Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye U.S. Macro analyst Christian Drake. Click here to learn more.
"... In the Chart of the Day below we show corporate profit growth vs forward year returns in the S&P500.
The takeaway is straightforward: While 2+ consecutive quarters of declining corporate profits haven’t always signaled recession, such occurrences have always signaled stock market crashes in the subsequent year."
“Lions Don’t Lose Sleep Over the Opinions of Sheep”
Some version of that mantra must maintain residence in the non-consensus psyche of a contrarian – even if it’s not said aloud.
We’ve been making and defending the late-cycle, growth-slowing call and selling rallies since July.
While commodities, currencies, EM and domestic small caps have been crashing and confirming that view for months, with the Dow and SPX now flirting with double digit drawdowns from their respective highs, our panglossian pushback stream has finally ebbed to a trickle.
Chinese traders getting multiple days off as the market trades limit down within minutes of the open is remarkable but not remarkably surprising.
The path by which being on the wrong side of the global growth curve manifests in interconnected market risk is always uncertain … the net result on prices, less so.
We’ll announce the details of our 1st major acquisition in the coming weeks but even if we never scale headcount beyond our core team from here, I won’t lose sleep.
I’d rather go to (macro alpha) war with 10 lions than a 100 sheep.
Back to the Global Macro Grind …
The capacity for information absorption is inversely related to density.
Drowning this missive with deep analytics may sound impressive and read well in the moment but a week from now most of it will be forgotten.
We are past peak in corporate profitability.
That’s not our contention, that’s simply the data.
The peak in both SPX operating margins and aggregate corporate profits is now rearview – and with growth estimates declining, income and consumption growth slowing, capex plans falling and inventories continuing to grow at a premium to sales, the retreat in margins looks set to persist over the nearer-term.
Earnings growth and corporate profits have been negative QoQ for two consecutive quarters as of 3Q15 and should be negative YoY in back-to-back quarters once 4Q15 is reported.
Earnings recessions have preceded actual recessions in each of the last three cycles and margin contractions greater than -60-70bps have almost always coincided with economic contractions.
The ‘almost’ modifier sits as the battleground point currently.
The last time we saw a significant earnings and margin contraction without a subsequent economic recession was in 1985-86 when oil prices dropped ~60% and profitability in the energy sector cratered, dragging broader EPS growth and profitability down as well.
Superficially, that sounds very much like the current setup – although global macro dynamics and the capacity for policy to cushion a decline are decidedly different.
So, could we again avoid a recession amidst an energy/industrial-centric profit recession?
Perhaps, but that may or may not be the right question.
In the Chart of the Day below we show corporate profit growth vs forward year returns in the S&P500.
The takeaway is straightforward: While 2+ consecutive quarters of declining corporate profits haven’t always signaled recession, such occurrences have always signaled stock market crashes in the subsequent year.
Limit down with no liquidity is the lion’s den for complacently long PnL. Last refuge currency devaluations and the limiting of shareholder sales to 1% of shares outstanding within a 3-month period (the CSRC response to today’s action in China) is a sheepish, reactionary policy response to market gravity.
Complacently long of Gravity is usually the better allocation.
To borrow the poker phrase: If you look around the lion’s den and can’t tell who the sheep is ….
… It’s okay, both sheepishness and asset allocation are (reversible) choices - keep moving.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.09-2.25%
Oil (WTI) 32.06-36.88
To long bonds and long sleeps,
Christian B. Drake
U.S. Macro Analyst
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Takeaway: The excessive amount of capital in play in commodity industries is only beginning to decelerate and inflect.
Below we offer three different conclusions to supplement the credit-cycle section in our Q1 themes deck:
- Planned capital spending cuts are only the first leg of the capital flush needed in commodity related sectors.
- There is a gross excess of capital chasing current production levels, and this excess greatly overshadows the near-term effect of planned capital spending cuts – The market needs an extended period of underinvestment to reduce the excess capital deployed.
- The non-GAAP reporting splurge should get worse with impairments and write-downs as the back side of the cycle plays out.
We outlined the risk that is beginning surface in credit markets in the themes presentation. Coming off the summer 2014 lows in spreads and volatility, credit spreads are now widening on an unprecedented amount of corporate credit outstanding.
