NEW$ & VIEW$ (20 APR. 2015): No recession, but inflation? China; Oil; Earnings.

Conference Board Leading Economic Index Remains in Growth Territory

The index rose 0.2 percent, which follows a 0.1 percent February increase (a downward revision from 0.2 percent).

Large positive contributions from initial unemployment claims and the yield spread more than offset the large negative contribution from building permits. In the six-month period ending March 2015, the leading economic index increased 1.8 percent (about a 3.7 percent annual rate), much slower than the growth of 3.3 percent (about a 6.7 percent annual rate) during the previous six months. But the strengths among the leading indicators have remained more widespread than the weaknesses.

As we can see, the LEI has historically dropped below its six-month moving average many months in advance of a recession.

Here is the same chart based on the six-month rate of change, which gives a similar insight into behavior of the index in relation to recessions.

Still, the U.S. is having another spring soft patch that few saw coming:

How bad is it? Last 3 months at annual rates (from D. Rosenberg):

• U.S. IP –3.7%
• Retail sales –1.6%
• Housing starts –46.2%
• Building Permits –7.7%
• Core capex orders –7.3%
• Exports –19.8%

Spring bounce back? Warmer weather and west coast ports reopening fuel hopes. Manufacturing IP, retail sales and housing starts ticked up in March. Jobless claims keep pointing to payroll gains north of 200k.

But another point of concern comes from a rather obscure set of data assembled by the National Association of Credit Management (via Lance Roberts):

The Credit Managers’ Index measures credit conditions for businesses in both manufacturing and services, breaking down “favorable factors” and “unfavorable factors.” The former consists of aspects like new credit applications and dollar amount of credit extended, while the latter, which I think is more important at cycle inflections, attempts to systemically quantify parameters like the rejection of credit applications (tightening conditions), accounts placed for collection (tightening abilities to pay) and dollar amount beyond terms (overextended financial position).

The March release of the CMI was absolutely atrocious, particularly among the “unfavorable factors.” From the release itself:

We now know that the readings of last month were not a fluke or some temporary aberration that could be marked off as something related to the weather. There is quite obviously some serious financial stress manifesting in the data and this does not bode well for the growth of the economy going forward. These readings are as low as they have been since the recession started and to see everything start to get back on track would take a substantial reversal at this stage. The data from the CMI is not the only place where this distress is showing up, but thus far, it may be the most profound.

The March reading was not quite in “contraction” territory, but that was entirely made up of “favorable factors” not deteriorating as much as “unfavorable.” Still, the index value was the lowest in the “recovery” period and equates to about January 2008 in the prior “cycle.” What makes this CMI somewhat compelling is its stability of measure, thus that increases the likelihood that an actual shift in the measure is picking up an actual change in the economy (which is where most sentiment surveys go “wrong”).

As in 2007-08, it is the “unfavorables” that shift first and worst:

The index has tumbled since October 2014 (a financially-relevant month) all the way to 48.5 which marks the lowest point since 2009, even “besting” the “dollar” eruption in August 2011 (which saw the S&P 500 drop almost 20% in a matter of about two weeks). That is the same level as February 2008 but on an even steeper decline.

Inside the “unfavorables”, the rejection of credit applications stands out as either totally out of line with real world possibilities or a signal that March got much worse than anyone expects (and not just orthodox economists who never imagine anything could be bad under ZIRP or QE). I honestly don’t know what to make of this except to say that next month will be interesting if it continues or even only bounces back partially.

While that looks like a one-month collapse in the chart above, it is actually spread out between February and March; January was all the way up at 51.9, and then February fell to 48.1 and March simply failed to 42.9. If those numbers are even close to an accurate proxy, then businesses found the credit door slammed shut in a manner that isn’t within our experience.

