Category: US & Canada

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Bailout time

Boeing has applied to the Federal government for a $60 billion bailout. The troubled aircraft manufacturer is in need of rescuing but has indulged in $54.9 billion of stock buybacks in support of its stock price.

Former UN ambassador and ex-South Carolina governor, Nikki Halley resigned from Boeing’s board, saying that she opposes federal support for Boeing. Smart political move. Public anger is growing.

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Many corporations used stock buybacks to boost earnings per share after earnings growth slowed in 2014/15. Boeing was no exception.

Stock Buybacks and LT Debt

The company had a reputation for engineering fine aircraft but in recent years that focus has shifted to financial engineering and cost-cutting to boost earnings per share. Free cash flow was squandered on stock buybacks, dividends and executive bonuses. No reserves were accumulated for a rainy day.

Well, a rainy day finally arrived in 2018. The Boeing 737 MAX airliner, which began service in 2017, was involved in two fatal accidents, Lion Air on October 29, 2018, and Ethiopian Airlines on March 10, 2019, caused by a malfunction of the aircraft’s new MCAS automated control system. The aircraft was grounded by airline authorities around the world and Boeing suspended production in December 2019. After a software bug was discovered in January, the return to service was delayed. Despite an outstanding issue over non-compliant wiring bundles the FAA has indicated that they expect the 737 Max to return to service in the second half of 2020.

The company had to raise almost $10 billion in bonds to help it weather the setback. CEO Dennis Muilenburg was ousted in late 2019 but still walked away with a golden parachute of up to $50 million.

A hit from the 2020 Coronavirus outbreak has put the company into difficulties, with the stock getting pounded. Boeing has been forced to apply for a government bailout.

Stock Buybacks and LT Debt

The company is a strategic asset of the United States and should be protected.

But rewarding bad behavior would promote moral hazard on a wide scale. To give management and stockholders a free ride would encourage risk-taking by other companies — with the expectation that they will be bailed out if something goes wrong.

Support the company but hurt the stockholders

Management and existing stockholders need to feel the pain.

Offer support in the form of $60 billion of convertible bonds or preference shares, ranking behind creditors but ahead of stockholders. Conversion into ordinary shares should be in 10 years time but at the current stock price of $100. Stockholders and management awards will take a huge hit,  while taxpayers can look forward to a sizeable gain when the company recovers.

Support should be non-voting (bonds or prefs) to keep political interference to a minimum.

Buybacks

Preventing future buybacks is a completely separate issue that should be addressed on a national basis and not by placing restrictions on individual companies. For the record, we are against buybacks because they can be used to artificially support stock prices. Companies that need to return capital to stockholders should declare a special dividend.

Avoid a Domino-effect

There are a string of companies lining up with bailout requests. It is important to put emotions aside and save those that are still viable businesses and not just strategic assets like Boeing. Millions of jobs are at stake. And disruption to credit markets could have a Lehman-like domino effect.

Just ensure that it is on terms that favor the taxpayer, so that stockholders will think twice about future profligacy.

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Fed brings out the big bazooka

The Fed is on a war footing.

The FOMC announced that it will cut the funds rate to zero. Timing of the announcement — Sunday, March 15th at 5:00 p.m. — signals the level of urgency.

“Consistent with its statutory mandate, the [FOMC] Committee seeks to foster maximum employment and price stability. The effects of the coronavirus will weigh on economic activity in the near term and pose risks to the economic outlook. In light of these developments, the Committee decided to lower the target range for the federal funds rate to 0 to 1/4 percent. The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”

Bond markets have been anticipating this cut since March 4th, when the 3-month T-bill rate plunged to 33 basis points.

Fed Funds Rate, Interest on Excess Reserves and 3-Month T-bills

The Fed also announced further QE of $700 billion, expanding its balance sheet by $500 billion in Treasury securities and $200 billion in mortgage-backed securities (MBS). This is in addition to the $1.5 trillion repo operations announced earlier in the week.

Fed Balance Sheet: Total Assets and Excess Reserves on Deposit

In a related announcement, the Fed is also encouraging banks to use the discount window, cutting the primary credit rate by 150 basis points to 0.25 percent, effective March 16, 2020.

