41 = 18,202
SPX + 5 = 2,144
NAS + 2 = 5,246
10 Y + .00 = 1.74%
OIL – .15 = 51.45
GOLD + .60 = 1,270.50

The consumer price index climbed 0.3% last month. The cost of shelter — rent, new homes and previously owned homes — rose at the fastest pace since May. Energy prices, mainly gas, also posted the biggest increase since early spring. The cost of food was unchanged for the month.

Over the past year, consumer prices have advanced 1.5%. The so-called core CPI, which strips out food and energy costs, gained 0.1 percent last month. That slowed the year-on-year increase in the core CPI to 2.2 percent.

Energy costs were up 2.9 percent in September as oil and gasoline prices rebounded from recent lows. Previous price declines still mean that gas costs 6.4 percent less than a year ago. So, what does this mean for the Federal Reserve? Since one of the biggest drivers of inflation is energy prices, which the Fed does not seem to control, maybe it is possible to have what Fed chair Janet Yellen described as a “high pressure economy”, in other words a tighter labor market, without igniting inflation.

Higher gas and electricity prices may push inflation closer to the Fed’s target of 2% but it is not an indication that the economy is getting healthier, rather higher energy prices serve as a tax on economic growth.

Outside of housing and energy, there’s not much inflation. Food prices have actually fallen in the past year. Prices of durable goods are down 2.3% in the past year, a continuation of a 20-year trend of falling prices. Falling prices aren’t great for retailers’ or manufacturers’ bottom line.

The other place where inflation is running hot is medical care (up 4.9%) and drug prices (up 7%) – again, not an indication of a growing economy. Meanwhile, we aren’t seeing inflation where most of us would like to see it – in our paychecks. Real or inflation-adjusted hourly wages fell 0.1% in September. Hourly pay is up just 1% in the past 12 months.

Americans who get Social Security will get a 0.3% increase in their monthly checks in 2017. The estimated average monthly benefit for all retired workers will rise to $1,360 from $1,355. Annual increases in Social Security are made every year based on changes in a component of the consumer price index known as CPI-W. Inflation has been quite low for several years largely owing to a plunge in oil prices. Grocery prices have also fallen in the past year.

The extra benefits kick in on Jan. 1. Social Security recipients got no cost-of-living adjustment in 2016 because inflation was even lower. The Social Security administration also announced that the maximum taxable earnings will rise to $127,200 from $118,500 in 2016.

The National Association of Home Builders’ index of homebuilder sentiment fell to 63 after surging to its highest in a decade in September. Any reading over 50 signals improvement. Current sales conditions dipped two points to 69, while the measure of sales expectations for the next six months rose one point to 72. The index of buyer traffic declined one point to 46. The NAHB says builders continue to see the same fundamental drivers of demand, such as a strong job market and low mortgage rates.

First-time buyers may be entering the U.S. home market in greater numbers than industry watchers had assumed. According to a survey by the real estate firm Zillow, nearly half of sales in the past year went to people who were buying their first home. Forty-seven percent of purchases in the past year went to first-time buyers. Their median age was 33.

It’s become harder to realize the dream of home ownership without a college degree. Sixty-two percent of buyers have at least a four-year college degree. Just 12 percent of homeowners in 1986 were college graduates.

Older Americans, age 65-75, are still buying homes, but they are downsizing; the median size is 1800 square feet, about 220 square feet smaller than the homes they sold. But that smaller new home still cost more. These retirement-age buyers paid a median of $250,000, nearly $30,000 more than the home they sold.

Netflix crushed earnings.  The video-streaming giant earned $0.12 a share on revenue of $2.29 billion, topping the $0.06 and $2.28 billion that were expected. Netflix added 3.2 million international subscribers, well ahead of the 2 million that analysts were looking for. The stock was up by more than 20% in after-hours action.

IBM earnings beat on the top and bottom lines. IBM earned $3.29 a share on revenue of $19.2 billion, beating the $3.24 and $19 billion that Wall Street was anticipating. The company has seen declining year-over-year revenue for 18 consecutive quarters.

