Tag: finance

Submitted by Probes Reporter

Alibaba’s SEC Probe: What’s Missing From This Disclosure?

Analyst Summary: On 24-May-2016, Alibaba Group disclosed what appears to be an informal SEC investigation. This is the first time this matter has been disclosed. Details are scant, leaving the investor unable to adequately assess the risk it poses. Using the template of who/what/where/when/why, we will examine what is missing. Our conclusion is you are left with a risk that management views as material but you cannot analyze. We generally recommend avoiding such scenarios.

Facts of Interest or Concern: The following is Alibaba Group’s disclosure from the 20-K filed 24-May-2016 –

Earlier this year, the U.S. Securities and Exchange Commission, or SEC, informed us that it was initiating an investigation into whether there have been any violations of the federal securities laws. The SEC has requested that we voluntarily provide it with documents and information relating to, among other things: our consolidation policies and practices (including our accounting for Cainiao Network as an equity method investee), our policies and practices applicable to related party transactions in general, and our reporting of operating data from Singles Day. We are voluntarily disclosing this SEC request for information and cooperating with the SEC and, through our legal counsel, have been providing the SEC with requested documents and information. The SEC advised us that the initiation of a request for information should not be construed as an indication by the SEC or its staff that any violation of the federal securities laws has occurred. This matter is ongoing, and, as with any regulatory proceeding, we cannot predict when it will be concluded. [emphasis added]

We’ve not researched Alibaba Group in the past. Therefore we have no history or documents in our database on this company.

Analyst Observations: Using our template of who/what/where/when/why, we now examine what is missing from the Alibaba disclosure.

• Who is investigating? So far it appears just the SEC is investigating which make this a civil matter.

• What are the issues? We draw your attention to those words, “among other things” that appear in the disclosure just before the company lists some of the items under investigation. Be careful: We’ve seen cases where something similar to that term of art was actually cover for matters left out of a disclosure that would really bother investors.

So while you are told the probe pertains to, “among other things: our consolidation policies and practices (including our accounting for Cainiao Network as an equity method investee), our policies and practices applicable to related party transactions in general, and our reporting of operating data from Singles Day”, we recommend you press the company to simply tell you what those “other things” are that were left out of the disclosure.

The best question to ask: What are all the matters on which the company has been asked to produce records, information, and/or testimony? The devil could easily be in those details. The company will know the answer and there is usually no restriction on them answering this question.

• Where does it stand? If the company is to be believed, the probe started earlier this year. That puts us in the early stages of what could easily become a multi-year investigation. Further, we also note there is just enough ambiguity in the language to have us wondering if this probe is now formal. It’s certainly worth asking.
• When did this begin? This is one of the most important questions investors need answered. Knowing when it began gives investors a sense of how long it has been going on. That alone is potentially valuable information. For example, if there were negative research reports or news stories circulating in the past, and you see the SEC started a probe shortly thereafter, it’s a good bet some of the items in those reports/stories either triggered the SEC probe or are included as part of it.

This is the first time a disclosure relating to this matter has been made by the company. In this case, we are a bit troubled by the language stating the probe started “Earlier this year”. How much earlier, exactly? The first time Alibaba had contact with the SEC’s Division of Enforcement on this matter cannot be discerned from the disclosure. You really want to know this.

• Why is the company disclosing this now? Including the 20-F filed on 24-May, Alibaba made four other official SEC filings this year (29-Jan, 12-Apr, 25-Apr, and 05-May-2016). Two of them were earnings announcements. For an SEC probe that began, “earlier this year”, it sure appears there was plenty of opportunity to disclose this sooner. This instantly begs the question of ‘what changed?’ That is, for all this time the company did not judge this matter sufficiently material to disclose. Something changed.

The materiality threshold, which is at the core of how we view the world, says that in general companies are only required to disclose matters deemed material and, often to the chagrin of investors, management is the judge.

It’s safe to assume that something about this matter caused Alibaba executives to feel compelled to make this disclosure, scant as the details are. Until now, they did not judge this posing a material risk to the company. Now they do, and there is not enough here for you to analyze.

Finally, whenever we examine disclosures from a company where we know there is more information available than the company is providing, it leaves us questioning the overall thoroughness of the company’s remaining disclosures and information being provided to investors.

