Market Recap

Posted on October 16, 2015 by Gemmer Asset

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Not a bad week for the global equity markets, but the action did little to answer the question of whether the rally the last few weeks is simply an oversold bounce or something more enduring. This is particularly because risk assets advanced on the back of fairly weak economic and corporate data.


For the week the S&P gained +0.9% while the international markets were up between +0.3% and +0.8%. Chinese equities saw the largest bounce with A-shares up +6.5% and H-shares up +2.8%. The commodity index was off -1.6% largely due to a -4.5% fall in crude oil prices. Crude inventories continue to grow and this is putting pressure on pricing.


Interestingly bond yields followed the economic news. Yields fell 0.08% and the 10-year closed at 2.02%. Long-term government bonds added +1.3% for the week while intermediate-term bonds were up +0.6%. Weak data and dovish signs from certain Fed governors spurred the rally. The Fed news also helped gold and silver which were up +1.5% and +1.1% respectively.


Stepping back for a minute, this week is a great example of just how frustrating markets can be for many people. The headline data was poor – everything from the growth numbers to earnings generally disappointed. However, stocks rallied, especially the most beaten up names and asset classes. Below is a quick summary.


Global Growth Estimates Ratchet Down


There were a number of economic reports this week:


• Industrial Production fell -0.2% in September after falling -0.1% in August.


• Philly Fed showed that both manufacturing and the labor markets softened in September.


• NY Fed showed the same thing. Activity declined for the third consecutive month and the labor numbers weakened.


• If we look at all the Fed surveys (blue line below) it points to a contraction in the national manufacturing index (red line) in September. This is a problem because the services sector, a much bigger part of the economy, often follows manufacturing.




• Retail sales were up +0.1% in September and +2.4% year-over-year.  While in line with estimates, there is a definite worry that sales are being goosed by auto sales.   As you can see below, if you strip out autos sales, retail sales have been flat to negative for most of the year.


Pulling it all together, estimates for 3rd quarter growth have softened. Goldman cut their estimate to +1.2% from +1.8% this week. JP Morgan is at +1.5%. And the widely watched Atlanta Fed estimate fell to +0.9% – a very soft number. You can see below how the consensus growth estimate for 3Q has trended the last few months (blue line) and where the Atlanta Fed is at.




Of course nothing is pointing towards contraction, but it wouldn’t take much to push us in that direction for a quarter. A crazy fall/winter weather pattern could easily do it.


Earnings, Energy, and Profit Margins


There were a number of earnings reports this week and a few big ones stand out. Wal-Mart was hammered after it lowered guidance for the coming years, while Netflix disappointed. The financial sector was generally below expectations with the exception of Citi. GE did reasonably well.


In total, analysts think 3rd quarter S&P 500 earnings will contract over -3% from year ago levels. But much of the weakness is in the energy sector where earnings are expected to shrink a massive -65%. Exclude energy and earnings should grow +3%. But that is a bit like saying the fall from the building was fine until the last few inches.


The key question will be whether expectations have come down enough so that companies can beat the reduced targets. Estimates are certainly down. As you can see below, estimates for 3Q earnings have fallen in every case expect telecom. In general estimates are down close to -3% over the last three months.




This is pretty much par for the course.  Over the last couple years estimates have typically fallen going into earnings season, only to see meaningful upside surprises.  What is different this time is that we are seeing sales contract.  As you can see below, revenues shrunk in both 1Q and 2Q and are expected to contract again in 3Q.




Again this revenue contraction has much to do with energy and commodity related revenues. But even Wal-Mart, a company that should benefit greatly from lower oil prices, saw its revenues grow only +0.1% year-over-year in the third quarter while operating income shrunk -10% from year ago levels.


And this gets to the heart of the earnings worries. Softening sales combined with static expenses means profit margins are shrinking. The chart below from BCA shows this very well. The bottom panel shows how elevated margins are compared to history. They are about as high as they’ve been since 1960. However, the top panel shows that sales are contracting while wages and salaries are still growing.




To quote BCA:


“With five sectors in top-line deflation, two others barely able to lift selling prices, and real global economic activity struggling to reach trend growth, companies will only be able to protect margins through wage restraint….(historically) employment follows profits, underscoring that labor market slack will build and that the Fed will be hard pressed to raise rates if earnings stay soft, as our model projects. While this is not a widely held view at the moment, perceptions may change if data softens further.”


And this last point gives us insight into why the markets rallied this week. If we are on the cusp of a profit recession (two consecutive quarters of falling profits) and new labor market weakness, this is an environment for more Fed stimulus, not rate hikes.


Fed Governors Commit Blasphemy


There were two keys speeches that undercut the hike in December idea. Governor Daniel Tarullo noted during a CNBC interview that, “I wouldn’t expect it would be appropriate to raise rates” when referring to the possibility of a rate hike this year. Lael Brainard gave a more in-depth peak into the doves’ thinking during a speech to the National Association of Business Economists (that sounds like a crazy group!!). She in essence explains why policy makers should delay hiking rates. The key quote is:


“In contrast to the considerable progress in the labor market, progress on the second leg of our dual mandate has been elusive. To be clear, I do not view the improvement in the labor market as a sufficient statistic for judging the outlook for inflation. A variety of econometric estimates would suggest that the classic Phillips curve influence of resource utilization on inflation is, at best, very weak at the moment. The fact that wages have not accelerated is significant, but more so as an indicator that labor market slack is still present and that workers’ bargaining power likely remains weak.”


This is radical stuff. The Fed lives and breathes the Phillips curve. This is the theory that as unemployment falls, inflation inevitably picks up. Many economists view this as a basic law like gravity or the fact that your alumni association will always find you no matter how many times you move.


Brainard is saying the Phillips curve is broken. This is puts her at odds with Janet Yellen who only recently made the case for why the Phillips curve works. Most analysts are taking this as a sign that the Fed is going to push rate hikes out into 2016, maybe way into 2016. The probability that the Fed stays at zero after the March 2016 meeting shot up to over 50% this week, as you can see below.




So let’s recap – economic data was soft, earnings are under pressure, sales are faltering, and margins are falling. But stocks rally, all because the Fed is likely to stay easier for longer. This is a tough market to short!! In essence this is where we have been ever since the financial crisis – reliant on policy makers to at least avoid making a mistake. And if they can goose things a bit more that is all the better.


It is a strange world we live in!


Charles Email Sig








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