As the pandemic drives markets to the 2018 lows, certain
relationships in trends between the markets and the COVID-19 virus are evident. As social distancing increases, markets
continue to fall. So, by looking at the expected breakout levels of the
virus, we can assess possible market reactions. The chart below shows the
inverse correlation between the expected peaks of the virus and potential lows
in the markets:
Source: FIPhysician – & Patrick Hill – 3/18/20
In the COVID-19 – SPX model above, the steep red line is a
forecast of new cases if social distancing were not in place. The green line shows how social distancing
will flatten the curve of new cases. The blue curve shows how growth in the
pandemic may unfold doubling every 4 – 7 days.
The lower chart shows how social distancing correlates to movements in
the SPX. As the number of cases peak, there is a related trough in the SPX.
Looking at present levels, we are likely to see more selling as the number of
cases increases to a possible low of 2000 in the May-June time frame.
Epidemiologists currently forecast the COVID -19 pandemic will unfold
in two waves, with the current breakout and remission during the summer
followed by a possible second breakout in the fall and winter of this
year. Researchers think the closest
analog to the COVID -19 pandemic is the Spanish Flu in 1918, which came roaring
back the following winter resulting in a second wave of even greater infections
The first blue dot shows where the SPX is today at this early
stage in the pandemic. The SPX index may
continue to fall as the economic damage increases and GDP declines in the first
and second quarters. Two consecutive declines will officially put the economy in
The SPX may fall to 2030 in this first wave, which represents a
Fibonacci retracement of 50 % from the 2008 low to the 2020 peak. From there, markets may rebound back up to
2350, a Fibonacci retracement of 61% as the virus breakout fades, relief rally emerges,
and economic activity picks up. However,
as this occurs, higher interest rates from massive stimulus spending may weigh on
financial markets, as seen in the spike of bond yields, the decline in gold
prices and other safe haven assets.
Consumers who are already financially stretched are being
furloughed or laid off, which will trigger loan defaults. Finally, corporations are now at the highest
level of debt since 2008 and are experiencing a steep decline in sales, causing
a cash squeeze leading to layoffs. The
most important consideration is that the
virus is exposing the heavy reliance on debt on major institutions and
consumers in our economic system.
The slide into a recession is evident in announced layoffs by significant
corporations. Marriott and other hotels have announced thousands of layoffs. Other
hospitality industry companies will follow. Harley-Davidson, GM, Ford, Fiat
Chrysler, Nissan, and Tesla have all suspended manufacturing for several weeks
in the U.S. Thousands of workers are on furlough until manufacturing resumes. There is a growing risk consumer demand may
not return to pre coronavirus levels forcing permanent layoffs.
While manufacturing is 30% of GDP, services contribute 70% of
GDP. Many services can be offered online
or via web conferencing. The present social
distancing experiment will provide significant insights into how well the
economy can perform when many knowledge workers are working from home. If working from home is successful, we expect
to see more companies permanently move employees to their homes to reduce
office space and cut expenses. This has grave implications for the commercial
real estate industry and investors of those properties.
The diverse U.S. economy is likely to recover quicker than the
world economy. However, an earnings
recovery may stall due to the fact most S&P 100 companies derive 55% of
their sales from overseas and 60% of their profits from international markets.
Looking at a possible second virus wave in the fall, it is likely that
economic damage will grow worse due to increasing unemployment, declining
corporate spending, falling consumer spending, and a resumption of social
distancing. The second wave fits a decline model seen in 2000 from the Y2K software
bug scare. That crisis was an external
event, causing a demand shock, though little supply shock. The bottom for the NDX did not happen until
18 months after the market peak. The virus seems to be compressing the market
drop period as there have been three trading halts of 7% in the markets in just
eight days of trading. SPX support is
near 1810 – 1867 in 2016, just above the Fibonacci 38% level of 1708.
In our post
of February 14th about the coronavirus triggering a
downturn, we saw the strong possibility of the economy sliding into a recession. In the post we noted that Allianz Chief Economic
Advisor, Mohammed El-Arian observed that we are likely headed into a U or L shaped
“…analysts and modelers should respect the degree of uncertainty in play, including the inconvenient realization that the possibility of a U or, worse, an L for 2020 is still too high for comfort.”
Hope is not a strategy. Of course, we hope the virus is contained, lives saved, and the economy can weather the stress on corporations and consumers. However, as long term investors, we need to look at the reality of what may happen based on research and plan our strategic investments accordingly. Plan for the worst, and hope for the best.
Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica, and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.
Will The Corona Virus Trigger A Recession?
As if waking up to an economic nightmare, investors see
headlines like these and many others flashing across their Bloomberg terminals:
Facebook says Oculus headphone production will be delayed due to virus
Apple extends country wide store closing for another week
Foxconn delays iPhone production
Qualcomm cuts production forecast due to virus uncertainty
Starbucks announces China store closures through Lunar New Year, uncertain when they may reopen
US Steel flashes a warning of a cut in demand
Nike shoe production halted
Under Armour missed on sales, and their outlook is weak. They partially blamed the Corona Virus outbreak.
IEA forecasts drop in oil demand this quarter- first time in a decade
never ending list of delays, disruptions, and cuts rolls on from retail to high
technology. Even services are impacted as flights and train trips are canceled
within and to and from China. While some
technology-based services are provided over the Internet service, restaurants,
training, and consulting, as examples, must be performed in person. Manufacturing operations require workers to be
at the factory to produce products. Thus, manufacturing is much more acutely
affected by quarantines, shutdowns, transportation disruption, and other government
It is as if an economic tsunami is rolling over the global economy. China’s economy was 18 % of world GDP in 2019. For most S & P 100 corporations, the Asian giant is their fastest growing market at 20 – 30 % per year. Even more critical, China has become the hub of world manufacturing after entering the World Trade Organization in 2000. Over the past two decades, U.S. corporations have relocated manufacturing to China to leverage an inexpensive labor force and modern business infrastructure.