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For those who need a quick and easy recap of all the main events that took place in the oil and gas services sector, here it is courtesy of Credit Suisse’s James Wicklung who present the various “things we’ve learned this week.“

* * *

You Will Get Nothing and Like It. According to Bloomberg, in the final gathering of OPEC officials prior to the June 2 meeting, no discussions of a production cut took place. Officials at the meeting concurred with OPEC’s most recent research report that supply and demand will start to balance in the second half 2016.

Foot on the Gas. Sunday, Iranian Deputy Oil Minister Rokneddin Javadi noted that the country has no plans to slow oil production, saying, “Currently, Iran’s crude oil exports, excluding gas condensates, have reached 2M bpd; Iran’s crude oil export capacity will reach 2.2M barrels by the middle of summer.” Prior to economic sanctions, Iran produced 4.5M bpd, which is down from peak production of ~7M bpd in the 1970s.

Time for a Change. Volatile oil and natural gas prices have accelerated planning by energy executives to change their business models; KPMG Global Energy Institute said in a May 24 release of annual survey results of US senior energy executives. Of more than 150 executives responding, 94% said commodity pricing coupled with the regulatory environment will require significant changes to their business models in 3-5 years. Executives said their top organizational priorities for the next 2 years are developing new growth strategies and implementing changes to their business models. When asked about mergers and acquisitions, 92% of respondents expect to be involved in a merger or acquisition in 2 years with 38% saying asset acquisitions are more likely than acquiring an entire company. Slightly more than half of oil and gas executives surveyed, about 51%, said they believe restructuring or bankruptcies primarily will drive acquisitions. Companies see the best way to remain competitive is by focusing on capital spending efficiency. “This new lower-for-longer commodity pricing environment has made it necessary for energy executives to devise new ways get access to capital,” said KPMG, adding that executives listed an unstable price environment as the leading factor hindering growth over the next year.

We Love Being Wrong. Baker Hughes announced it is consolidating its previous regional operations structure into one global organization and, in conjunction, is making leadership changes. Most importantly, there was no change to the CEO position. Previously, we thought a shake-up in leadership could cost the CEO his job; we love being wrong and wish Martin the best. Notable changes that were made include Belgacem Chariag, former Chief Integration Officer, who will serve as President, Global Operations. In addition, Art Soucy, Derek Mathieson and Richard Williams will serve as President, Products and Technology, Chief Commercial Officer and Senior Advisor to the company’s Executive Leadership team, respectively. CEO Martin Craighead commented, “While we have more hard work ahead of us, the entire Baker Hughes team is committed to building on our strong foundation as a product innovator to deliver outstanding performance to our customers and significant value to our shareholders.” We emphasize the above to demonstrate BHI’s focus on transitioning back to a product-based manufacturing company from a global service provider.

Grab the Sunscreen. SLCA announced it completed the purchase of a fully permitted, 327 acre parcel of land adjacent to its existing mine in Ottawa, Illinois. The land is expected to add 30M tons of proven reserves. In addition to oil and gas, the Ottawa facility serves multiple end  markets such as glass, building products and chemicals.

Big Money. A CVX lead consortium is set to invest up to $37B starting in 2017 as output from the giant onshore Tengiz oil field in Kazakhstan is ramped up. Other players include XOM (25% stake), Kazakhstan’s state run oil company (20% stake) and Lukoil (5% stake). Many thought the majors couldn’t completely walk away from deepwater, because finding enough places to spend their massive capital budgets did not exist onshore US. This large international onshore investment is another example of the Major’s tendency to stay away from deepwater for the foreseeable future.

Straight to the Heart. According to a Reuters report, CVX’s onshore activities in Nigeria’s Niger Delta have been shut down after the facility’s main electrical feed was blown up by a militant group called the Niger Delta Avengers. This is the same group that has targeted Shell’s and CVX’s platforms in the past few weeks. The attacks have pushed Nigeria’s oil output near a 22-year low. Crude oil sales in the Niger Delta account for 70% of national income. As of publishing, CVX had yet to confirm the attack.