The actual CMI release is more direct: “This is credit crunch territory—unseen since the very start of the recession. Suddenly companies are having a very hard time getting credit. The accounts placed for collection reading slipped below 50 with a fall from 50.8 to 49.8 and that suggests that many companies are beyond slow pay and are faltering badly. The disputes category improved very slightly from 48.8 to 49, but is still below 50. This indicates that more companies are in such distress they are not bothering to dispute; they are just trying to survive.

One other “unfavorable” subcomponent suggests that any huge surge in credit rejections is not solely as a matter of businesses being overextended (which would actually be a positive condition if businesses were rapidly expanding and maxing out while doing so), at least not to the same degree. That would tend to offer that this is both a factor of existing credit “demand” conditions as well as something very much awry in the willingness of financial intermediaries to offer (either lending standards went up dramatically in the past two months or liquidity is really starting to bite actual credit rather than the gambling-type we have seen in prior outbreaks; or both of those).

The CMI release adds: “The only semi-bright spot was that filings for bankruptcies stayed almost the same—going from 55.0 to 55.1. This is the one and only category in the unfavorable list that did not fall into contraction territory and that suggests that there are big, big problems as far as the financial security of these companies are concerned.”

Interestingly, the problems are as much in manufacturing as in services:

You can read more about the CMI here. It does not have a long enough history to put a high degree of credibility on it yet. The NFIB credit condition index does not validate a credit crunch at this time:

Five percent of owners reported that all their credit needs were not met, up 2 points but historically low. Thirty-five percent reported all credit needs met, and 48 percent explicitly said they did not want a loan. Only 3 percent reported that financing was their top business problem. (NFIB March 2015)

Consumer Prices Tick Up, in Sign of Emerging Inflation

The consumer-price index, which reflects what Americans pay for everything from sneakers to airline tickets, rose a seasonally adjusted 0.2% in March from a month earlier. That matched the increase the previous month, which was the biggest increase since June. (…)

Compared with a year earlier, overall prices declined slightly. But core prices—excluding the volatile food and energy categories—have climbed 1.8% over the past year, reflecting higher costs for housing and medical care services. (…)

Friday’s report showed energy prices rose 1.1% from February, with the gasoline index jumping 3.9%, its largest increase in more than two years.

Increases in the cost of housing and medical care drove up core prices in March. Shelter expenses-reflecting the cost of housing, including rent-increased 0.3%, and prices for medical care services jumped 0.4%. Prices for new and used vehicles, apparel and alcoholic beverages also rose last month.

Food prices decreased 0.2% in March, due in part to a decline in prices for many grocery-store products, including fruits and vegetables, nonalcoholic beverages, dairy, meats, poultry, fish and eggs. (…)

The various measures used by the Cleveland Fed suggest that core inflation is running at +0.2% per month, nearly +2.5% annualized. Deflation has suddenly become passée...

…while inflation is back haunting the Fed and investors in general. Maybe the market is behind the curve this time:

Inflation Warning

Last week, the 4/16 WSJ reported: “U.S. wages may be starting to pick up, a development that could help policy makers at the Federal Reserve feel more confident that sluggish U.S. inflation also will gain traction, Fed Vice Chairman Stanley Fischer said Thursday.” He said so on a panel discussion in Washington. That same morning, in a CNBC interview, he said the Fed knows the markets “look ahead somewhat, so I think–I hope–that they are taking into account that the Fed, at some point, is likely to raise the interest rate.” On timing, he said markets “can’t depend on the current situation continuing forever–or even probably–beyond the end of this year.”

He reiterated that “there are more signs every day” of mild wage increases. What is he looking at? Let’s have a look:

(1) Minimum wage. Anecdotally, the minimum wage was raised in 21 states at the start of the year. However, during March, average hourly earnings rose only 2.1% and 1.8% for all workers and for production and nonsupervisory workers.

(2) McDonald’s. On 4/15, fast-food cooks and cashiers demanding a $15 minimum wage walked off the job in 236 cities in what organizers called the largest mobilization of low-wage workers ever. On April 1, McDonald’s announced plans to give employees a 10% pay bump and some extra benefits. The raise will affect about 90,000 workers at a small fraction of McDonald’s stores. Employees at franchises, which make up the majority of the burger chain’s locations, won’t be affected.

