Monday, 1 October 2018

Macro and Credit - The Armstrong limit

"Men go abroad to wonder at the heights of mountains, at the huge waves of the sea, at the long courses of the rivers, at the vast compass of the ocean, at the circular motions of the stars, and they pass by themselves without wondering." - Saint Augustine

Watching with interest the Japanese Nikkei index touching its highest level in 27 years at 24,245.76 points, with US stock indices having rallied strongly against the rest of the world during this year, and closing towards new highs, when it came to selecting our title analogy we decided to go for another aeronautic analogy "The Armstrong limit". The Armstrong limit also called the Armstrong's line is a measure of altitude above which atmospheric pressure is sufficiently low that water boils at the normal temperature of the human body. Humans cannot survive above the Armstrong limit in an unpressurized environment. Above earth, this begins at 18-19 km (59,000-62,000 feet) above sea level. The term is named after United States Air Force General Harry George Armstrong who was the first to recognize this phenomenon. Commercial jetliners are required to maintain cabin pressurization at a cabin altitude of not greater than 2400 m (8,000 feet). The Armstrong limit describes the altitude associated with an objective, precisely defined natural phenomenon: the vapor pressure of body-temperature water.  Back in August in our conversation the "Dissymmetry of lift", we discussed our Quantitative Tightening (QT) amounted to reducing global liquidity and tightening global financial conditions overall as well as less airflow to maintain growth (we are already seeing signs in Europe).  When it comes to airflow and liquidity relating to equity indices we touched in this subject in two previous conversations: "The Coffin corner" in April 2013, the other being "The Vortex Ring" in May 2014. When it comes to our analogy and our reference to the Nikkei and US equity indices we remember clearly that the Nikkei hit its all-time high on 29 December 1989, during the peak of the Japanese asset price bubble, when it reached an intra-day high of 38,957.44, before closing at 38,915.87, having grown six fold during the decade. Sure the S&P 500 has grown six fold during the decade since the collapse of Lehman Brothers but it's within 1% of its all time high. One question investors are starting to ask themselves is what is the "Armstrong limit" for US equities? Bank of America Merrill Lynch in their recent The Flow Show note from the 27th of September entitled "Jay stalking" have two very interesting charts when it comes to equity allocation from Global Wealth and Investment Management (GWIM) into equities and cash allocation levels:
- source Bank of America Merrill Lynch

One might indeed wonder what level is the "Armstrong limit" before boiling point we think...

In this week's conversation, we would like to look at once again at the US consumer which seems to be increasingly relying on his credit card as well as other signs that warrants monitoring at this stage in the cycle.

  • Macro and Credit -  What's the Armstrong limit for the US consumer's confidence?
  • Final charts - The "profit" illusion

  • Macro and Credit -  What's the Armstrong limit for the US consumer's confidence?
In continuation to our last conversation, we think it is essential for the US growth outlook and forward earnings to continue to focus on the state of the US consumer. After all, the first on the line in any case of trade war escalation is the US consumer who gets the price increase passed onto by corporations facing a surge in costs. With the US consumer confidence index climbing to 138.4 in September from 134.7 in August, the highest since September 2000 we are wondering if it is the absolute Armstrong limit.

On this question we read with interest Wells Fargo's take from their US Consumer Confidence note from the 25th of September:
"In the past 51 years, only 11 times has confidence been higher than it is today. Said differently, roughly 98% of the time confidence is lower than it is now. That’s good news for the consumer, but for how long?
Remember the Sock Puppet Commercials?
The last time consumer confidence was as high as it is today was in the year 2000. A number of financial and economic indicators from that era are similar to where they are today. The stock market was soaring to all-time record highs, the unemployment rate was below 4% and the economy was in its 10th year of uninterrupted expansion. Then, as now, there were few people seeing an end in sight.

While we still think the current expansion has room to run, we would be remiss not to make note of just how rare a thing it is to see confidence at these lofty levels. Only in 11 individual months since 1967 have we seen confidence higher than it is today. Nine of those months were in the year 2000. The other two were in 1999. This is the thin air of the high peaks.