“Narrowing the spread of the primary credit rate relative to the general level of overnight interest rates should help encourage more active use of the window by depository institutions to meet unexpected funding needs. To further enhance the role of the discount window as a tool for banks in addressing potential funding pressures, the Board also today announced that depository institutions may borrow from the discount window for periods as long as 90 days, prepayable and renewable by the borrower on a daily basis. The Federal Reserve continues to accept the same broad range of collateral for discount window loans…”

Not all the $1.5T repo facility is likely to be taken up — the Fed just used a big number for dramatic effect, to get everyone’s attention — but we expect the Fed’s balance sheet expansion to get close to $6 trillion (compared to $4.3T on March 11th) before this is over.

While these rescue operations are normally announced as temporary, they soon become permanent as the market resists any efforts to unwind the Fed’s role.

As I said on Saturday: “To infinity and beyond…“

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A worm in the Apple

Apple Inc (AAPL) enjoyed stellar growth over the past 12 months, jumping more than 50%.

Apple Inc (AAPL)

But is that due to solid operating performance or window-dressing, with almost $140 billion of stock buybacks in the last two years?

Apple Inc (AAPL)

Free cash flow — operating cash flow less stock compensation and investment in plant and equipment — has been falling since 2015.

Apple Inc (AAPL)

And the company has depleted its cash reserves over the last two years, to fund stock buybacks. The graph below depicts the change in Apple’s net cash position (cash plus marketable securities less debt).

Apple Inc (AAPL)

So why the management enthusiasm for stock buybacks?

Is the stock a good investment? No. Free cash flow per share has barely lifted since 2015 despite $237.5 billion used to repurchase 1144 million shares.

Apple Inc (AAPL)

Apple have returned surplus cash to stockholders in the most tax-efficient way possible, by buying back stock rather than paying dividends. The added bonus is the reduced share count which gooses up earnings per share growth and return on equity.

Apple Inc (AAPL)

Investors in turn get excited and run up earnings multiples. The current price/free cash flow ratio of 23.2 exceeds that of the heady growth days up to 2015.

Apple Inc (AAPL)

The stock keeps climbing, supported by buybacks and rosy EPS projections. The problem for Apple is when they run out of cash, or exceed reasonable debt levels, then the band will stop playing and those heady multiples are likely to come crashing down to earth.

It’s not only Apple that’s doing this. The entire S&P 500 is distributing more by way of buybacks and dividends than it makes in earnings, eating into reserves meant to fund new investment.

S&P 500 Buybacks & Dividends

The result is likely to be low growth and even more precarious earnings multiples.

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The S&P 500 and Plan B

The S&P 500 penetrated its rising trendline, warning of a re-test of support at 3000. But selling pressure on the Trend Index appears to be secondary.

S&P 500

Transport bellwether Fedex retreated below long-term support at 150 on the monthly chart — on fears of a slow-down in international trade. Follow-through below 140 would strengthen the bear signal, offering a target of 100. The bear-trend warns that economic activity is contracting.

Fedex

Brent crude dropped below $60/barrel on fears of a global slow-down. Expect a test of primary support at 50.

Brent Crude

Dow Jones – UBS Commodity Index broke primary support at 76 on the monthly chart, also anticipating a global slow-down.

DJ-UBS Commodity Index

South Korea’s KOSPI Index is a good barometer for global trade. Expect a re-test of primary support at 250.

KOSPI

While Dr Copper, another useful barometer, warns that the patient (the global economy) is in need of medical assistance.

Copper (S1)

The Fed can keep pumping Dollars into financial markets but at some point, the patient is going to stop responding. In which case you had better have a Plan B.

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S&P 500 in a precarious position

A long-term chart of the S&P 500 highlights the precarious position of the index, having now doubled since its October 2007 high at 1576. Any time that a stock doubles in price, you are likely to get profit-taking, leading to resistance. The same holds true for the index. Probably even more so because individual stocks have the capacity to post higher gains — of even 5 or 10 times — while that isn’t feasible for the index. Even in the Dotcom bubble.

S&P 500

On the one hand we have a massive triple stimulus creating irrational exuberance, while on the other we have concerns over a coronavirus epidemic spreading from China and Donald Trump’s looming impeachment.

CoronaVirus

If you think that Trump is a shoe-in for re-election in November, this analysis of his chances is quite eye-opening.

