Posts published in April 2016
The language with which the financial press documents the doings of central banks has taken a notable turn towards military vernacular in recent years. We have “shock and awe” campaigns to talk up growth prospects, and jaw-clenched proclamations of doing “whatever it takes” to stave off collapses in currency, bond or equity markets. Once more unto the breach, dear friends, once more! Descriptions of their policy implementation vehicles are likewise bellicose. Consider the “bazooka” by which Bank of Japan Governor Haruhiko Kuroda fired a new package of stimulus via quantitative easing and negative interest rates back at the end of January. Like most such stimulus programs, the explicit goal was to provide a monetary boost to stimulate economic activity, while the largely unspoken but implicit aim was to weaken the currency (the Japanese yen) and stimulate domestic asset prices. How’s that working out for the BoJ so far? Not so well, as the chart below shows. Since the 1/29 stimulus, the yen has soared against the dollar and the Nikkei 225 stock index has fallen even while world equity markets have enjoyed a broad-based rally.
Hold Your Fire
“Damned if we do, damned if we don’t” must be the frustrated sentiment in Nihonbashi, the Tokyo district where both the BoJ and the Tokyo Stock Exchange are located. Following another policy meeting this week, the central bank announced on Thursday that it would be holding off for the moment on any new stimulus measures. The no-action decision took markets by surprise, as most observers predicted the bank would serve up another cocktail of negative rates and/or increased asset purchases. Once again the yen jumped – this time by four percent in a single day – and stocks cratered.
The official reason for the decision to hold fire, according to Governor Kuroda, was that the bank is still assessing the impact of the January move. It would not be prudent, according to this argument, to implement new policies until members have a better sense of how the current ones are working. He added that the policy impact should be better understood in the not too distant future, giving a guideline of six months or so from implementation as a reasonable time frame. That sets up the possibility for another stimulus move in June, which of course would pull it firmly into the gravitational tractor beam of Janet Yellen and her FOMC colleagues. The Fed meets on June 14-15, and pundits are currently split as to whether rates are likely to rise or remain on hold following that meeting. Should the Fed raise rates in June, Kuroda’s thinking may go, it could give some added force to another round of BoJ stimulus for the Japanese economy. And such a move would be very much in keeping with the Japanese governor’s established penchant for big, dramatic moves rather than incremental policy tweaks.
Running Out of Ammunition?
Such a move would also support an increasingly prevalent view that while the BoJ’s bazooka may be in fine shape, it is running low on ammunition. The decision to move into negative rate territory was controversial when it was announced and continues to be a matter of contention in Japanese financial circles. There are limits to how far into negative territory rates can go, even if no one really knows where that lower bound is. On the quantitative easing side, any moves by the BoJ into riskier asset territory like common stocks are also likely to generate resistance.
Meanwhile, the economy shows few signs of improvement. At this week’s post-meeting press conference the BoJ announced a series of downward revisions to its economic forecasts. Growth is now projected to be 1.2 percent versus the prior estimate of 1.5 percent through March 2017. Inflation – which Governor Kuroda has pledged to see reach the target rate of 2 percent before he leaves office in 2018 – was also revised down from 0.8 percent to 0.5 percent. The likelihood of a return to 2 percent within the next 24 months is looking ever less likely. Labor market conditions have improved but, as in other countries, a fast clip of jobs creation is failing to deliver the kind of wage increases normally seen in the past.
Given this context, it perhaps makes sense that the BoJ would keep its limited store of powder dry for now and hope to get more bang for the buck (ahem, yen) in a June move. But it is a risky gambit; the Fed is far from certain to raise rates then, and any number of other unknowns could manifest between now and then to complicate the policy landscape. Governor Kuroda has two years left in his term to shore up the BoJ’s credibility. Increasingly, that credibility appears to be dependent on events beyond his control.
The Passover holiday starts this evening, and children in Jewish households around the world will be preparing for a traditional rite of passage in reciting the Four Questions to their elders. Investors watching the two month-long rally in equity markets may well have a question of their own: Why is this rally different from all other breakout rallies since the S&P 500 reached an all-time high of 2130 nearly one year ago, in May 2015? To put it a different way, is there anything plausible to suggest a sustained move above a fiercely resistant valuation ceiling? After the three year-plus multiple expansion rally topped out last year there have been five upside breakout attempts that have fallen short, including the current one thus far. The chart below illustrates this topping-out effect.
Tiptoeing Over the Low Bar
Much of the current focus is, rightfully, on first quarter earnings. There are two ways to interpret the results that have come in so far (about 27 percent of all S&P 500 companies have reported Q1 earnings as of today). The first is the expectations game: a number of firms thus far have managed to clear an exceedingly low expectations bar. Back in December, the consensus among analysts was that earnings per share growth would be more or less flat for the first quarter. Today, the same analysts expect Q1 EPS to decline by nine percent from their levels one year ago, when all is said and done. So all that a company has to do in order to give the market an “upside surprise” is to report earnings slightly higher than these sharply reduced expectations.
