Takeaway: Investors favored passive ETFs last week, continuing the trend that has brought 2015 ETF inflows to +101B versus fund redemptions of -$143 B
Investment Company Institute Mutual Fund Data and ETF Money Flow:
Investors pulled funds from almost all risk categories in the 5-day period ending November 18th. Total equity mutual funds lost -$4.9 billion, including another -$4.5 billion outflow from domestic stock funds. Fixed income mutual funds lost -$3.0 billion with investors continuing to flee the taxable bond category on fears of a rate hike. Meanwhile, investors favored passive ETFs, contributing +$1.5 billion and +$1.9 billion to equity and fixed income ETFs, respectively.
The chart below shows that the ongoing shift out of active domestic equity funds to passive U.S. equity ETFs year-to-date which has produced -$143.4 billion in outflows versus the +$101.1 billion that has been reinvested into ETFs over the same period. We recommend a short position in shares of T. Rowe Price as a way to express this ongoing shift (see our TROW reports). TROW's organic growth rate has been steadily dropping and what was once a double digit growth rate is moving to flat at best with our estimates calling for negatives growth through 2016. TROW funds still perform strongly however the shift out of the mutual fund structure is just too pervasive for the company to make the Street's still rosey expectations.
In the most recent 5-day period ending November 18th, total equity mutual funds put up net outflows of -$4.9 billion, trailing the year-to-date weekly average outflow of -$773 million and the 2014 average inflow of +$620 million. The outflow was composed of international stock fund withdrawals of -$438 million and domestic stock fund withdrawals of -$4.5 billion. International equity funds have had positive flows in 44 of the last 52 weeks while domestic equity funds have had only 8 weeks of positive flows over the same time period.
Fixed income mutual funds put up net outflows of -$3.0 billion, trailing the year-to-date weekly average inflow of +$161 million and the 2014 average inflow of +$926 million. The outflow was composed of tax-free or municipal bond fund contributions of +$649 million and taxable bond fund withdrawals of -$3.6 billion.
Equity ETFs had net subscriptions of +$1.5 billion, trailing the year-to-date weekly average inflow of +$2.2 billion and the 2014 average inflow of +$3.2 billion. Fixed income ETFs had net inflows of +$1.8 billion, outpacing the year-to-date weekly average inflow of +$1.1 billion and the 2014 average inflow of +$1.0 billion.
Mutual fund flow data is collected weekly from the Investment Company Institute (ICI) and represents a survey of 95% of the investment management industry's mutual fund assets. Mutual fund data largely reflects the actions of retail investors. Exchange traded fund (ETF) information is extracted from Bloomberg and is matched to the same weekly reporting schedule as the ICI mutual fund data. According to industry leader Blackrock (BLK), U.S. ETF participation is 60% institutional investors and 40% retail investors.
Most Recent 12 Week Flow in Millions by Mutual Fund Product: Chart data is the most recent 12 weeks from the ICI mutual fund survey and includes the weekly average for 2014 and the weekly year-to-date average for 2015:
Cumulative Annual Flow in Millions by Mutual Fund Product: Chart data is the cumulative fund flow from the ICI mutual fund survey for each year starting with 2008.
Most Recent 12 Week Flow within Equity and Fixed Income Exchange Traded Funds: Chart data is the most recent 12 weeks from Bloomberg's ETF database (matched to the Wednesday to Wednesday reporting format of the ICI), the weekly average for 2014, and the weekly year-to-date average for 2015. In the third table are the results of the weekly flows into and out of the major market and sector SPDRs:
Sector and Asset Class Weekly ETF and Year-to-Date Results: In sector SPDR callouts, the materials XLB ETF ceded -4% or -$94 million to redemptions in the 5-day period ending November 18th.
Cumulative Annual Flow in Millions within Equity and Fixed Income Exchange Traded Funds: Chart data is the cumulative fund flow from Bloomberg's ETF database for each year starting with 2013.
The net of total equity mutual fund and ETF flows against total bond mutual fund and ETF flows totaled a negative -$2.3 billion spread for the week (-$3.4 billion of total equity outflow net of the -$1.1 billion outflow from fixed income; positive numbers imply greater money flow to stocks; negative numbers imply greater money flow to bonds). The 52-week moving average is +$963 million (more positive money flow to equities) with a 52-week high of +$27.9 billion (more positive money flow to equities) and a 52-week low of -$19.0 billion (negative numbers imply more positive money flow to bonds for the week.)
Exposures: The weekly data herein is important for the public asset managers with trends in mutual funds and ETFs impacting the companies with the following estimated revenue impact:
Jonathan Casteleyn, CFA, CMT
Joshua Steiner, CFA
Takeaway: DE gave low quality guidance that exceeded consensus, a strategy we think may backfire later this fiscal year. While the key components of the guidance look conservative at first, the outlook assumes stabilization in collapsing unit sales – a very tall order given our view of industry trends. DE’s outlook also benefits heavily from a convenient change in pension & OPEB assumptions. Long-term, we think DE is trapped in a less severe version of the 1980s Ag Equipment down-cycle, offering perhaps ~30% relative downside from current levels. DE is increasingly shifting to an FY17 story, as well. Shorter-term, we expect the report to pressure bears and allow us to repeat our ‘short-a-squeeze’ strategy.
