I’ve just updated Current Market Tactics to address the question of what the market selloff induced by weak earnings from majore chemicals firms means.
China is currently in the process of its once a decade change in the top leadership of the Communist Party. Official nominees for the highest posts will be officially announced in about two weeks. They’ll be ratified in a pro forma vote next March.
New leaders often mean new policy directions. While the old leaders are on the way out and the new ones are waiting to be anointed, the most prudent stance for lower-level Party functionaries (read: basically everyone) is to do as little as possible that could conceivably be second-guessed later on.
During the six- or nine-month transition period, the Chinese economy slows. It reaccelerates as new leaders clarify what their priorities are.
I expect the same will happen this time around. But as I try to imagine what I would do if I were running China, I’m beginning to think that the character of China’s growth from this point on may differ substantially from what it has been to date.
is the developing country growth model broken?
The standard developing country growth model that helped the EU and Japan recover after WWII and which has been duplicated by every successful emerging economy since, is broken.
The model, which I’ve written about extensively, has two parts:
1. gear your economy toward exporting to the huge, healthy, fast-growing US, and to a lesser extent the EU, and
2. peg your currency to the US$ so foreign exchange movements won’t erode your labor cost advantage.
The breakdown has come in both areas:
1. aging of the Baby Boom is reducing the long-term growth rate of the US to around 2%. The need to repay immense government debt suggests to me that 2% will be a ceiling over the next few years, not a floor. And the EU, China’s largest export market, probably won’t show much life for the next half-decade.
2. keeping the currency peg means more or less mirroring US monetary policy, which is now calibrated for an economy in intensive care, not one in full bloom. Keeping the local currency in sync implies maintaining domestic monetary policy that’s much too loose.
In addition to this, there are signs in China that, at least on the more heavily industrialized east coast, it is running out of the cheap labor needed to fuel the export-oriented development model.
For all these reasons, I think the new Chinese leadership is going to make a substantial effort to re-orient growth away from exports to the US and EU (where there’s little growth to be had). Exports will continue to go to other developing nations.
The two other areas for development are the domestic service economy and higher value-added manufacturing. In free-market economies, forces of the status quo (labor-intensive exports) typically use their substantial political clout to stifle progress here. And there are certain to be similar efforts made in China. But Party control of the Chinese economy suggests the status quo will be less successful.
If this shift in priorities is underway, and is successful, the biggest winners will be suppliers of products and service for average Chinese consumers. Luxury goods will continue to do well, I think, but mass-market products will do better. The trick will be finding ways to play them.
On the other hand, suppliers of export-oriented industrial machinery–to some degree domestic, principally overseas-based–to Chinese firms seem to me to potentially be the biggest losers. (We may already be seeing this phenomenon in 3Q12 earnings results and in management guidance.
…after all, what ultimately matters is how much profit a company’s management is making for its shareholders, isn’t it?
Yes, and no.
two special cases
Let’s deal with two special cases before getting to the main topic.
–Investors who focus a lot of their attention on startups that are not yet making money will typically use sales growth as their major metric. There are no profits yet.
–Value investors will be drawn to mature companies with lots of sales and little or no earnings because of their turnaround potential. This is especially true if they can see other firms in the same industry who are comfortably profitable with similar levels of sales.
Neither is an example of the phenomenon we are now seeing as some companies report 3Q12 results.
strong earnings, weak sales
When earnings meet/beat the consensus estimates of brokerage house analysts–and sales don’t, the stock in question often goes down, sometimes by a lot.
it’s all about recurring earnings
1. Investors typically look for recurring gains when they buy stocks, not one-off profits.
Consider this oversimplified example:
A company reports earnings per share of $1 for the current quarter. If you know that this is all the profit the firm will ever make, then–assets (if any) aside–you won’t pay more than $1 for a share of stock. (In fact, you’d probably pay less, since the $1 of profits is in the hands of management, not in yours.)
On the other hand, if you thought the company would earn $1/share every three months for the next ten years, you could be willing to pay up to $40 for a share of stock.
So there’s a huge difference between the value to investors of recurring and non-recurring profits.
2. If a company reports higher earnings without what analysts consider an appropriate increase in sales, investors assume that the firm has achieved its profit target through cost-cutting of some type. They argue, correctly in most cases, that the profit increase isn’t sustainable.
More than that, they view the slower sales increase as a leading indicator of slowing profit growth that will emerge in subsequent quarters. They can see the train coming at them, as it were, so they don’t wait to get off the track. They sell now.
Their picture is this:
Suppose the company has been spending $1 million a quarter on marketing up until now, but cuts the budget to $500,000 for the just-reported quarter. That produces just enough extra margin that the company reports $1/share in earnings instead of $.90, thus meeting consensus eps expectations.
The worst case is that the reduced marketing is a mistake that will negatively affect sales and profits in coming quarters. But even in the best case–that this is a true savings–the company can only cut marketing expense once.
