Financial Review

Inversion Dysfunction

Sinclair Noe — November 23, 2015

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DOW – 31 = 17,792
SPX – 2 = 2086
NAS – 2 = 5102
10 YR YLD – .01 = 2.25%
OIL + .09 = 41.99
GOLD – 8.50 = 1069.70
SILV – .04 = 14.25

Belgian authorities have extended a lockdown of Brussels for a fourth straight day after police raids searching for those behind last week’s Paris attacks failed to find a prime suspect. The Belgians say they have credible threats of imminent attacks against public gathering places like shopping malls and public transportation. The lockdown will see Brussels’ subway and many shops closed, as well as schools, offices, and mosques; although it is doubtful the terrorists are in mosques.

France’s economy slowed following the Nov. 13 terror attacks in Paris. However, that slowdown in the eurozone’s second-largest member wasn’t sharp enough to slow the Eurozone as a whole.

Economic activity in the eurozone grew at the fastest pace since May 2011 in November, giving some optimism over the health of the region’s economy. Markit’s flash composite Purchasing Managers’ Index climbed to 54.4 from 53.9 last month, as a recovery continued to be led by the service sector. Growth meanwhile accelerated to a three-month high in Germany, where Markit’s flash composite PMI rose to 54.9 from 54.2, fueled by a big improvement in new business.

A reading of manufacturing sentiment in the US fell in November to its lowest level in 25 months. The flash manufacturing purchasing managers index from Markit fell to a reading of 52.6 from 54.1 in October, with all five of the PMI components deteriorating. Any reading above 50 indicates the manufacturing sector is still expanding.

Sales of previously owned homes in the U.S. fell 3.4% in October to an annual rate of 5.36 million. Despite the decline last month, existing home sales are still 3.9% higher compared to the same period a year ago. The National Association of Realtors reports the median price of homes sold in October, meanwhile, was 5.8% higher vs. a year ago at $219,600.

Foreclosures and short sales dropped to 6% in October, down from 9% a year ago, and the lowest level since the National Association of Realtors stared tracking distressed sales in October 2008. By region, existing home sales in the West fell 8.7% in October, but are still 2.7% above a year ago.

The economic data continues to show steady, although sluggish growth; in other words, good enough for a rate hike in about 3 weeks when the FOMC meets. And we have been hearing from the Fed policymakers that they generally think it is time for a rate hike, with the caveat that they are data dependent.

Their intentions have been well telegraphed, and the data would have to be pretty nasty to avoid a rate hike. The Fed has pretty much run out of reasons to keep rates at zero, and leaving rates unchanged would raise a red flag that something evil is lurking. So we can figure that a rate hike has now been priced into the market, and then the question is how much more they will tighten and over what period of time. And the most likely answer is small and slow; again, this has been priced into the markets.

By about the middle of next year we should learn more about how the Fed will handle its balance sheet. And the big question is whether the Fed can pull it off. Other central banks have been less-than-successful in their efforts to pull off of the zero bound, not exactly a hopeful precedent.

Profits from S&P 500 companies have fallen by about $25 billion in the first three quarters of this year, and a further drop is expected before the end of 2015 as energy companies battle with lower oil prices and a sharp rally in the dollar hits exporters. About 96% of S&P 500 companies have reported third quarter results so far, and their aggregate net income from continuing operations for the first three quarters is $804 billion, compared with $828 billion for the first three quarters last year.

The aggregate revenue for S&P 500 companies has fallen by $287 billion over the same period last year. On a share-weighted basis, S&P 500 profits were down 3.3 percent on year in the third quarter, making this earnings season the worst since 2009, and marking a second consecutive quarter of negative earnings growth.

Oil futures were volatile in early trade today, failing to hold on to a sharp but brief bounce higher after Saudi Arabia said it would work with global oil producers toward stable prices. Oil futures spiked higher after the announcement from the Saudi Press Agency. The rebound soon lost steam, because the remarks were in line with previous Saudi statements. So far, there’s little indication Saudi Arabia is prepared to begin cutting production.

Copper lost 2% to the lowest level since 2009. Nickel touched the lowest in more than a decade; there is a supply glut right now. The London Metal Exchange’s index of six industrial metals is having its worst year since the global financial crisis in 2008.