Key Earlier Notes:
Replay & Materials From Ag Equipment Black Book
Best Ideas Addition (5/22/15)
Where To From Here (9/21/15)
Removing As Best Ideas Short (11/24/15)
Dissecting the Outlook
We’ll let others summarize DE’s quarter, as only one section of the release really matters: Guidance. We think DE’s FY2016 guidance is truly incredible in that it is difficult to believable. Management overshot with a back-end loaded $1.4 billion net income outlook, we think, which was puffed up with a “candidly…more accurate” change in pension & OPEB assumptions. Ag Equipment demand in DE’s key markets is in free fall; management ought to have included a larger buffer to accommodate continued deterioration. The outlook instead appears to assume stabilization at current run-rate levels.
Short Squeezes: For longs, the aggressive, low quality guidance risks an outlook cut later in the fiscal year. Who wants to buy DE shares on that? For the moment, the answer is weak longs and those trying to pick an Ag Equipment cycle bottom. We plan to wait for a fairly clear squeeze to add it back as a Best Ideas short, even though that strategy risks missing the next down move in the shares.
Big Picture: Our view is that the Ag Machinery industry is in a 1980s-lite scenario, a case we laid out in our Twin Peaks & Mid-Cycle Myths black book. In major capital equipment downswings, management and investors are typically surprised at just how far demand can fall. The recent downturn in mining equipment is a good example - sales of new equipment pretty much evaporated. Used equipment often competes with new equipment just as deteriorating borrower credit disrupts financing. If our view for the Ag Equipment industry is accurate, sales levels should continue to slip from the lofty 2013 peak.
Weak Guidance Strategy: The character of the FY2016 guidance may prove to be another hit to management credibility* following the unneeded FY2Q to FY3Q guidance fiasco. We would have expected management to guide to consensus, and then hope to ratchet the outlook higher over time. Fiddling with actuarial assumptions and guiding higher than needed is likely to be unhelpful. The guidance also assumes that the free fall in equipment sales abates, which may prove optimistic.
Implied Decrementals Not Too Aggressive: Maintaining current FY15 decrementals should prove challenging as DE cuts production to abnormally low utilization (e.g. single shift). However, guidance assumes a drop in decrementals excluding the benefit of the Pension/OPEB assumption change.
Yield Expectations Also Reasonable: Sure, yields could drop a bit.
Lowering Costs Through New Pension/OPEB Assumptions: A driver of the higher guidance relative to expectations is Pension & OPEB expense, a huge 2016 tailwind. In late 2014, DE’s FY2015 guidance included a far smaller $85 million headwind. It is a low quality cost decline, but it has also been a market where accounting quality has been largely ignored. It may push out the DE short case, which is increasingly shaping up as a late FY16/FY17 story.
Source: Company Filings
Units Likely Unreasonable: DE is a short thesis that is in the process of playing out, we think, and it is easy to mistake ‘new lows’ for a ‘bottom’. Cyclicals also tend to look “cheap” all the way down. Guidance assumes a significant deceleration in unit sales declines, by our estimates. Sales are in a free fall from very high productivity adjusted levels. In the late 1990s and early 1980s, unit declines continued at a pretty severe pace without much let up. Early order indications for 2016 have been horrific vs. 2015 levels (which were already down). Declines from peak look large, but can readily continue. There is no quick cure for too much industry capacity/equipment.
Too Reliant On Deere Financial, Especially Into FY17: The 2016 profit outlook also relies heavily on Deere Financial. Credit quality is likely to follow softening metrics like farm values, used equipment prices, and past dues. As the portfolio shrinks into FY17, in our estimates, Deere Financial may prove an uncertain source of a high percentage of DE’s profitability.
ICYMI - Why the strong quarter? Continuing the low quality theme, much of the beat relates to a lower tax rate.
Upshot: DE gave low quality guidance that exceeded consensus, a strategy we think may backfire later this fiscal year. While the key components of the guidance look conservative at first, the outlook assumes stabilization in collapsing unit sales – a very tall order given our view of industry trends. DE’s outlook also benefits heavily from a convenient change in pension & OPEB assumptions. Long-term, we think DE is trapped in a less severe version of the 1980s Ag Equipment down-cycle, offering perhaps ~30% relative downside from current levels. DE is increasingly shifting to an FY17 story, as well. Shorter-term, we expect the report to pressure bears and allow us to repeat our ‘short-a-squeeze’ strategy.
DE & Segment Margins
*To clarify, we believe management is doing very well with what they have. Unfortunately, outside of subject experts, few market participants are likely to notice as the cycle overwhelms excellent execution.
