November 2017 – Page 3

BMO Sees Risk Of Curve Inverting “As Early As March 2018”

Over the weekend, we published an analysis from Citigroup looking at how long after the yield curve inverts do investors “have to worry.” The results were interesting: as Citi wrote, while sometimes inversion provides a timely signal for the economic cycle a la 2000, “where Professor Curve predicted almost the ding-dong high in the SPX”, other times, like the 2006 inversion, dished up 7 months of pain for equity bears, with 18% further upside for the SPX. The same occurred for the 1989 episode where equities continued to rally 22% into the 1990 recession.

Whatever the timeframe between inversion and subsequent events, however, the curve first has to invert. So when will that happen. One bank provided a surprising answer earlier this week, when Morgan Stanley forecast a “completely flat” yield curve around the time of the FOMC’s September meeting.

Now, in its 2018 rates outlook, BMO’s Ian Lyngen and Aaron Kohli have unveiled a far more aggressive forecast, warning that there is a “risk of an inverted 2s/10s curve as early as the March meeting – if not, then by June.”

Here are the details, as excerpted from the report:

As we contemplate our Treasury market call for 2018, 10-year yields are at 2.35% — not dissimilar to the end of 2016 (2.44%), 2015 (2.27%), and 2014 (2.17%). While the yearly figures suggest that there has been a gentle upward grind in yields, in fact the path has been more volatile and along the way 10s managed to reach 2.63% during 2017 on the back of Trump-o-nomics euphoria, only to retrace to as low as 2.016% as geopolitical risks combined with the realities of lowflation. Our primary focus for 2018 will be on the shape of the yield curve and we expect that as the Fed’s hiking campaign soldiers on, the most material risk is that monetary policy inverts the 2s/10s curve more quickly than anticipated. We have 10-year yields penciled in as closing 2018 at 2.40%, but not before a test of the bottom of the recent range (2.00%) and the risk of an inverted 2s/10s curve as early as the March meeting – if not, then by June.

While we’ve been focused on this risk since September ‘17 when the Fed signaled its intension to push forward despite realized inflation, it has become increasingly consensus – a dynamic that always gets us nervous, but we’re nonetheless convinced of the fundamentals behind the call. If anything, the newfound popularity of the forecast leaves us open to an inversion earlier in 2018, which will subsequently be followed by a resteepening.

* * *

We are certainly cognizant that forecasting 10-year yields will end next year at 2.40% after spiking in the first quarter only to rally throughout the summer months is consistent with the seasonal patterns and doesn’t represent an exciting break from the norm. As we watch the market trade a version of effectively the same tax reform deal for the fourth time and 10-year yields unable to even touch the 2.64% peak achieved immediately in the wake of Trump’s election, we find ourselves content to continue playing the range for the time being.

As BMO adds, “the inflection point will be a result of either the real economy falling far short of the Committee’s expectations or a moment when the Fed effectively blinks via a pause in the tightening campaign. The outcome of either event will be a flattening out of the OIS curve and the resteepening of 5s/30s. If 5s/30s is the coalmine canary of monetary policy expectations in the current environment, then the bullish steepening that followed a dovish read on the November FOMC meeting Minutes is a useful roadmap for the return of term premium.”

BMO sees one case in which the curve steepens:

the curve will steepen out and term-premium will return if the Powell-Fed sees unexpectedly high inflation and doesn’t step-up the hawkish rhetoric – implicitly or explicitly signaling a willingness to let the economy ‘run hot’ for a time. An alternative method for getting term-premium back would be to alter the Fed’s communication strategy so drastically as to leave the market uncertain as to how the Fed will address the developments in the real economy – said more directly: dropping the dot-plot and forward rates guidance.

However, as the authors concede, “we seriously doubt this is in the cards and only offer it as an example of the degree of change in the Fed’s behavior that it would take to reintroduce volatility in the longer end of the Treasury curve (10s and 30s).”

Ultimately, the conclusion is simple: “whenever the Fed is actively engaged in raising rates the curve simply continues to flatten even with an acceleration of inflation.” And if BMO is right, the Fed’s rate hike cycle has roughly 2 more quarters to go.