Charts of the commodity indices are the definition of a downtrend since 2011. Two factors in the energy and materials sectors: a supply glut and a stronger dollar. That means some downward pressure on stocks, but generally good news for consumers. The average nationwide price of unleaded gasoline is expected to hit $1.99 on Thanksgiving; that’s down about 82 cents from Thanksgiving last year. I’ve seen prices around $1.85 a gallon here in Phoenix.

Pfizer and Allergan will merge in a tax inversion deal worth about $160 billion that would create the world’s biggest drug maker by sales. The takeover would be the largest inversion ever, moving one of the top names in corporate America to a foreign country. Such deals enable a U.S. company to move abroad and take advantage of a lower corporate tax rate; in this case, the new Pfizer will have corporate headquarters in Dublin Ireland, even though their administrative headquarters will be in New York.

A Pfizer-Allergan combo would still face anti-trust scrutiny, but the US Treasury, concerned about losing tax revenue, has been taking steps to clamp down on tax inversion deals, but it doesn’t look like the existing rules are enough to stop this deal. Pfizer is confident the deal will pay off in lower taxes and cost cutting, unless…, unless Medicaid and Medicare changed their rules and started negotiating drug prices; in which case they could require that administrative headquarters match corporate headquarters, or else.

Looking to create the world’s largest ATM maker, Diebold has launched a $1.8 billion bid in stock and cash for German rival Wincor Nixdorf. A deal would see the two companies land about 35% of the ATM market, leaving NCR, the global number two, with an estimated share of 25%. Wincor expects the transaction to yield at least $160M in annual cost savings.

Petco agreed to be acquired by CVC Capital and the Canadian Pension Plan Investment Board for $4.6 billion. Petco, the No.2 U.S. pet supplies retailer, had been put up for sale by a group of investors led by private equity firms TPG Capital LP and Leonard Green & Partners. It’s not the first time. The two buyout firms took the company private in 2000 for $600 million, and then took it public again in 2002. Then they bought it back again in 2006 in a $1.7 billion deal, taking it private again.

AstraZeneca has finalized plans to divest its Crohn’s disease drug Entocort by selling U.S. rights to the medicine to Perrigo for $380 million. The move is part of AstraZeneca’s “externalization” drive, which aims to sell non-core products to help it fill a short-term revenue gap caused by older drugs, while investing in a pipeline of new medicines.

Walmart can’t wait for Cyber Monday. So, they are starting a day early, launching all its Cyber Monday deals on the Sunday after Thanksgiving rather than the early hours of Monday morning as in previous years. Actually, the starting line is already blurred. A number of retailers are promoting deals for ‘Black Friday’ – the day after Thanksgiving and traditionally one of the busiest shopping days – weeks in advance.

A jury in West Virginia has been struggling with the idea of sending a CEO to jail. The CEO is Don Blankenship; the company is Massey Energy. The trial was to determine whether Blankenship is guilty of conspiring to break safety laws, defrauding mine regulators and lying to both investors and regulators about mine safety. Massey’s Big Branch mine in West Virginia turned out to be anything but safe; an explosion in 2010 killed 29 people. In the year leading up to that catastrophe, mine inspectors had cited it nearly 500 times, often for “significant and substantial” violations. Blankenship faces 30 years in jail if convicted.

The prosecutors seem to have laid out a damning pattern of facts. Blankenship clearly raked in millions in compensation. He was a micromanager, with a staff of individuals whom prosecutors derided as “yes men”, who seems – based on some documents and tape recordings he himself made of his own phone calls – to have been concerned about the costs of safety regulations and their impact on production levels. Orders reached the miners to cover up safety violations, and it seemed clear to many from who they had originated, according to testimony. But for now, the jury is deadlocked.

Facebook’s Mark Zuckerberg has announced he will take two months of paternity leave after his daughter’s birth, though he did not say when she is due, or who would be his interim successor. Facebook allows its U.S. employees to take up to four months of paid maternity or paternity leave, which they can use all at once or throughout the year.

