Market Recap: Earnings Beats, China’s Wild Ride, and 3 Scenarios for Greece

Posted on April 24, 2015 by Gemmer Asset

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The global equity markets were up across the board this week. In the U.S., the S&P gained +1.8% while the Russell 2000 added +1.3%. The tech/biotech heavy NASDAQ put up its best weekly performance (+3.2%) in six months on the back of solid earnings from Microsoft and Amazon. The overseas markets were also solid. China led the pack with a +2.5% gain followed by Europe (+1.9%) and Japan (+1.8%).


Oil continued its impressive rally, adding another +2.2% this week to bring its YTD gain to +6.6%. Bonds sold off though. The yield on the 10-year moved closer to 2% and intermediate-term government bonds lost -0.3% for the week. The 30-year Treasury was of -1.8%.


When Less Bad is Good


Corporate earnings played a big role behind this week’s rally. Earnings season in the U.S. is roughly half over, and so far things have been better than feared. At the beginning of April S&P earnings were expected to fall in the first quarter by roughly 3% year-over-year. By the end of this week expectations are basically flat. Considering energy earnings are likely to be down over 60% YoY this is a pleasant surprise.


Also encouraging is the number of so called earnings beats. The table below shows the percent of companies beating earnings expectations quarter-by-quarter. So far the ratio is at 66.5% – the highest level since 2010 and a sign that analysts had clearly grown too pessimistic the last couple months.




Goldman had an interesting point on Friday.  During earnings season corporations cannot buy back their own stock.  Thus, during April corporate buybacks slowed down significantly.  However, starting next week 81% of the S&P will be able to start buying their shares again.  And buybacks this year should be huge.  Goldman forecasts that companies in the S&P 500 will return more than $1 trillion of cash to investors this year.  Buybacks will increase 18% over last year while dividends are on pace to increase 7%.  Goldman’s numbers are below:




So roughly 47% of cash spent by corporate America will go towards buybacks and dividends – more than capex and R&D combined.


China’s Wild Ride


China is nothing if not interesting. The local A-share market was up almost +53% in 2014 after a number of years of underperformance, and through Friday they are up another +35%. Despite a slowing economy equities have rallied on the hope of policy easing from the Chinese authorities. However, last week stocks in China were hammered by a couple moves designed to dampen speculation. The list of securities available to short was expanded while regulators took steps to limit margin lending.


The last point is a big deal. Chinese stock investors have built up $375 billion in margin loans the last few months. Loans have tripled in the past year and are 50% larger in total than in the U.S. Another way to look at it is margin debt relative to shares available to trade (free float). The chart from the WSJ below shows that this ratio hit 8.2% in April – the highest ever in China and far higher than U.S. levels. It is also much higher than margin loans in Taiwan right before the Asia crisis hit.




However, the clamp down didn’t last long. Over the weekend the central bank rode to the rescue by cutting the amount of cash that banks must hold as reserves. This was the second cut in two months and biggest single reduction since the depths of the global crisis in 2008. In total this move should release around a trillion yuan into the economy. What’s driving this move is something China hasn’t seen in years – capital flight. To quote Goldman:


“It’s important to recognize the sea change that’s occurred in China’s FX reserve holdings- they’re not going up any more. To be sure, some of the decline has represented a fall in the value of non-USD currencies in the basket (cough, euro, cough), but the sheer scale of the recent falls is highly suggestive of actual sales due to speculative capital flight. That, in turn, sucks RMB out of the system, and a nice RRR cut is an easy way of putting some liquidity back into the money market by loosening up dead cash on bank balance sheets.”


The chart below from Reuters illustrates the big reversal in Chinese reserve accumulation (yellow bars).




So can the equity rally be justified on fundamentals? Or is it a debt fueled speculative binge? We will only know in time, but BCA has a great chart to capture the spirit:


“…it may be no coincidence that the number of new retail brokerage accounts has increase 15-fold, while gaming revenue from mainland visitors to Macau has fallen by nearly half (chart below). The gambling spirit has simply migrated from casinos and the property market into the stock market.”