Goldman Sachs reported a profit of $2.09 billion, or $4.88 a share. That compares with $1.43 billion, or $2.90 a share, in the same period last year. Sluggish trading activity across Wall Street – particularly in fixed-income, where Goldman is strongest – dragged down earnings.

UnitedHealth Group hiked its 2016 earnings forecast again after its profit swelled 23 percent to nearly $2 billion in the third quarter. UnitedHealth earned $1.97 billion in the three-month period that ended Sept. 30, up from $1.6 billion in the previous year’s quarter. Total revenue grew nearly 12 percent to $46.3 billion in the quarter. The insurer added nearly a million customers through its employer-sponsored and individual coverage. Medicare Advantage membership grew 12 percent, and total enrollment topped 48 million in the quarter.

Johnson & Johnson, the world’s largest maker of healthcare products, reported third-quarter revenue and profit just ahead of Wall Street estimates, fueled by strong sales in its prescription drugs business. J&J earned $1.68 per share on revenue of $17.8 billion. Despite solid earnings, J&J shares dropped today on news Pfizer would begin U.S. shipments of Inflectra, its biosimilar form of Remicade, by late November at a 15 percent discount to J&J’s current wholesale prices. Remicade is J&J’s biggest product, with US sales of around $5 billion.

Burberry’s second quarter comparable retail sales rose for the first time in four quarters, growing 2% and topping expectations for a 1% increase. The U.K. luxury fashion retailer was helped by the slump in the pound following the Brexit vote in June.

A federal judge in San Francisco said today that he is “strongly inclined” to approve a record-setting $10 billion proposed buyback and compensation offer from Volkswagen for 475,000 owners of polluting 2.0-liter diesel vehicles which were equipped with illegal software to defeat emissions testing. U.S. District Judge Charles Breyer said he will issue a final decision in the matter by Oct. 25.

Of the 52 S&P 500 companies that have reported results to date for the third quarter, 81 percent have reported earnings that have topped analysts' average estimate, according to Thomson Reuters. These market-beating reports have led analysts to narrow their estimates.

Now analysts estimate earnings at S&P 500 companies rose 0.2 percent in the quarter, compared with their estimate of a 0.7 percent drop at the start of the earnings season. Profits at these companies last rose in the second quarter of 2015. If the good earnings continue, the latest third quarter will be the first since 2014 in which both earnings and revenue of S&P 500 companies increased.

According to the latest research from analysts at Bank of America Merrill Lynch, investors are increasingly worried about a massive bond market pullback. Only the “EU disintegration” beat out “Crash in bond market/rising credit spreads” in terms of what money managers feel is the biggest “tail risk”: Fund managers pushed their cash balances to 5.8 percent of their portfolios in October, up from 5.5 percent last month, matching levels not seen since the aftermath of the Brexit vote.

The share of cash hasn’t been higher than that since November 2001, shortly after the terrorist attacks in the US. There is no shortage of risks on the investor horizon, according to market participants surveyed, with 18 percent fearful of a disorderly adjustment in the bond market. Elevated cash balances potentially set the stage for a stock-market rally, triggering a contrarian buy signal.

Another consideration – even though fund managers might be turning to cash, the central banks are still investing in stocks. Among the central banks with disproportionately large equity holdings are the Bank of Russia, the Bank of China, the Swiss National Bank, the Bank of Japan, the Hong Kong Monetary Authority, the Bank of Israel, the Czech Central Bank, the Bank of Denmark.

The Federal Reserve is not allowed to buy company stocks directly; however, many market observers speculate that the Fed is using indirect methods to prop up the US equity indexes. And the Fed has certainly discussed more direct investment as a possible option in the future.

There is no doubt the Fed would like to “add to their toolkit”. If the discussion ever gets to the point where the Fed starts talking to Congress about approving Federal Reserve direct stock purchases, it would set the stage for another leg higher in this increasing tired bull market.

Central banks investing in equities are not active stock pickers. Rather, central banks use exchange-listed ETFs, which passively track a major equity benchmark index. In this way, central banks remain “neutral”, not favoring one company over another or obtaining voting rights in company general assemblies.

The central banks’ choice to use ETFs explains the success of passive investing recently, as their purchases “lift all boats”. Similarly, the outperformance of expensive large cap stocks can also be attributed to central bank equity purchases, as ETFs track generally market-cap weighted indexes.