(3) Walmart. At the start of April, Walmart raised its minimum starting wage to $9 an hour, 24% higher than the federal minimum. A 4/10 story on PBS NewsHour noted, “The company says that its wage increases will impact 500,000 workers, but the number who will see their wages rise from the federal minimum of $7.25 to $9 is much smaller. Only 5,000 of its 1.4 million workers actually make the minimum wage. And the minimum in most of the country, 29 states, is already considerably higher than the federal minimum. Seven states and the District of Columbia have minimums of $9 or higher. So the average pay raise for the affected Walmart workers will be far less than the 24% raise for the very small number currently earning the federal minimum.”

(4) Quit rate. The quit rate in retailing tends to be relatively high, especially among low-paid workers. Retailers are raising their wages to reduce their labor turnover costs.

(5) Q1 wages and prices. Average hourly earnings for all workers rose 3.9% (saar) during the first three months of the year, the highest since December 2008. That’s the kind of y/y increase that Fed officials have said would allow them to normalize monetary policy sooner and at a faster clip.

In addition, the core CPI inflation rate edged back up to 1.8% during March, closer to the Fed’s 2% target–which is really for the core PCED, which was 1.4% during February. The three-month annualized change in the core CPI through March was 2.3%, suggesting that the core PCED, which was 0.9% through February, might show a higher increase when March data are released on Thursday, April 30.

China Cuts Banks’ Reserve Ratio China’s central bank cut the reserve requirement on bank deposits by one percentage point, in a move to free up funds for loans to struggling companies.

The move followed a half-point reduction in February and would mean that the nation’s bigger banks now need to keep a still hefty 18.5% of their deposits on reserve with the central bank. (…)

Last week Premier Li Keqiang visited some of the nation’s big banks and urged them to try to lower borrowing costs and roll over loans when possible to aid companies in need of a helping hand.

He also promised more targeted measures in the future, though he didn’t give any details of the government’s plans.

The central bank on Sunday also said that it would make an additional cut of one full percentage point in the reserve requirement for agricultural cooperatives and the smallest banks as well as a two-percentage-point reduction for the Agricultural Development Bank, a key policy bank that supports farm projects. It offered another cut of 0.5 percentage point to banks that qualify with sufficient loans to small borrowers and the agricultural sector. (…)

China’s biggest problem in two charts from Zerohedge:

Overnight, the NBS reported that in March, Chinese house prices dropped in 69 of 70 cities compared to a year ago. According to Goldman’s seasonal adjustments, in March home prices dropped another 0.5% from February, the same as the prior month’s decline, suggesting that the February 28 rate cut hasn’t done much to boost housing spirits.

However, it is the annual data that truly stands out, because with a drop of 6.1% this was the biggest drop in Chinese house prices in history.

Global Central Bankers Don’t See Yuan Devaluation on Horizon Global central bankers don’t expect Chinese officials to devalue their currency as part of a widening campaign to boost output in the world’s second-largest economy.

Russia’s economy shrinks 2-4% despite Putin’s positive spin

Monthly statistics published on Friday showed that consumers turned even more bearish in March despite the currency’s recent stabilisation, and economists estimated that gross domestic product was likely to have shrunk by between 2 and 4 per cent in the first quarter. (…)

In March, investment dropped 5.3 per cent compared with the same month last year. Industrial production contracted 0.6 per cent, sustained by the food and chemical industry’s gaining market share after Russia restricted western imports.

But the main downward pressure comes from consumers, who helped sustain growth last year. In March, retail sales contracted 8.7 per cent. The official consumer sentiment index in the first quarter plummeted 14 percentage points compared with the previous quarter — its worst since the last financial crisis in early 2009. (…)

This week, inflation slowed for the first time since the start of the food embargo, bringing the annualised rate to 16.8 per cent. But analysts believe it will be several more months until the economy turns a corner. (…)

Is Saudi Arabia Setting The World Up For Major Oil Price Spike?