Does Greece Matter Anymore?


One key question on everyone’s mind today is whether Greece matters anymore?  The news from the battered country is certainly bleak.  The country is once again running out of money and debt payments are due.  They are going cap in hand to European officials for the last installment of the existing bailout package.  As The Economist notes:


The problem is that Greece’s new government has refused to implement reforms promised by its predecessor, and has not proposed alternatives its creditors consider adequate. Talks continue, but the two sides remain far apart. If Greece does not secure more cash, it will soon have to default either on its own citizens or on the IMF and the European Central Bank (ECB). That, in turn, could prompt the ECB to withhold support for Greek banks, forcing Greece to impose capital controls and perhaps to withdraw from the euro.”


All very familiar stuff.  It is generally viewed in the investment community that Greece has few options.  Greece has to engage with Brussels because Greece has no long-term financing options outside of the EU, IMF, and the ECB.  Also, the public is strongly pro-euro giving Syriza few options short of plunging the country into chaos.  The pain in the bond market is certainly severe.  As you can see below, 3-year bond yields have shot up from 5% to above 28% the last few months.




But the only investors being hurt by this are non-economic entities or domestic Greeks likely to receive IOU’s as payment (something very familiar to Californians).  As you can see below, the bulk of the debt maturing through the end of this year belongs to the ECB and the IMF.




Only 11% of Greece’s bonds are in private hands, so the systemic implications of a default are dampened. There are basically three scenarios for Greece:


1) Another resolution is hammered out this quarter and the can is kicked until the next big debt maturity – probably in mid-to-late 2016. We possibly see a mild rally in the euro under this scenario. Equities do well.


2) A contentious debate this quarter that unnerves everyone involved but a deal is hammered out in the second half of the year. This will entail a default on debt due the IMF and probably deposit flight from the country. More euro weakness. Stocks are volatile. But ECB bond purchases cap any systemic risk.


3) Euro exit. This is obviously the worst case scenario. The euro would come under serious pressure as investors bet on who is next. Stocks would correct quickly. However, we think investors would soon realize that Spain and Italy are unlikely to follow Greece out of the euro. A Greek exit would almost certainly mean that Greece’s banking system collapses – why would Italy and Spain want to follow that example? We’d probably also see the ECB expand their already massive QE plan to dampen systemic risks.


So what are the odds? #2 looks possible after today’s acrimonious talks. But the Greek saga is getting to the point where bad news could be good. To quote The Economist again:


“Optimists argue that the euro zone is much better able to absorb a Greek shock today than it was in 2011. Banks are better capitalised and have virtually no exposure to Greece; quantitative easing is propping up bond and equity markets; and thanks to the weak euro, exports are much stronger. …Some even argue that Grexit would do markets good by frightening other countries into accelerating reforms, reducing support for protest parties such as Podemos in Spain and giving twitchy investors the confidence that the euro zone can weather such a crisis. The contagion to worry about… would come from Europe caving in to Greek recalcitrance, giving other countries an incentive to follow suit.”


Will Liftoff Come In September?


Next week brings us another Fed meeting on Tuesday and Wednesday. While no actions are expected, the statement will be closely scrutinized for hints about any policy changes this summer. If you remember, at the March meeting the Fed lowered their projection of where rates will be in coming months, and since then the economic data has been soft. For example, the chart below shows the economic surprise index which records how many economic reports have either beat or missed expectations. The low reading indicates a lot of misses – actually, the most since 2011.




Along these lines we get the first estimate on 1st quarter GDP on the same day the Fed statement is released. Consensus is around +0.7%, although we’ve seen estimates as low as 0%.


What this all means is that the Fed is likely to strike a cautious tone at this meeting. Recent speeches have supported this idea. Both Janet Yellen and New York Fed President Dudley have sent very accommodative messages lately. Anecdotally, a Wall Street Journal columnist frequently thought to have the ear of the Fed penned a particularly dovish piece last week.


All in all this would seem to indicate no fireworks at the upcoming meeting. The debate appears to be shifting from June versus September to September versus December.


Have a good weekend.


Charles Email Sig


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