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Saudis Intercept Ballistic Missile Fired From Yemen

It's deja vu all over again in Saudi Arabia. Al Arabiya reports that a ballistic missile from Yemen has been intercepted on Thursday by Saudi air defense forces in southern city of Khamis Mushait in the south western province of Assir.

The missile attack is the second this month since the November 4 missile intercepted near King khalid International Airport in Riyadh.

The Arab League in November 19 cited that since the beginning of the conflict in Yemen 78 ballistic missiles have been fired towards Saudi Arabia from Yemen.

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WhatsApp Down: Outages Reported Around The World

In an apparent global system outage, WhatsApp users have been shut out from sending or receiving messages on Thursday afternoon. As of 2:10pm ET the worst-hit are Brazil, the Netherlands, the US, the UK, Switzerland, Italy, India, and the Middle East.

On Downdetector.com reports started spiking after 1:20pm ET with a peak of 3250 reports at 2pm ET.

The app is not sending or receiving messages according to multiple users, many of whom have taken to social media to highlight the issue according to The Independent. It is unclear if the problem is focused on one particular part of the world but many users appear to be affected.

The outage appears to be focused on South America, particularly in Brazil, where users are currently unable to send or receive messages through the app.

A spokesperson for Whatsapp said: “WhatsApp users around the world are unable to access the service. We apologize for the inconvenience and are working to fix the issue as soon as possible.”

Users on social media said they could not send or receive any messages which has sparked a trending topic on Twitter #whatsappdown.

When Whatsapp is down and you don’t know what to do anymore. #Whatsapp http://pic.twitter.com/jSti7OuKm7

— Laurens1998 (@laurensstade) November 30, 2017

o whatsapp morreu http://pic.twitter.com/JeXLOmHYhA

— Grey’s é legal, mas (@greyselegalmas) November 30, 2017

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What Wall Of Worry? US Equity Investors Are The Most Levered-Long Since Brexit

What wall of worry?

The S&P 500 Index is heading for its longest streak of monthly gains since 2007, and, as Bloomberg reports, investors are betting there’s more to come.

A sudden jump in trading of bullish options on SPY (the ETF tracking the S&P 500), means there has not been more 'investors' holding S&P 500 Calls relative to Puts since Summer 2016…

Notably the last four times that investors were so levered long, things did not end well for stocks…

Aug 2015 – down 8% (China deval/flash-crash)
Sep 2015 – down 7.4%
Jan 2016 – down 7%
Aug 2016 – down 5%

And judging by the decoupling between stocks and risk, something is ready to break…

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Declining to Bake a Gay Wedding Cake Is Not the Same As Banning Gay Marriage

Next Tuesday the Supreme Court will hear Masterpiece Cakeshop v. Colorado Civil Rights Commission, which poses the question of whether the government violates a baker’s right to freedom of speech when it compels him to produce a cake for a gay wedding despite his religious objections to same-sex marriage. Like most (all?) libertarians, I think this sort of coercion is wrong, although I’m not sure the relevant right is freedom of speech. The principle also could be described as freedom of religion or freedom of conscience. At bottom, as Scott Shackford has observed, the dispute is about freedom of association and freedom of contract. But one thing should be clear: It is the government, at the behest of an aggrieved gay couple, that is initiating the use of force. It is the baker, Jack Phillips, who is asking to be left alone. The question is whether he has a right to expect that—or, to put it another way, whether the government’s use of force is justified.

That point seems lost on The New York Times. In a recent story about the Alliance Defending Freedom (ADF), which is representing Phillips, reporter Jeremy Peters conflates the baker’s desire to avoid an implicit endorsement of gay marriage with a government ban on gay marriage. Under the headline “Fighting Gay Rights and Abortion With the First Amendment,” Peters says Phillips and the ADF are trying to “blunt the sweep of Obergefell v. Hodges, the ruling that enshrined same-sex marriage into law.” Obergefell said states must recognize marriages between people of the same sex. It did not say anyone is legally obligated to bake a gay wedding cake.

“We think that in a free society people who believe that marriage is between a man and a woman shouldn’t be coerced by the government to promote a different view of marriage,” ADF senior counsel Jeremy Tedesco tells Peters. “We have to figure out how to live in a society with pluralistic and diverse views.”