In order to maintain a grip on market share by pushing U.S. shale producers out of the market, Saudi Arabia (and OPEC) is willing to use up its spare capacity. That could lead to a price spike.

Saudi Arabia produced 10.3 million barrels per day in the month of March, a 658,000 barrel-per-day increase over the previous month. That is the highest level of production in three decades for the leading OPEC member. On top of the Saudi increase, Iraq boosted output by 556,000 barrels per day, and Libya succeeded in bringing 183,000 barrels per day back online. OPEC is now collectively producing nearly 31.5 million barrels per day, well above the cartel’s stated quota of just 30 million barrels per day. (…)

But, more Saudi oil comes at the cost of a shrinking global spare capacity. Saudi Arabia is essentially the only oil producer that has significant slack production capabilities, which can be ramped up or down depending on market conditions. (…)

OPEC’s actual levels of spare capacity are somewhat opaque, which makes estimates difficult. But Saudi Arabia producing at its highest level in three decades certainly eats into that reserve. Moreover, Saudi Arabia typically consumes more oil in the summer for domestic purposes, which could further shrink spare capacity in the months ahead. PIRA Energy Group warned of such a scenario in its latest weekly oil report. “Incremental Saudi crude burn demand could push its volume this summer to levels that would substantially reduce global spare capacity, at a time when oil markets will be tighter and geopolitical risks to supply are growing,” PIRA wrote on April 14. Spare capacity may shrink to just 1.7 million barrels per day.

Saudi Arabia is succeeding in pushing out U.S. shale production, but in the meantime, the world is getting hooked on low prices. Oil demand is growing quickly – the IEA predicts global demand will jump from 92.66 million barrels per day in the second quarter up to 94.67 million barrels per day in the fourth quarter.

That will put oil markets in an interesting situation. U.S. production will continue to shrink as the year goes on and Saudi Arabia will have very little spare capacity. If a supply disruption occurs somewhere – more loss of Libyan oil, violence in the Middle East, or a faster-than-expected drop off in U.S. production – the Saudis will be left with little firepower to control a price spike (not that a price spike would necessarily be bad for them).

There is an argument that U.S. shale has emerged as a sort of collective swing producer – shale operations ramp up and down much quicker than conventional drilling. But they don’t turn on and off that quickly. They can’t mimic the latent supply that the Saudi’s have in their back pocket. Furthermore, shale production is the result of drilling by hundreds of companies, and future investments and drilling will be made by private individuals based on individual financial circumstances, as opposed to state-level geostrategic calculations.

In other words, shale producers, now that they are shrinking their footprints and production levels, will not be able to step up to the plate in a pinch. If global supplies shrink unexpectedly, and Saudi Arabia has run down its spare capacity to low levels, oil markets will tighten to a precarious point.

• Hedge Funds Turn Most Bullish on Oil in 8 Months as Output Slows

Speculators boosted their net-long position in West Texas Intermediate crude by 9 percent in the seven days ended April 14 to the highest since August, U.S. Commodity Futures Trading Commission data show. Shorts, or bets on falling prices, tumbled to the lowest since February.

“The shorts are throwing in the towel,” Phil Flynn, senior market analyst at the Price Futures Group in Chicago, said by phone on April 17. “A lot of the people that were betting on a price collapse are changing their mind based on the fact that we are seeing U.S. production start to fall.” (…)

• Oil falls as Saudi output remains near record high

“I have said many times we will always be happy to supply to our customers with what they want. Now they want 10 million,” Naimi told Reuters on Monday in Seoul, (…)

Naimi earlier this month said Saudi Arabia produced 10.3 million bpd of crude in March, eclipsing a previous record of 10.2 million bpd (…)

SENTIMENT WATCH

Corporate Results Fuel U.S. Stock Sentiment Greek and Chinese events and disappointing corporate sales isn’t a welcome combination for equity markets.

