the Trump rally and its aftermath (so far)

the Trump rally

From the surprise election of Donald Trump as president through late December 2016, the S&P 500 rose by 7.3%.  What was, to my mind, much more impressive, though less remarked on, was the 14% gain of the US$ vs the ¥ over that period and its 7% rise against the €.

the aftermath

Since the beginning of 2017, the S&P 500 has tacked on another +4.9%.  However, as the charts on my Keeping Score page show, Trump-related sectors (Materials, Industrials, Financials, Energy) have lagged badly.  The dollar has reversed course as well, losing about half its late-2016 gains against both the yen and euro.

How so?

Where to from here?

the S&P

The happy picture of late 2016 was that having one party control both Congress and the administration, and with a maverick president unwilling to tolerate government dysfunction, gridlock in Washington would end.  Tax reform and infrastructure spending would top the agenda.

The reality so far, however, is that discord within the Republican Party plus the President’s surprisingly limited grasp of the relevant economic and political issues have resulted in continuing inaction.  The latest pothole is Mr. Trump’s refusal to release his tax returns–that would reveal what he personally has to gain from the tax changes he is proposing.

On the other hand, disappointment about the potential for US profit advances generated by constructive fiscal policy has been offset by surprisingly strong growth indications from Continental Europe and, to a lesser extent, from China.

This is why equity investors in the US have shifted their interest away from Trump stocks and toward multinationals, world-leading tech stocks and beneficiaries of demographic change.

the dollar

The case for dollar strength has been based on the idea that new fiscal stimulus emanating from Washington would allow the Fed to raise interest rates at a faster clip this year than previously anticipated.  Washington’s continuing ineptness, however, is giving fixed income and currency investors second thoughts.  Hence, the dollar’s reversal of form.

tactics

Absent a reversal of form in Washington that permits substantial corporate tax reform, it’s hard for me to argue that the S&P is going up.  Yes, we probably get some support from a slower interest rate increase program by the Fed, as well as from continuing grass-roots political action that threatens recalcitrant legislators with replacement in the next election.  The dollar probably slides a bit, as well–a plus for the 50% or so of S&P earnings sourced abroad.  But sideways is both the most likely and the best I think ws can hope for.  Secular growth themes probably continue to predominate, with beneficiaries of fiscal stimulation lagging.

Having written that, I still think shale oil is interesting   …and the contrarian in me says that at some point there will be a valuation case for things like shipping and basic materials.  On the latter, I don’t think there’s any need to do more than nibble right now, though.

 

 

a French sovereign debt default?!?

First there was the surprise Brexit vote in the UK, after which sterling plunged.

Then there was the improbable victory of Donald Trump in the US presidential election, which sent the dollar soaring.

Now there’s France, where the odds of a far-right presidential victory by the Front National have improved.  A competing right-of-center candidate, former frontrunner François Fillion, has been hurt by allegations that his wife and children did little/no work in government jobs he arranged for them (with aggregate pay totaling about €1 million).

If Marine Le Pen, the FN leader and standard bearer, were to win election in May (oddsmakers now give this about a 1 in 12 chance), her victory might conceivably snowball into a similar sea change in the National Assmebly election in June.  Were the FN to win control of the legislature too, the party says it will leave the euro and re-institute the franc as the national currency.  In addition, it intends to, in effect, default on €1.7 trillion in French government bonds by repaying the debt in new francs, at an exchange rate of 1 Ffr = 1 €.

Improved prospects for Ms. Le Pen–plus, I think, President Trump demonstrating he means to do his best to keep all his campaign promises–have induced a mini-panic in the market for French-issued eurobonds.  Trading at a 40 basis point premium to similar bonds issued by Germany as 2017 opened and +50 bp in late January, they spiked to close to an 80 bp premium last week.

my take

At this point, the conditions that would trigger a French exit from the euro and its refusal to honor its euro debt instruments seem high unlikely.  Still, the possibility is worth thinking through, since the financial markets consequences of Frexit would likely be much more severe than those of Brexit.

More tomorrow.

 

 

 

 

 

 

 

Brexit, sterling and InterContinental Hotels Group (LN:IHG)

Early indicators after the UK vote to “Leave” the EU are already showing the country is dipping into recession.  Nevertheless, large-cap stocks in the UK have held up surprisingly well.

This can clearly be seen in the results just announced yesterday by IHG.  The fear of markets before Brexit about hotels had been that the post-recession cyclical upsurge in vacationing had just about run its course–and that, as a result, hotel profits were just about to peak/had already peaked.  But the figures from IHG were good and the stock rose by about 3% on the news.