That stance, Peters suggests (citing “civil liberties groups and gay rights advocates”), is a cover for “a deep-seated belief that gay people are immoral and that no one should be forced to recognize them as ordinary members of society.” But whatever the ADF’s views of homosexuality, it is entirely consistent to say the government should neither ban gay marriage nor force people like Phillips to endorse it.

That is the position taken by the Reason Foundation (which publishes this website), the Cato Institute, and the Individual Rights Foundation, which jointly filed a brief in support of Phillips. As the headline over a recent Daily Signal story notes, “These Groups Support Gay Marriage While Backing a Cake Baker’s First Amendment Rights.” According to the Times, however, they are “Fighting Gay Rights…With the First Amendment.”

Peters also conflates government and private action in his discussion of National Institute of Family and Life Advocates v. Becerra, a case the Supreme Court recently agreed to hear that challenges a California law requiring anti-aborton “crisis pregnancy centers” to provide information about abortion. Just as Masterpiece Cakeshop has nothing to do with banning gay marriage, the California case has nothing to do with banning (or restricting) abortion. Both cases are about the constitutionality of forcing people to engage in speech that violates their moral principles.

As Peters sees it, “the First Amendment has become the most powerful weapon of social conservatives” seeking to “roll back laws on same-sex marriage and abortion rights.” That gloss is not just misleading but blatantly false. If the ADF wins these cases, its victories will have no effect whatsoever on gay marriage or abortion rights. They will simply carve out some space for peaceful dissent from the social consensus on these issues.

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Kinder Eggs Coming to America? Sadly, No—Ban on Chocolate Candies Still Persists

Objectively speaking, Kinder Eggs are not particularly good candy. But with chocolate halves breaking open to reveal a tiny toy prize inside, Kinder Eggs are cool, from a kid’s perspective. And like many things made arbitrarily illegal, these chocolate treats have earned a kind of kitsch cache with U.S. audiences that transcends taste buds or age. So a lot of folks were excited when headlines last week announced that Kinder Eggs are finally legal in America.

But it’s fake news. While a modified Kinder Egg can now be purchased legally here, the original “Kinder Surprise” variety—the kind you’ll find for sale in other countries—is still prohibited, since embedding non-food-items in candy is still banned. The American Kinder Egg will feature two separate halves: one for eating, one with a toy inside.

As Gawker noted back in 2013, Kinder Eggs “have been banned in the States since long before they were first manufactured in the early ’70s” by Italian company Ferrero (also the masterminds behind Nutella). A ban on candies with embedded toys has been in place since 1938, when it was included as part of the omnibus Food, Drug, and Cosmetic Act. Under the new law, confectionery products were prohibited from having “any nonnutritive object” either “partially or completely imbedded therein.” (An exception exists when “such object is of practical functional value to the confectionery product and would not render the product injurious or hazardous to health.”)

The Kinder Egg’s illegal status only seemed to up American enthusiasm for the candies, which were smuggled back from abroad in many an ordinary citizen’s suitcase over the decades.

I wonder how many knew they faced a fine of $2,500 an egg?

Yes: That’s the legal penalty for Kinder Egg trafficking. And Americans have been prosecuted for the crime, though this is rare; airport agents will generally just confiscate the eggs when found.

The blog Today I Found Out provides some more backstory, noting that Nestle challenged the embedded object ban in 1997 after the company introduced a Kinder Egg–like product called Nestle Magic:

When Nestle was preparing to launch the product, the FDA explicitly notified them it was illegal under the 1938 Federal Food, Drug, and Cosmetic Act, but Nestle disagreed, noting the product was completely safe so should be considered one of the exceptions. Their position was backed by a report from the Consumer Product Safety Commission, who did their due diligence on the candy and determined it, and the non-edible item inside, were not a choking hazard.

Nestle went forward with the product anyway. It also lobbied Congress to change the law. But after a long legal batttle, the company had to discontinue the product and pull it from stores.

