Despite the apparent economic and profit news improvements recently, JPMorgan CIO Michael Cembalest notes there are a few instances where people are still flipping out. It’s worth reviewing them, he suggests, as they're indicative of risks and opportunities in financial markets heading into 2015, and of the continued presence of central banks affecting asset prices.
Flipping out: Oil company investors. Oil prices have fallen by 30% since June 2014. What’s not to like about an effective tax cut for consumers? Well, there’s the issue of the world’s largest oil companies which took on a trillion dollars of debt in recent years to find and develop new fields, usually with the expectation that oil prices would be higher than they are now. Biggest borrowers: Petrobras (by far), PetroChina, Total, Shell and BP. Even before this year’s oil price decline, only a little more than half of the top 100 had positive free cash flow (see 1st chart below). If WTI prices remain at ~$80, which oil futures markets are pricing in until 2018, the positive free cash flow universe will probably fall further.
Investors have flipped out about this turn of events, driving valuations of energy and oil service stocks lower (see above), and driving credit spreads wider on HY energy issues, 50% of which are rated B or CCC. Lower oil prices reflect weaker global GDP growth, a supply shock from the US shale boom and decreased energy intensity in places like China, whose oil demand per unit of GDP has fallen by 35% since 2005. Given this backdrop, S&P 500 profit forecasts for 2015 have come down ~3%, with energy-related reductions outweighing increases in consumer discretionary forecasts so far.
The bottom line: lower oil prices help consumers (see below), but cut into US energy-related investment and production, and may also result in disruptions and distressed stock/bond opportunities in a highly leveraged global energy sector.
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Oil price declines and GDP growth
Benefits from lower oil prices are greatest in countries whose energy spending as a % of consumption is high; where energy taxes are lower, passing on more of the oil price decline to consumers; where savings rates are lower, so more of the increase in disposable income gets spent; and where energy intensity (barrels of energy equivalent per unit of GDP) is high. Many of these conditions are true for the US, at least relative to other countries. However, these growth benefits are partially offset when the dollar is rising, which encourages more imports and less exports. As per a recent note from Goldman Sachs, a 10%-15% decline in oil prices when combined with a stronger dollar would boost US GDP growth by just 0.10%-0.15%.
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Flipping out: the Bundesbank. While the Eurozone is not falling back into recession, growth and inflation are stuck at ~1% and unemployment is still high outside Germany. There are signs of rising voter discontent, particularly given better outcomes in European countries not using the Euro. There’s pressure on the ECB to purchase government bonds, since its loans and purchases of private sector securities may only result in 1/3 of its EUR 1 trillion balance sheet expansion target. The prospect of ECB government bond purchases is reportedly causing current and former Bundesbank leaders to flip out; the Bundesbank prefers productivity-enhancing measures by member states instead. However, my sense is that Draghi and his allies will continue to squelch Bundesbank opposition, and that we will see ECB purchases of Eurozone government bonds next year.
The bottom line: if the ECB buys gov’t bonds, markets will probably take it positively, but ECB balance sheet expansion is not having nearly the same multiplier effect on growth or profits that it had in the US/UK.
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Draghi: Hast Du nicht mehr alle Tassen im Schrank?
Former ECB chief economist Jurgen Stark called existing ECB unconventional policy measures “an act of desperation” and described its purchases of asset-backed securities as adding “incalculable risks”. Current Bundesbank President Weidmann cautions that ECB government bond purchases “would raise legal questions, set wrong incentives and may not produce desired results.”
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Flipping out: Brazilian manufacturers. The combination of rising interest rates, rising inflation and falling demand/prices for Brazilian commodity exports has caused Brazilian manufacturers to flip out: their confidence levels are close to the lows of the global recession. Even with all the bad news, the Bovespa was up 20% for the year in September since markets were pricing in the possibility of a new government. After the recent election, however, the Bovespa is down for the year as markets price in a continuation of the status quo. Too much optimism was probably priced in even if there were a change in governance, since the choices are all difficult at this point.