Yes, the company will also report an extra $.10 in eps for the next three quarters. But that’s it. This is really no longer a company earning $1 a share per quarter for as far as the eye can see. It’s a company that’s earning $.90 a quarter + a non-recurring $.10 now and for the next three reports.
If you were previously willing to pay $40 for $1 a share in quarterly earnings, you should (at most) pay $36 for $.90 a quarter profits. Add (at most) $.40 for the non-recurring earnings.
The main point is that cost-cutting has to end relatively quickly–and should not be mistaken for a permanent element of a company’s profitability.
3. Some managements won’t be inclined to call attention to this information and will just show it somewhere in the financials (in the hope analysts won’t bother to read the fine print). The cost-cutting could also be a bunch of little things, significant in the aggregate but not big enough individually to require disclosure. If so, the slowdown in sales is the only clue to what’s really going on.
4. For multi-line companies, the situation isn’t so simple. Sometimes, a firm may be phasing out a line of business where it earnings little or no profit, so it’s sales growth sags while profits advance smartly. Here, “Shoot first, ask questions later,” may be the wrong strategy. But it’s what short-term traders always do. And, in my experience, “Shoot first…” is right more often than not.
Here’s the second installment of the Bond Market Environment letter to clients by Denis Jamison of Strategy Asset Managers. The first appeared yesterday.
debt without cost
Federal government borrowing has spiraled since 2008. Total public debt outstanding–an amount that includes the notional amount owed by the Federal government to the various government trust funds–was $15.2 trillion at the end of 2011 compared with $9.2 trillion four years earlier. Now, that debt is probably a trillion higher and exceeds nominal Gross Domestic Product.
You would think that much borrowing would put a huge strain on the federal government’s budget.
Well, it hasn’t.
In fact, for the year ended December 31, 2011, the interest payments on the federal debt were just 5% higher than in 2007, despite a 65% increase in the debt outstanding. Moreover, the interest on the federal debt last year was just 1.5% of GDP. That’s less than the 3%-plus drain on the country’s earnings during the second half of the Eighties and through the Nineties.
two reasons for this happy situation:
–first, the growth miracle during the Clinton Presidency provided a huge expansion in GDP while temporarily reducing the actual level of federal government debt. And,
–second, the Federal Reserve’s zero interest rate policies begun in 2008 that reduced the interest cost of that debt from about 4.5% to less than 3%.
The trend in the cost of the federal government’s debt is glacial. It takes a while for old bonds to mature and be replaced by new ones. So the federal government’s debt costs will remain manageable for the next few years. Investors should be very aware that the higher level of federal debt to GDP plus the extraordinary low level of current interest payments could provide a severe headwind to economic growth down the road.
Bond investors have every reason to be confused. They have enjoyed thirty years of high rates of return caused by steadily declining interest rates. For various reasons, we experienced a secular decline in inflation since 1985. Meanwhile, monetary policy amplified the impact of that decline on bond prices by steadily reducing the real rate of return (the nominal yield less the inflation rate). We may have gone as far as we can down this road. Real yields of most US Treasury securities are negative. That’s happened before–in the Seventies. Then it was caused by high inflation against a backdrop of loose monetary policy. The inflation cure involved tight money, sharply higher interest rates and back-to-back recessions in the first half of the Eighties.
While Fed Chairman Bernanke draws parallels between the economic problems of the Thirties with those of today, he might want to consider the legacy of the Burns and Miller policies of the Seventies. After the 1.5% inflation rates of the Sixties, these Fed chairmen didn’t think future inflation would be a problem, either. And low interest rates seemed a good idea in exchange for economic growth.
It is likely bond investors will suffer a bear market someday–we just don’t know when. For the moment, the music is still playing, so you have to keep dancing.
The only way to earn a real return today is to accept greater risk–maturity (or call) risk, credit risk, currency risk, liquidity risk and a lot of other risks that you won’t know are risks until something bad happens. While I can’t pick the next winners (or losers), I can see a sector by sector return pattern created by the various waves of Federal Reserve policy.
By pushing short-term interest rates to zero, the Fed caused a huge rally in the US Treasury securities. The gains now are limited because the real yield from these securities has reached zero. Next, mortgages rallied as they were seen as a low risk alternative to government debt. Now they, too, are exhausted because, at current price levels, prepayment losses are wiping out most of their coupon income. That leaves maturity risk and credit risk still on the table for most investors.
The yield spreads between ten and thirty-year bonds are still attractive. In the US Treasury market, that spread is about 125 basis points. But the price risk for any change in interest rates is very high. For example, investors in the current US Treasury thirty-year bonds would lose 15% if rates increase from the current 3% to 3.5% ove the next six months.
Assuming maturity risk isn’t to your liking, maybe the answer is corporate bonds. Of course, there’s a lot of supply here because companies are busy selling new bonds to pay off old ones. Maybe all this supply is keeping yields relatively high. The spread between AAA-rated corporate bonds to ten-year US Treasuries is about 160 basis points. If you can stomach BBB-rated securities, you’ll earn a 300 basis point advantage over governments.