First-quarter U.S. corporate revenue, now beginning to be reported, is coming in even lower than analysts’ sharply reduced forecasts had indicated. Through Friday, most big companies were reporting profits above expectations, but more than half were announcing sales lower than analysts estimated. (…)

Not that big a deal when you look at the numbers (see EARNINGS WATCH below).

Dollar’s rise casts shadow on US earnings Driver of equities depends on how multinationals weather currency

A surging dollar is expected to hit some of the largest US multinationals this week, as more than a fifth of S&P 500 companies report results for a quarter marked by a 9 per cent jump in their domestic currency. (…)

With the S&P up only 1.1 per cent this year, investors are concerned that several companies could emulate General Electric and Philip Morris, which each said last week that the dollar reduced their revenues by nearly $1bn in the first quarter. GE said currency swings hit profits by $120m, and Philip Morris reported a $585m hit to “operating companies income”. (…)

FactSet expects first-quarter earnings for the S&P 500 to decline 4 per cent and revenues to drop 3 per cent. But it expects both earnings and revenues to be down 10 per cent for companies that generate less than half their sales in the US. (…)

Technology companies are acutely exposed to the dollar’s strength, as the sector generates more of its revenues abroad than any other, according to S&P Dow Jones Indices. (…)

For the record: During the course of the first quarter, the dollar strengthened relative to the euro. On December 31, one euro was equal to $1.21 dollars. On March 31, one euro was worth about $1.07 dollars. The dollar has also strengthened relative to year-ago values for both the euro and the yen. In the year ago quarter (Q1 2014), one euro was equal to $1.37 dollars on average. For Q1 2015, one euro was equal to $1.13 dollars on average. In the year-ago quarter (Q1 2014), one dollar was equal to $102.76 yen on average. For Q1 2015, one dollar has been equal to $119.17 yen on average.

Other companies citing currency headwinds:

• “The decline in adjusted EPS of 4.3% versus the prior year was entirely due to the negative impact of movements in currency rates in the translation of our results, particularly the weakening of the euro compared to prior year. This resulted in a negative impact to EPS in the quarter of approximately $0.13 per share. EPS on a constant currency basis was $1.69 or up 3.7% over the prior year.” –Johnson & Johnson (Apr. 14)
• “At the same time, challenging macroeconomic conditions and then appreciating U.S. dollar weighed on our business in important geographic markets.” –Intel (Apr. 14)
• “We estimate that 1% move in the pound sterling versus the dollar from current levels would impact our adjusted EPS by approximately $0.01 per share.” –Walgreens Boots Alliance (Apr. 9)
• “There is no doubt, however, that the further weakening of foreign currencies has led to what now appears to be a $0.35 to $0.40 headwind for this fiscal year, primarily concentrated in corn gross profit and to a lesser degree in Ag Productivity gross profit, and driven by the deterioration of several key currencies versus the dollar very close to today’s rate.” –Monsanto (Apr. 1)
• “The year-over-year impact from the strengthening dollar cost us $0.06, including both translational and transactional currency impacts.” –Carnival Corp. (Mar. 27)
• “Nearly every currency in which we do business weakened against the U.S. dollar, when compared to Q4 last year, last quarter, against guidance or versus the full
  year of fiscal 2014…..For the full fiscal year 2015, total revenue would have been $36 million higher using rates from last year and $20 million higher using the rates given in March of 2014 when we first set fiscal year 2015 guidance.” –Red Hat (Mar. 25)
• “we had a significant headwind from currency this period….Our adjusted operating income excludes special charges and declined 2%, but if we also exclude currency, we achieved modest growth of 1%.” –McCormick & Co. (Mar. 25)
• “Net sales totaled $4.4 billion, down 1% due to foreign currency effects.” –General Mills (Mar.18)
• “In the International Export segment, excluding fuel, yield per package decreased 0.8%, primarily driven by the negative impact of exchange rates, which offset positive weight, rate, and discount changes.” – FedEx (Mar. 18)
• “The currency headwind ended up being 6% for software and cloud revenues as well as total revenue, 7% for total hardware revenue, and $0.06 a share – and $0.06 for earnings per share.” –Oracle (Mar. 17)
• “From a year-over-year currency perspective, FX decreased revenue by $26 million. Considering the $24 million in hedge gains in Q1 FY 2015, versus $3 million in hedge gains in Q1 FY 2014, the net year-over-year currency decrease to revenue considering hedging gains was $5 million.” –Adobe Systems (Mar. 17) (Factset)

