On the Fast Track?

Surprise, surprise: A few recent economic indicators suggest that the US economy could be turning red hot. That would be a very big surprise indeed given all the recession fears at the year’s start. Consider the following:

(1) Record tonnage. February was an awesome month for truck tonnage. The American Truck Associations’ measure soared 7.2% m/m and 8.6% y/y. The index, which is a good indicator of the broader economy since trucks account for 69% of tonnage carried by all carriers, jumped to a new record high.

However, ATA’s Chief Economist Bob Costello cautioned: “The strength was mainly due to a weaker than average January, including bad winter storms, thus there was some catch-up going on in February.” The result was a big seasonally adjusted gain. Costello also cited inventory overhangs as a reason he’s waiting to see March’s data before getting too excited.

There is a good correlation between the trucking index and real business inventories, which may be somewhat bloated as Costello notes. However, even if there is some payback in March, the uptrend in the trucking business may boost sales of medium-weight and heavy-weight trucks, which have been stalled at a cyclical high over the past year. (See our Truck Tonnage Index.)

(2) Coast to coast. What are trucks hauling? Imports have surged recently at the West Coast ports. Inbound traffic of 20-foot equivalent containers made a good showing during February, jumping 8.6% y/y based on its 12-month moving sum. Of course, a year ago imports were depressed by strikes at the ports. (See our West Coast Ports Container Traffic.)

(3) Regional factory boom. Manufacturing business survey results came in strong for three of the earliest reporting Fed districts: New York, Philadelphia, and Richmond. The average of their composite manufacturing indexes shot straight up from -7.8 in February to 11.7 this month, the highest since November 2014. Of the contributing components, new orders and shipments rose sharply, while employment readings were steady to slightly positive.

Fed Has Slack

Fed officials must be very pleased to see that the unemployment rate is under 5.0% and that the core PCED inflation rate is approaching 2.0%. However, the doves among them, especially Fed Chair Janet Yellen, might justify slowing the pace of monetary normalization so that they can be more certain that the economy has normalized for sure. They can argue that there is still slack in the labor market. The recent rapid increase in the labor force suggests that workers are coming back because they’ve heard that there are plenty of job openings and they are finding jobs. The influx of reentering as well as new workers seems to be keeping a lid on wage inflation, which is another sign of slack in the labor market.

With regard to inflation, a few Fed officials recently have signaled that they prefer to target the headline rather than the core inflation rate since the plunge in oil prices seems to be having a depressing impact on inflationary expectations. Using the PCED measure, the former was 1.3% y/y while the latter was 1.7% during January. I wouldn’t be surprised if Fed officials started to suggest that they wouldn’t mind if the core rate overshot their 2.0% target for a while. Now let’s have a close look at all the recent data that members of the FOMC are likely to depend on when they meet on March 15-16--and most likely decide to do nothing and to signal nothing about another rate increase at the next meeting on April 26-27:

(1) Earned income. Friday’s employment report for February was sweet and sour. Payrolls rose solidly (0.2%), but wages edged down (-0.1) and weekly hours worked declined (-0.6). As a result, our Earned Income Proxy, which tracks private-sector aggregate wages and salaries, declined by 0.5% m/m. (See our YRI-EIP.)

(2) Employment. Payroll employment rose 242,000 last month, and the previous two months were revised up to 172,000 during January and 271,000 during December for a total gain of 685,000. Even more impressive is that the household measure of employment jumped by 1.6 million over the past three months, while the labor force surged by 1.5 million. With the significant influx of reentering and new workers in the labor force, the civilian labor force participation rate finally seems to be turning up.

(3) Wages. This is Yellen’s dream scenario. However, it is only starting to play out. The rise in the labor force confirms her view that there is plenty of slack still in the labor market as previously discouraged workers who dropped out come back into the labor force. The slack thesis is also corroborated by the relative weakness in average hourly earnings, which rose only 2.2% y/y last month for all workers. Yellen has previously said that she would like to see wages rising between 3% and 4%.

(4) Trade. Also on Friday, the Commerce Department reported that the US trade deficit widened more than expected in January as a strong dollar and weak global demand helped to push exports to more than a five-and-a-half-year low, suggesting that trade will continue to weigh on economic growth in the first quarter. On an inflation-adjusted basis, exports fell 2.2% m/m and 3.8% y/y to the lowest since February 2014. West Coast ports’ outbound container traffic fell 8.1% y/y through January.

The trade-weighted dollar is down 3.0% from its recent peak on January 20, but remains up 19% since July 1, 2014. That’s clearly weighing on exports. This is yet another reason to postpone further rate hikes so that the dollar doesn’t move still higher.