Source: The Wall
Street Journal – 2/7/20
Prior to the epidemic,
world trade had begun to slow as a result of the China – U.S. trade war and
other tariffs. World trade for the first
time since the last recession has turned negative.
Analytics, The Wall Street Journal, The Daily Shot – 1/19/20
Based on severity
estimates, analysts have forecasted the impact on first-quarter China GDP
growth. In the chart below from Fitch Ratings, growth for first quarter drops
almost in half and for year growth drops to 5.2 % if containment is delayed:
Sources: The Wall
Street Journal, The Daily Shot – 2/6/20
When news of the
virus first was announced, the market sustained a quick modest decline. The
next day, investors were reassured by official news from China and the World
Health Organization that the virus could be contained. Market valuations
bounced on optimism that the world economy would see little to no damage in the
first quarter of 2020. Yet, there is growing
skepticism that the official tolls of the virus are short of reality. Doctors
report that at the epicenter of Wuhan that officials are grossly underestimating
the number of people infected and dead. The London School of Hygiene and
Tropical Medicine has an epidemic model indicating there will be at least
500,000 infections at the peak in a few weeks far greater than the present 45,000
The reaction, and not statements, of major governments to the epidemic hint that the insider information they have received is far worse and uncertain. U.S. global airlines have canceled flights to China until mid-March and 30 other carriers have suspended flights indefinitely – severely reducing business and tourist activities. The U.S. government has urged U.S. citizens to leave the country, flown embassy staff and families back to the U.S., and elevated the alert status of China to ‘Do Not Travel’ on par with Syria and North Korea. All of these actions have angered the Chinese government. While protecting U.S. citizens from the illness it adds stress to an already tense trade relationship. To reduce trade tension, China announced a relaxation of import tariffs on $75 billion of U.S. goods, reducing tariffs by 5 to 10 %. President Xi on a telephone call with President Trump committed to complete all purchases of U.S. goods on target by the end of the year while delaying shipments temporarily. It remains to be seen if uncontrolled events will drive a deeper trade wage between the U.S. and China.
chaos in the supply chain operations is creating great uncertainty. Workers are
being told to work from home and stay away from factories for at least for another
week beyond the Lunar New Year and now well into late-February. Foxconn and Tesla announced plant openings on
February 10th, yet ramping up output is still an issue. It will be a
challenge to staff factories as many workers are in quarantined cities and train
schedules have been curtailed or canceled.
Many factories are dependent on parts from other cities around the
country that may have more severe restrictions on transportation and/or workers
reporting to work. Thus, even when a plant is open, it is likely to be operating
at limited capacity.
On February 7th,
the Federal Reserve announced that while the trade war pause has improved the global
economy, it cautioned that the coronavirus posed a ‘new threat to the world
economy.’ The Fed is monitoring the
situation. The central bank of China infused CNY 2 trillion in the last four
weeks to provide fresh liquidity. The
liquidity will help financially stretched Chinese companies survive for a
while, but they are unlikely to be able to continue operations unless
production and sales return to pre epidemic levels quickly.
Will the Federal
Reserve really be able to buffer the supply chain disruption and sales declines
in the first quarter of 2020? The Fed already
seems overwhelmed, keeping a $1+ trillion yearly federal deficit under control
and providing billions in repo financing to banks and hedge funds causing soaring
prices in risk assets. While the Fed may
be able to assist U.S. corporations with liquidity through a tough stretch of
declining sales and supply chain disruptions, it cannot create sales or build
Prior to the
virus crisis, CEO Confidence was at a ten year low. Then, CEO confidence levels improved a little
with the Phase One trade deal driving brighter business prospects for the
coming year. Now, a possible black swan epidemic has entered the world economic
stage creating extreme levels of sales and operational uncertainty. Marc Benioff, CEO of Salesforce, expresses
the anxiety many CEOs feel about trade:
“Because that issue (trade) is on the table, then everybody has a question mark around in some part of their business,” he said. “I mean, we’re in this strange economic time, we all know that.”
Adding to the uncertainty
is a deteriorating political environment in China. During the first few weeks of December, local
Wuhan officials denounced a doctor that was calling for recognition of the new
virus. He later died of the disease, triggering a social media uproar over the
circumstances of his treatment. Many Chinese people have posted on social media
strident criticisms of the delayed government response. Academics have posted petitions for freedom
of speech, laying the blame on government censors for making the virus outbreak
worse. The wave of freedom calls is
rising as Hong Kong protester’s messages seem to be spreading to the mainland. The
calls for freedom of speech and democracy are posing a major challenge to
President Xi. Food prices skyrocketed by
20 % in January with pork prices rising 116 % adding to consumer concerns. Political
observers see this challenge to government policies on par with the Tiananmen
Square protests in 1989. The ensuing massacre of protestors is still in the
minds of many mainland people. As seems to be true of many of these events that
it is not the crisis itself, but the
reaction and ensuing waves of social disorder which drive a major economic
has forecast a slowdown in US GDP growth in the first quarter of 2020 to just
Economics, The Wall Street Journal, The Daily Shot – 2/6/20
Will U.S. GDP
growth really be shaved by just .4 %? If
we consider the compounding effect of the epidemic to disrupt both demand and
supply, the social chaos in China challenging government authority (i.e., Hong
Kong), and a lingering trade war – these factors all make a decline into a
recession a real and growing possibility.
We hope the epidemic can be contained quickly and lives saved with a
return to a more certain world economy.
Yet, 1930s historical records show rising world nationalism, trade wars,
and the fracturing of the world order does not bode well for a positive
outcome. Mohammed A. El-Arian. Chief Economic Advisor at Allianz in a recent Bloomberg
opinion warns of a U shaped recession or worse an L :
“I worry that many analysts do not fully appreciate the notable differences between financial and economic sudden stops. Rather than confidently declare a V, economic modelers need more time and evidence to assess the impact on the Chinese economy and the related spillovers – a consideration that is made even more important by two observations. First, the Chinese economy was already in an unusually fragile situation because of the impact of trade tensions with the U.S. Second, it has been navigating a tricky economic development transition that has snared many countries before China in the “middle income trap. All this suggests it is too early to treat the economic effects of the coronavirus on China and the global economy as easily containable, temporary and quickly reversible. Instead, analysts and modelers should respect the degree of uncertainty in play, including the inconvenient realization that the possibility of a U or, worse, an L for 2020 is still too high for comfort.”