EARNINGS WATCH

From Factset:

Overall, 56 companies have reported earnings to date for the first quarter. Of these 56 companies, 77% have reported actual EPS above the mean EPS estimate and 23% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate is above
both the 1-year (74%) average and the 5-year (73%) average.

In aggregate, companies are reporting earnings that 5.8% above the estimates. This surprise percentage is above both the 1-year (+4.1%) average and the 5-year (+5.4%) average.

If the Energy sector is excluded, the estimated earnings growth rate for the S&P 500 would jump to 4.0% from -4.1%.

In aggregate, companies are reporting sales that are 0.3% below expectations. This surprise percentage is well below the 1-year (+0.9%) average and the 5-year (+0.7%) average. If the Energy sector is excluded, the estimated revenue growth rate for the S&P 500 would jump to 3.1% from -3.0%. It was +3.0% one week ago.

Due to companies beating earnings estimates in aggregate, the blended (combines actual results for companies that have reported and estimated results for companies yet to report) earnings decline for Q1 2015 is -4.1%, which is smaller than the estimate of -4.7% at the end of the first quarter (March 31) and -4.9% last week

Due to companies missing revenue estimates in aggregate and analysts continuing to revise revenue estimates downward for companies yet to report, the blended revenue decline for Q1 2015 is -3.0%, which is larger than the estimate of -2.6% at the end of the first quarter (March 31).

At this point in time, 10 companies in the index have issued EPS guidance for Q2 2015. Of these 10 companies, 6 have issued negative EPS guidance and 4 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the second quarter is 60%. This percentage is below the 5-year average of 69%.

Better than expected earnings and decent guidance are needed as we navigate the soft patch and higher core inflation. Just as it seemed that equities were about to traverse the “20” line into overvalued territory, Friday’s inflation numbers cooled everybody off. The Rule of 20 formula is now using 1.8% inflation, up from 1.5% in February. This suggests a fair P/E of 18.2x, down from 18.5x, just as trailing EPS are dropping from their Q3’14 peak of $114.51 en route for $112.23 after Q2’15 under current projections. Rising inflation and declining EPS are pretty strong headwinds for equities (yellow line in chart), especially if odds of a more hawkish Fed are rising.

This just as we are about to enter a seasonally weaker bout for equities:

Here’s an important snapshot of world equity market valuations (LPL Research):

FYI, here’s the last 20 years for U.S. large cap stocks: P/Bk is back to its late 1990’s level but ROE has levelled off since 2012. The forecast ROE of 19% for 2015 (red dot) seems heroic at this point.

In case you ask, here’s the picture for smaller caps. Careful! (Charts from Morningstar/CPMS)

Gundlach Says Market Hasn’t Seen Full Impact of Fed Moves

DoubleLine Capital’s Jeffrey Gundlach, the bond manager who has beaten 99 percent of his peers over the past five years, said the full impact of the Federal Reserve’s “extreme policies” have yet to be felt in the market. (…)

Known for his contrarian views and top returns, Gundlach said rating the Fed very highly at this point is “sort of like a man who jumps out of a 20-story building, and after falling 18 stories, says, ‘So far, so good.’” (…)

Gundlach reiterated caution on high-yield bonds, saying that default rates could go higher. He also cautioned investors that some mall real estate investment trusts are in a “death spiral.” (…)