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Takeaway: Domestic economic growth continues to slow on a trending basis, effectively threatening the consensus 2016 recovery narrative.
2016 U.S. Consumer Recession?
I’m off today flying back to Seattle to spend five days with my family. While our profession + modern technology = you’re never truly offline, I generally try to shut it down this weekend given that I don’t see them very often. That said, however, I can’t help but smell the stench of this morning’s #GrowthSlowing data from 35,000 feet in the air.
The most important U.S. economic data release we’ve received in 4Q15-to-date came out this morning in the form of Personal Income & Spending data for the month of OCT. From the prospective of our rate-of-change framework, the key takeaways from the release are two-fold:
- Real Personal Consumption Expenditures – which account for 69% of GDP – decelerated a fair amount, settling at +2.7% YoY from +3.1% in SEP. Real household consumption growth is now decelerating on a sequential, trending and quarterly average basis.
- Real Disposable Personal Income held flat at a healthy +3.9% YoY, but the +30bps sequential uptick in the Household Savings Rate to 5.6% caused growth in the headline consumption figures to decay.
Point #2 above corroborates the trending deceleration we’ve seen in consumer confidence, as most recently highlighted by this morning’s University of Michigan reading for the month of NOV, as well as the Conference Board reading which was released yesterday morning. True to its volatile form, the former index showed sequential strength in NOV, while the latter plunged and is now decelerating on a sequential, trending and quarterly average basis.
While the aforementioned volatility in the UMich index makes the data set less substantially predictive of forecasting recessions, the somewhat linear nature of the Conference Board index makes it one of the key indicators for timing peaks in the economic cycle.
With consumer confidence slowing in conjunction with dramatically steepening base effects for Real PCE growth and sharply receding base effects for Headline CPI, the most likely scenario with respect to domestic economic growth is that the U.S. consumer continues to decelerate – perhaps meaningfully – from here.
Specifically, the next four quarters of compares for Real PCE growth are the toughest since the four-quarters ending in 3Q08 and the next four quarters of compares for CPI are the easiest since the four quarters ended in 4Q11. It’s worth noting that Real PCE growth decelerated sharply from +2.7% YoY in AUG ’07 to -1.2% in SEP ’08 and Headline CPI recorded a massive acceleration from +1.1% YoY in NOV ’10 to +3.9% in SEP ’11.
While we’re not anticipating a similar crash in household consumption or a commensurate rip in CPI, we do think the principles of differential calculus are in our favor with respect to our anticipation of an outcome that is decidedly worse for Real GDP growth over the intermediate term (i.e. growth in the key driver “C” slows, while the GDP deflator accelerates). In a meeting yesterday, a very astute client summarized our analysis perhaps better than we could have:
“… If you’re saying Real PCE growth slows to 1% annual growth over the next 6-9 months, the U.S. economy could indeed experience a technical recession with the S&P 500 down -20% on that.”
Bingo. Why would you care to make it any more complicated than that?
Not All Is Bad, However
Since we are data nerds, however, we do care to sweat the small stuff. In the week-to-date, there has indeed been a few data points that have made us less right on our cyclical outlook for the U.S. economy, at the margins:
- Growth in the New Orders components of Durable Goods and Core Capital Goods ticked up in OCT. Despite this, both series are still contracting on a YoY basis – effectively implying a continuation of the domestic industrial recession as most recently highlighted by the NOV Markit Manufacturing PMI reading;
- The YoY growth rate of the 4-week rolling average of NSA Initial Jobless Claims decelerated to -8.2% YoY from -6.5% prior, which implies continued improvement in the domestic labor market; and
- Corroborating continued improvement in the domestic labor market were the sequential upticks in the Markit Services and Composite PMI readings for the month of NOV given that SMEs account for 98% of total U.S. employment.
All that being said, the 2016 outlook for a recovery in domestic economic growth largely hinges on continued strength in household consumption. To the extent Consensus Macro is wrong on its outlook for the U.S. consumer, you can expect negative revisions to both top-down GDP and bottom-up EPS estimates for 2016E.
For our latest thoughts on why a U.S. (and potentially global) recession is likely to commence in 2016, please review the following presentations and research notes:
- U.S. Economic Cycle Indicators: http://docs3.hedgeye.com/macroria/Hedgeye_U.S._Economic_Cycle_Indicators.pdf
- Global Demographic Analysis: http://docs3.hedgeye.com/macroria/Hedgeye_Global_Demographic_Analysis.pdf
- What’s Driving Our Bearish Forecasts for Domestic and Global Growth? (11/9/15): http://app.hedgeye.com/feed_items/47442
- Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? (11/19/15): http://app.hedgeye.com/feed_items/47658
Enjoy your Thanksgiving weekend with your respective families!
In this brief excerpt from The Macro Show this morning, Hedgeye CEO Keith McCullough discusses quantitative easing and explains how to respond to any economist at your Thanksgiving dinner table who thinks the U.S. jobs market is great.
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