Patrick Hill is the Editor of The Progressive
Ensign, https://theprogressiveensign.com/ writes
from the heart of Silicon Valley, leveraging 20 years of experience as an
executive at firms like HP, Genentech, Verigy, Informatica, and Okta to provide
investment and economic insights. Twitter: @PatrickHill1677.
Can Six Myths Keep The Market Going?
Piper Jaffray forecasts by year end 2020, the S&P 500 (SPX) will hit 3600, a 12.8 % increase. Of eighteen analysts interviewed by Marketwatch only three forecasters expect a decline for the SPX. Will the SPX reach 3600? The SPX has soared over 400 % from a low of 666 in 2009 to over 3200 at the close of 2019. Mapping the SPX ten year history onto a psychology market cycle map of growth and decline phases poses interesting questions. As the market has zoomed over 400% upwards over ten years, it is clearly in the Mania Phase. Yet, the US economy is growing at the slowest rate of any economic recovery since WWII at 2.2 % GDP per year, why the disconnect?
Patrick Hill – 12-31-19
reason for the disconnect is investment analysts and the media lead investors
to believe there is no downside risk. On New Year’s Eve, Goldman Sachs released
a prediction for 2020 claiming that the ‘tools of the Great Moderation’ (Fed
policy shift) begun 30 years ago low-interest rates, low volatility,
sustainable growth and muted inflation are still in place and were only
interrupted by the 2008 financial crisis. Plus we would add the Dotcom crash.
GS concluded that the economy ‘was nearly recession-proof.’
mainstream financial media also feed the Mania Phase with stories like Goldman
Sachs declaring the Great Moderation is working with our economy in a ‘new
paradigm’. We are to believe there will not be a recession because our
policymakers have the economy under control.
Really? With over $17 trillion of
negative debt worldwide to keep the world economy going, central banks have
succeeded in sustaining worldwide GDP at 1 – 2 % and falling as of late! For
the SPX market to not descend into the Blow Off phase, investors will need to continue to believe in six economic myths:
Phase of the Economic Cycle is Continuing
Will Bailout the Economy
The Fed Will
Keep the Economy Humming
If the Fed
Fails Then the Federal Government Will Provide Stimulus
The Trade War
Won’t Hurt Global Growth
and Markets Are Insulated from World Politics
Let’s look at each myth that is likely to affect portfolio and market performance in the next year. This analysis is based on research data of economic, social, government, business trends and observation of markets and the economy. If markets are to continue to climb, either policymakers must solve difficult issues or investors must continue to believe these myths are true. The first myth establishes a critical framework for viewing all economic activity. We are actually at the end of the growth phase of the economic cycle; here is why.
Myth 1. The Growth Phase of the Economic Cycle is Continuing
The Fed has reported that the economy is still in ‘mid-cycle’ phase. We differ with this position as several indicators show the economy is reaching the end of its growth cycle and ready to revert to the mean. As GDP is driven 70 % by consumers, let’s look at what is really happening to consumers. The ratio of current consumer conditions minus consumer expectations is at levels seen just before prior recessions not mid-stage growth economies.
Sources: The Conference Board, The
Wall Street Journal, The Daily Shot – 6/14/19
In the chart below, consumers are stretched as
loan default rates are rising despite a 50-year low unemployment rate. Rising
delinquencies tend to signal rising unemployment and economic decline is likely
in the near future.
Sources: Deutsche Bank, Bureau of
Labor Statistics, The Wall Street Journal, The Daily Shot – 6/4/19
Of major concern is that the manufacturing
sector is now in a recession based on five months of ISM reports below the 50 %
economic expansion benchmark. The overall contraction is validated as 70 % of
manufacturing sub-sectors are contracting as noted in the report below. While the US economy is primarily driven by
services, the manufacturing sector has a multiplier effect on productivity,
support services, and employment with high paying jobs. Note the contraction in
sub-sectors is reaching levels last seen before recessions.
Oxford Economics, The Wall Street Journal, The Daily Shot – 12-20-19
There are other indicators pointing to the end of the growth phase. For example, the inversion of the 2 – 10 yield curve last summer is now steepening – often seen before an economic slowdown. Another indicator is the number of firms with negative earnings launching IPOs in 2019 was at levels not seen since 2000. Finally, productivity and capital investments are at ten year lows.
Myth 2. Consumers Will Bailout the Economy
Market pundits have been quick to rely on the consumer to continue spending at growth sustaining rates. Yet, budgets for the middle class are squeezed as consumers cope with student loan debt payments, new car payments, health care bills, and credit card debt. The Bloomberg Personal Finance Index dropped significantly in October:
Source: Bloomberg, The Wall Street
Journal, The Daily Shot – 11/10/19
Car loans now span seven years on average
versus five years a few years ago. Further, the new loans ‘roll in’ debt from
previous car purchases due to negative equity in the owner’s trade-in vehicle. Vehicle price increases up to 10 % over the
last year for both cars and trucks add to the debt burden. Car debt is beginning to weigh on consumers
as delinquencies are climbing:
Sources: NY Federal Reserve, The
Wall Street Journal, The Daily Shot – 10/29/19
Today, credit card rates are running at a ten-year
peak of 17 – 22 % have seen no relief despite the Fed cutting rates. There is a record spread between the Federal
Funds rate and credit card rates as banks seek new revenue sources beyond
making loans. Many consumers are turning to credit cards to pay bills to
sustain their lifestyle as their wages are not keeping up with rising living
In addition, consumers are increasingly working
at more than one job to be sure they can pay their bills.