Borrowing from Within. Carbo Ceramics received $25M from two of the Company’s Directors, William C. Morris ($20M) and Robert S. Rubin ($5M). Each note matures in April, 2019 and pays interest at 7%. The notes will be subordinate to CRR’s revolving credit facility.

Not Again. Shell announced an additional 2,200 job cuts this week in conjunction with the BG acquisition. The company has now cut 12,500 jobs in 2015 and 2016 combined and anticipates at least 5,000 job cuts to be made this year.

Revolving Door. Petroleum Geo-Services amended its credit facility; total debt to adjusted EBITDA covenants were temporarily relaxed and a covenant allowing the company to add proceeds from an equity offering (if PGS decides to go this route) to adjusted EBITDA was added. Dividend restrictions remain in place.

Where Have All the Good Wells Gone? According to a study done by Rystad energy done this week, there are 3,900 DUCs across all U.S. shale basins, with more than 90% located in the major liquids plays (see Figure 1). In a recent unofficial industry survey we conducted, participants estimated there were 4,800 DUCs, which is 3,500 above normal (1,300 would be normal at current drilling levels). The number of DUCs and the impact they will have continues to be a hot topic of conversation in the industry. We anticipate that these wells will be the first to be completed when operators decide to put significant capital to work.

Framing the Damage. Wood MacKenzie released a study that detailed the size and scale of the industry downturn from a capital expenditure perspective. Since peak capex in 4Q14, $370B of planned capex has been cancelled. As we would expect, the deepest cuts have come in the US Lower 48 where capital investment has halved; the majority of production declines come from this region as well. While pre-FID greenfield costs have fallen an average of 10% (in capex/boe terms) from 2014 levels, WoodMac estimates that global costs need to fall at least 30-40% from 2014 levels for much of the current project pipeline to progress.

Despite All Odds. The North Yorkshire County Council (located in Northern England) approved a bid by Third Energy to frac a gas shale well. The well will be the first fracking operation in England since a ban was lifted in 2012. Despite protest from local residents, the county council voted 4 to 7 in favor of allowing Third Energy to proceed. Operations are expected to start by the end of the year. It should be noted that there  is a national policy supporting the development of shale gas which was an important consideration for the local officials.

Dating. Pemex, who has postponed investments in deepwater this year in the midst of $5B in budget cuts, is reportedly looking for partners to develop deepwater fields in the GoM; XOM, CVX, and TOT have been named as potential suitors. Mexico is set to conduct its first ever deepwater oil auction covering ten potentially lucrative blocks on December 5. 76% of Mexico’s oil reserves are located in the deepwater.

The Struggle Is Real. Despite operating more drilling rigs than the rest of Africa combined, Algerian oil production is still not recovering after years of decline. Last year, Algeria drilled 149 wells and only made 22 minor oil discoveries, resulting in flat YoY crude output of 1.1M bpd. The decline in oil prices, combined with poor drilling results, has resulted in the nation’s first current-account deficit in more than a decade. The IMF estimates that the breakeven oil price for Algerian crude is $87.60. For additional context, fellow African nation Nigeria produced 600,000 bpd more crude than Algeria in April while only running six rigs, compared to Algeria’s 36. Furthermore, Iraq produced 4x the amount of crude running just over 40 rigs in April.

First Time in a Long Time. Tuesday, the Indian Oil Ministry announced it is putting nearly four dozen small oil and gas fields up for auction. 26 will be on land, 18 will be in shallow water and two fields will be in deepwater. Bids will be accepted from July 15 to October 31 of this year. This auction will be the first since 2010. The blocks that are up for auction were formerly held by state-owned E&Ps but were given back to the government due to high development costs. Recently, Indian Prime Minster Narendra Modi set a goal to cut the country’s crude oil imports by 10% by 2022.

Calling for Change. The American Petroleum Institute (API) has called on the federal government to align its offshore leasing program to reflect the United States’ role as a global energy leader. EVP Louis Finkel noted in a press briefing that ~87% of federal offshore areas remain off limits to oil and natural gas production and that leaving these areas off limits to exploration and production puts the U.S. at a serious global competitive disadvantage. Earlier this year the Department of the Interior removed the Atlantic from the 2017-2022 Outer Continental Shelf Oil and Gas Leasing Program.