We have seen this reduced-expectations narrative play out among early reports in the financial and metals & mining sectors, two of the more beaten-down industry groups of late. For example the market takeaway from JPMorgan Chase, which led off earnings for the major banks last week, could be summed up thus: “bad, but could have been worse.” Bank stocks rallied sharply following the JPMorgan release, and were no less giddy a week later when Goldman Sachs reported a decline of 56 percent in net income from the period one year ago. If bad news is not awful news it must be good news, the convoluted logic seems to go.
Math Is Still Math
The second way to interpret Q1 earnings results is to ignore the Kabuki-like theatrics of the expectations game and point out that, however you want to frame the context, low earnings are still low earnings. Stocks are therefore still expensive. At the beginning of 2012 the ratio of the S&P 500 price index to average earnings per share for the last twelve months (LTM P/E) was 12.4 times. Investors would pay $12.40 for each dollar of average per share earnings. Over the subsequent three and a half years the LTM P/E ratio jumped from 12.4 times to 18.1 times – a “multiple expansion” rally where prices grow faster than earnings.
Today, despite two market corrections of more than 10 percent and the repeated failure to regain last year’s high water mark, the S&P 500 is as expensive as it was a year ago. It is more expensive than it ever was at the peak of the previous bull market of 2003-07. It is even dearer on a price-to-sales (P/S) basis; the current LTM P/S ratio of 1.8 times is the highest this ratio has been since the immediate aftermath of the late-1990s tech bubble.
Animal Spirits, to a Point
The fact that the market remains expensive does not necessarily preclude a breakout to the upside into new record high territory. Stranger things have happened; asset markets are the stomping grounds of John Maynard Keynes’ “animal spirits” far more than they are the purview of the fictitious rational actors of economics textbooks. The vague but often telling indicator of investor sentiment seems tilted to the upside. The question, though, is how sustainable a strong upside breakout would be in the absence of improvement in corporate earnings prospects.
We are unlikely to see the earnings math for Q1 make much of a compelling growth case. It remains to be seen whether some of the headwinds that have clipped sales and earnings prospects of late will abate further into the year – perhaps driven by a softer US dollar and a demand pickup in key consumer markets. Until then, we tend to believe that this rally is not much different from the four post-high rallies which preceded it, and that it would be a good idea to keep one’s animal spirits in check. Not in a defensive crouch, but in check.
The big news after last month’s National People’s Congress in Beijing was the announcement by Premier Li Keqiang of the government’s intention to set a range, rather than an individual target, for annual real GDP growth. The range was to be between 6.5 and 7.0 percent, seen as striking a balance between the admission that a steady rate of seven percent, the previous target, was not sustainable, while still delivering enough top-line growth to reach the country’s GDP targets for 2020. Today China released its GDP results for the first quarter of 2016 and – lo and behold – the number came in at 6.7 percent. Observers met the release with the usual skepticism over how much the reported figure varied from what is actually going on in the world’s second largest economy. We’re less concerned about whether the “real” top line is 6.7 or 7.0 or even 5.5 percent, and more concerned about what recent data tell us about the progress, or lack thereof, towards China’s much ballyhooed economic rebalancing.
More Bridges to Nowhere?
Specifically, much of the data released since the March NPC meeting points to an apparently deliberate decision on the part of Beijing policymakers to reach for the elixir of investment-driven stimulus – the key growth driver for much of the past 10-plus years – as a way to head off concerns that efforts to rebalance towards a more domestic consumption-driven economy may be falling short. Those concerns have manifested in recent months in the form of massive capital outflows and a resulting 20 percent decline from peak foreign exchange reserves. Premier Li’s NPC remarks reflected the view that a sugar fix is the best response. Markets took note: iron ore prices jumped by a ridiculous amount on the Monday after the NPC, and commodities generally surged in anticipation of a pickup in China demand. Were they right? Consider the chart below showing other recent key data releases.
Among these four charts, you can see the sharpest reversal of recent trends in industrial production and wholesale prices, both of which came in comfortably ahead of analyst expectations. Fixed asset growth – a key metric for China’s activity in infrastructure and property development – is still nowhere near the levels of recent years, but has actually increased for the first time since 2014. Meanwhile the growth rate of retail sales, an important benchmark of consumer activity, is lower than at any time in the past twelve months.