This would also offer insight into why the markets have been able to maintain and grow despite surprisingly high valuations. Central banks are not value buyers, rather they seem to be indiscriminate. And of course, this only works when central banks continue to buy.

Disney decided against buying Twitter recently partly due to concerns that the hate speech that’s rampant on the social network would undermine Disney’s family friendly image, Bloomberg reports. Another reason is that although Twitter has a market cap of almost $12 billion, it continues to lose money, which sparked opposition to the purchase among some of Disney’s largest investors.

Wednesday, May 21, 2014 - Congratulations Graduates, Yada, Yada, Yada

Financial Review with Sinclair Noe

DOW + 158 = 16,533
SPX + 15 = 1888
NAS + 34 = 4131
10 YR + .02 = 2.53%
OIL – .33 = 103.74
GOLD – 2.40 = 1292.90
SIL  un = 19.49

Earnings season is winding down; about 96% of S&P 500 companies have reported results, with profit growth this quarter of 5.5% and revenue up 2.8%. While more companies have topped earnings expectations than usual, fewer have beat on the revenue side. This has been an ongoing theme for corporate profits; bottom line growth without corresponding sales. If this formula sounds unsustainable, it is, unless there is some other factor pumping up the markets.

Follow-up from yesterday: China has signed a 30-year deal to buy Russian natural gas worth about $400 billion. The gas deal gives Moscow an economic boost at a time when Washington and the European Union have imposed visa bans and asset freezes on dozens of Russian officials and several companies over Ukraine. It allows Russia to diversify its markets for gas, which now goes mostly to Europe; essentially opening the door to Asia’s gas market and potentially closing the door on the petro-dollar.

The Federal Reserve today released the minutes of the most recent FOMC meeting. Fed policymakers considered several approaches to tightening monetary policy, but decided to remain flexible; which is another way of saying QE is a big experiment and they are just hoping nothing explodes in their face. By making no decisions, the Fed is making it difficult for Wall Street to be spooked by tightening talk, at least for now.

In the minutes, the Fed made no decisions on which tools to use. One great advantage of extending the debate about how to tighten is that it keeps the question of when stuck in background. If the Fed laid out a detailed exit strategy the markets would start to trade the strategy and essentially kill it in its tracks.

The minutes show the Fed still thinks the first quarter slowdown was weather related, and things will pick up, any day now. Fed officials still see slack in the labor force, but there wasn’t consensus on how much slack or what to do about it. Inflation is picking up just a little, but is regarded as stable and not a problem.

After the minutes were published, we heard from several Fed officials, starting with Janet Yellen delivering a commencement address to NYU grads. Yellen delivered what you might expect, and nothing to do with monetary policy: graduates, she said, should “tend the fires of curiosity,” listen to others, show grit in the face of failure, and the courage of her hero Ben Bernanke (yada, yada, yada).

Federal Reserve Bank of San Francisco President John Williams said he’s inclined to delay any action that would allow the central bank’s balance sheet to get smaller until after the Fed has lifted interest rates for the first time. Williams  believes the Fed needs to take into account the troubles it had last year when it first floated plans to wind down its bond-buying policy, and make sure markets understand what the central bank does with its bond holdings is entirely different than what it does with short-term rates.

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said the Fed is still failing to deliver on its employment and inflation goals. Kocherlakota says the current unemployment rate of 6.3% overstates the nature of the improvement. He said the labor market is not healthy but he didn’t call for additional levels of stimulus, but he did say it was possible for the Fed to switch to a system where instead of targeting a specific level of inflation, it could shift to a regime where it allowed inflation to rise above target to make up for past shortfalls.

One area of agreement in the FOMC minutes is that officials are concerned about weakness in the housing market; citing factors like higher home prices, construction bottlenecks from a shortage of labor and harsh winter weather, as well as tight credit.

Former White House advisor Larry Summers thinks student debt is slowing the housing market, which in turn is slowing the broader economy. Since 2003, student loan balances have nearly quadrupled to $1.2 trillion, during a period when mortgage debt rose “only” 65% to $8.2 trillion and credit card debt actually declined by 4.2% to $660 billion. The burden of servicing that ever growing student loan debt is eating into other forms of borrowing and spending, such as the purchase of a home. And so the proportion of first-time buyers has been shrinking for years.