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The Mean-Reverting History Of Profit Growth

Authored by Lance Roberts via RealInvestmentAdvice.com,

As the markets push once again into record territory the question of valuations becomes ever more important. While valuations are a poor timing tool in the short term for investors, in the long run, valuation levels have everything to do with future returns.

Yesterday, Doug Kass penned an interesting note on the current market advance:

“Consistently advancing and uninterrupted rising stock prices have a way of spreading fallacious arguments not grounded in fact. Here are some recent examples of that meme — namely, of an earnings-driven market.

This is the new meme, but it increasingly resembles ‘Group Stink.’

Contrary to the pablum delivered by many in the business media, the rise in stocks over the last 12 predominantly has been a valuation-driven story, just as it was in 2016 when S&P 500 profits were up 5% and the S&P Index rose by about 11%.

And going back even further, since 2012 S&P earnings have risen by 30% compared to an 80% rise in the price of the S&P lndex.”

The current belief is the market will surge even higher as a result of corporate “tax cuts” which further boost corporate profits. While the estimates of higher profits via tax cuts is obvious, the question remains as to how much of any tax cut received by corporations is already priced in? More importantly, is the sustainability of the growth of earnings going forward.

John Hussman, via Hussman Funds, once penned:

“I’ve noted frequently that after-tax corporate profits as a share of national income are about 70% above historical norms; that these profit shares are heavily mean-reverting and strongly (inversely) associated with subsequent profit growth over the following 3-4 year period; and that the current surplus of corporate profits is the mirror-image of corresponding deficits in household and government savings (a relationship detailed in prior weekly comments). Recent profits data, as well as the entire historical record, are tightly explained by these factors.

Notably, this data is derived from the national income accounts computed by the Bureau of Economic Analysis, and it’s worth understanding how the BEA computes profits. Specifically, the BEA points out, ‘Because national income is defined as the income of U.S. residents, its profits component includes income earned abroad by U.S. corporations and excludes income earned in the United States by foreigners.’”

The chart below shows corporate profits, per the BEA, divided by GDP. (You can substitute GNP but the result is virtually identical between the two measures.)

Note, that while operating earnings per share are hitting a record this quarter, reported corporate profits after tax have not. The difference comes from the accounting gimmicks used to report higher earnings while the profits on which tax is paid is an entirely different matter. Furthermore, corporate profits should be a reflection of the underlying economic strength, but due to financial engineering, wage and employment suppression and increase in productivity, they have become extremely deviated.

This deviation begs the question of sustainability. The chart below is an expansion of the real, inflation-adjusted, profits after-tax versus the cumulative change to the S&P 500. Here is the important point – when markets grow faster than profitability, which it can do for a while, eventually a reversion occurs. This is simply the case that all excesses must eventually be cleared before the next growth cycle can occur. Currently, we are once again trading a fairly substantial premium to corporate profit growth.

Again, since corporate profit growth should be a function of economic growth longer term, we can also see how “expensive” the market is relative to corporate profit growth as a percentage of economic growth. Once again, we find that when the price to profits ratio is trading ABOVE the long-term linear trend, markets have struggled and ultimately experienced a more severe mean reverting event. With the price to profits ratio once again elevated above the long-term trend, there is little to suggest that markets haven’t already priced in a good bit of future economic and profits growth.

While none of this suggests the market will “crash” tomorrow, it is supportive of the idea that future returns will substantially weaker than in recent years.

The sustainability of corporate profits is dependent on two primary factors; sustained revenue growth and cost controls. From each dollar of sales is subtracted the operating costs of the business to achieve net profitability. The chart below shows the percentage change of sales, what happens at the top line of the income statement, as compared to actual earnings (reported and operating) growth.

Since 2000, each dollar of gross sales has been increased to more than $1 in operating and reported profits through financial engineering and cost suppression. The next chart shows that the surge in corporate profitability in recent years is a result of a consistent reduction of both employment and wage growth. This has been achieved by increases in productivity, technology, and off-shoring of labor. However, it is important to note that benefits from such actions are finite.

(Note the acceleration in profits starting with the Reagan Tax Cuts in the 1989’s. There is no evidence that cutting taxes for corporations leads to higher wages for employees.)

