Category: Countries & Regions

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What is causing the current S&P 500 rise and how is it likely to end?

In November 2007, six months after the inverted yield curve (3M-10Y) recovered to a positive slope, bellwether transport stock Fedex broke primary support at 100 to warn of an economic slow-down.

Today, two months after rate cuts restored an inverted yield curve to positive, Fedex again broke primary support, this time at 150. Their CEO observed that the stock market might be booming but the “industrial economy does not reflect any growth at all.”

Fedex

Real GDP growth is slowing, with our latest estimate, based on weekly hours worked, projecting GDP growth of 1.5% for the calendar year.

Real GDP and Weekly Hours Worked

While real corporate profits are declining.

Corporate Profits Before Tax adjusted for Inflation

What is keeping stocks afloat?

First, a flood of new money from the Fed. They expanded their balance sheet by $375 billion since September 2019 and are expected to double that to $750 billion — bringing total Fed holdings to $4.5 trillion by mid-January — to head off an expected liquidity crisis in repo and FX swap markets. The red line below shows expansion of the Fed’s balance sheet, the blue is the S&P 500 index.

S&P 500 and Fed Assets

Second, ultra-low bond yields have starved investment markets of yield, boosting earnings multiples. P/E of historic earnings rose to 22.01 at the end of the September quarter and is projected to reach 22.82 in the December quarter (based on current S&P earnings estimates).

S&P 500 P/E (maximum of previous earnings)

That is significantly higher than the peak earnings multiples achieved before previous crashes — 18.86 of October 1929 and 18.69 in October 1987 — and is only surpassed by the massive spike of the Dotcom bubble.

How could this end?

First, if the Fed withdraws (or makes any move to withdraw) the $750 billion temporary liquidity injection, intended to tide financial markets over the calendar year-end, I expect that the market would crash within minutes. They are unlikely to be that stupid but we should recognize that the funding is permanent, not temporary.

Second, if bond yields rise, P/E multiples are likely to fall. 10-Year breakout above 2.0% would signal an extended rise in yields.

10-Year Treasury Yields

China has slowed its accumulation of US Dollar reserves, allowing the Yuan to strengthen against the Dollar (or at least weaken at a slower rate). Reduced Treasury purchases are causing yields to rise. The chart below shows in recent months how Treasury yields have tracked the Yuan/US Dollar (CNYUSD) exchange rate.

CNYUSD

Accumulation of USD foreign exchange reserves (by China) is likely to be a central tenet of US trade deal negotiations — as they were with Japan in the 1985 Plaza Accord. Expect upward pressure on Treasury yields as growth in Chinese holdings slows and possibly even declines.

Third, and most importantly, are actual earnings. With 98.6% of S&P 500 companies having reported, earnings for the September quarter are 6.5% below the same quarter last year. Poor Fedex results and low economic growth warn of further poor earnings ahead.

We maintain our view that stocks are over-priced and that investors need to exercise caution. We are over-weight cash and under-weight equities and will hold this position until normal P/E multiples are restored.

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Cracks are showing in China’s Debt Markets

“You only learn who has been swimming naked when the tide goes out…” ~ Warren Buffett

Beijing’s de-leveraging campaign, to set the economy on a sustainable path, is starting to expose some of the excesses in financial markets.

Local Government

Local governments owe some 49 trillion yuan (about $7 trillion or 50% of China’s GDP) in off-balance-sheet debt through local government finance vehicles (LGFVs). LGFVs generate no income themselves and are reliant on revenue flows from the city government to service the debt. Local governments in the past generated substantial revenue through land sales but dwindling sales make debt servicing a challenge. Many LGFVs are experiencing cash flow problems and have resorted to borrowing in shadow finance markets to meet their commitments. Interest rates are close to 10% and will simply accelerate the inevitable implosion.

This map from Rhodium highlights the most severely affected LGFVs, where debt in some cases exceeds 30 times local government revenues:

China: City Level Financial Stress

China’s Ministry of Finance (MOF) is attempting to keep a lid on the problem, offering long-term low interest loans from China Development Bank to repay shadow financing. Zhenjiang, an eastern city of Jiangsu province was one of the first beneficiaries, in March 2019. But debt substitution merely prolongs the crisis unless the city can sell off marketable assets to repay debt. Marketable assets which are, in many cases, proving hard to find.