Earnings & Margins: Different Strokes

On the downbeat side for US stocks at the beginning of the year were Q4 corporate profits, which were reported during January and February. Thomson Reuters (TR) reported that S&P 500 operating earnings fell 0.7% y/y during Q4 to $29.45 per share. Standard & Poor’s (SP) reported a whopping 12.2% y/y decline to $23.49. The $5.96 divergence between these two measures is the biggest on record, exceeding even the $5.71 during Q4-2008. The biggest discrepancies were attributable to the Energy and Materials sectors, where SP showed much weaker results than did TR. (See our S&P vs. Thomson Reuters Earnings.)

The S&P 500 quarterly profit margin peaked at a record 10.7% during Q2-2015 and edged down to 10.2% at the end of 2015 according to TR. The SP data show the margin peaking at a record 10.1% during Q3-2014 and dropping to 8.1% at the end of last year.

Why is there such a divergence between SP and TR? Consider the following:

(1) GAAP rules are highly conservative. US public companies are required to report on EPS in their financial statements based on Generally Accepted Accounting Principles (GAAP). In short, GAAP earnings are fully loaded with all income statement line items pertinent to the reporting periods. Even when a judgment call exists, GAAP accountants will lean towards the outcome that reveals the least amount of profit. That’s because accountants are trained to follow the principle of conservatism in accordance with GAAP.

Public companies report on several variations of EPS. Those include basic and diluted EPS based on total net income, or loss, with further subdivision by continuing and discontinued operations. They will also report on other variations as discussed below.

(2) “Unusual” exclusions are usually not GAAP. Public companies typically want to demonstrate the best view of their results to investors, and so may wish to exclude (or include) items considered “unusual” in nature from their EPS calculations. Any such related financial measures would be considered non-GAAP. It’s no surprise that non-GAAP measures tend to be more favorable than GAAP as it tends to be more conservative. In a 2014 note, SP’s Senior Index Analyst, Howard Silverblatt, quipped: “[D]uring difficult times, the term ‘unusual’ appears to be used more liberally [by companies].”

Note that to avoid misleading investors, the SEC requires that any non-GAAP financial measures are presented and also reconciled against the most directly comparable GAAP measure.

(3) S&P’s “operating per share” is closer to GAAP. SP reports on two primary EPS series, namely “as reported per share” and “operating per share.” Here’s how the footnotes in S&P’s data release characterize the two: The former is derived from income from continuing operations as GAAP defines. SP’s “operating per share” further adjusts for “unusual” items based on SP’s own interpretation of such items. Importantly, SP does not always exclude (or include) the same “unusual” items as companies do. That’s because SP’s goal is to ensure comparability across industry groups.

(4) Majority rules for TR’s operating EPS. TR also collects data on a variety of different EPS measures including a GAAP and adjusted one. TR’s goal with its adjustments is to align its EPS data with analyst estimates. Analysts and companies often work together to ensure that forecasts are consistent with how “adjusted” earnings will be reported. So analysts tend to exclude (or include) the same line items that companies do!

TR’s July 2015 proprietary “Methodology for Estimates” notes: “When a company reports their earnings, the data is evaluated by a Market Specialist to determine if any Extraordinary or Non-Extraordinary Items (charges or gains) have been recorded by the company during the period. … If one or more items have been recorded during the period, actuals will be entered based upon the estimates majority basis at the time of reporting.

“Any submission of an estimate by a contributing analyst using a non majority actual or on a non majority basis results in a call from a Thomson Reuters Market Specialist requiring the contributing analyst to adjust to the majority basis or have their estimates footnoted for an accounting difference and excluded from the mean calculation for the fiscal years in question.”

China: Sleeping With the Fishes (excerpt)

Some very smart people are taking very big bets that China may be the subject of the sequel to “The Big Short,” the movie about how the subprime mortgage crisis triggered the housing and financial meltdown of 2008. That’s according to a 1/31 WSJ article titled “Currency War: U.S. Hedge Funds Mount New Attacks on China’s Yuan.” Here is an interesting item from the piece:

Kyle Bass’s Hayman Capital Management has sold off the bulk of its investments in stocks, commodities and bonds so it can focus on shorting Asian currencies, including the yuan and the Hong Kong dollar. It is the biggest concentrated wager that the Dallas-based firm has made since its profitable bet years ago against the U.S. housing market. About 85% of Hayman Capital’s portfolio is now invested in trades that are expected to pay off if the yuan and Hong Kong dollar depreciate over the next three years--a bet with billions of dollars on the line, including borrowed money. "When you talk about orders of magnitude, this is much larger than the subprime crisis," said Mr. Bass, who believes the yuan could fall as much as 40% in that period.

