MACRO MONITOR - Old Blackheath Companies

MACRO MONITOR
February 24 th , 2015
Yellen Testimony & FOMC
No matter what Yellen says, we believe that the risk is for
a more hawkish rather than more dovish interpretation to
the Humphrey Hawkins (biannual) congressional
testimony and generally Fed-speak over the coming
months. So far the market has keyed in on one thing in
Yellen’s testimony today: that the FOMC is not likely to
raise rates for the “next few meetings.” That seems to be the
status quo of the interpretation of lift off/normalization
plans. That means that the potential for a June rate hike
is still on the table.
The operative word here is “flexibility.” Chair Yellen is
seeking maximum flexibility in monetary policy, yet we
believe she is setting the table for a nearer term rate hike
than the market currently implies or believes. She
obviously wants to avoid another “taper tantrum” or
volatility in the Treasury market (more on that below).
It’s pretty obvious that wage growth is the key to any
game-time decision should it come down to the wire, all
else being equal. When Yellen testified that to
hike/not to hike may be decided on a “meeting-bymeeting basis” it is hard not to believe that there are
considerable risks to the downside for bonds – or at
least for additional bond volatility. That means that
the Fed is, if you didn’t believe it before, completely
data dependent! Yes, surprise, surprise, the Fed looks
at data and makes decisions based upon the data rather
than ideology or some type of secret handshake.
It is the Chair’s and the FOMC’s job to keep the market
guessing to a certain degree. The worst thing for a central
banker is to be backed into a corner, cowered, by the
market. At that point, the credibility of a central bank is
in play and that is potentially utter doom for fiat
currencies. So the financial media will sum up today’s
Yellen testimony through a couple of neat, tied-up-in-abow, statements and lines. Markets will somewhat pay
attention to those articles and there is likely to be a focal
point (e.g., when Yellen states “there is no single trigger for
rate hikes” so THUS THE FOMC MUST BE
DOVISH…). Really. The cacophony of commentary
around this testimony is likely to be deafening, confusing
and counterproductive in many respects.
By way of illustration, this is what the US 10 Year
Treasury Note has done today at 12:00 noon EST:
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So at 9:57 a.m. EST, the US 10 YR was at a yield of 2.07%.
“Holy crap, did she just say something hawkish? Sell, sell, sell!
Wait, did she just say something dovish? Is she talking about the
international economy again?! No!!! Buy, buy, buy!” That is the
nature of trading. People made and lost money in the
moment, battling algos, themselves and most importantly
the temporal competition to read the tea leaves better
than the next guy/gal slinging rates trades.
The ultimate analysis is always a balancing act. There is
no formula that accords monetary policy the legitimacy
of science. This is a judgment call although the market
wants to make it a formula1 . Again, we view the key
balance as full employment and wage growth against the
lag time of monetary policy sprinkled in with some
Richard Fisher crankiness over financial stability.
Lower Oil Prices
In the chart above, when the red line (supply) is above
the blue line (demand) the price of oil is likely to be
declining2. It is estimated that the world has a total excess
supply of 400 billion barrels. From last Wednesday to
today, five trading days, WTI has lost roughly 7.5% in
price value. The recent run up in prices appears to be a
bounce back based upon speculative entry points into the
crude curve as well as value seeking throughout the
energy complex.
We believe that these factors will continue to keep crude
at lower prices: muted demand, continuing supply
stocking, Iran coming online with additional supplies, US
production remaining steady and banks continuing to
support existing reserved based lending clients. One item
to certainly keep eyes on is the crack spread. The
speculative trade into long oil positions may reemerge
should crack spreads continue to widen.
We think that WTI crude oil prices are likely to go lower
in the near term and linger at a lower level. The data
related to supply is simply not favorable for oil prices in
the near term.
1
OK, you want a formula? Here: maximum employment which is not below
NAIRU + continued wage growth + status quo financial stability (mostly in
credit markets as the Fed doesn’t care so much about stocks) + a nondecelerating US and global growth picture (it can be soft, but can’t worsen
materially) / amount of time which still affords enough lag time for monetary
policy changes to transmit and catch up to where US growth is expected to
be = June 0.25% rate hike + LOADS of language to signal rates hikes will be
glacial and rolled back if need be. Its medicine, but it tastes like sweet grapes.
Drink it up!
2 This chart is from Erico M. Tavares of Sinclair Advisors and uses
information provided by the US Energy Information Agency.
2
Ultimately, oil prices are going to ping pong around off
of supply data for the next while as demand data seems
pretty clear – that it will be low if not lower. The fact that
rig counts have declined in non-conventional fields (shale
oil in the US) doesn’t mean that the supply of oil will go
down. This is simply not a one-for-one correlation.
Taking down rigs means that oil companies (E&P
companies) are managing their costs and no longer
spending on lower margin drilling or less productive sites.
That means that US shale is “high grading” which means
that they are still using their existing, highly productive,
drilling operations at full bore. The market’s assumption
that rig counts = lower output is false in the very near
term3. That bodes poorly for oil prices.
US Earnings Season
In summary: US stocks continue to chug along with
multiples expanding while earnings and sales continue to
be a mixed bag. The bears have been extremely wrong
for an extremely long time while remaining very vocal.
This has actually worked in favor of US stock investors
as the general sentiment around stocks has been balanced.