This detailed report from Rhodium examines the problem.

State-owned Enterprises (SOEs)

We are also witnessing a $1.25 billion default by local government-owned Tewoo Group:

“China’s Tewoo Group has forced investors to take losses on a US dollar bond, marking the largest failure to repay dollar debt by a state-owned company in two decades….The commodities trader, which is wholly owned by the city government of Tianjin, completed an exchange offer this week that made investors take significant discounts on their holdings in the company’s debt.”
“The offer was ‘tantamount to a default’, S&P Global Ratings said on Thursday.” ~ FT.com

Based out of Tianjin, Tewoo is a bulk trader of commodities such as metals (ferrous & nonferrous), energy, minerals and chemicals….

In 2017, it had a turnover of $66.6 billion with profits of $122 million and was ranked 129th in the Fortune Global 500 list & 28th in the Chinese enterprises list. The company employs more than 19,000 professionals and has operations across the US, Germany, Japan and Singapore.

Tewoo’s financial challenges are closely linked to Bohai Steel Group, a business associate which has filed for liquidation due to high leverage. Bohai’s bankruptcy in 2018 triggered systemic risk in Tianjin’s financial market and Tewoo has been facing serious liquidity challenges in recent months. ~ MoneyControl

Bank Bailouts

Many small and medium-sized banks are overly reliant on wholesale markets for funding and tightening credit has left them high and dry.
Barclays Research highlighted a number of banks that had failed to submit their 2018 annual reports on time (source Zero Hedge/Macrobusiness):

China: Troubled Banks

  • Baoshang Bank underwent a state takeover in May.
  • Bank of Jinzhou was taken over by state-owned strategic investors in July.
  • Heng Feng Bank was taken over by China’s sovereign wealth fund in August.
  • Troubled Anbang Insurance Group is selling a 35% stake in Chengdu Rural Commercial Bank to “an investment firm owned by the southwestern city of Chengdu.” (Caixin)

While, according to Caixin:

“China’s Hengfeng Bank will raise 100 billion yuan ($14.21 billion) through a private placement to a group of state and foreign investors…..The troubled Shandong-based lender will issue 100 billion shares, Hengfeng said Wednesday in a statement.”

Foreign investment is simply window-dressing, with Singapore’s United Overseas Bank subscribing for 4% of the new issue. Probably with a “put” on the other state-owned purchasers.

“The bailouts for China’s troubled small banks roll on……China’s sneaky system-wide bank bailout is well underway.” ~ Trivium China

Efforts by Beijing to curb exponential debt growth are praiseworthy, but are likely to come at a substantial cost. Expect GDP growth to slow and gradual “Japanification” as the state attempts to avoid hard choices, supporting the continued existence of “zombie” companies ……and sclerosis of the Chinese economy.

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Serious plumbing problems at the Fed

Fed activities in repo markets are growing. They have already expanded their balance sheet by $335 billion since the beginning of September and the party is just getting started. Former Fed repo expert Zoltan Pozsar, now at Credit Suisse, warns that major banks are heavily overweight in US Treasuries and underweight in excess reserve deposits at the Fed. The result is likely to be a major liquidity squeeze over the December year-end, with the Fed balance sheet expected to expand to more than $4.5 trillion by mid-January – a total injection of close to $750 billion in little more than 3 months!

S&P 500 and Fed Assets

Pozsar is critical of the Fed’s strategy, warning that purchases of short-term T-bills (done to avoid flattening the yield curve) will not solve the problem as the banks need to sell longer-term Treasuries in order to improve liquidity. Current operations have failed to lift excess reserves on deposit at the Fed.

Excess Reserves on Deposit and Fed Assets

The result, according to Pozsar, is that the Fed may be forced to commence QE4 — purchasing longer-term Treasuries despite its reluctance to do so. The alternative could be far worse:

“….the dismal liquidity situation within the US commercial bank sector is so dire, that the shortage of reserves will start a cascade of liquidations beginning in the FX swap market, progressing to Treasurys, and culminating in stocks… and a full-blown market crash.”

Underlying the repo crisis are the usual suspects, according to Zero Hedge:

….massively levered hedge funds engaging in Treasury relative value trades (think of these as a modern twist on the LTCM trade)

“High demand for secured (repo) funding from non-financial institutions, such as hedge funds heavily engaged in leveraging up relative value trades,” was a key factor behind the chaos according to Claudio Borio at the BIS.