Sources: Deutsche Bank, Bureau of
Labor Statistics, The Wall Street Journal, The Daily Shot – 10/21/19
Workers need to take on multiple jobs in the
gig economy. McKinsey & Company estimates that 52
million people are gig workers or a third of the 156 million person workforce.
Contractors have no job security. Gig workers often receive hourly wages
with no health, retirement or other benefits. The lack of benefits
means they have limited or no financial safety net in the event of an economic
There are other key indicators of consumer financial distress, for example, consumer spending on a quarter over quarter basis has continued to decline, Bankrate reports that 50 % of workers received no raise in the last year. Real wages (taking into account inflation) for 80 % of all workers have been stagnant for the past twenty years. Uncertain economic forces are putting consumers in a financial bind, for more details, please see our post: Will the Consumer Bailout the Economy?
Myth 3. The Fed Will Keep the Economy Humming
The Fed has said it will do whatever necessary to keep the economy growing by keeping interest rates low and injecting liquidity into the financial system. However, a survey on Fed actions shows that 70 % of economists interviewed believe the Fed is running out of ammo to turnaround the economy.
Sources: The Wall Street Journal, The Daily
Shot – 12-30-19
We agree with their perspective that the Fed is entering an economic space where
no central bank has gone before. In
the past, the Fed lowered rates when an economic downturn was evident. Just
prior to earlier recession’s interest rates were at a higher starting level of
at least 4 – 5 %. Plus, today the Fed has
returned to pumping liquidity into the economy via its repo operation and QE as
Sources: The Federal Reserve of St. Louis, The
Wall Street Journal, The Daily Shot – 12/30/19
The International Bureau of Settlements (BIS)
disclosed in their analysis of recent Fed repo operations that funding
supported not only banks but hedge funds. A key concern is the nature of the
hedge fund bailout. How steep is the loss being mitigated? Is there a possibility
of contagion? Is more than one hedge fund involved? Should the Fed be bailing out hedge funds
that are overextended due to speculation? The
Fed is already using its tools at the height of the current economic growth
cycle. The Fed financial tools are too stretched to turnaround an economy in a recession
from multiple financial bubbles bursting.
The Fed continues to declare that inflation is
at 2.1 %, missing the reality of what
consumers are actually paying for goods and services. We find from industry research that finds inflation
is likely in the 6 – 10% range. Inflation should be defined as price increases of goods and
services that consumers buy, not inflation defined by a formula to suit
political needs. Using inflation lifestyle ‘cost of living’ data, which is not
transparent or available for audit does not meet the foundational data needs of
investors. Gordon Haskett Research Advisors conducted a study by
purchasing a basket of 76 typical items consumers frequently buy at Walmart and
Target. Their study showed that from June 2018 to June 2019, prices
increased by about 5.5%.
industry research supports inflation running at a much higher level than
government figures. On a city by city basis, Chapwood has developed an index
for 500 items in major metropolitan areas of the US. Chapwood reports the average national
inflation level to be about 10 %. Note
inflation is compounded; for example, in San Jose a five year average price
increase of 13% is for each year. An item costing $1.00 would cost $1.13 the
next year and then $1.28 the third year and so forth. It islikely workers caught
in a squeeze between stagnant wages and 10 % inflation will not be able to
continue to sustain present levels of economic growth.
inflation at 6 – 10 % has major policy, portfolio, and social
implications. For example, with the ten
year Treasury Bond at 1.90% and inflation at 6 %, we are actually living in a ’de facto negative interest’
economy of – 4.10 %. Higher inflation levels fit the financial
reality of what workers, portfolio managers, and retirees are facing in
managing their finances. Many
workers must take multiple jobs and develop a ‘side hustle’ to just keep up
with inflation much less get ahead. For portfolio managers, they must grow
their portfolio at much higher rates than was previously thought just to
maintain portfolio value. Finally, for
retirees on a fixed income portfolio it is imperative they have additional
growth income sources or part-time work to keep up with inflation eating away
at their portfolio. For more details on our analysis of a variety of inflation,
categories see our post: Is
Inflation Really Under Control?
One additional assumption about Fed
intervention repeated by many analysts is the Fed liquidity injections mean
that corporate sales and profits will bounce back. For some financially sensitive industries
this argument may be true. For other firms with excellent credit ratings, they
may be able to obtain low-interest loans to ride out falling sales. But, the reality is that corporations build and
sell products based on demand. If demand falls, low-interest loans will not
increase sales. Only new products, new
channels, reduced pricing, marketing and other initiatives will revive sales.
Myth 4. If the Fed Fails Then the Federal Government Will Provide Stimulus
European Central Bank leaders have called on European governments to provide economic stimulus for their markets. Picking up on this idea, analysts have proposed the US government move on infrastructure and other spending programs. However, tax cuts, low-interest rates, stock buybacks, and record corporate debt offerings have shifted a huge balance of world-wide wealth to the private sector. For 40 years, there has been a significant increase in private capital worldwide while public wealth has declined. In 2015, the value of net public wealth (or public capital) in the US was negative -17% of net national income, while the value of net private wealth (or private capital) was 500% of national income. In comparison to 1970, net public wealth amounted to 36% of national income, while net private wealth was at 326 %.
Source: World Inequality Lab, Thomas Piketty,
Gabriel Zucman et al. – 2018
Essentially, central banks, Wall Street, and governments have built monetary and economic systems that have increased private wealth at the expense of public wealth. The lack of public capital makes the creation of major levels of public goods and services nearly impossible. The US government is now running $1 trillion yearly deficits with public debt at record levels not seen since WWII and total debt to GDP at all-time highs. The development of public goods and services like basic research and development, education, infrastructure, and health services are necessary for an economic rebound. The economy will need a huge stimulus ‘lifting’ program and yet the capital necessary to do the job is in the private sector where private individuals make investment allocation decisions. Congress may pass an ‘infrastructure’ bill in 2020 but given the election, it is likely to be lightly funded to pass both houses of Congress and receive the president’s signature.