Filling the Schedule. Petrobras is preparing to sell $10-20B in assets over the next two years. Specific assets, which could end up being Brazil’s most ambitious sale in decades, have yet to be marketed to the public. Two Brazilian officials will be going on road a show to New York, London and other financial hubs in mid-July to market the assets.

King of the Hill. Russia was China’s largest crude oil supplier for a second month this year, with shipment in April surpassing imports from Saudi Arabia and hitting a record high of 1.17M bpd. The record import figure is expected to subside in June as a rebound in oil prices is set to squeeze margins for refiners. In our view, it is clear that that market share war between Saudi Arabia and Russia has not abated.

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Following Yellen’s uncharacteristicaly hawkish tone, the odds of a July rate-hike have shot higher – now higher than June or September have ever been – to record highs. This has sent short-term bond yields higher, the yield curve dramatically flatter, stocks lower, and gold down…

July Rate hike odds soar… (note these are the odds of a rate hike in that month – which suggests The Fed will be “one more and done”)

 

and the reaction in asset markets as bonds close early and correelations break down…

 

Big flattening in the yield curve suggest the market remains doubtful that this is the right move.

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Submitted by Charles Hugh-Smith of OfTwoMinds blog,

There are limits on what the Fed can do when this bubble bursts, as it inevitably will, as surely as night follows day.

It's no secret that virtually every pension fund is dead man walking, doomed by central banks' imposition of low yields on safe investments, i.e. Zero Interest Rate Policy (ZIRP).

Given that both The Economist and The Wall Street Journal have covered the impossibility of pension funds achieving their expected returns, this reality cannot be a surprise to anyone in a leadership role.

Many unhappy returns: Pension funds and endowments are too optimistic

Public Pension Funds Roll Back Return Targets: Few managers count on returns of 8%-plus a year anymore; governments scramble to make up funding

Here's problem #1 in a nutshell: the average public pension fund still expects to earn an average annual return of 7.69%, year after year, decade after decade.

This is roughly triple the nominal (not adjusted for inflation) yield on a 30-year Treasury bond (about 2.65%). The only way any fund manager can earn 7.7% or more in a low-yield environment is to make extremely high risk bets that consistently pay off.

This is like playing one hand after another in a casino and never losing. Sorry, but high risk gambling doesn't work that way: the higher the risk, the bigger the gains; but equally important, the bigger the losses when the hot hand turns cold.

Here's problem #2 in a nutshell: in the good old days before the economy (and pension funds) became dependent on debt-fueled asset bubbles for their survival, pension fund managers expected an average annual return of 3.8%–less than half the current expected returns.

In the good old days, the needed returns could be generated by investing in safe income-producing assets–high-quality corporate bonds, Treasury bonds, etc. The risk of losing any of the fund's capital was extremely low.

Now that the expected returns have more than doubled while the yield on safe investments has plummeted, fund managers must take risks (i.e. chase yield) that can easily wipe out major chunks of the fund's capital if the bubble du jour bursts.

Here's problem #3 in a nutshell: everyone who rode the great bubble of 1994 – 2000 (including pension funds) soon reckoned 10%+ annual returns on equities was The New Normal, so expecting 7.5% – 8% annual returns seemed downright prudent.

When that bubble burst, decimating everyone still holding equities, the Federal Reserve promptly inflated two new bubbles: one in stocks and another in housing. Once again, everyone who rode these two bubbles up (including pension funds) minted hefty profits year after year.

This seemed to confirm that The New Normal included the occasional spot of bother (a.k.a. a severe market crash), but the Federal Reserve would quickly ride to the rescue and inflate a new bubble.

When the dual bubbles of stocks and housing both burst in 2008, once again the Fed rushed to inflate another set of bubbles, this time in stocks, bonds and rental housing. Lowering interest rates could no longer generate a new bubble. This time around, the Fed had to lower interest rates to zero indefinitely, and embark on the most massive monetary stimulus in history–quantitative easing (QE) 1, 2 and 3–to inflate a third bubble in stocks.

This unprecedented expansion of free money for financiers and dropping interest rates to zero generated a bubble in bonds and an echo-bubble in real estate–specifically, commercial real estate and rental housing.