The Chinese government has taken note and has already sent George Soros a dead fish wrapped in newspaper. Actually, the warning to Soros and others not to start a currency “war” with China appeared in an opinion piece by a low-level government official in the 1/27 People’s Daily Online headlined “Think twice before declaring war on Chinese currency.” The official wrote: “Soros’ challenge to the RMB and Hong Kong dollar are doomed to fail, without any doubt.” We will see who wins. However, betting against China seems to be a very good bet these days. Consider the following:

(1) Depreciating currency. The yuan is already down 8.2% since it peaked on January 1, 2014. As Debbie and I have been monitoring since mid-2015, the problem is a big swing from capital inflows before last year to massive capital outflows, as shown by the 12-month sum of China’s trade surplus and the 12-month change in China’s non-gold international reserves. This proxy implied about $1.0 trillion in capital outflows last year. (See our China Capital Flows.) The author of the op-ed in China’s leading communist newspaper wrote, “But it is hard for the dollar to be strong against the RMB for the long run, since China is still maintaining an expanding trade surplus.” He didn’t mention the capital outflows.

(2) Dialing for dollars. Several factors triggered the capital flight. The Chinese government has stepped up an anti-corruption drive since it was first started during November 2012. Perhaps that caused wealthy Chinese to move funds abroad. More importantly, the tightening of US monetary policy with the termination of QE during October 2014 and the widely anticipated rate hike late last year caused Chinese companies that had borrowed in dollars to scramble to pay these loans. The resulting drop in the yuan accelerated the capital outflows. A 1/26 FT article by Gillian Tett covered this subject very well.

(3) Fewer opportunities. Of course, capital outflows may also reflect fewer profitable investment opportunities in China. Profits earned by Chinese industrial companies in November fell 1.4% y/y, marking a sixth consecutive month of decline. China’s official M-PMI dipped to 49.4 last month, the sixth consecutive reading below 50.0 and the weakest since August 2012.

On the other hand, the NM-PMI was 53.5, remaining solidly above its December 2008 low of 50.8. Still, there is no doubt that China’s economy is slowing, as evidenced by the 8.3% y/y decline in railways freight traffic through December. Last year, electricity output rose just 2.4%, the slowest pace since 2009.

The China Syndrome Again

Another movie that comes to mind, of course, is the “China Syndrome.” There is no shortage of doomsday scenarios with China as the epicenter of a global meltdown. For example, a 1/26 CNBC article is titled “A China bank contagion could blow up global markets.” While the headline is alarming, the story is actually relatively reassuring, at least relative to the headline. Here are a few of the key excerpts from this comprehensive and well done piece by Tim Mullaney:

(1) Low default risk among banks:

A measure of default risk used by Moody’s Investors Service puts the risk of any of the Big Four Chinese banks--Bank of China, the Industrial and Commercial Bank of China, China Construction Bank and Agricultural Bank of China--defaulting in the next year at no more than 1.5 percent, and for some as little as 0.5 percent.

(2) Government backed:

Even with nearly $11 trillion of assets and loans that reach into all sectors of China’s $10.3 trillion economy, for now, experts see little likelihood the banks themselves will be a problem; China’s largest banks are all controlled by a government that has the determination and resources to prop them up if necessary. And their ties to U.S. institutions are narrow enough that bond-rating agencies don’t foresee anything like the financial contagion of 2008, when liquidity problems quickly spread from bank to bank and nation to nation as the extent of the mortgage crisis became clear. …

China’s banks also benefit from the explicit backing of the government there, in contrast to the U.S., where bank bailouts remain controversial seven years after the crisis. China’s central bank also has much more room to lower interest rates than does the U.S. Federal Reserve, which has set the target range for its key policy rate at 0.25 percent. The current Chinese base interest rate is 4.35 percent.

(3) Credit growing:

To date, China’s banks have not experienced anything like the cataclysms that rumbled through U.S. and European institutions between 2007 and 2009. Neither have their problems resulted in any significant shortages of credit: Retail sales in China rose 11 percent in December 2015, and housing sales have begun to rebound from an earlier dip. …

China’s banks are mostly funded by deposits rather than the capital markets, said Grace Wu, an analyst for Hong Kong-based Fitch Ratings. That makes them less vulnerable to short-term twists in the mood of markets, she said. They also have loan-loss reserves, collectively, that are nearly twice as big as the amount of loans that are 90 or more days past due, according to Moody’s Investors Service.

(4) Some cracks:

That said, China’s banks are in worse shape than a year ago, by many measures. Reported loan delinquencies have risen to 1.59 percent of loans as of Sept. 30, up from 0.95 percent at the end of 2012, Moody’s Investor Service says. And critics have seized on banks’ decisions to classify fewer loans whose borrowers are more than 90 days late on their payments as non-performing, saying banks and the government are trying to paper over the extent of a fast-growing problem.

Moody’s Investor Service cut its outlook for China’s bank sector to negative from stable, on Dec. 11. It pointed to the loan-loss problems, as well as an increase in overall borrowing to 209 percent of gross domestic product, from 193 percent a year ago, that it says raises systemic risk.