Myth 5. The Trade War Won’t Hurt Global Growth
By closing the Phase One trade deal, the market has been sighing with relief with observers declaring that trade will resume a growth track. Yet, the Phase One deal is not a long term fix. If anything, the actions on the part of both governments have been to dig in for the long term. The Chinese government has taken several key actions in parallel to the deal to move their agenda ahead.
China has quietly raised the exchange rate of
their currency to offset some of the impact of still in place tariffs on the
U.S. economy. The government made a
major move to block US and foreign companies from providing key technical
infrastructure. The technology ministry has told government agencies that all IT
hardware and software from foreign firms are to be replaced by Chinese systems within
three years. If the Chinese government decides to establish ‘China only’
network standards it may be difficult for US firms to even work with state-sponsored
companies or private businesses that must meet China’s only standards. Apple
and Microsoft would have to build two versions of their products. One version
for the Chinese economy and one for the world.
A critical change is taking place
in world trade which is the establishment of a two-block trading world. China is a key growth market at a 20 % – 30 %
increase in sales annually for US multinational companies. For these
corporations navigating the trade war will be problematic even with the Phase
One agreement. Our post characterizing
this major change in world trade can be found at: Navigating
a Two Block Trading World.
The U.S. has placed sanctions on Chinese
sponsored network provider Huawei, effectively limiting the network vendor from
US government and private networks. The
Phase One agreement includes the US canceling planned tariffs for December 15th
in 2019 and rolling back tariffs to 7.5 % on $120 billion of goods imposed on
September 1st of last year. Yet, tariffs of 25 % remain in place on
$250 billion of Chinese goods. The
Chinese have canceled retaliatory tariffs planned for December 15th
and plan to increase purchases of US goods and services by $200 billion over
two years. In addition, China will purchase US agriculture products at a $40
billion rate per year from a baseline of $24 billion in 2017. If the
Chinese follow through on their purchase commitments US companies should see
increased sales. However, history on
Chinese purchases shows they forecast large purchases but small purchases are
A major trade issue has been created when the
US decided not to appoint any new judges to the World Trade Organization court
for disputes. The court cannot hear or make decisions on any disputes any
longer; meaning countries will resort to free-for-all negotiations on trade
disputes. We expect as economies falter, nationalist policies on trade will gain
more popularity and world trade will continue to decline after a slight
blip up from the U.S.-China Phase One deal.
Sources: BCOT Research, The Wall Street
Journal, The Daily Shot – 12/16/19
Finally, prior to the trade war global trade
has been facing major headwinds. Since 2008, global firms have looked to open
more international markets to sell their goods, but have met sales resistance
causing revenue and profits to be flat or decline. We expect the flattening of global
sales to output to continue and eventually decline as overall world trade falls.
CEOs in a Conference Board survey rate trade as
a major concern as they look at a highly uncertain economic picture. Marc Benioff, CEO of Salesforce, described
his concerns at a company all hands meeting last November:
“Because that issue (trade) is on the table,
then everybody has a question mark around in some part of their business,” he
said. “I mean, we’re in this strange economic time, we all know that.”
Myth 6. The Economy and Markets Are Insulated from World Politics
Protests have broken out in Hong Kong, Iraq, Iran, Chile, and other world cities while stock markets continue their climb. Yet, when the U.S. killed a key Iranian general the overnight S &P futures market fell 41 pts before recovering and closing 23 pts lower. The VIX soared 22 % overnight before settling back to close for a 12 % increase at 14.02. The U.S. – Iran conflict does not seem to be under control with most Middle East analysts predicting a major retaliation by the Iranian government. The price of oil spiked 4 % before settling to a 3.57 % increase on fears the Iranians may attack oil tankers in the Gulf. An escalating conflict will drive oil prices higher, disturb supply chains and likely tip the world economy into a recession.
saw during the negotiations for the Phase One trade deal how rumors both in
China and the U.S. would send the S & P futures market up or down by 10 –
15 points depending upon whether the news was positive or negative. Algo
traders would drop 30k contracts in a matter of seconds to make huge moves in
SPX price, while the VIX was at 12.50, supposedly a calm market. The chart
below shows how positive and negative news whipsawed the market.
Liz Ann Sonders – Schwab – 12-7-19
news not only moves markets but the economy as well. When the president tweets a tariff threat,
consumers and industry move swiftly to buy those goods before their prices go
up. Businesses have to build the product
quickly, sell it and they are left with falling sales as future purchases are
pulled forward. Business to business
deals are caught up in this constant flip flop on trade policies as well. CEOs
must make investment decisions to build a plant in a particular country 1 – 3
years in advance. They must calculate their allocation plans based on
inadequate information and in a highly uncertain policy environment. Often, rather
than make an investment decision, executives will wait for the economic clouds
The current bull market run has set record highs continuously. Yet, as the saying goes: markets go up in stair steps and down in an elevator. As a selling panic sets in the market goes into a free fall. If an economic myth is revealed by market action, corporate results, economic reports or an event the loss of belief causes the market to fall much faster than a slow stair step up.
The prudent investor will recognize the end of
the business cycle is likely underway. It is time to prepare for an economic
slowdown and a resulting equity market reversion to the mean. A reversion to
the mean quite often requires that markets swing beyond the mean.
The wary investor will ask hard questions of
their financial advisor and review corporate reports with an eye on fundamentals.
Financial success is likely to result from good risk management and
implementation combined with agility to make mid-course corrections. Investors should test their assumptions based
on breaking trends that may impact portfolio performance. At the same time, constantly flipping
investments will lead to poor performance. Allocate funds to different
portfolio groups based on long, medium and short term goals to keep from being
emotionally swept up in temporary market swings. The key is to be prepared for
the unknown, or a black swan event. Expect
the unexpected and consider the advice of market legends like Bernard Baruch:
“Some people boast of selling at the top of
the market and buying at the bottom – I don’t believe this can be done. I had
bought when things seemed low enough and sold when they seemed high enough. In
that way, I have managed to avoid being swept along to those wild extremes
of market fluctuations which prove so disastrous.”