The BIS’s finding was novel, and surprising, as it highlighted the “growing clout of hedge funds in the repo market” echoing something we pointed out one year ago: hedge funds such as Millennium, Citadel and Point 72 are not only active in the repo market, they are also the most heavily leveraged multi-strat funds in the world, taking something like $20-$30 billion and levering it up to $200 billion. They achieve said leverage using repo.

As baseball icon Yogi Berra said:

“It’s like deja-vu, all over again.”

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Trade deal announced

Donald Trumps latest tweets on a trade deal with China:

Twitter

As Trish Nguyen predicted, Trump was never going to introduce the Dec15 tariffs as they directly impact on US consumers, not producers as in earlier rounds of tariffs.

Prof Aaron Friedberg (Princeton) gives an interesting summary of the impact this deal will have. The bottom line is that China will not change its ways:

 

  • CCP-ruled China has long exploited advanced industrial economies – by pursuing a variety of predatory and market-distorting policies

  • The CCP is exceptionally unlikely to offer any fundamental concessions on these policies – they are deeply embedded in China’s economic system and the CCP views them as essential to its hold on power

  • Even if CCP-ruled China were to modify some of its more objectionable economic practices, so long as its domestic political regime remains unchanged, it will continue to pose a serious geopolitical and ideological challenge to the U.S.

  • In light of these realities, the U.S. should pursue a four-part strategy for defending U.S. prosperity and security, by moving toward a posture of partial economic disengagement from China.

De-coupling will continue.

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ASX 200 hesitant

The resources sector is strengthening.

The ASX 300 Metals & Mining index broke resistance at 4450, suggesting another advance. Buoyed by rising iron ore prices, the breakout offers a target of 4800.

ASX 300 Metals & Mining

Talk of an imminent trade deal lifted iron ore above previous support at 90. Expect another test of primary support at 80, but respect would confirm that a base has formed above 80.

Iron Ore

Financials, on the other hand, are still weak.

The ASX 300 Banks index continues in a down-trend. Expect retracement to test resistance at 7600 but reversal seems unlikely at this stage. Respect of resistance would confirm a target of 6800.

ASX 300 Banks

The ASX 200 REITs index broke support at 1600 after a false break through 1650. Typical of a bull trap, expect a decline to test support at 1500.

ASX 200 REITs

A bearish outlook for banks is keeping the ASX 200 hesitant. The daily chart shows narrow consolidation below resistance at 6750; a bullish sign. Breakout is likely but the Trend Index below zero warns that buyers are cautious.

ASX 200

We maintain low exposure to Australian equities, with a focus on defensive and contra-cyclical stocks, because of our bearish outlook.

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S&P 500 recovers but employment gains sluggish

Short retracement on the S&P 500 that respected support at 3000 strengthens the bull signal. Further gains are expected in the short- to medium-term.

S&P 500

Corporate profits before tax continue to decline after adjusting for inflation, exposing the vulnerability of high earnings multiples.

S&P 500

Hours worked (non-farm payroll x average weekly hours) for November also point to low annual GDP growth of around 1.5% after inflation.

Real GDP and Hours Worked

Employment growth for the 12 months to November came in at a similar 1.48%.

Employment Growth & Fed Funds Rate

Not enough to justify a P/E multiple of 23.25.

Average hourly earnings growth is increasing, especially for production & non-supervisory employees (3.65% for 12 months to November), but in the present environment the Fed seems unconcerned about inflationary pressures.

Average Hourly Earnings

Patience

Patience is required. We have had a weak S&P 500 retracement confirm the breakout but there is minimal up-turn in November employment indicators to support the bull signal. Market risk is elevated and investors should exercise caution.

“The world has a way of undermining complex plans. This is particularly true in fast moving environments. A fast moving environment can evolve more quickly than a complex plan can be adapted to it….”
~ Carl Von Clausewitz, Vom Kriege (On War) (1780-1831)

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Banks drag on ASX 200

Banks are plagued by fears of large AUSTRAC penalties for breaches of anti money-laundering and counter-terrorism regulations. Commonwealth have paid a $700 million fine, Westpac have already been charged, NAB alerted investors of potential liabilities in their annual report, while ANZ says there are no signs of transgressions.