The euphoria is not limited to the consumer sector. The ISM manufacturing index is at its highest level since 2004 and the NFIB Small Business Optimism Index, an indicator of small business confidence, is at its highest level on records that date back to 1974. The fact that these measures are at record highs does not preclude them from going higher, but one characteristic that they all share is a tendency to peak before a slowdown.
No Time Like the Present
There is an interesting dynamic going on between consumers’ assessment of the present situation, compared to expectations for the future. As seen in the middle chart, the present situation measure is running well ahead; in the prior cycle there was a similar divergence late in the cycle.
Some Things That Are Different From 2000
The below chart plots consumer confidence alongside both retail sales (ex-autos) and real income growth on a per-capita basis. Here we see something that Fed policymakers have been wringing their hands over throughout this cycle, which is: if the labor market is so hot, how come income growth is so tepid?

That slower income growth tempers our enthusiasm for the ability of consumer spending to sustain growth indefinitely. We will get the latest read on this when the personal income and spending numbers hit the wire on Friday of this week.
I Don’t Know Why I Go to Extremes
For now, the surge in retail sales cannot be denied and we would be foolish to bet against the consumer with such a solid backdrop for consumer confidence. The official write-up that accompanied the release stated that “Consumers’ assessment of current conditions remains extremely favorable, bolstered by a strong economy.” We would not disagree, but what takes the shine off the apple for us is that extremes, by definition, imply “reaching a high, or the highest degree.” If this is the extreme, there is nowhere to go but down." - source Wells Fargo
With US Personal Income rising 0.3% in August, slightly less than expected (0.4%) last Friday, then indeed slower income growth should indeed temper slightly your enthusiasm we think.

As a reminder from last week's conversation, and as per the below Macrobond chart, the University of Michigan Consumer Confidence turning points tend to coincide with significant S&P 500 12 months return. It is worth remembering this from an Armstrong limit perspective:
- graph source Macrobond (click to enlarge)

Also, keep that in mind when looking at the significant rise of the S&P 500, because we think that we are in the melt-up "euphoria" phase and have yet to touch the "Armstrong limit":
- graph source Macrobond (click to enlarge)

Or you could also ask yourself as well what is the "Armstrong limit" when it comes to the S&P 500 Profit Margins in this long in the tooth credit cycle:
- graph source Macrobond (click to enlarge)

You could as well ask yourselves when will we reach "peak" M&A, which is also a sign you generally see in late credit cycles:
- graph source Macrobond (click to enlarge)

In last week's conversation, "White Tiger" we indicated that although everyone is focusing on the flattening of the yield curve, from an inflationary expectations perspective we worry a lot for asset prices about a spike in oil prices if we do get geopolitical flares up in November between the United States and Iran:
"The issue of course for the stretched US consumer would be if Core PCE inflation continues to pick up slightly faster than core CPI if healthcare service price inflation accelerates while rent inflation gradually slows. This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further, not to mention the issue with gas prices at the pump should oil prices continue as well to trend up. Remember that the acceleration of inflation is a dangerous match when it comes to lighting up/bursting asset bubbles." - source Macronomics, September 2018
So for us, from an Armstrong limit perspective, we are closely watching the evolution of oil prices:
- graph source Macrobond

An inflation spike is very much on our radar. Oil has extended its gains after the longest quarterly rally in a decade thanks to a slowdown in American drilling as well as supply concerns. The U.S. and Saudi Arabia have discussed market stability yet it seems there are some questions relating to spare capacity with traders highlighting a potential surge towards $100 a barrel at some point. 

From an Armstrong limit perspective relating to the state of the US consumer, oil prices matter because not only retail has been sustained by the rise in credit card use but housing is seeing headwinds already thanks to rising mortgage rates. The issue at hand is the size of energy costs for the US consumer relative to his consumer spending. On that subject we read with interest Wells Fargo's take from their note from the 28th of September entitled "What Good is a Bigger Paycheck if it All Goes to Gas Money?":
"Wages and salaries posted the largest monthly increase since January, but increasingly higher gas prices and other energy costs are commanding a larger share of consumer spending.
Income Gets Boost from Wages
Personal income increased 0.3% in August, which was a bit shy of the 0.4% that had been expected by the consensus.

More than two thirds of the increase was due to the fact wages and salaries notched a solid 0.5% gain. That was the best monthly increase since January and the latest indication that the hot job market is at last translating into meaningful improvement in wages.
Personal interest income, which comprises less than a tenth of overall income, was down for the second straight month and was in fact the only category of personal income that declined during the period.
Energy Costs Taking up Larger Share of Consumer Spending
Despite the slightly softer print on the income side, spending did not disappoint with the 0.3% pick-up in outlays, matching the consensus expectation. The fact that wages and salaries drove much of the increase explains why the saving rate was able to remain unchanged at 6.6%.