FINANCIAL REVIEW

Lather, Rinse, Repeat

Sinclair Noe — November 4, 2014

Podcast: Play in new window | Download (Duration: 13:15 — 6.1MB)

Financial Review

DOW + 17 = 17,383
SPX – 5 = 2012
NAS – 15 = 4623
10 YR YLD – .01 = 2.34%
OIL – 1.31 = 77.47
GOLD + 2.90 = 1169.20
SILV – .11 = 16.13

Election Day 2014! We should all be very, very happy. Forget about red and blue, we can all count our blessings because the campaign ads on radio and TV are going away. There is one redeeming thing about this whole election. It will be over in a few hours. Say hallelujah!

Or you could say that it’s amazing that anyone bothers to vote given that our choices are between tweedle dumb and tweedle dumber. Still, I went to the polls today, early, and I cast my ballot. I was the only voter voting. In a few hours we’ll get the results. And the most likely result is that not much will change, despite the drama and despite hundreds of millions to persuade you. It takes a fortune for a politician to get beat these days, but most of the money isn’t real, it’s magic money that doesn’t belong to anybody, or at least nobody is willing to admit they spend money on politics. We’ve got the best politicians money can buy.

The present split Congress is the least-productive in US history. Regardless of the election’s outcome, the 114th Congress is unlikely to be any more productive than the 113th. Maybe that’s good news; when they do something is when they become dangerous. There are plenty of issues worthy of intelligent discussion and debate, however that never seemed important in this midterm election. That we have been burden with such an abundance of bull and still survived just shows we are a super nation.

Lather, rinse, repeat.

Let’s look at the economic news.

Home prices were down slightly in September, according to Corelogic prices were down 0.1% for the month and that resulted in year to year growth of 5.6%, the slowest pace in 2 years. So, the rate of growth in home prices has clearly slowed. For Arizona, home prices are still down 30% from the peak.

New orders for US factory goods fell for the second straight month, down 0.6% in September. August’s orders were slightly revised to show a 10.0 percent fall instead of the previously reported 10.1 percent decline. The decline in orders was led by aircraft, machinery, capital goods and computers and electronic products.

Yesterday we reported that auto sales were up in the third quarter, but the car companies are calling them back faster than they can sell them. Toyota is recalling 5,850 vehicles because of a possible loss of steering control. Ford is looking at 5 recalls totaling 202,000 vehicles for a variety of issues, including an incorrect repair of a steering problem in a previous recall.

Oil futures dipped under $76 a barrel for a while today. If there was any doubt on which country Saudi Arabia was targeting with their price shattering oil production, there is not any doubt now. While Russia, Iran and Venezuela might turn out to be collateral damage in the Saudi oil production surge, the message that Saudi Arabia is trying to send is directed to the US shale producers. The Kingdom made no secret of their displeasure yesterday when they cut oil prices to US buyers while raising them for everyone else in the world. Saudi Aramco next month will sell its Arab Light to clients in Asia for 10 cents less than Middle East benchmarks, the November discount was $1.05 yet it lowered prices for all grades to the US.

The plan is to maintain market share in the US and bury the US energy producers. The Saudis fear predictions that US oil imports could fall to zero by 2037 as a reason they need to nip US oil producers in the bud. They are threatened by US oil production and they are acting to try to break the US producers back. That is one of the reasons todays balance of trade numbers weren’t much higher, even in the face of a strong dollar. The US not only has reduced oil imports but has become a major exporter of oil products.

The nation’s trade deficit increased 7.6% in September to the highest level since the late spring as exports to Europe, China and Japan all fell. In turn, this will likely lead to a lower revision of third quarter GDP; probably a drop from the 3.5% initial estimate, down to about 3%. In September, the trade gap climbed to a seasonally adjusted $43 billion from a slightly revised $40 billion in August. Yet if petroleum is excluded, the nation’s trade gap climbed to $47.2 billion in September to mark the highest level in seven years. Here’s the downside of a strong dollar: US exports of goods fell 3.2% with China, 6.5% with the European Union and 14.7% with Japan.

It’s not just a strong dollar but a combination of weak global economies. Today the European Commission said the Eurozone will need another year to reach even a modest level of economic growth. The new forecast calls for 0.8% growth across the Eurozone economy this year, and just 1.1% growth next year.