Corporate Debt – China’s Mountain Dew
Fixed asset investment doesn’t happen without infusions of new debt capital. New bank loans in China are up $351 billion in March, on the heels of an even brisker pace of $385 billion in January new loan creation. That January number represents the fastest pace of monthly loan growth on record. While January is often the busiest month of the year for new loan creation, with newly-approved projects tapping their sources of credit financing, the strong follow-up in March raises expectations that China’s outstanding debt will continue to set new high ground. Bear in mind that China’s total non-financial debt to GDP has soared from around 100 percent of GDP in 2009, at the outset of a new bank lending stimulus program, to 250 percent of GDP today.
The aggregate level of debt is not the only concern; much of the lending is still tied to the so-called “zombies” – troubled state-owned companies whose loans constitute a potentially significant credit quality problem for the banks that originate them. Bankruptcies and loan write-downs are a delicate matter in China, and reminiscent of the chronically inept way Japan’s financial institutions and regulators tried to deal with that country’s nonperforming debt problems in the 1990s.
When the Sugar Wears Off
All sugar highs come to an end, a fact not lost on Beijing’s Mandarins. We do not think it is on anyone’s agenda to try and embark on another decade of hypergrowth fueled by bank loans and fixed asset investment. The Mountain Dew is meant to buy some time and give the urban services sector a chance to establish enough momentum to take over as the economy’s growth engine. This is China’s own version of “kick the can,” a game in which almost every globally significant economy has indulged over the past seven years. For the time being we expect the China story to be net-neutral to positive in its contribution to the overall market narrative, premised on expectations of no imminent hard landing and a stimulative effect on commodities prices. Come autumn, though, policymakers may need to show they have an effective antidote to the sugar high.
The home page for Barron’s online this morning is an instructive sign of the times. One of the lead articles is headlined thus: “Investors Regain Interest in U.S. Stocks,” going on to talk about a $4.6 billion of net inflows into global equity ETFs and mutual funds in the past week. Just two articles below that happy headline is a somewhat more dour take on things: “Unprecedented Outflows from U.S. Stocks Could Leave Remaining Investors Holding the Bag.” It may be the best of times, it may be the worst of times, but in any case it does appear to be a remarkably confusing time.
With that confusion in mind, let us consider Brazil. The once-high flying South American bellwether is rarely far from the top of the headline stream in both the financial and the political sections of major media outlets. Investors with the stomach for event risk, though, have little to complain about in the first quarter-and-a-bit of this year. The chart below shows the price performance of the domestic Bovespa stock index for the year to date.
No Country for the Weak of Heart
The Bovespa is up an impressive 37 percent from its low for the year reached on January 26. Over the course of this rally we have learned the following pieces of information about Brazil: Real GDP in 2015 fell by 3.8 percent, the most in 25 years; the magnitude of GDP decline from peak to trough is 7.2 percent, the worst since the 1930s; and the economy is set to shrink another four percent in 2016. Inflation is over 10 percent, and the total public debt to GDP is over 70 percent, a level not compatible with the country’s existing socio-economic commitments.
All of which is to say nothing of the toxic political climate, long mired in a financial corruption scandal surrounding Petrobras, the national oil concern. Brazilian President Dilma Rousseff has fought attempts by opposition lawmakers to bring impeachment charges against her for some time. She appears to be losing the fight with the defection of three political parties from the coalition led by her Workers’ Party (PT), most notable of which is the Brazilian Democratic Movement (PMDB) led by Michel Temer. With polls showing around 70 percent of the population supporting impeachment, Rousseff may find herself at least temporarily out of power before the end of this month.
Salto do Gato Morto
Given the dire state of both the economy and the political system, can the current rally in the Bovespa be anything other than a dead cat bounce (approximately translated into Portuguese above)? The bullish case would start with the observation that oversold assets will attract mean reversion at some point. The Bovespa is currently around 49 percent below the post-2008 high reached in November 2010. Does that qualify as “oversold”? Perhaps yes, if one assumes that the likelihood of a Dilma Rousseff exit – with PMDB head Temer as the potential replacement – is fully priced into current levels. This outlook would also be premised on the view that the wrenching GDP retreat will bottom out in 2016, that a weak currency will give a tailwind to exports and that a stabilization in commodity prices will boost the economically important resource sector.
Of course there is no certainty that events will play out to such a tidy resolution of the current problems. The PMDB is hardly a squeaky-clean political establishment; six of its members including both the upper house and lower house speakers are under investigation in the Petrobras affair. Nearly 60 percent of the Congress is under some form of criminal investigation for a range of misdeeds including homicide. On the economic side of things the banking system, which has stayed relatively intact amidst the general gloom, may be vulnerable (especially the large public sector banks) to growing capital adequacy pressures if the recession doesn’t trough in the near term.