These three bubbles once again generated handsome yields for pension funds. Once again fund managers' faith in the Federal Reserve maintaining a New Normal of occasional crashes quickly followed by even bigger bubbles was rewarded.

But the game is changing beneath the surface of Fed omnipotence. The returns on zero interest rates (or even negative rates) have diminished to zero, and the Fed's vaunted monetary stimulus programs have been recognized as enriching the rich at the expense of everyone else.

Even with the unprecedented tailwinds of one massive bubble after another, pension funds are in trouble. The high-risk returns of Fed-induced bubbles followed by the inevitable crashes cannot replace the safe, high yields of the pre-bubble-dependent economy.

If funds are in trouble with stocks in a new unprecedented bubble high, how will they do when stocks fall back to Earth, as they inevitably do in boom-bust cycles?

The usual justification for nose-bleed valuations is sky-high corporate profits. But profits have rolled over, and irreversible headwinds are increasing: a stronger U.S. dollar, an aging populace desperate to save more for retirement, an entire generation burdened with student debt and often-worthless college diplomas, a global economy on the brink of recession, diminishing returns on firing workers, diminishing returns on financialization legerdemain, etc.

Meanwhile, commercial real estate loans have soared above the previous bubble highs.

This seems to prove that no bubble bursts for long with the Federal Reserve at the helm, but there are limits on what the Fed can do when this bubble bursts, as it inevitably will, as surely as night follows day.

The Fed can't lower interest rates below zero without signaling that the economy is well and truly broken, and it can't force people who are wary of debt to borrow more, even if it effectively pays borrowers to take on more debt.

All the Fed can do is extend new debt to unqualified borrowers who will default at the first sneeze. This will trigger the collapse of whatever new credit-fueled bubble the Fed might generate.

The political winds are also changing. The public's passive acceptance of central banks' let's make the rich richer and everyone else poorer policies may be ending, and demands to put the heads of central bankers on spikes in the town square (figuratively speaking) may increase exponentially.

It's looking increasingly likely that third time's the charm: this set of bubbles is the last one central banks can blow. And when markets free-fall and don't reflate into new bubbles, pension funds will expire, as they were fated to do the day central banks chose zero interest rates forever as their cure for a broken economic model.

*  *  *

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Authored by Jim Strugger of MKM Partners

Death by Theta

Even the most skeptical among us have to be impressed by the rip higher in U.S. equities over the past week. Absent an obvious positive catalyst, the S&P 500 Index (SPX, 2090.10) jumped 2.5% after flirting with lows since March and a potential test of the 200-day moving average.

More broadly, the SPX is just revisiting the top end of its range back to late 2014 while equity volatility has shifted back to a trough though importantly without having descended to a level that suggests a structural change in the high-volatility regime.

Still, there is little doubt that if stocks do manage to break out and sustain fresh highs than the broad swath of volatility metrics will collapse to levels more indicative of a low-volatility cycle. The period dating back to last August will have been an anomaly relative to historical regimes that have lasted upwards of five years. We are skeptical of that outcome and see support from measures of crossasset and geography risk that remain elevated (GFSI Index in left graph).

As of next week, the U.S. economic expansion will reach its seven year anniversary. The prior three cycles since 1990 averaged 95 months in length measured from trough to peak. That puts the current cycle just shy of a year from eclipsing the mean duration. As MKM Partners Chief Economist Michael Darda points out, business cycles historically survive for around two years once the Fed begins tightening. If the U.S. cycle is late in its expansion then it follows from precedent that  volatility broadly but more specifically U.S. equity implied volatility should remain structurally elevated into and through an eventual recession (and likely bear market) before subsiding once the next sustained recovery has begun.

That is precisely why we have struggled with the idea that the high-volatility regime intact since last August may truncate at less than a year. If our reasoning is correct and volatility remains structurally elevated, it follows that the recent three-month cyclical trough, as the longest such period on record, is statistically unlikely to last much longer.

Admittedly, it doesn’t feel that way. Stocks have displayed impressive buoyancy over the last couple of months when pressed lower even while the SPX remains contained within its range back to late 2014. Of course, market psychology can turn on a dime and we can’t help but to see underlying instability amidst this recent market strength. That suggests a dislocation is likely prior to equities escaping to a new all-time high.