Most institutional investors remain nervous about stocks
citing stretched valuations, no 10% decline in two years,
slowing sales (revenue) numbers, and potentially
changing interest rate policy. All of these things overhang
the market, have overhung the market, and will continue
to overhang the market. Absent one of the risks we
briefly discuss below materializing in full, we expect that
US stock multiples will continue to slowly expand in
20154.
Fourth quarter 2014 earnings season is pretty much over
and 75% of companies have reported earnings above
expectations and 58% have reported sales above
expectations. Earnings growth is much weaker than was
anticipated late last year with the energy sector drawing
down numbers. Consequently, the forward price to
3
Disclosure: OBHC has a short position in oil via ticker SZO. This is a
hedge position.
4 Like everyone else, we think higher volatility is likely.
5 These statistics are courtesy of Factset.
6 With all due respect, and we mean that in the most sincere way, it is very
easy for people who already have a significant wealth to stand aside in cash
earnings ratio of the S&P 500 is 17 right now while the
“Shiller PE” (Cyclically Adjusted Earnings Ratio) stands
at 27.755.
There has been a lot of commentary about Nobel
Laureates and other market luminaries getting out of
stocks because they are “overpriced” and there is no
upside6. We recognize that the idea of an average PE
ratio in determining the fair value of a market is habitually
used by market pros and commentators alike. Context is
everything in investments and saying that a market has a
high PE and thus it is overvalued and thus it is a bad riskto-reward proposition or that therefore the market will
go down is really amateur hour thinking. Yes, there is a
strong tendency to revert to the mean – over time that is.
The fact of the matter is that even if the FOMC does raise
interest rates, discounting future cash flows in equity
analysis will still be an exercise in using very low discount
rates. Thus, one can make the very cogent and plausible
argument that at such a low discount rate, stocks actually
deserve a higher valuation because their cash flows are
worth more. This is really stock analysis in its junior form
and should be very self-evident to any professional
investor. Instead, we are inundated by the claims that
stocks are overvalued because they have high historical
PE ratios.
We are not unabashedly bullish. Not at all, but we
recognize that this market has climbed many walls of
worry and keeps on keeping on. Is it stock buybacks?
Yes. Low interest rates. Yes, also. Great balance sheet
management? Agreed. Financial engineering and too
many analysts drinking the Kool Aid? A bit. A much
more attractive asset class on a relative basis? Definitely.
If we want to get negative on US stocks, our starting
point is price to sales. Earnings can be manipulated, sales
are not as malleable. Q4 sales grew far above
expectations at 1.9% (estimate was 1.1%). However,
earnings are only growing at an average pace at 3.54% per
annum (average is 3.52%) while the multiple on the price
and yield-focused investments and tell others about their plans as though they
should also follow. It is one thing to go to cash or rotate out of stocks in a
declining, overly volatile or technically terrible market. It is quite another
thing to suggest getting out of equities because there is limited upside when
they continue to go up.
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to sales ratio is quite high now at 1.83. OK, we jest, the
price to sales ratio is actually the highest it’s been since
2000. It is high.
Risks to Global Markets
Bond market volatility. We think one of the
underappreciated risks to all markets is the potential for
US bond market volatility. Most likely such volatility
would be caused by unexpected moves in US interest rate
policy. The secondary cause could be related to a bond
market which is universally recognized as being less liquid
with fewer dealers than ever before7. At a bare minimum
we urge consideration of this issue in its base format: that
bond market volatility forces a risk off environment
which eventually metastasizes into other asset classes. In
particular, when the US 10 Year Treasury Note is volatile,
it can force traders out of portfolio positions due to the
leverage employed and the fact that the 10 YR is a
frequent hedging instrument. We wrote about it here in
more detail.
China. A material slowdown in China is a still a very real
risk to global economies and risk assets. This risk is
almost always counterbalanced with the prospect of the
People’s Bank of China stimulating the economy. That
whole notion scares us as it is deflationary at best.
US Dollar Strength. One of the soft spots for US stocks
is USD strength. So far, only the obvious multi-national
companies have warned about USD strength as a
considerable risk for earnings and sales. Our feeling is
that the market got ahead of itself in analyzing the
velocity of this risk – how quickly that USD strength
would hit US stocks. Now that the issue hasn’t bled
through to Q3 and Q4 2014 earnings in a massive way,
many market participants have dismissed the issue as less
important. We think that this issue will be with us for the
remainder of the year.
Kool Aid. Definitely a risk:
Geopolitics. We still think that geopolitical risks are
rampant. Ukraine is clearly devolving and the likelihood
that Russia and Putin will attempt to, if not actually, test
NATO’s resolve is very high. Also, we believe that
Eastern Ukraine is not going to be given back to Ukraine.
The world has to understand this idea. The fact that the
world does not understand this idea creates the potential
for very bad, unintended consequences. The other
geopolitical issue that we believe will shortly be back on
the hot burner is an Israeli attempt to neutralize Iranian
nuclear assets. We believe that Israel views the ongoing
US-Iranian nuclear negotiations as a charade and that the
upcoming Israeli general elections could give cover to any
government acting to neutralize the perceived existential
threat (to Israel) of a nuclear capable Iran. This is a
complicated issue and we are loathe to cover it in three
sentences. Acknowledge however, that it exists.
7
More debt outstanding + retail chase for yield + fancy ETF products + less
dealer inventory = risk of bond liquidity crunch.
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