But all four of China’s largest commercial banks, each majority-owned by the government, are still rated A1/Stable--six notches above speculative grade and higher than all six of the top U.S. banks, which are rated A2 or A3. Bigger problems lurk in smaller Chinese banks that are less systemically important, the ratings agency said.”

(5) Conclusion: I know what you are thinking: Didn’t the rating agencies completely miss seeing the subprime mortgage disaster? We all know that they were actually part of the problem because they failed to rate junk credit as junk. Instead, they rated most of the junk that was sliced and diced into credit derivatives as investment grade, even AAA. It’s all in the movie.

The author of the CNBC article acknowledges the worries about a repeat of 2008. He notes:

The problems China’s banks have are focused in manufacturing and wholesaling--and an increasing number of those borrowers are relatively small businesses, Moody’s said. That raises the risk that their problems are not well understood or that they could worsen.

However, it is true that China’s bank loans are funded entirely by deposits. The ratio of M2 to bank loans was 1.48 during December and has exceeded 1.28 since the start of the data in December 1999. Then again, in yuan terms, bank loans are up a whopping 210% since December 2008. In dollar terms, they are up $10.2 trillion, from $4.4 trillion during December 2008 to $14.6 trillion during December 2015. Yet despite all that credit, the economy has slowed significantly.

Something is fishy in the state of China.

(Based on an excerpt from YRI Morning Briefing)

Blaming the Fed (excerpt)

How did we get into this mess? Despite all the easy money provided by the Fed and the other major central banks, global economic growth is subpar. Indeed, it may be heading into a recession. Inflation remains below the 2% target of the major central banks. Commodity prices are crashing, and stock prices have been weak since the start of the year. Consider the following:

(1) High price of easy money. Today’s problems may be traced to the termination of the Fed’s QE program on October 29, 2014 and the subsequent anticipation of a mere 25bps hike in the federal funds rate, which finally happened on December 16, 2015.

The Fed’s easy monetary policies at the beginning of the previous decade certainly contributed to the subprime mortgage mess. This time, the Fed’s easy money in recent years encouraged borrowers in emerging markets (EMs) to borrow lots of money from banks and in the bond markets to expand commodity production. A significant amount of that debt was in dollars. The prospect of the tightening of US monetary policy after so many years of near-zero interest rates caused EM borrowers to scramble to sell their own local currencies to buy dollars to pay off their dollar-denominated debts.

(2) Scrambling for dollars. Fed officials have been either blithely oblivious or negligently unconcerned about how the “reach for yield” by investors in the US might have facilitated the capital flows into EMs, which now have been reversing, as evidenced by the 15.6% drop in the Emerging Markets MSCI currency index since July 9, 2014.

The EMs have had to intervene in the forex markets to slow the descent of their currencies. Their non-gold international reserves have declined $838 billion to $7.4 trillion from July 2014 through October of last year. Of course, some of that decline is exaggerated by the depreciation of reserves held in euros and in yen, though that also has depressed the dollar value of reserves.

From this perspective, the 23% increase in the trade-weighted dollar since July 1, 2014 is to a large extent a massive short-covering rally by EMs. The soaring dollar increased the local currency prices of commodities priced globally in dollars. It’s likely that the plunge in commodity prices might have been triggered by the short-covering dollar rally combined with the tightening of credit for EMs. Of course, the supply-led glut of commodities only made things worse.

(3) End the Fed. Fed officials don’t spend much time analyzing credit market developments and flows of funds, especially on a global basis. The Fed does have an excellent flow-of-funds database for the US. However, it lacks any data on credit derivatives, which might explain why Fed officials were blindsided by the subprime mortgage disaster. The Fed’s research staff conducted no significant research on mortgage credit derivatives prior to the previous financial crisis.

Similarly, this time around, the Fed mostly has ignored the impact of ultra-easy monetary policy on global credit flows, particularly to EMs. That analysis was left mostly up to the Bank for International Settlements (BIS). Just as bad, Fed officials show virtually no interest in the dollar. They take no responsibility for its movements; nor do they try to understand the implications of these movements.

(4) Are EMs subprime? The fear is that all this is leading to another emerging markets crisis that could set off a global financial contagion similar to what happened in 2008. It’s actually surprising that nothing big has blown up so far. There could shortly be a Venezuela debt crisis, according to the financial press. My relatively optimistic spin has been that the dollar borrowing by EMs has been largely financed in the capital markets, which are better able to absorb shocks and losses than banking systems. Loans to EMs haven’t been sliced and diced into different tranches of credit derivatives as were subprime mortgages.

Of course, there are many high-yield bonds that were priced too cheaply and have seen their yields soar since mid-2014. However, they were never rated as anything other than junk. EMs and junk bonds have been great shorts recently, but I doubt there will be a sequel to “The Big Short” based on them.