To see how this can be, it’s important to note    that the post-Brexit decline in the fortunes of the UK has been expressed almost entirely in a 10%+ decline in the British currency.  This is an unexpected boon for British-based multinationals.

As Richard Solomons, the CEO of IHG, put it in yesterday’s report to shareholders:

“Note that whilst the UK comprises around 5% of our group revenues,

approximately 50% of our gross central overhead and

40% of Europe regional overhead are in sterling.

At 30 June 2016 exchange rates, approximately 70% of our debt is denominated in sterling.”

All of these figures are now 10% less in purchasing power terms than they were pre-Brexit.  Without any price changes, revenues will be 0.5% lower in dollar terms than they would have been.  But overheads will be down by much more.  In addition, the dollar value of the company’s debt is sliced by about $128 million.

This situation has two positive effects in the minds of UK investors:

–profits will likely be higher than anticipated, making the stock more attractive, and

–to the extent that a company like IHG, which has the lion’s share of revenues outside the UK, is affected by Brexit, the influence is likely to be positive.  This means that it can act as a way for British residents to preserve the purchasing power of their savings.

 

internal and external economic adjustment

This is ultimately about the euro and the EU.  Today’s post is about creating a framework for thinking about this issue.

It’s a condensed version of a longer post I wrote six years ago on Balance of Payments (actually, a series, for anyone who’s interested).   Although a big simplification of what is actually going on in the world, it highlights what I believe is a central structural issue facing the EU and Japan today   …and potentially the US, at some point.

 

imports and exports

The residents of any given country typically don’t consume only items made in that country.  They buy imported goods as well.  In fact, the marginal propensity to consume imports is normally higher than the marginal propensity to consume, meaning that as spending increases imports rise at a faster rate.

paying for imports

The country as a whole gets the money to pay for imports in one of a number of ways:  it can make things to sell to foreigners, it can use accumulated savings, it can sell assets to foreigners or it can borrow.

imbalances

In an ideal world, every country would make and sell exactly enough goods and services through export to pay for the imports it purchases.  That’s seldom the case, however.

chronic deficit

Consider a country that, year after year, buys more from foreigners than it can pay for with the proceeds from what it sells.  To continue consuming foreign goods at the same rate, such a country has to either sell assets, like land or companies, or borrow from foreigners.  At some point, however, it will reach the limits either of what it has that others want to buy or the amount foreigners will lend.

This situation sets the stage for a potential foreign currency/trade/economic growth crisis.

internal/external adjustment

Here’s where we get to internal/external adjustment.

There are two ways of dealing with this issue:

internal

–the government can slow down overall consumption (essentially, create a recession) by raising interest rates/taxes by enough to decrease consumption of foreign goods and services

–domestic industries can voluntarily restructure themselves, with/without government help, to improve quality and lower prices so they make more things foreigners will want (unlikely to happen on a large scale)

–the government can erect tariff or regulatory barriers to imports, to try to redirect consumption to domestic goods (almost always a bad idea:  look at the US auto industry since the mid-Seventies)

None of these actions are likely to win unanimous applause from voters.  And if legislative action produces negative results, it will be completely clear who is to blame.  So politicians everywhere, and particularly in badly-run countries, tend to not to want to choose any one of them.  Instead, they most often opt for the external adjustment route.

external

–This means to encourage or embrace a decline in the local currency versus that of trading partners.  That simultaneously makes foreign goods more expensive for locals and local goods cheaper for foreigners.  Devaluation will encourage exports and inhibit imports, achieving the same end as rising interest rates, but without the sticky legislative fingerprints attached.  It’s those horrible foreign exchange markets instead.

 

More tomorrow.

 

 

 

 

 

 

yen strength a minus for Abenomics

This time a year ago $1 bought about 120 yen.  That figure was 125+ last June.  The rate was 113, however, a week ago–and 108- today.

This amounts about a 10% year-on-year gain in the yen’s purchasing power against the dollar, half of that strength during the past week.

The rise is good for consumers for whom the cost of imported items like food has skyrocketed under the administration of Prime Minister Shinzo Abe.  Not so good, though, for Mr. Abe’s grand plan to resuscitate his country’s still moribund industrial sector through massive currency depreciation.

There’s no particular reason for the yen to strengthen that I can see.  Yes, Mr. Abe did recently observe that aggressive intervention in currency markets is an imprudent strategy.  And, yes, this is the time of year when corporate cash flows back into Japan causes mild currency strength.  But the Bank of Japan recently initiated a negative interest rate policy designed to weaken the yen.  And in my view there’s no sign yet that Mr. Abe’s bet-the-farm gamble on 1980s-era export industries is paying off.