Moreover, commodity producers in mature industries have chased inflation expectations with free money to gain a much larger share of this expanding ‘debt pie’. One rhetorical question that we’ll ask with regards to monetary policy’s attempt to create inflation post-crisis:
Has monetary policy, in its attempt to create inflation, actually perpetuated deflation? Or, taking the policy discussion off the table, have inflation
expectations from producers created deflation?
The answer is elusive, but we can probably make at least one conclusion: Free-money policy harvested a credit binge from commodity producers anchoring on higher prices:
Investment banker A says “don’t bother predicting commodity prices. Assume today’s prices (at the highs) and model the economics of digging a hole, pulling something out of it, and selling it. Then we can pitch this free money capital raise to Company X” - Leverage yourself up, and undertake projects at peak margins while everyone else is doing it.
Using a sample of 34 different producers in 4 different subsectors, commodity producer debt as a % of corporate credit outstanding has multiplied ~2.5x in 10 years. This group’s aggregate debt level is up ~5x in 10 years. The chart below shows the jump in commodity producer debt as a share of aggregate corporate debt levels.
To help illustrate the height of the leverage problem as rates move wider, the chart below shows interest expense charges for that same group of 34 producers. Every interest rate cycle since coming out of the early 1980s has led to lower lows in rates, and near the lower bound in rates commodity producers splurged.
Even though a bulk of the financing happened near this lower bound, interest expense has gone straight up over the last 10 years.
Looking at three completely different markets (Energy, Gold Mining, and Potash), these price chasing charts paint the same picture. Projects look attractive to all of the same people at the same time at peak margins:
With one of the conclusions in the deck yesterday being that the deflation sewing investment splurge has taken credit markets to peak leverage, the cyclical bubble charts below show that the move off the low in rates and volatility of mid-2014 is in transit.
And now that spreads are widening, the leverage problem worsens. Once credit spreads begin to widen for an extended period of time, they don’t revert within the same cycle without the commencement of a recession.
A key call-out to monitor with regards to balance sheet trouble with spreads now moving is that a large amount of credit in the commodity space is on the edge of high yield even though much of it still trades like investment grade credit. Looking at a number of large producers in our sample of 34 companies above:
- 9 of the larger producers have $211Bn in credit outstanding that could be tiptoeing the high yield line by late 2016 (arguably longer for BHP and Rio Tinto, but our macro view is not in their favor). That $211B is nearly 3% of corporate credit outstanding
- Several IG credits trade like high yield is inevitable
- 5 of the 9 listed below are on negative watch by Moody’s
To conclude with the most important point of the note, the capital in play chasing each unit of production is excessive and is just beginning to inflect. As mentioned at the top, the market needs an extended period of underinvestment to flush at the excess capital deployed per unit of production across the space, with energy and gold mining exemplified below:
While we look at the delta in aggregate capex as an indicator of capacity coming online, on the unwind, looking at capital in play or capital on balance sheet for every unit produced may be the best metric to gauge the flush.
There is still way too much capital chasing every unit produced, especially when considering the empirical evidence to support that, in general, producers have gotten better and more efficient at producing commodities over the long haul. The supply-side backstop that builds the foundation for a favorable long-term outlook for these businesses takes time to surface.
Conclusion: China and Japan are the latest two economies to demonstrate how our #CurrencyWar theme continues to perpetuate global economic and financial market volatility. Specifically, our work shows the Chinese yuan depreciation narrative is likely to continue weighing on global financial stability, which, in turn, should continue weigh on Japanese equities amid misguided guidance out of the BoJ.
Over the past ~48 hours, Chinese policymakers have enacted various measures designed to stabilize mainland equity markets, with the latest bout of stabilization coming via rumors of pending regulation (read: restrictions) of large shareholders sales. Additionally, Beijing was out reassuring investors that there is minimal risk of a sharp yuan devaluation despite the persistent trend of almost-daily devaluations since early November.
Since its 11/2 post-devaluation low of 6.3154 per USD, the PBoC’s USD/CNY reference rate (which the spot rate is allowed to trade within +/- 2% of) has been devalued by -3.3%. That the CNY has declined by the exact same amount in the spot market speaks volumes to the PBoC’s early success in maintaining the illusion of control over its managed devaluation.
That said, however, one key risk we are picking up on in the spread between the spot rate and the reference rate widening to the largest gap since the August devaluation throughout the WTD. While the -0.4% to -0.5% spread is hardly in the area code of the -1.5% spread we saw prior to the sharp devaluation seen in early August, another [major] cause for concern for Chinese policymakers and investors broadly is the widening spread between the offshore yuan (CNH) and its onshore counterpart (CNY). That gap has widened to -2.2% in favor of the [manipulated] CNY and is the widest spread seen on record.