Given the economic landscape of recent years, large offsetting sectoral deficits and surpluses are not surprising, but they should not be taken as evidence that the long-term profitability of the corporate sector has permanently shifted higher. Stocks are not a claim to a few years of cash flows, but decades and decades of them. By pricing stocks as if current profits are representative of the indefinite future, investors have ensured themselves a rude awakening over time. Equity valuations are decidedly a long-term proposition, and from present levels, the implied long-term returns are quite dim.

The chart below (CPATAX/GNP) provides a good summary of the present situation, and a reasonable sense of what we expect for corporate profit growth over the coming several years.”

As we know from repeatedly from history, extrapolated projections rarely happen. Could this time be different? Sure. However, believing that historical tendencies have evolved into a new paradigm will likely have the same results as playing leapfrog with a Unicorn.

There is mounting evidence, from valuations being paid in M&A deals, junk bond yields, margin debt and price extensions from long-term means, “irrational exuberance” is once again returning to the financial markets. However, such does not mean a mean reversion process is imminent. It was in 1996 when Alan Greenspan first uttered those famous words, it was 4 years later before investors regretted not paying attention them. It is likely that the same will be true this time. With the Central Banks still pushing liquidity into the markets, there is little to deter the “bullish bias” presently. However, as noted above, investors that fail to heed the warning signs will likely ensure themselves a rude awakening over time.

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OPEC Meeting Concludes: This Is What Was Agreed

As previewed earlier this morning, when the flurry of leaks began, today OPEC reached a deal with non-OPEC partners to extend the oil production cuts until end of 2018 (recall these were supposed to be “temporary” when originally unveiled one year ago) at their meeting in Vienna, as part of producers’ strategy to reduce global inventory levels. Below is a summary, via Bloomberg, of the key items agreed on:

Analysts had previously predicted an extension; a survey showed 9 months as the most likely duration, measured from end of March 2018
Thursday’s Vienna agreement will have an effective start date of Jan. 1 and run through end-December 2018, superseding previous deal
Total volume of supply cutbacks from participating nations was left unchanged at ~1.8m b/d, ministers say
In addition, Nigeria and Libya agreed to a collective cap of 2.8m b/d; they had previously been exempt from supply curbs
Discussions in Vienna progressed as expected, with Joint Ministerial Monitoring Committee proposing on Wednesday an extension of 6 to 9 months, with a preference for 9
Thursday’s meeting has concluded; deal will be reviewed at June meeting
Joint Ministerial Monitoring Committee to meet every 3 months, chaired by Saudi Arabia and Russia

A key part of today’s agreement was the provision that a “further adjustment” would be considered in June.

In view of the uncertainties associated mainly with supply and, to some extent, demand growth, it is intended that in June 2018, the opportunity of further adjustment actions will be considered based on prevailing market conditions and the progress achieved toward re-balancing of the oil market at the time.

Confirming this was a statement from the Russian energy minister Novak, who said that the agreement can be adjusted in June – suggesting the deal is in reality a 6 month extension – if the situation changes.

The OPEC communique, in its raw form:

Opec communique. Review in June #OOTT #OPEC http://pic.twitter.com/eOprm1pG2Z

— David Sheppard (@OilSheppard) November 30, 2017

As for the energy complex, in line with the Goldman forecast that today’s meeting would likely be a sell the news event, both WTI and Brent are trading near session lows.

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House Committee Advances Legislation Allowing Concealed Guns In All 50 States

Though it was mostly overlooked amid the Senate’s crucial procedural vote on tax reform, the House Judiciary Committee late yesterday voted 19-11 in favor of a highly controversial bill, dubbed the Concealed Carry Reciprocity Act of 2017, which would amend the federal criminal code to allow the concealed transport of handguns across state lines, so long as both states allow it. If passed, the bill would prevent states from imposing their individual requirements for a concealed carry license on armed travelers from other states. Here’s a summary of the Concealed Carry Reciprocity Act of 2017:

This bill amends the federal criminal code to allow a qualified individual to carry a concealed handgun into or possess a concealed handgun in another state that allows individuals to carry concealed firearms.