Patrick Hill is
the Editor of The Progressive Ensign, https://theprogressiveensign.com/
writes from the heart of Silicon Valley, leveraging 20 years of experience as
an executive at firms like HP, Genentech, Verigy, Informatica and Okta to
provide investment and economic insights. Twitter: @PatrickHill1677.
Is Inflation Really Under Control
analysts have been discussing the pros and cons of using negative interest
rates to keep the U.S. economy growing. Despite
this, Fed Chairman Jerome Powell has said that he does not anticipate the
Federal Reserve will implement a policy of negative interest rates as it may be
detrimental to the economy. One argument
against negative interest rates is that they would squeeze bank margins and
create more financial uncertainty. However, upon examining the actual rate of
inflation we are likely already in a ‘de facto’ negative interest
rate environment. Multiple inflation data sources show that actual inflation maybe
5%. With the ten year Treasury bond at 1.75%, there is an interest rate gap of – 3.25%. Let’s look at multiple inflation data
points to understand why there is such a divergence
between the Fed assumptions that inflation is under control versus the much
higher rate of price hikes consumers experience.
October, the Bureau of Labor Statistics (BLS) reported that the core consumer
price index (CPI) grew by 2.2% year over year.
The core CPI rate is the change in the price of goods and services minus
energy and food. Energy and food are not
included because they are commodities and trade with a high level of
volatility. However, the Median CPI
shows a ten year high at 2.96% and upward trend as we would expect, though it
starts at a lower level than other inflation indicators. The Median CPI
excludes items with small and large price changes.
Source: Gavekal Data/Macrobond, The Wall Street Journal, The Daily Shot – 11-29-19
key items that have small and large price changes is not what a consumer buying
experience is like. Consumers buy based
on immediate needs. When a consumer drives up to a gas pump, they buy at the
price listed on the pump that day. Consumers
buying groceries don’t wait for food commodity prices to go down; they have to pay the price when they need the
food. Recent consumer purchase research shows that prices of many goods and
services continue to increase at a rate much higher than 2.2%.
Haskett Research Advisors conducted a study by purchasing a basket of 76 typical
items consumers buy at Walmart and Target.
The study showed that from June 2018 to June 2019, prices increased
Gordon Haskett Research Advisors, Bloomberg – 8/10/19
and Target are good proxies for consumer buying experiences. Walmart is the
largest retailer in the U.S. with over 3,000 locations marketing to price-conscious
consumers. Target has 1,800 locations in the U.S. and is focused on a similar
consumer buyer profile, though a bit less price sensitive. Importantly, both
Walmart and Target have discount food sections in their stories.
has been rapidly increasing in cost as well.
Rental costs have soared in 2019 as the following chart shows a month
over month shift to .45%, which is an annualized rate of 5.4%.
Bureau of Labor Statistics, Nomura – 5/13/19
of other services like health care and education have increased dramatically as
well. Service sectors, which make up 70% of the U.S. economy, are where wages
are generally higher than in manufacturing sectors. Techniques to increase
service productivity have been slow to implement due to service complexity. Without
productivity gains, prices have continued to rise in most services sectors.
Deutsche Bank – 11/14/19
care costs have increased by 5.2% per year, and education costs have risen 6.8
% per year. Wages of non-supervisory and production workers have fallen behind
at 3.15 % increase per year. Note that the overall CPI rate significantly
underestimates the rate of costs in these basic consumer services, likely due
to underweighting of services in the cost of living calculation.
consumers, housing, utilities, health care, debt payments, clothing, and
transportation comprise their major expenses. Utility and clothing costs have
generally declined. While transportation, housing, and health care costs have
increased. The rate of new car annual inflation
was as low as 1 percent in 2018. Yet, according
to Kelly Blue Book, the market shift to SUVs, full-sized trucks, and increasing
Tesla sales have caused average U.S. yearly vehicle prices to zoom 4.2% in 2019.
The soaring price of vehicles has caused auto loans to be extended out to 7 or
8 years, in some cases beyond the useful life of the car.
are financing 25% of new car purchases with ‘negative equity deals’ where the
debt from a previous vehicle purchase is rolled into the new loan. The October consumer spending report shows
consumer spending up by .3% yet durable goods purchases falling by .7%
primarily due to a decline in vehicle purchases. A 4.2%
increase in vehicle prices year over year is unsustainable for most buyers and
indicates likely buyer price resistance resulting in falling sales.The October durables sales decline could have
been anticipated if inflation reporting was based on actual consumer purchasing
wars with China, Europe, and other countries are contributing to significant price
increases for consumer goods. Tariffs
have driven consumer prices higher for a variety of product groups, including:
appliances, furniture, bedding, floor coverings, auto parts, motorcycles, sports
vehicles, housekeeping supplies, and sewing equipment.
Department of Commerce, Goldman Sachs, The Wall Street Journal, The Daily Shot
chart above, prices increased by about 3.5% over 16 months before mid-May 2019.
As uncertainty in the trade wars grows and earlier cheaper supplies are sold, prices
will likely continue to rise. The President has announced new tariffs of 15% on
$160 billion of Chinese consumer goods for December 15th if a Phase
One deal is not signed. On December 2nd, he announced resuming
tariffs on steel and aluminum imports from Argentina and Brazil and 100 %
tariffs on $2.4 billion of French goods. The implementation of all these
tariffs on top of existing tariffs will only make consumer inflation worse. Tariffs are driving an underlying
inflationary trend that is being under-reported by government agencies.