Investors face difficult choices. Old strategies aren’t working well in the current investment environment. Unfortunately, when you step out on a new path, you never know where it will lead.
This is the quarterly letter sent by Strategy Asset Managers, LLC, a bond management firm, posted with permission from my friend and mentor, Denis Jamison.
Today’s post sketches out the current situation. Tomorrow’s wil give Mr. Jamison’s investment conclusions.
a market of bonds
It’s an old saying on Wall Street–this isn’t a stock market but a market of stocks. In other words, individual stocks can rise or fall regardless of the general direction of the market. The same can now be said of the fixed income market. formerly, the direction of interest rates dictated returns across most segments of the bond market. If Treasuries called the tune and the rest of the fixed income market danced along–some a little slower or faster–but they were all moving to the same beat.
That’s now changed.
Policies implemented by the federal Reserve effectively have eliminated real yields for “riskless” securities like US Treasury bonds. (By riskless, I mean credit risk–that is, the risk of not getting paid at maturity. T-Bonds still have plenty of market risk.) Without government bond yields calling the tune, all sorts of other factors are determining returns in various segments of the fixed income market.
The markets are now being driven by monetary policy designed to:
(1) keep interest rates at zero for short-term, low-risk investment-like savings accounts and US Treasury bills and notes,
(2) narrow the yield spread between “safe” investments like US Treasuries ans riskier investments like corporate bonds, and
(3) lower the return spread between fixed income assets and securities with no maturity–like common stocks.
In fact, the Federal Reserve would really like investors to go out and spend their money on real goods and services. It has stated that zero interest rates are here to stay until the economy has fully recovered–that means much lower unemployment and much stronger economic growth. Chairman Bernanke, unfortunately, doesn’t have a crystal ball and isn’t telling us when he thinks that will happen. At the moment, however, he plans no change in interest rate policy through 2014. Of course, he has pushed out the probable end date of his quantitative easing program before and is likely to do it again. Market pundits have started referring to the Federal Reserve’s monetary policy as QE unlimited.
When the bank is playing…
…you just keep dancing. We have just entered the third phase of the Federal Reserve quantitative easing. in the wake of the 2008 financial collapse. Essentially, “quantitative easing” means that the Federal Reserve will buy financial assets from banks and put cash in their–the bankers’–hands. The hope is that, somehow, this money will filter through the system and the banks will loan that money to you and you will buy a house or a car or anything.
Why doesn’t the Federal Reserve just lower interest rates and make the loans cheaper? Well, interest rates are already at zero so they need to do something else. Since the banks are stuffed with money, will they loan the money to you? No, because you don’t have a stellar credit history and your house is under water. They refuse to take credit risk because they face political and regulatory retribution if they suffer any losses.
Has the quantitative easing program improved the economy? Not yet, but it has certainly been a windfall for the financial markets. The S&P market index is up 115% off the 2009 lows and every time it seems to be losing steam, we get another QE program.
Is all this going to end badly? Probably, yes, but in the meantime don’t fight the Fed, don’t fight the tape and keep dancing.
The quantitative easing programs are having one clear impact–a massive increase in the Federal Reserve’s balance sheet. The Federal Reserve was created in 1913 through a bill sponsored by two legislators, Carter Glass and Parker Willis. Mr. Glass later went on to co-sponsor a bill that prohibited commercial banks from being securities firms. (Interestingly, that 1933 piece of legislation was struck down during the Clinton administration. Some say the repeal was a root cause of the 2008-2009 financial collapse.) The Federal reserve’s mandate was to provide liquidity to the banking system in times of crisis and to gradually expand the money supply to support non-inflationary economic growth.
Until 2008, the Federal Reserve provided that liquidity to the banking system by gradually expanding its assets through the purchase of government bonds from the banks. That has changed. Federal Reserve assets grew from $890 billion in June 2008 to $2.8 trillion most recently. This is the result of asset purchases made by the Federal Reserve through its various QE programs. Government bonds account for $1.6 trillion of those assets. Another $800 billion are mortgage-backed securities and the Fed plans to add about $60 billion a month to that pile. Unfortunately, the Federal Reserve’s capital base hasn’t kept up with the asset growth. Now, $55 billion in capital supports those $2.8 trillion in assets–a leverage ratio of 50:1!
So, the Federal Reserve has done an excellent job of reducing leverage in the banking system through the purchase of all those assets and, as an additional benefit, helped keep government borrowing costs low. But it has transferred a large portion of private sector bank leverage to its own balance sheet. Any percentage change in the price of the assets on its balance sheet will be reflected fifty-fold as percentage change in the Fed’s capital.
In the movie”It’s a Wonderful Life,” the banker,George Bailey, was lucky enough to have an angel when his depositors make a run on the bank. I hope Mr. Bernanke has an angel on his side if interest rates ever rise.