Trump: Long Shot rather than a Slam Dunk

Expect more erratic behavior in the lead up to November.

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Irrational Exuberance

I believe this warrants a separate post:

The market is running on more stimulants than a Russian weight-lifter. Unemployment is near record lows but the US Treasury is still running trillion dollar deficits.

Federal Deficit & Unemployment

While the Fed is cutting interest rates.

Fed Funds Rate & Unemployment

And again expanding its balance sheet. More than twelve years after the GFC. The blue line reflects total assets on the Fed’s balance sheet, mainly Treasuries and MBS, while the orange line (right-hand scale) shows how shrinking excess reserves on deposit at the Fed have helped to create a $2 trillion surge in liquidity in financial markets since 2009. Even when the Fed was supposedly tightening, with a shrinking balance sheet, in 2018 to 2019.

Fed Totals Assets & Net of Excess Reserves on Deposit

The triple boost has lifted stock valuations to precarious highs. The chart below compares stock market capitalization to profits after tax over the past 60 years.

Market Cap/Profits After Tax

Ratios above 15 flag that stocks are over-priced and likely to correct. Peaks in 1987 and 2007, shortly before the GFC, are typical of an over-heated market. The Dotcom bubble reflected “irrational exuberance” — a phrase coined by then Fed Chairman Alan Greenspan — and I believe we are entering a second such era.

Recovery of the economy under President Trump is no economic miracle, it is simply the triumph of monetary and fiscal stimulus over rational judgement. Trump knows that he has to keep the party going until November to win the upcoming election, so expect further excess. Whether he succeeds or not is unsure but one thing is certain: the longer the party goes on, the bigger the hangover.

William McChesney Martin Jr., the longest-serving Fed Chairman (1951 to 1970), famously described the role of the Fed as “to take away the punch bowl just as the party gets going.” Unfortunately Jerome Powell seems to have been sufficiently cowed by Trump’s threats (to replace him) and failed to follow that precedent. We are all likely to suffer the consequences.

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Bull Markets & Irrational Exuberance

Bob Doll from Nuveen Investments is more bullish on stocks than I am but sets out his thoughts on what could cause the current run to end:

“Stock valuations are starting to look full, and technical factors are beginning to appear stretched. As stock prices have risen since last summer, bond yields have crept higher. Should this trend persist, it could eventually cause a headwind for stocks. Credit spreads are signaling some risks, as non-energy high yield corporate bond spreads have dropped to multi-decade lows.

As such, we think stocks may be due for a near-term correction or consolidation phase. Nevertheless, we expect any such phase to be mild and brief as long as monetary conditions remain accommodative and economic and earnings growth holds up. In other words, although we see some near-term risks, we don’t think this current bull market is ending.

That raises the question of what might eventually cause the current cycle to end. We see three possibilities. First, recession prospects could increase significantly. We see little chance of that happening any time soon, given solid economic fundamentals. Second, a political disruption like a resurgence in trade protectionism could occur. We also don’t think that is likely to happen, especially in an election year. Third, bond yields and interest rates could move higher as economic conditions improve, creating problems for stocks. This one seems like a higher probability, and we’ll keep an eye on it.”

Economy

The upsurge in retail sales and housing starts may have strengthened Bob’s view of the economy but manufacturing is in a slump and slowing employment growth could hurt consumption. The inverted yield curve is a long-term indicator and I don’t yet see any indicators confirming an imminent collapse.

Treasury 10 Year-3 Month Yield Differential

I rate economic risk as medium at present.

Political Disruption

US-China trade risks have eased but I continue to rate political disruption as a risk. This could come from any of a number of sources. US-Iran is not over, the Iranians are simply biding their time. Putin’s attempted constitutional coup in Russia. China-Taiwan. Libya. North Korea. Brexit is not yet over. Huawei and 5G are likely to disrupt relations between China, the US and European allies, with China threatening German automakers. Europe also continues to wrestle with fallout from the euro monetary union, a system that is likely to eventually fail despite widespread political support. Impeachment of Trump may not succeed because of the Republican majority in the senate but could produce even more erratic behavior with an eye on the upcoming election. Who can we bomb next to win more votes?