A qualified individual must: (1) be eligible to possess, transport, or receive a firearm under federal law; (2) carry a valid photo identification document; and (3) carry a valid concealed carry permit issued by, or be eligible to carry a concealed firearm in, his or her state of residence.

Additionally, the bill specifies that a qualified individual who lawfully carries or possesses a concealed handgun in another state: (1) is not subject to the federal prohibition on possessing a firearm in a school zone, and (2) may carry or possess the concealed handgun in federally owned lands that are open to the public.

As Bloomberg points out, the National Rifle Association has called the concealed carry bill, which would make it easier for gun owners to keep their firearms hidden when crossing state lines, its “highest legislative priority in Congress.” Despite concerns raised by Democrats about states’ rights and domestic violence, the Republican-controlled Congress has pushed the proposal one step closer to becoming law.

Hand Gun

Of course, Trump openly courted NRA members during the 2016 election cycle and vowed in a speech to the NRA earlier this year: “you came through for me, and I am going to come through for you.” Here is a portion of Trump’s speech transcript courtesy of Newsweek:

But you came through for me, and I am going to come through for you. I was proud to receive the NRA’s earliest endorsement in the history of the organization. And today, I am also proud to be the first sitting President to address the NRA Leadership Forum since our wonderful Ronald Reagan in 1983. And I want to thank each and every one of you not only for your help electing true friends of the Second Amendment, but for everything you do to defend our flag and our freedom.

With your activism, you helped to safeguard the freedoms of our soldiers who have bled and died for us on the battlefields. And I know we have many veterans in the audience today, and we want to give them a big, big beautiful round of applause.

But we have news that you’ve been waiting for for a long time: The eight-year assault on your Second Amendment freedoms has come to a crashing end. You have a true friend and champion in the White House. No longer will federal agencies be coming after law-abiding gun owners. No longer will the government be trying to undermine your rights and your freedoms as Americans. Instead, we will work with you, by your side. We will work with the NRA to promote responsible gun ownership, to protect our wonderful hunters and their access to the very beautiful outdoors. You met my son—I can tell you, both sons, they love the outdoors. Frankly, I think they love the outdoors more than they love, by a long shot, Fifth Avenue. But that’s okay. And we want to ensure you of the sacred right of self-defense for all of our citizens.

Not surprisingly, the bill has drawn harsh criticism from the Left which argues that it effectively neuters the laws of individual states and turns the most lax state laws into federal laws…

The bill has found its fair share of detractors as well, including New York Police Department Commissioner James O’Neill. “I don’t think there is any reason for anybody to bring a gun into New York City,” O’Neill said in an interview earlier this year. “We don’t need any more guns.” Historically, many firearms used in killings in more highly regulated northeastern states originate in southern and western states with fewer or no gun restrictions.

Moms Demand Action, a gun control group that attended Wednesday’s hearing, has also attacked the bill, arguing it “is a chaotic and dangerous policy that would gut every state’s gun laws and make our communities less safe.”

The group argues that the bill “would effectively turn the weakest state’s laws into nationwide laws” because conceal carry laws vary state by state. For example, convicted stalkers are banned from concealed carry in some states, but not all, and the age for concealed carry also varies. In the event the bill passes, a Georgia permit, a state that allows abusive partners to carry hidden firearms, would become effective in New York, a state that currently doesn’t recognize any other state’s conceal carry permits.

Responding to Republicans during the hearing, Representative Jerrold Nadler, a Democrat from New York, said he “strongly opposed” the bill and argued it would override state’s rights, a traditional policy priority for Republicans. “Public safety would suffer if we were to unwisely adopt this legislation,” he added.

…but Republican take a slightly different stance…

“This would end abuses in anti-gun states like New York and New Jersey and allow law-abiding concealed carriers to exercise their rights nationwide with peace of mind,” the NRA website states. “[The bill] would not, as some critics claim, affect how states issue their own concealed carry permits.”

U.S. Representative Richard Hudson, the North Carolina Republican who introduced the legislation, called the bill “welcome progress” in efforts to expand and protect access to firearms.

So what say you? Is this a hypocritical trampling of states rights, a traditional priority of Republicans, or a necessary fight against liberal strongholds intent upon circumventing the Second Amendment?