In other problem areas, mortgage stress continues to rise, with Martin North (Digital Finance Analytics) estimating that 32.5% of households are now in mortgage stress “based on an assessment of their cash flow.” Worst hit are fringe suburbs, where the rate is as high as 60%.

Elsewhere, RBNZ eased their calls for major banks to increase Common Equity Tier 1 Capital (CET1) to 13.5%, with a further 2.5% comprising other forms of capital such as hybrids and convertible preference shares, and relaxed the phase-in from 5 to 7 years. But the changes will still $13.8 billion in additional capital, according to the big four banks. APRA, by comparison, requires a CET1 ratio of 10.5%.

The ASX 300 Banks index continues to trend lower, with declining peaks on the Trend Index warning of selling pressure. Expect retracement to test resistance at 7600; respect would confirm the  target of 6800.

ASX 300 Banks

The ASX 200 REITs index is again testing support at 1600 after a false break above 1650. Breach of support remains unlikely, with financial markets searching for yield, but would offer a target of 1500.

ASX 200 REITs

Iron ore has made a bear market rally to test resistance at 90. Respect of resistance is likely and would warn of another decline.

Iron Ore

A Trend Index peak near zero on the ASX 300 Metals & Mining index warns of another test of support at 4100 (neckline of a large head-and-shoulders reversal pattern). Breach would offer a target of 3400, while respect of support would indicate that a base is forming.

ASX 300 Metals & Mining

Declining banks are dragging the ASX 200 lower and another test of support at 6400 is likely. A resources sector reversal would increase the chance of top forming on the broad index

ASX 200

We maintain low exposure to Australian equities, with a focus on defensive and contra-cyclical stocks, because of our bearish outlook.

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S&P 500: Betting on QE

The S&P 500 continued its cautious advance in a shortened week due to Thanksgiving. Expect retracement to test the new support level at 3000.

S&P 500

I believe that the latest surge has little do with an improved earnings outlook and is simply a straight bet that Fed balance sheet expansion (QE) will goose stock prices in the short- to medium-term. The chart below highlights the timing of the increase in Fed assets and its effect on the S&P 500 index.

S&P 500 and Fed Total Assets

There is plenty of research on the web pointing to a strong correlation between QE and equity prices. Here are two of the better ones:

Economic Activity

If we look at fundamentals, many of them are headed in the opposite direction.

Bellwether transport stock Fedex (FDX) is testing primary support at 150. Breach would warn of a slow-down in economic activity.

Fedex

Monthly container traffic at the Port of Los Angeles shows a marked year-on-year fall in imports and, to a lesser extent, exports.

Port of Los Angeles: Container Imports & Exports

Rather than boosting local manufacturers, industrial production is falling.

Industrial Production

Production of durable consumer goods is falling even faster, though the October figure may be distorted by the GM strike.

Industrial Production: Durable Consumer Goods

What is clear is that slowing growth in the global economy is unlikely to reverse any time soon.

Market Cap v. Corporate Profits

Yet market capitalization for non-financial stocks is at a precarious 24.7 times profits before tax, second only to the Dotcom bubble. The surge since 2010 coincides with Fed injection of a net $2.0 trillion into financial markets ($4.5T – $2.5T in excess reserves).

Nonfinancial corporations: Market Capitalisation/Profits before tax

The problem, as the Fed unwind showed, is that once central banks embark on this path, it is difficult for them to stop. The Bank of Japan started in the late 1980s — and is still at it.

Bank of Japan: Total Assets

Margin Debt

This chart from Advisor Perspectives compares the S&P 500 to margin debt. The decline since late 2018 appears ominous but November margin debt levels may reflect an up-turn. We will have to keep a weather eye on this.

FINRA Margin Debt & S&P 500 Index

Patience

Patience is required. First, wait for S&P 500 retracement to confirm the breakout. Second, look for an up-turn in November economic indicators, especially employment, to support the bull signal. Failure of economic indicators to confirm the breakout will flag that market risk is elevated and investors should exercise caution.

“If the mind is to emerge unscathed from this relentless struggle with the unforeseen, two qualities are indispensable: first, an intellect that, even in the darkest hour, retains some glimmerings of the inner light which leads to truth; and second, the courage to follow this faint light wherever it may lead.”
~ Carl Von Clausewitz, Vom Kriege (On War) (1780-1831)

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Gold: Kill the chicken to scare the monkey

10-Year Treasury yields retreated from resistance at 2.0%, helped by increased Chinese purchases.