Evidently, the prices for goods and
services that consumers experience are vastly different from what the federal
government reports and uses to establish cost of living increases for programs
like Social Security. So, why is there a disconnect between the government CPI rate
of 2.2% and consumer reality of inflation at approximately 5%? The raw data that the Bureau of Labor
Statistics (BLS) uses to calculate the CPI rate is not available to the
public. When a Forbes reporter asked the
BLS why the data was not available to the public the BLS response was companies
could ‘compare prices’. This assumption does not make sense as companies can compare
prices on the Internet, in stores, or find out from suppliers. The ‘basket of
consumer items’ approach was discontinued in the 1980s for a ‘cost of living’
index based on consumer buying behaviors. There was political pressure to keep
the inflation rate low. If real inflation figures were reported the government
would have to increase payments to Social Security beneficiaries, food stamp
recipients, military and Federal Civil Service retirees and survivors, and
children on school lunch programs. Over
the past 30 years the BLS has changed the
calculation at least 20 times, but due to data secrecy there is no way to audit
the results. The BLS tracks prices on 80,000 goods and services based on
consumer spending patterns, not price changes on goods and services per
se. For example, if consumers substitute
another item for a higher-priced one it is discontinued in the
Williams has calculated inflation rates based upon the pre-1980s basket
approach versus the cost of living formula used by BLS today. His findings show a dramatically higher rate
of inflation using the 1980s formula.
Government – 10/2019
using the earlier basket formula sets the present inflation rate at nearly
10%. Based on our research on various
price reporting services, we think the real consumer inflation rate is probably
about 5 to 6%.
of this gap between real inflation and reported inflation rates are profound
and far-reaching. Federal Reserve
complacency about a low inflation rate to justify a low Fed Funds rates is
called into question. In fact the
economic reality of today is we are living in a 3.25% ‘de facto’ negative interest rate environment where
the ten year Treasury bond rate is 1.75%, and inflation is 5%. The liquidity
pumping into the economy, based in part on low inflation, is overheating risk
assets while providing support for corporate executives to take on debt at decade
economic framework on erroneous inflation data versus the reality for consumers
and businesses lead to massive financial dislocations. This economic bubble is
unsustainable and will require a brutal recession to rebalance the
economy. As part of a possible soft
‘landing’ policy, the BLS could make price data available to all economists.
Full data access will provide an opportunity for objective comments and
feedback based on other consumer price research.
The Fed actually
focuses on the even lower Personal Consumption Expenditure rate of 1.6%
reported by the Bureau of Economic Analysis for October. The Fed prefers the
PCE rate because a consumer survey technique is used, while economists prefer
the CPI, which is more granular so it is easier to identify goods and services categories
that are driving inflation. Using
unrealistically low inflation assumptions leads to misguided policy decisions
and perpetuation of the myth that inflation is under control. Yet, in fact
inflation it is out of control due to extremely low Fed interest rates,
liquidity injections, and trade war tariffs.
Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.
Corporate Profits Are Worse Than You Think – Addendum
A topic not
raised in the article, but a frequent theme of ours, is the role that share
buybacks have played in this bull market. Corporations have not only been the
largest buyer of stocks over the last few years, but share buybacks result in misleading
earnings per share data, which warp valuations and makes stocks look cheaper. Over
the last five years, corporations have been heavily leaning on the issuance of
corporate debt to facilitate share buybacks. In doing so, earnings per share
appear to sustain a healthy upward trajectory, but only because the denominator
of the ratio (number of shares) is being reduced as debt on the balance sheet
rises. This corporate shell game is one of the most obvious and egregious
manifestations of imprudent Federal Reserve policies of the past decade.
importance of debt to share buybacks, we provide two graphs below which
question the sustainability of this practice.
graph below compares the growth of corporate debt and corporate profits since
the early 1950s. The growing divergence, especially as of late, is a clear warning
that debt is not being used for productive purposes. If it were, profits would be
rising in a manner commensurate or even greater than the debt curve. The
unproductive nature of corporate debt is also seen in the rising ratio of
corporate debt to GDP, which now stands at all-time highs. Too much debt is
being used for buybacks that curtail capital investment, innovation,
productivity, and ultimately profits.
Data Courtesy St. Louis Federal
graph uses the same data but presents the growth rates of profits and debt since
2015. Keep in mind the bump up in corporate profits in 2018 was largely due to
Data Courtesy St. Louis Federal
present a favorite chart of ours showing how the universe of corporate debt has
migrated towards the lower end of the investment-grade bucket. Many investment-grade
companies (AAA – BBB-) are issuing debt until they reach the risk of a credit
downgrade to junk status (BB+ or lower). We believe many companies are now limited
in their use of debt for fear of downgrades, which will naturally restrict
their further ability to conduct buybacks. For more on this graph, please read The
Corporate Maginot Line.
The Market Soars As Corporate Profits Slump!
The SPX recorded
new highs this week. Investors appear to
be excited about the U.S. – China Phase 1 trade agreement, which only goes so
far in ending the trade war. Plus, the
Fed is cutting interest rates, injecting $100 billion in repo financing over
the next month, and embarking on a new round of QE. So, is it clear sailing for
corporate America? Maybe companies are not as financially viable as record SPX
levels would indicate.
at the lifeblood of a company, cash flow.
Goldman Sachs analysis of corporate cash flows shows that SPX companies
are actually running, in aggregate, negative cash flow at 103.8% while keeping
stock buybacks and dividends flowing to shareholders. Debt is up 8% squeezing
corporate cash flow to the point where aggregate cash flows are down 15% versus
the prior year.
Source: Goldman Sachs – 7/25/19
Cash is the lifeblood of a company,
but a company can’t borrow money forever without being a viable profitable
entity able to pay back debt.
corporations have taken on record debt at 47% to GDP. The last time corporations approached this level
of debt was during the Great Recession.
Yet, default rates have not gone up.