Consumer durable goods outlays slipped 0.1%, but every other major category of spending was either flat or positive to varying degrees. Echoing one of the themes from the August retail sales report in which gas stations reported faster sales than other types of stores, the biggest category gainer in terms of price was energy goods and services, up 1.9% on the month. This category includes spending on gasoline but also includes energy goods delivered to the home through utilities like electricity and natural gas. The takeaway is that higher energy prices in August might have been holding back spending in other categories. Excluding food and energy, spending was flat in August.
Inflation Dynamics
People are not suddenly buying a lot more gasoline. Prices, of course, are largely to blame. The energy prices category within the price indices has seen double-digit percentage gains in each of the past four months. Mercifully for consumers, prices for durable goods have also been lower in each of those past four months, ameliorating the impact of higher energy prices. The headline measure for the personal consumption expenditures deflator, the Fed’s preferred inflation gauge, slowed slightly to 2.2% from 2.3% on a year-over-year basis in July.

Existing tariffs on a variety of imports totaled roughly $100 billion in August; with this week’s additional tariffs on $200 billion going into effect, the price effects for consumers might become more tangible. The nation’s largest retailer this week warned that it might be forced to charge higher prices.
In its statement earlier this week, the Federal Reserve noted that “inflation on a 12-month basis is expected to move up in coming months” before eventually stabilizing near the Fed’s 2% target rate." - source Wells Fargo
Tariffs and rising gas prices do not bode well for the euphoric US consumer we think in the near future. Sure US equities, consumer confidence and even US High Yield have had a very good run in 2018 (CCCs have outperformed higher quality by a wide margin: +5.6% of excess returns) in comparison to the rest of the world, so it's highly likely that the "risk-on" euphoric mood will continue given financial conditions are still fairly accommodative (as per the most recent Fed SLOOs), but we think that 2019 could start becoming much more challenging as QT accelerates and depending on the Fed's hiking path as we are officially out of negative real rates for now.

In continuation to our “macro” long conversation “The Money illusion”, where we concluded that liquidity is a coward and where we repeated what we indicated back in June 2015 from our conversation "The Third Punic War", bear markets for US equities generally coincide with a significant tick up in core inflation, given the amount of buybacks since with the issuance of debt in many instances in our final charts below, we are wondering if there could be as well a "profit illusion" when it comes to the US markets.

  • Final charts - The "profit" illusion
Sure, liquidity is a coward and as many have pointed out, with dwindling inventories on banks balance sheet and the very significant rise in corporate debt issuance in credit markets, one can indeed ask if "liquidity" is an illusion. On the question of the "profit illusion" our final charts come from our esteemed former colleague David P. Goldman who now writes in Asia Times and ask if buybacks are creating the illusion of profit in his article from the 28th of September entitled "Something strange is happening with US corporate profits":
"Are companies creating the illusion of higher profits through stock buybacks? 
It was reported earlier this week that S&P 500 companies bought back a record US$189 billion of their own shares in the first quarter of this year. The buybacks make results look better than they really are, as The Wall Street Journal reported.
The charts below show that raw, unadjusted US corporate profits actually FELL year on year, and corporates are creating the illusion of higher profits by buying back shares.
This is the rawest, simplest measure of profits, before tax and inventory/capital consumption adjustments, which are model driven. This is basically what corporations report on their income tax, and it doesn’t look terribly strong.
Are profits rising or falling? 
- source Asia Times - David P. Goldman

One could contend that the boiling frog which is a fable describing a frog being slowly boiled alive, could be related to the Armstrong Limit looking at the altitude reached by equities and some valuation metrics. As a reminder, the premise of the fable is that if a frog is put suddenly into boiling water, it will jump out, but if the frog is put in tepid water which is then brought to a boil slowly, it will not perceive the danger and will be cooked to death. The story is often used as a metaphor for our inability or unwillingness to react to or be aware of sinister threats that arise gradually rather than suddenly such as the markets we are seeing one could argue. Though some would add that "thermoregulation" by changing location is a fundamentally necessary survival strategy for frogs and other ectotherms, rendering the legend a "myth". From an Armstrong Limit perspective, we certainly hope that some investors have their "g-suits" on given the lofty levels reached in some instances. Also we do not know yet what is the Fed's own "Armstrong limit" in their current hiking path but we ramble again...

"There can be no rise in the value of labour without a fall of profits." -  David Ricardo

Stay tuned !

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