For those looking to get directionally longer, we prefer synthetic exposure which can be had simply via outright calls where implied volatility is suitably low rather than by deploying significant capital at the top of the range. While it is tough to push hedges and long volatility given the theta burn from prior recommendations, we still think clients should retain a healthy dose of skepticism about how much longer markets can ward off a bout of instability.

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Dove, hawk, or nothing at all? That's the question as Fed chief Janet Yellen speaks after she receives the Radcliffe Medal from Harvard University's Radcliffe Institute for Advanced Study. There are no prepared remarks, but a scheduled 30-minute Q&A session with Greg Mankiw could give insight into Yellen's thoughts on two key issues: whether she now has more faith that recent evidence of rising inflation is convincing, and the degree to which she feels overseas risks have receded. Most (including the market) expect Yellen to stick to the hawkish meme ascribed by the latest FOMC statement and numerous Fed speakers. Some, including DoubleLine's Jeff Gundlach expect a dovish Yellen to re-appear. Still others believe she will say nothing at all – instead waiting for a more formal speech on June 6 to drop her tape bombs.

As SocGen notes, Fed Chair Yellen will be honoured at Harvard, with a conversation on her achievements at the ceremony. However, little emphasis on the monetary policy outlook is expected at this event. The appearance to look forward to will be the Chair's speech in Philadelphia on June 6, the Monday following the May employment report and a day before entering the blackout period for the upcoming FOMC meeting.

Live Feed (The event started at 1030ET with Yellen is due to speak at 1315ET.. though it appears they are running late)…

• *BERNANKE SAYS WE'RE LUCKY TO HAVE YELLEN LEADING THE FED

click image for link to Harvard live feed – no embed available

 

As we noted previously,

With verious Fed presidents having whipping up the market into a hawkish frenzy in the past two weeks, leading to a dramatic repricing in summer rate hike odds with expectations for a July rate hike now over 50%, many can be "disappointed" by Yellen's speech today, at least according to Jeff Gundlach who said Yellen appears to be more cautious on raising interest rates and he expects her comments to be dovish again on Friday, when she is scheduled to speak at an event in Harvard-Radcliffe.

 

Specifically, during a DoubleLine event in Bevely Hills, he said said the Fed is "a bit stuck" given that it will not have ammunition available for the next recession unless it raises rates, despite continued lackluster economic growth. He noted that some developed countries, including Australia and Sweden, tried to raise interest rates in 2010, but ended up having to reverse course. "The Fed seems hell bent on raising interest rates until something breaks, which is what happened in these countries," he said.

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Following last week's unchanged oil rig count – breaking a 21-week streak of declines – as the rig count inflected perfectly with lagged oil prices. However, despite a rise in lagged oil prices, the oil rig count declined 2 to 316 this week – new lows since Oct 2009. Total rig count dropped to 404 – a new record low. Crude traders appear to have left for the day as there was no visible reaction to this data.

• *U.S. OIL RIG COUNT FALLS 2 TO 316, BAKER HUGHES SAYS
• *U.S. TOTAL RIG COUNT 404 , BAKER HUGHES SAYS

Is production about to slump?

 

Charts: Bloomberg

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With Janet Yellen due to speak in under an hour (in a speech that will be a big dud because as SocGen notes, “little emphasis on the monetary policy outlook is expected at this event”), a recurring question is why does the market remain so nonchalant about the possibility of a rate hike as soon as one month from now.

One of the better explanations on the matter comes from Citi’s Steven Englander, according to whom it boils down to the market’s sentiment about what happens with the Fed’s hiking path after the first hike.  As the Citi strategist points out, this is merely the latest feedback loop the Fed has found itself trapped in:

Asset markets have done very well since the fed funds market began pricing in a summer hike. The question is why? We think that investors are trading the equation

 

an extra 2016 hike but very little else  +   better Q2 growth data = stronger asset markets

 

The question is whether this is a sustainable equation. Better growth, if sustained, is likely to induce more hikes. If we go from ~2.5% GDP in Q2 to 1.5-2% subsequently, we are likely to unwind the recent optimism.