The bottom line: Brazil (and Turkey) remain EM question marks given rising inflation, weak growth and large reliance on foreign capital. We prefer EM manufacturers like Mexico, Poland and South East Asia instead.
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Flipping out: Some Japanese economists. In Japan, inflation and inflation expectations are now above zero, and employee compensation and full-time employment are growing at +2%, their highest levels in years. So despite the bad Q3 GDP result, there are some signs that “Abenomics” is having its desired impact, although it has taken a 30% Yen decline vs the US$ since mid-2012 to get here.
However, not everyone is a fan of the Bank of Japan’s almost total monetization of government debt issuance and its purchases of Japanese equities and real estate investment trusts. In fact, some Japanese economists are flipping out:
In the Nikkei Asian Review, Izuru Kato from Totan Research highlights that little is being done to address Japan’s structural problems (i.e., Japan used to rank in the top ten in the World Bank’s Ease of Doing Business Index; Japan is now 27th, and 120th in “starting a business”). Negotiations have stalled on the Trans-Pacific Partnership4, a centerpiece of government plans to increase productivity and GDP growth. Kato is nervous about the BoJ’s massive balance sheet growth (2nd chart above) and criticizes the BoJ’s “monetary shamanism” resulting from its private sector asset purchases.
Former BoJ chief economist Hayakawa believes the government should “quit while it’s ahead”, and start shrinking the balance sheet. The risk of current policies: cost-push inflation in which prices go up mostly due to a weak Yen, but without boosting growth, exports or employment enough.
As per economist Richard Koo at Nomura, that’s exactly what’s happening: “Most of the price increases reported in Japan recently have been imported inflation fueled by the weak Yen. The resulting decline in the nation’s terms of trade implies an outflow of income, which naturally depresses domestic final demand.” Koo’s latest report shows almost no growth (yet) in bank lending or in the money supply despite growth in base money. Furthermore, the rise in corporate profits in Japan is almost entirely a result of translation effects of a weaker Yen on foreign sourced revenues.
On Halloween, the Bank of Japan announced even more purchases of Japanese government bonds, and a tripling of its purchases of Japanese stocks. To augment the forced march to higher asset prices, government-controlled Japanese pension funds are being brought along for the ride: mandated equity allocations have been doubled. The Bank of Japan vote was 5-4, with 5 bureaucrats and academics voting in favor, and 4 board members with private sector experience voting against. I imagine that at some point soon, holding cash in Japan without the intention of investing it will qualify as some kind of misdemeanor.
The bottom line: there are some signs that Japan is reflating and BoJ purchases are good news for investors in Japanese equities (if you hedge the Yen exposure), but what if a perpetually weakening Yen is needed to keep Abenomics moving? This is without question the world’s greatest Central Bank High Wire Act.
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Flipping out: Voters in highly indebted US states. A surprise from the mid-term elections: the blue states of Massachusetts, Maryland and Illinois flipped governors from blue to red (how blue are they? See table below). There are a lot of factors involved in elections, and it’s difficult to pinpoint why things turned out the way they did. But in looking at the shift in these states, it brings to mind an analysis we did earlier this year on the fully loaded funded and unfunded debt of US states:
What percentage of state tax collections is needed to pay interest on funded debt and amortize the state’s unfunded pension and retiree health care obligations, assuming a 30 year amortization period and a 6% return in the pension plan?
Our estimates are shown in the chart. The higher the percentage, the greater the pressure on the governor and the state legislature to increase state tax collections and/or reduce discretionary spending. There’s a big difference between the states, making national generalizations misleading.
What’s notable is that three states that flipped from blue to red this year (Massachusetts, Maryland and Illinois) ranked in the top ten according to our computations.
It’s hard to say for sure, but it is possible that the difficult choices on mandatory spending, discretionary spending and state taxes are starting to play a role in US gubernatorial elections.
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Source: JPMorgan Eye On The Market
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