Over 70% of the students who are sitting through a commencement speech this spring have student loans. They will start their career, if any, with about $33,000 in debt. Even when adjusted for inflation, it’s about twice as much as 20 years ago. Back then, only 43% of students graduated with student loans. And as education costs have jumped, the idea of working your way through school just doesn’t work anymore.

One of the reasons why education costs have jumped is because of austerity. States cut back on funding for state universities; the schools raised tuition and they discovered they could charge whatever they want, or get away with, because the students just borrow the money. Once upon a time state governments held the reins of university budgets and they would tighten their grip occasionally; no more; and through the student loan programs, designed with whatever intentions, the government is simply aiding and abetting colleges in extracting ever more money from the future lives of their students.

And so for the Class of 2014, you now face the prospect of rising interest rates, a mountain of student loan debt, almost no chance of buying a home in the foreseeable future, and the prospects for a good job in your chosen field are not looking good. Congratulations, don’t despair, just have the grit and courage of Ben Bernanke (yada, yada, yada) and you’ll work your way out of your parents’ basement in 10 or 15 years.

Earlier this week, the Oregon Legislature approved a plan that could pave the way for college students to finance their education by selling equity stakes in their future income. It’s an interesting idea. With both unsubsidized and subsidized Federal loan rates now at 6.8%, and Grad PLUS rates even higher, the student loan burden that comes with an undergraduate degree, let alone further education can be daunting. Unfortunately, Federal loans are often the only option that a student has to pay for school nowadays.

Equity financing would allow these students to avoid debt in exchange for a portion of their future income for a set number of years. Proponents of the Oregon plan claim that 3% per year for 20 years would be enough to keep the program afloat. One concern is that students who expect to be high earners will not participate if it could mean they end up paying more in tuition when all is said and done. Equity financing would be costly for a medical student. A cap on repayment could help solve such a problem. The cap would still have to be higher than the average tuition rate charged by the school. Meanwhile, a equity financing might be a sweet deal for a student taking classes that don’t lead to a big paycheck; it might even encourage them to pursue higher education without regard to finance.

The best that can be said for the plan is that it is a tax on future earnings, the worst is that it is a newfangled name for indentured servitude.

So, back to the housing market for a moment; you have a massive number of young adults living at home with very little financial means for purchasing a home. The recent argument was that as economies grew, this wealth would eventually lift the standard of living for all. There is new economic research showing that this isn’t always the case especially when a rentier class emerges. In fact, this wealth gap is being fully visualized through real estate. Some analysts have been scratching their heads wondering how housing prices could go up while homeownership is actually falling.

How do you have soaring home prices with household incomes dropping? The fact that investors are dominating in the housing market shows how large and powerful these big pools of money have become. The financial sector rarely had an interest in being actual property owners until the housing market imploded. But in the first quarter of this year, cash sales from investors reached an all-time high; that isn’t Mom and Pop buying a crib with cash and it certainly isn’t the first time buyer a few years removed from college.

Since 2005, we have increased the number of rental households by roughly 7 million (a 21 percent increase). Interestingly enough, we have a foreclosure graveyard of 7 million over this same period. Owner occupied housing has actually fallen over this period. We are looking at close to one decade of data and we have fewer individual homeowners today than we did in 2004.

In previous recoveries, you would also see home building picking steam up but that hasn’t happened. In better days, we would see more than 2 million housing starts per year. In this recovery, we’ve been doing our best to close in on 1 million.

And when the Fed last year floated the idea of taper, the markets responded with a taper tantrum, and rates increased, modestly, but an increase; and that was enough to slam the brakes on regular home buyers last year. Mortgage apps are now near an all-time generational low. Regular buyers are becoming a minority. Many of the “pent up demand” argument assumes first, that younger buyers have the means to buy. Second, it also assumes homes are affordable based on their income (which they are not). And so we have cash investors, spurred on by strong stock returns, but what happens if or when the inevitable stock market correction comes along?