Yet the currency is going up.

This may just be bad luck.

If we assume that the US dollar has peaked, then the question for short-term currency traders is which of the two remaining majors, the yen or the euro, is a better bet.  Given renewed uncertainty about Greece and the upcoming vote in the UK on a referendum to exit the EU, traders may think they have little choice other than to shift their holdings toward yen.

Still, the biggest economic problem for Japan–and the reason Japan is a cautionary tale for the US–is that the political power structure there is totally committed to defending the status quo and retarding structural change.  It’s subsidizing industries whose heyday was in the 1980s, and it’s allowing its workforce to shrink by its anti-immigration stance in the face of an aging domestic population.  A rising currency will only make the circle harder to square.

 

 

currency effects on US companies’ 1Q16 earnings

Over the past year or more, the international portion of the earnings results of US publicly traded companies has suffered from the strength of the US dollar.

Data dump:

-By and large, US products sold in foreign countries are priced in local currency.  When the dollar rises, the dollar value of foreign sales falls.  Speaking in the most general terms, firms can raise prices without damaging sales volumes only at the rate of local inflation, meaning that it can take quite a while for a US company to recoup a currency-driven loss through price increases.

-The rise in the dollar has come from two sources:

–the collapse of the currencies of emerging countries with unsound government finances and radically dependent on exports of natural resources like oil and base metals, and

–the greater strength of the US economy vs. trading partners like the EU and Japan.

-What appears on the income statement as a currency gain or loss is the result of a complex process with two components:  cash flows; and an adjustment of balance sheet asset values. There’s no easy way to figure out what the exact number will be.

-We do know, however, the very important fact that the dollar has been weakening against the euro and the yen for the past several months.  If the quarter were to end today, the euro would be 3.2% stronger vs. the dollar than at the end of 1Q15.  The yen is now 5% stronger than it was at the end of last March.  The Chinese renminbi is 5% weaker against the dollar than this time a year ago, but there’s much greater scope to raise prices in China.

My conclusion:  US companies with mainly and EU or Japanese assets/earnings will likely post modest foreign exchange gains during 1Q16 vs. large losses in 1Q15.

Hedging?  Many international  firms try, more or less successfully, to smooth their foreign earnings by hedging.  This activity is crucial for an exporter with long lead times, cosmetic for everyone else.  The key point, however, is that in my experience when hedging results in a gain, this is recognized in operating profit and companies say nothing.  When the hedging makes a loss, companies disclose the figure and argue that this is a non-recurring item.  For whatever reason, Wall Street usually ignores a loss of this type.

So, ex emerging markets, currency can be a significant positive surprise for internationally-oriented firms this quarter, instead of the earnings drag it has been in recent quarters.  My guess is that Wall Street hasn’t factored this likelihood into prices yet.

 

 

 

 

Shaping a Portfolio for 2016: currency and interest rates

currency

Japan and the EU have tried over the past several years to jumpstart their economies through massive currency  depreciation.  This has resulted in a gigantic loss of national wealth in both regions.  It has also depressed the local standard of living by making dollar-denominated commodities–energy, food, metals, textiles–more expensive.

But the move has also revived industry, at least in the EU, by making end products cheaper.

Therefore, Europe could see substantial export-based growth in 2016.  As usual, I’m thinking that Japan is a lost cause.

interest rates

The US is alone among major countries of the world to have recovered far enough from the 2008-09 recession to begin to raise interest rates from their current intensive care lows.

The Fed Funds rate will most likely be be boosted to +0.25% next week.  And the benchmark will doubtless be raised again in 2016.  Nevertheless, the initial increases will probably have little, if any, negative effect on economic activity.

My guess is that we’ll exit 2016 with the Fed Funds rate at 1%.

At first blush, it would seem that by increasing interest rate differentials between the US and the rest of the world, the Fed would induce international fixed income investors to reposition their portfolios. Selling foreign bonds and buying US Treasuries would give them both higher interest income and the chance at a currency gain–since the flow of foreign funds into the US would imply further strength in the US$.

However, the Fed move has been widely telegraphed for an extended period of time.  We’ve already seen considerable struength in the US$ in 2015.  My guess is that most of the potential asset shift has already taken place in 2015.

So, I’m thinking that the Fed’s interest rate moves will be a non-event in both domestic economic and currency terms.

Tomorrow:  petrodollars