For those who missed the Bovespa ride in the first quarter, we would be skeptical of any tactical overlay opportunities for the coming months and view the potential case for Brazil as net-negative. For those with a taste for wading back into riskier LatAm equities, we are somewhat more favorably disposed towards Brazil’s neighbor to the south. Argentina is returning to international capital markets next week after a 15 year exile, with a global bond offering investors expect to fetch between $12-15 billion. The proceeds from this offering will be applied to repaying a consortium of creditors led by U.S. hedge fund Elliott Management, on which the prior Argentine government defaulted in 2001. Observers expect that a successful bond offering next week will pave the way for Argentina’s ability to return to global debt markets at least once more later this year.
Argentina’s Merval stock index has also fared well this year, with the latest close about 28 percent above its January low. But whereas Brazil faces a daunting challenge to recapture the performance of its glory days in the early years of this decade, Argentina’s new reformist government could potentially be the catalyst for significant upside ahead after the many years in the wilderness under the previous isolationist government of Christina Kirchner. Not without risk, of course – Argentina has broken the hearts of many an investor going back to the Baring Crisis of 1890. On the other hand, as a Russian proverb has it, no risk means no Champagne.
It’s April Fool’s Day, but nothing in the way of impish pranks came from the Bureau of Labor Statistics this morning. The BLS served up another predictable, steady helping of employment data, headlined by monthly payrolls growth of 215,000, slightly ahead of expectations, and a slight uptick in the unemployment rate to five percent. That small rise in unemployment itself was nothing to bemoan, as it resulted from gains in the size of the labor force (more people looking for work with not all of them finding jobs right away). Wages grew at a decent 2.3 percent annual clip. The labor force participation rate is still low by historical comparison, but is up a bit from its 2015 lows.
Different Trends for Different Times
In fact, most key employment indicators are modest by comparison to previous recovery periods. That is concerning to some, especially given that it follows the deepest losses in the labor market since the Second World War. The chart below shows the monthly change in nonfarm payrolls, and the corresponding unemployment rate, going back to 1950. The gray columns indicate recession periods.
It is true that the pace of job creation in the current recovery period falls short of what the long recovery periods of the 1980s and 1990s produced. The growth period from December 1982 to July 1990 saw average monthly payroll gains of 228,000 and an average unemployment rate of 6.8 percent. The corresponding figures for the go-go years of the 1990s (April 1991 to March 2001) were 201,000 monthly jobs and a 5.5 percent average unemployment rate. Since the most recent recession officially ended in July 2009, 157,000 payroll gains and a 7.6 percent unemployment rate are the corresponding monthly averages.
But when we take into account other contextual considerations, the second decade of the 21st century doesn’t look all that bad. Consider that during the great growth run of the 1960s, a time when average annual GDP growth ran to 4.9 percent (March 1961 to December 1969), average payroll gains ran to 167,000 with an unemployment rate of 4.7 percent. GDP growth during the most recent recovery, by comparison, has averaged just 1.8 percent. It’s a different time, with a more mature economy unlikely to return to the kind of growth we experienced in the 1950s and 60s. This is not to downplay the very real problems we have in the economy today, about which we have made extensive comment in recent articles. But the continuingly predictable employment picture indicates a firm underpinning to this recovery, and a correspondingly low likelihood of an imminent recession. And one final note on this historical comparison: the span of time from the last negative payroll number (September 2010) to the present is the longest postwar streak of positive monthly gains.
Next Up: Wages and Prices
This month’s BLS report also contained some good news on wages, which increased by seven cents to an average hourly rate of $25.43. That represents a 2.3 percent annual increase, meaning that inflation-adjusted purchasing power grew for the average worker over the past year. We are starting to see signs of a general recovery in prices, with core inflation and personal consumption expenditure among the recent data points indicating a drift back towards the Fed’s target expectations. Fed Chair Janet Yellen herself sees no urgency in the latest numbers, as clearly conveyed in her dovish post-FOMC comments and again in a speech in New York earlier this week. Markets also remain unconvinced that the pace of inflation is picking up all that much. That could change, though, if the headline macro numbers continue to beat consensus estimates.
Kinder, Gentler Spring?
Jobs Fridays like today’s are unlikely to move markets much; as we write this, the S&P 500 is more or less flat for the day as it heads to the end of what has been a fairly lethargic week. With the Q1 earnings season getting underway next week, more attention is likely to be focused on how companies are guiding their sales and earnings estimates, and whether recent softness in the dollar is starting to influence mindsets in the boardroom and on the trading floor. Valuations may continue to provide resistance on the upside. What Jobs Fridays like today may do, however, is to suggest that we may still have some way to go before the next recession bear casts its shadow. That in turn may help cushion any further pullbacks emerging out of the myriad global risks that remain at play.