Bonds & Interest Rates

I don’t see inflation as a major threat — oil prices are low and wages growth is slowing — and the Fed is unlikely to raise interest rates ahead of the November election. Bond yields may rise if China buys less Treasuries, allowing the Yuan to strengthen against the Dollar, but the Fed is likely to plug any hole in demand by further expanding its balance sheet.

Market Risk: Irrational Exuberance

The market is running on more stimulants than a Russian weight-lifter. Unemployment is near record lows but Treasury is still running trillion dollar deficits.

Federal Deficit & Unemployment

While the Fed is cutting interest rates.

Fed Funds Rate & Unemployment

And again expanding its balance sheet. More than twelve years after the GFC. The blue line reflects total assets on the Fed’s balance sheet, mainly Treasuries and MBS, while the orange line (right-hand scale) shows how shrinking excess reserves on deposit at the Fed have helped to create a $2 trillion surge in liquidity in financial markets since 2009. Even when the Fed was supposedly tightening, with a shrinking balance sheet, in 2018 to 2019.

Fed Totals Assets & Net of Excess Reserves on Deposit

The triple boost has lifted stock valuations to precarious highs. The chart below compares stock market capitalization to profits after tax over the past 60 years.

Market Cap/Profits After Tax

Ratios above 15 flag that stocks are over-priced and likely to correct. Peaks in 1987 and 2007, shortly before the GFC, are typical of an over-heated market. The Dotcom bubble reflected “irrational exuberance” — a phrase coined by then Fed Chairman Alan Greenspan — and I believe we are entering a second such era.

Recovery of the economy under President Trump is no economic miracle, it is simply the triumph of monetary and fiscal stimulus over rational judgement. Trump knows that he has to keep the party going until November to win the upcoming election, so expect further excess. Whether he succeeds or not is unsure but one thing is certain: the longer the party goes on, the bigger the hangover.

William McChesney Martin Jr., the longest-serving Fed Chairman (1951 to 1970), famously described the role of the Fed as “to take away the punch bowl just as the party gets going.” Unfortunately Jerome Powell seems to have been sufficiently cowed by Trump’s threats (to replace him) and failed to follow that precedent. We are all likely to suffer the consequences.

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US Stocks: Bull or Bear?

I have read several commentators proclaiming that the crisis is over and the stock market and US economy are back on track for solid growth. Let’s examine some of the evidence.

The Yield Curve (Bearish)

While the US yield curve has uninverted in the past and yet a recession has still come along, the uninversion seen in recent months coming after such a shallow and short-lived inversion provides confidence that the inversion seen last year gave a false signal…. (Shane Oliver at AMP)

Treasury 10 Year-3 Month Yield Differential

Yield curve inversions seldom last long. For one simple reason: the Fed fires up the printing press to reduce short-term interest rates and boost the economy. The yield curve uninverted before the last three recessions and this time looks no different.

Consumer Confidence (Bullish)

Retail sales kicked up in December, a sign of growing consumer confidence.

Retail excluding Auto

Auto sales are still flat but housing starts have also jumped.

Housing Starts & Permits

Economic Activity (Bearish)

When it comes to economic activity, Cass freight shipments are falling.

Cass Index

Rail freight indicators also point to declining activity levels.

Rail Freight

Employment (Neutral)

Leading employment indicators, such as temporary jobs and job openings, warn that labor market growth is slowing.

Temporary Jobs

Job Openings

But overall payroll growth, albeit subdued is still stable, with the 3-month TMO of non-farm payroll growth respecting the 0.5% amber warning level.

Payroll TMO

Valuations (Bearish)

Last week we compared market cap to profits before tax. This week, we compare to profits after tax. Recent levels above 20 have only previously been exceeded, in the past 60 years, during the Dotcom bubble.

Market Cap/Corporate Profits after Tax

Dallas Fed president Robert Kaplan conceded that expansion of the Fed balance sheet is helping to lift asset prices.

Commenting on the Fed’s massive liquidity response to the repo crisis, Kaplan said that “my own view is it’s having some effect on risk assets……It’s a derivative of QE when we buy bills and we inject more liquidity; it affects all risk assets. This is why I say growth in the balance sheet is not free. There is a cost to it. And we need to be very disciplined about it and sensitive to it.”

This is a clear warning to investors to stay on the defensive. We maintain our view that stocks are over-valued and will remain under-weight equities (over-weight cash) until normal earnings multiples are restored.