The Independent Evaluation Office of the International Monetary Fund issued a report that basically says the IMF did a poor job responding to the financial crisis; the IMF ignored its own research and pushed too early for richer countries to trim budgets. They admit the IMF was overly concerned about high debt levels and large fiscal deficits, and urged countries like Germany, the United States and Japan to pursue austerity in 2010-11 before their economies had fully recovered from the crisis. At the same time, the IMF advocated loose monetary policies to sustain growth and boost demand in advanced economies, initially ignoring the possible spillover risks of such policies for emerging market countries. In 2012, the IMF finally admitted that it had underestimated how much budget cuts could hurt growth and recommended a slower pace for austerity policies. But its auditor said the IMF’s own research showed this relationship even before the crisis.

The European Central Bank meets Thursday to try and figure out their next course of action.

Lather, rinse, repeat.

While every major economy in the world has followed essentially the same monetary policy since 2008, their fiscal policies have been very different and the divergence in outcomes, especially when we compare the United States and Europe, has been exactly the opposite to what was implied by the rhetoric of most politicians and central banks.

Countries that took emergency measures to reduce public borrowing have mostly suffered weaker growth, as in the case of Britain from 2010 to 2012, Japan this year and the United States after the 2013 “sequester” and fiscal cliff deal. In more extreme cases, such as Italy and Spain, fiscal tightening has plunged them back into deep recession and aggravated financial crises. Meanwhile countries that ignored their deficit problems, as in the United States for most of the post-crisis period, or where governments decided to downplay their fiscal tightening plans, as in Britain this year or Japan in 2013, have generally done better, both in terms of economics and finance.

When faced with private sector deleveraging, there are limits to the persuasive powers of low interest rates to revive private economic activity; low rates may help in an inflationary environment, but in a deflationary environment, spending is needed to stimulate demand. With interest rates at or near zero, private demand cannot be simulated with further rate cuts and this means that monetary easing can no longer offset fiscal tightening. As a result, any reduction in budget deficits becomes more and more deflationary. The flip side is that fiscal expansion could truly provide economic stimulus without the worry of interest rate increases. That doesn’t mean that we will see fiscal expansion to correct the problem, just because there is indisputable mathematics to support it.

Lather, rinse, repeat.

JPMorgan Chase has added $2.4 billion to its estimate of the amount of legal costs it may face. That figure was disclosed yesterday in a securities filing in which the bank also formally acknowledged that it was facing a criminal investigation by the Justice Department into the behavior of traders in the foreign exchange market. In the past few days, Citigroup, Royal Bank of Scotland, HSBC, and Barclays all announced new reserves totaling more than $2.3 billion to deal with investigations into foreign exchange rate manipulation. Deutsche Bank added more than $1 billion to legal reserves for the expected cost of settlements. The cases involve collusion in the $5.3 trillion daily foreign exchange market to affect rates.

If it sounds familiar, well that is because we have seen settlements like this before. In 2012 Barclays and UBS entered deals to pay fines totaling almost $2 billion; a UBS subsidiary pleaded guilty to rigging Libor. The prosecutors and regulators probably thought the agreements would deter further bad behavior. The deals involved non-prosecution or deferred prosecution agreements. The agreements allow the Justice Department to reinstate charges if there is any future violation of the law. Most important, admissions by the bank as part of the settlement can be used against it as evidence later, essentially stripping the bank of any possible defenses if the case were to proceed further. There is little chance, then, that a bank could fight the charges, so it would have to agree to a new settlement with more onerous terms and a new penalty.

But it turns out that simply slapping the banks with more and bigger fines, does not deter future bad behavior. The government is not required to minimize the collateral consequences of a conviction, and individuals are usually required to fend for themselves if they are convicted of a crime. But the foreign exchange inquiry involves a number of leading global banks, each with thousands of employees worldwide. So federal prosecutors go for punishment that does not threaten the continued existence of one of the banks. In other words, punishment that doesn’t actually punish.

The government has imposed billions of dollars in fines over the past few years for corporate violations, part of an effort to show that no company is “too big to jail”, while steadfastly refusing to actually jail a bank or major bank executives for criminal violations.

Lather, rinse, repeat.