Or maybe we won’t, because the only thing more bullish than a hawkish Fed is a dovish Fed.  Let’s assume for the sake of this argument that the market is, like it was in December, fixated on the favorable “growth” outcome as a result of an upcoming rate hike (something with Jeff Gundlach mocked two days ago), as the alternative of yet another Fed policy error may be just too much of a shock. Here is why Eglander is cautious in reading this interpretation:

On the better sustained growth/faster hiking scenario, the slope of the Fed’s policy rate path will steepen. This will be another challenge to commodity and EM currencies. It may well turn out that a modestly steeper path of Fed hikes does not damage global growth prospects or asset prices a lot, but that is not likely to be the immediate response.

 

Alternatively if the hiking path reflects the expectation that better growth is temporary, the recent strength of US asset markets may come into question. The shallow path of hikes now priced in will not take the Fed away from the danger zone of a negative shock pushing them into the incipient negative policy rate. So a resumption of 1-2% growth rates after a solid Q2 may sap the confidence that markets have displayed in recent weeks.

In other words, the market is confident that the Fed’s rate hike itself will be enough to stop any more rate hikes, irrelevant of the data. What the market is forgetting however is that the rate hikes in early 2016 were delayed not so much because of the data, which was already deteriorating as the Fed hiked, but because of the market’s reaction. As such, the “market” is hoping to skip the critical step where it sells off to delay even more tightening. That however is the very problem the market, which no longer can discount anything, would create.

Consider the chart below which shows from bottom to top how many bps of hikes has been added fed funds expectations for July 16 (light blue), Dec 16 (dark blue), Dec 17 (red) and Dec 18 (green).  We have 15 extra bps now for the rest of 2016 and only 21 or 22 for the next two years. And obviously there has been no change of expectations for 2018 relative to 2017.

 

As Englander points out, “literally since the trough of fed funds the market has not even added a full hike over the next three years and about 70% of what  has been added is in 2016. By contrast when lift-off expectations were priced into fed funds last October, the outyears moved much more than the near contracts. This suggests that the market then saw liftoff as signaling a steepening of the pace of fed hikes, whereas the recent move is add one but no accelerated pace beyond.”

Or, on other words, one and done.  Cue Englander:

The scenario that the market seems to be buying is that the signs of growth that we are seeing will embolden the fed to one but no more additional hike.  The rationale may be that EM currency weakness will deter the Fed in the future, although that is not clear. If we look at asset price performance since May 9,  oil (dotted green), equities (thick dotted blue),  and high yield (solid dark blue) have done the best. EM equities (solid light blue), and non-oil commodities (red) are up but not quite as much. EM currencies overall (solid grey) and non-CNY Asia (dotted thin blue) are down. It is possible that the outperformance of US asset reflects an assessment that the hike won’t damage US growth prospects a lot but could lead to underperformance in EM assets. This is, of course, a very speculative explanation for the lack of conviction that on future fed hikes, despite their reiteration of the 2+ hikes scenario in various speeches and discussions.

 

 

Whether this is true or not, and whether the Fed’s rate hike will only damage the “global environment” while leaving the US and domestic corporate profits unscathed, is unclear but what the market makes very clear is that it itself is confident none of that will impact the market itself. What the market is also forgetting most of all, is that the only “data” the Fed is dependent on is the “Dow Jones” – in other words, if the market is pricing in no more rate hikes, it itself will have to crash, a step which the market is hoping it can simply skip at this moment.

Head spinning from all this reflexivity yet? Good.

How does all this get resolved? Here is Englander with the longer explanation:

The way to reconcile these asset price moves is either 1) investors see a temporary pick up in US activity (GDP ~2.5%), but will fall back in H2 to around trend without any significant inflation move, 2) US activity will be ok  but not great and the spillover into the rest of the world will be negative enough to deter further hikes.

 

It is also possible that the outcome is a compromise between optimists who see an extended period of 2.5% GDP growth and the 2-3 hikes that come with it and pessimists who see ongoing soft outcomes and FOMC worries about drifting into recession. Anecdotally, it is hard to find any client or colleague who feels that economic outcomes we will be on the knife edge that the market is pricing  – just good enough to prevent disaster but not good enough for anything beyond token subsequent hikes.

 

But it would seem to us that the equity outcome in the weighted average view is a lot less positive. There are few S&P 2500 optimists even at 2.5% growth but plenty of S&P 1600 or less pessimists on the negative scenario.