Warren Buffett is not infallible but the level of cash on Berkshire’s balance sheet seems to indicate a similar view regarding stock valuations.

Berkshire Hathaway Cash Holdings

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Trump gets his Deal

Donald Trump signed the Phase One US-China trade deal with China’s Vice-Premier Liu He in Washington D.C. on Wednesday.

The deal is important for Trump politically as he needs to disrupt media focus on his impeachment playing out in the Senate.

China attempted to downplay the significance of the deal by sending their Vice-Premier rather than Xi Jinping for the signing ceremony. But the deal is no less important for them in order to halt/slow the relocation of manufacturing jobs by multinationals to avoid US tariffs.

Trivium China sum up the outcome:

  1. We are still in a trade war. Tariffs remain levied on hundreds of billions of USD worth of goods.
  2. A phase two deal looks dead in the water. US President Trump has already said that he might wait until after the November election to negotiate the next phase. More importantly, there is little appetite in China to make concessions on any of the remaining issues.
  3. Third countries are getting screwed. China’s overall import bill is unlikely to jump by USD 200 billion over the next two years, so increased purchases of US goods will come at the expense of producers in other countries.
  4. This deals another blow to the multilateral trading system. The world’s two largest economies just bypassed the multilateral rules-based system to negotiate a deal that undermines the principles of free trade.
  5. China is downplaying the deal. The fact that Liu He – not Xi Jinping – signed the deal sent a strong signal domestically that this is not a big deal. And Chinese officials have said that most of these measures would have happened irrespective of a deal.
  6. Finally, the deal is a positive for stability. This will serve to halt – or at least slow – economic decoupling. That’s a positive for the global economy and security.

Rhodium Group in The Good, The Bad and The Missing focus on what should have been in the deal but isn’t:

  1. Chapter 1 Pledges greater protection for a handful of specific products – pharmaceuticals, medicines and unlicensed software – and generally more enforcement against counterfeit products but the concerns of other industries are not addressed
  2. There are no robust enforcement mechanisms in Chapter 7. It provides a forum for discussion and consultation but not arbitration. If unable to resolve the issue, the aggrieved party can withdraw from the Agreement. This creates little incentive to resolve issues and may result in a logjam.
  3. The managed trade approach does not even start to remedy systemic concerns like the predominance of state enterprises, the prevalence of foreign investment limitations in the vast set of industries that did not get early attention in this deal, the lack of consistency in competition policy treatment and the general asymmetry of information and the playing field for private firms foreign and domestic.
  4. Phase One fails to address growing challenges at the intersection of economics and national security: Huawei and 5G telecommunications, detentions and pressure on expatriates and travelers from the other side, foreign investment screening and export controls, and the threat of financial decoupling.

Rhodium concludes:

The agreement is a limited one, primarily capping the potential for further escalation of protectionism on both sides rather than taking serious steps to address long-standing issues in Chinese trade practices. The managed trade outcomes in which China promises additional US imports are the most significant substantive commitments made, but China’s capacity and willingness to meet these targets remains in question. Significant tariffs remain in place on both sides, uncertainty about the future path of the US-China relationship will persist, and the broader decoupling trends in security-sensitive areas of the bilateral relationship will continue. Progress toward any Phase Two agreement is likely to be minimal in 2020. (The Chinese side immediately said after the January 15 signing that it wanted to go slow before any further talks.)

The deal attempts to head off further escalation but falls well short of addressing long-standing issues with Chinese trade practices. Trade tensions and decoupling are likely to continue.

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Playing the long game

Chart for the Week

GDP growth is slowing, while US corporate profits (before tax) are also declining as a percentage of GDP.

Corporate profits Before Tax/GDP

Yet the S&P 500 and other major indices are rising, lifted by Fed liquidity injections in the repo market. The red line shows total assets on the Fed’s balance sheet.

S&P 500 and Fed Assets

The Long Game

We play the long game — reducing exposure to equities when market risks are high and staying on the defensive until normality is restored — even if this means sitting on cash while equities rise. The only alternative, unless you trust your ability to accurately identify exact market tops and bottoms, is to hang on to your positions no matter what happens. But there are few individuals who can withstand the stress and make rational decisions during a major market draw-down.

Updates for Market Analysis Subscribers

Best wishes for the New Year. It promises to be an eventful one.

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