Sources: Federal Reserve Bank of St. Louis, Edward Altman – 8/5/19
time for debt payment defaults different? It would seem this is a ‘benign credit cycle’
when defaults don’t rise. However, a
more likely cause is that corporate cash flows are being pumped up by low
interest rate loans. This corporate financial cliff maybe one reason the Fed is
moving quickly to keep overnight and interest rates low. The Fed has said it is concerned about high
levels of corporate debt. What is wrong
with corporate debt at 47% of GDP?
is when profits sink due to the trade war or as consumer spending slows,
companies will no longer qualify for low interest loans. Banks and investors will
hesitate to take on risky loans to companies raking up continuous losses. Without low cost loans to provide needed cash
flows, sales decline will result in a freeze on hiring, the layoff of full time
workers, and a closure of offices and plants. Management will take these
measures to try to keep the company open until sales turnaround.
margin squeeze has been happening over the past 4 ½ years, well before the
trade war started. Profits were flat for
the past nine years, supported by a huge corporate tax cut from the Tax Cut
Bill of 2018. The contraction in profit margins has been the longest one on
record since WWII. Note how recessions usually follow steep declines in profit
margins at 1 to 4 years.
Source: Oxford Economics, The Wall Street Journal, The Daily Shot – 10/28/19
margins been contracting? Margins can be
increased by investing in automation, lowering material costs, deploying productivity
enhancements, and other efficiencies. Instead of investing in margin increasing
activities, corporate executives have been spending available cash from profits
and debt on stock buybacks totaling $1.15 trillion in 2018. Stock buybacks are a way to boost corporate
stock prices thereby increasing the income of shareholders and executives. Executives
have squandered over the past ten years the opportunity to use profits for investments
in research, productivity enhancements, raising wages, or cutting costs. Management has focused on short term stock
gains at the cost of long term corporate viability. The chickens are finally
coming home to roost.
addition, profit margins are declining due to declining international sales. It is difficult to maintain healthy margins
when sales are falling due to base spending for sales, support, and
transportation to reach a certain sales threshold of profitability. Major
corporations face increasing trade headwinds.
For most S & P 100 corporations 50 to 60% of their sales come from
overseas with prior growth rates from 15 – 25% per year in emerging
markets. The Asia – Pacific region is
the fastest growing sales region for many companies. Yet, the accumulating tax
of trade tariffs and trade uncertainty is stifling sales growth.
Sources: U.S. Census Bureau, Tariffs Hurt the Heartland, USTR Office, The Wall Street Journal, The Daily Shot – 10/28/19
January of 2018, U.S. companies have paid about $34 billion in tariffs. To hold
price levels and market share, companies largely paid tariff costs themselves rather
than passing them onto customers. Taking tariff costs onto corporate ledgers
has squeezed profit margins. The loss of decent margins in high growth markets
is creating a huge profit challenge for companies.
Phase 1 agreement with China may provide a pause to the trade war, breaking up
into two major trade blocks.
Corporations will have to navigate selling into two opposing markets
with focused sales, support, and product features and pricing. For more details, see our post Navigating
A Two Block Trade World to see how companies plan on changing supply
chains, and the implications for investors.
executives see a loss of profits and margin tightening in the future. A recent
CEO survey showed confidence levels of SPX CEOs at recession levels. The survey results indicate a possible SPX
decline beginning as soon as four months from now.
Sources: USA CEO Confidence Survey, Macrobond, The Wall Street Journal, The Daily Shot – 10/18/19
concerns that CEOs see in revenue and profitability were borne out in 3rd
quarter reports of 40% of S &P companies.
Companies with more than 50% of sales in international markets report a
9.1% decline in profits and a 2.0% decline in revenue. All S &P companies report a 3.7% slip in
earnings thus far for 3rd quarter of 2019.
Source: Factset – 10/25/19
markets recognizing the decline in profits for corporations? The chart below shows the SPX rising despite flat
national corporate profits since 2013, with a huge divergence emerging in the
past four years. The SPX soaring to new heights tells us that stock marketcomplacency is at record levels in appraising stock valuations
versus actual corporate profits. The chart below shows how wide the gap has
become which is about twice the gap size just before the Dotcom decline into
2002 from a peak in 2000.
Source: Soc Gen – Albert Edwards – Marketwatch – 10-28-19
The economic storm corporate executives see on the horizon is likely to be a future economic reality, and not liquidity fueled soaring valuations. Executives are closest to economic reality because they have to make the economic system work for their company day in and day out.A reversion of equity valuations to the reality of falling corporate profits is coming. The only question remaining is: when will the SPX reversion happen?
Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.
Hint For Stock Investors: Margins Matter
or later, stock prices are related to corporate profits. Anything can push stock
prices around in a day, month, or year. But a stock or an ownership unit of a
business ultimately has to do with how profitable that business is. When you
buy a stock, you’re buying an interest in a company’s future profits, pure and
Since around 2000, corporate profits as a percentage of GDP have been stellar. Accordingly, stocks have traded at prices relative to underlying earnings that can only be justified if profits will be permanently higher than they were prior to 2000. Will they be? Justin Lahart of the Wall Street Journal said no over the weekend. And that could mean bad news for stock investors.
first time in over two years corporate profit margins are falling, according to
Lahart. Nobody knows if that’s a permanent trend, but Lahart argues that
margins rose so much in the first place because of a lower share of revenues
going to labor, increased global trade, lower taxes, and gains in market share.
All of these factors seem to be at risk now. Concerns about inequality might make squeezing workers further difficult politically. A trade war may change how we conduct commerce with China. And big companies with high market share that set prices and have little competition for labor are on the defensive.
article had three excellent charts — one showing increased net profit margin
since 2010 for S&P 500 constituents
(from around 8% to nearly 12.5% last year), another showing decreased employee compensation
as a share of GDP since 1970 (from 58% to 53%), and the last showing decreased
corporate taxes since 1975 (from more than 35% to less than 15%).
Here’s another one we constructed with data from the St.Louis Fed’s website, showing corporate profits as a percentage of GDP since 1947. The average from 1947 to 2000 was a little more than 6%, but the average since 2000 is nearly 9%.
If profit margins decline, Lahart is correct about that being bad news over the longer term for stock investors. That doesn’t mean nobody should invest in stocks. But it means investors should moderate their return expectations.
For more on the intersection of profit margins, valuations and return expectations we suggest reading our article : DIY Market Forecast.
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