Source: Bloomberg L.P.
This confirms that persistent capital outflow pressures persist on the mainland, which should weigh incrementally on Chinese economic growth among a myriad of other structural headwinds. For more details regarding those headwinds, we encourage you to review our recent work on China:
- Can Beijing Maintain Exchange Rate Stability Or Is the Chinese Yuan the Next Thai Baht? (11/9/15)
- The Real Reason You Should Be Concerned By China’s Recessionary Trade Data (12/8/15)
- Our #EmergingOutflows Theme Accelerates Into “Liftoff” (12/11/15)
- Structural Headwinds to Chinese Economic Growth (presentation; updated as of 1/6/16)
Investors would do well to disregard China’s trending economic and property market stabilization as something that is sustainable. Just because various measures of Chinese economic growth are no longer careening downhill doesn’t mean Chinese demand for the world’s raw materials and finished goods has reached an investable bottom.
In fact, there remains real risk of cross-asset contagion and further global economic deceleration as a result of the aforementioned headwinds to growth and inflation on the mainland that are perpetuating China’s need to devalue the yuan in the first place. All told, we reiterate our bearish bias on China.
Meanwhile in Japan, that same cross-asset contagion is weighing on Japanese equities (the Nikkei 225 has dropped -6.7% MoM) via a stronger JPY (up +4% MoM vs. the USD). Recall that Japan’s net international investment position is a surplus that amounts to 75% of the country’s GDP (vs. a -40% deficit ratio in the U.S.); this implies that Japanese investors have considerable scope to repatriate capital from global asset markets during episodes of global economic turmoil.
Also a threat to consensus JPY shorts (us included) is BoJ Governor Haruhiko Kuroda’s recent guidance, which continues to be implicitly hawkish. Despite reiterating his “whatever it takes” comments and the BoJ’s willingness to ease policy further in the face of growing speculation that the BoJ may have limited scope to expand its QQE program – they are already the 2nd largest holder of JGBs at nearly 29% of the float, up from 13% prior to the April ’13 QQE launch – he continues to [foolishly] talk up Japanese inflation trends, suggesting that the board’s +2% target for core CPI can be reached without additional LSAP. Moreover, he confirmed that it may take longer to sustainably reach that target because of the ongoing deflation in crude oil prices.
Source: Japan Ministry of Finance
In short, market participants are effectively calling Kuroda’s bluff on incremental QQE because his sanguine and delayed outlook for achieving the BoJ’s inflation target implies less, not more, monetary easing over the intermediate term.
It’s important to note that our analysis suggests the BoJ’s bullish bias on Japanese inflation is quite misguided in the context of Japan’s demographic headwinds.
***CLICK HERE for a full discussion of the global demographic headwinds underpinning our slower-and-lower-for-long theme with respect to the global economy and interest rates.***
As such, it is likely that we’ll need to see both Japanese stocks and market-based inflation expectations continue their respective declines before the BoJ’s hand is officially forced; 10Y breakeven rates have already declined -15bps MoM to 0.69%, which is the lowest level since the Abenomics agenda was introduced back in early 2013.
All told, we think there could be another ~8% of downside in the Nikkei 225 Index – specifically because that would represent a crash from the late-June highs – before the BoJ would be forced by the markets to temporarily arrest economic gravity once again. As such, we find it prudent to [temporarily] downgrade our TREND-duration fundamental investment outlook for Japanese shares to “neutral” from a formerly-bullish bias.
For longer-term investors, we think it’s safe to reiterate our long-term TAIL bullish bias on Japanese equities and long-term TAIL bearish bias on the Japanese yen given the aggressive monetary easing we’re likely to see amid the LDP’s efforts to reach a borderline-ridiculous nominal GDP target of ¥600T by FY20 (requiring a CAGR of +4.6% from here).
That target is certainly ridiculous in the context of Japan’s trailing economic momentum as well as the demographic headwinds highlighted above. The BoJ will be forced by the Japanese economy to do exactly what economist Paul Krugman wanted them to do nearly 15 years ago: “PRINT LOTS OF MONEY”.
Best of luck out there navigating these globally-interconnected risks. Feel free to email us with any questions, comments or concerns.
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