 

Bottom line – one more and pretty much done is unlikely to be as risk positive as recent asset market prices action suggests. But it may allow EM to bounce back a bit once the snail pace of Fed hikes is restored as the baseline expectation. We do not think that EM is as vulnerable to two hikes a year as pessimists argue, but the transition to pricing in two hikes a year is likely to be rocky, even if the EM ultimately bounces back.

That was the long way of saying the market is currently overpriced for precisely the event it is trying to price in, and not correctly accounting for the path of future rate hikes.

The short one is far simpler, and goes back to the chart we showed a week ago. 

In short, the only thing that can prompt the Fed to delay a rate hike is neither the global nor the local economy, but the market itself… which because it is back at 2100 shows no interest in actually prompting the Fed’s move that it is “pricing in.”

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French president Francois Hollande is not bending to pressure by labor unions trying to force the government to retract unpopular labor laws that were recently forced through parliament. Unions have gone on strike in order to shut down refineries, and have blocked fuel distribution with barricades and pickets in hopes that the economy will suffer enough to get the government to back off the reforms. In response, the government is now sending police in riot gear to break up the blockades.

The unions, as they intended, are certainly having an impact. Fuel shortages intensified as 30 percent of the country's 12,200 stations across the country are short of fuel and Total SA, France's largest oil company said that 346 out of it's 2,200 French gas stations are completely out of stock, while 395 lack some fuels according to Bloomberg.

Walkouts at Electricite de France SA cut more than 5,000 megawatts of combined output at a dozen nuclear reactors on Thursday (but have since returned to normal on Friday), and unions have gone on strike at all 8 French oil refineries, with Total reporting that five of its refineries have been completely halted.

In response to the actions, Prime Minister Manuel Valls told the unions that continued disruptions would be dealt with "extremely firmly", and president Hollande has shown no signs of letting up on the new laws. Hollande warned protesters that he would not let them strangle the economy, perhaps taking comfort in the fact that consumer confidence surged to the highest level since 2007.

"I'm going to stick with this because I think it's a good reform. This is not a moment to endanger the French recovery."

Hollande further added "We can't accept that there are unions that dictate the law. As head of state, I want this reform. It fits with everything we have done for four years. I want us to go right to the end."

Indeed, it will be a bitter fight between Hollande and the unions to get this situation resolved. CTG union boss Philippe Martinez said the strikes will continue until the labor law is reformed.

"We'll see this through to the finish, to withdrawal of the labor law. This government which has turned its back on its promises and we are now seeing the consequences."

In another important development, oil tankers at the country's biggest oil port (the Fos-Lavera oil port in southern France) are still waiting to unload, and the backlog is growing. According to Reuters, 38 oil tankers are queued up waiting to unload at the port Friday, up from 12 the previous day. To make matters worse, members at the CIM oil terminal at the port of Le Havre which handles 40 percent of French crude imports voted to extend their strike until Monday.

• UNION OFFICIAL SAYS MANAGERS HAVE REOPENED PIPES TO SUPPLY CRUDE TO EXXON MOBILREFINERY, FUEL TO PARIS AIRPORTS

As Reuters reports, at least some relief has come since police started to break up barricades. In the Seine Maritime region North of Paris, local government official Nicole Klein said the number of petrol stations without fuel had fallen significantly and rationing orders have been lifted.

• *TOTAL: 659 FRENCH STATIONS OUT OF GAS AT 5PM VS 815 YDAY

In addition to the economic issues, there has been violence as well. As hundreds of thousands of protesters have taken to the streets, hundreds of police have been hurt and more than 1,300 arrested according to Reuters. Most recently, protesters attacked a police station and smashed bank windows on Thursday during rallies against the reform. According to the Interior Ministry, seventy seven people were arrested during the rally in which  more than 150,000 marched.

France is hosting the Euro 2016 soccer tournament in two weeks, and with already dwindling popularity, the last thing Hollande wants voters to draw upon during elections next year is such a huge event being a disaster because labor reforms were forced through parliament without a vote. It will be interesting to see which side blinks first in this standoff, but at the moment it appears that nobody is willing to budge.

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