10-Year Treasury Yields

Evidenced by the Yuan falling against the US Dollar. Breach of recent support 14.15 would warn of another test of primary support at 14 cents.

Chinese Yuan CNY/USD

Further Yuan weakness and lower Treasury yields are likely after President Trump signed the Hong Kong Human Rights & Democracy Act into law. This puts China in a difficult position. China’s foreign ministry:

“We urge the United States not to continue going down the wrong path, or China will take countermeasures and the U.S. must bear all the consequences.”

Their economy is hemorrhaging and they badly want an interim trade deal but failure to respond to the latest US action would reveal a weak hand. Expect an indirect response as in the popular idiom – kill the chicken to scare the monkey – making an example of someone in the hope that it will deter others.

Gold continues to test support at $1450 but lower Treasury yields (from a weaker Yuan) would strengthen demand as it lowers the opportunity cost of holding Gold. Breach of support is unlikely unless Treasury yields again test resistance at 2.0%.

Gold (USD/ounce)

Silver is similarly testing support at $16.80/ounce but we are unlikely to see a follow-through unless Treasury yields strengthen.

Silver (USD/ounce)

Australia’s All Ordinaries Gold Index continues in a downward trend channel. An up-tick in the Trend index and short-term support at 6500 suggest a rally to test the upper trend channel, around 7000. Breakout from the trend channel, while still unlikely, would warn that a bottom is forming. Breach of support at 6500 is more likely and would offer a short-term target of 6000.

All Ordinaries Gold Index

Patience

Gold remains in a long-term up-trend. The current correction may offer an attractive entry point but we first need to confirm that the up-trend is intact.

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ASX 200: Don’t argue with the tape

“A prudent speculator never argues with the tape. Markets are never wrong; opinions often are.” ~ Jesse Livermore

The ASX 200 broke resistance at 6800, signaling a fresh advance with a short-term target of 7200. Declining Trend Index peaks still warn of secondary selling pressure at present. Expect retracement to test the new support level at 6800. Respect of support would confirm the advance.

ASX 200

But divergence from fundamentals is growing.

NAB cut their GDP forecast to 1.5% in their November Forward View.

Housing markets in Sydney and Melbourne have recovered somewhat, but building approvals for houses remain 21% below their 2017 high and 57% for apartments. Construction activity is likely to remain low.

Exports are strong, boosted by increased LNG exports, but iron ore prices are falling. Currently testing short-term support at 80, our long-term target for iron ore is $65/metric ton.

Iron Ore

Business investment has slowed, causing wages to stagnate.

Australia: Business Investment

Retail sales weakened as a consequence, contracting for the first time since the early 1990s.

Australia: Retail Sales

Annual credit growth slowed to 2.5%, the lowest since 2010.

Banks were spooked last week by AUSTRAC pursuing Westpac for 19.5 million breaches of anti money-laundering and counter-terrorism regulations. The ASX 300 Banks index broke support at 7600, completing a double-top reversal, but this week they consolidated in a narrow range. Expect retracement to test resistance at 7600. Declining peaks on the Trend Index, however, continue to warn of selling pressure. Respect of resistance would confirm the decline, with a target of 6800.

ASX 300 Banks

The ASX 200 REITs index broke out of its descending triangle, signaling another advance. Financial markets are searching for yield.

ASX 200 REITs

The ASX 300 Metals & Mining index penetrated its descending trendline, suggesting that a base is forming. Expect another test of support at 4100 (neckline of a large head-and-shoulders reversal pattern). Breach would offer a target of 3400. The Trend Index penetrated its descending trendline but a peak near zero would warn of continued selling pressure.

ASX 300 Metals & Mining

We shouldn’t argue with the market but we should wait for confirmation; bull and bear traps are common. Investors, bear in mind that market risk remains elevated. I leave you with this quote from Westpac in their recent credit update:

For businesses, the economic backdrop has become more challenging. The global economy is slowing and household spending is soft. In this environment business investment in the real economy has lost momentum across the non-mining sectors – which will weigh on credit demand.

….and on jobs, wages growth and household spending.

We maintain low exposure to Australian equities, with a focus on defensive and contra-cyclical stocks, because of our bearish outlook.

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