Lots Of “Bull” In The Bull Market- Let’s Look At What’s “Really” Growing- By NEIL SISKIND

BY NEIL S. SISKIND

Wall Street Bulls, including, analysts, CEOs, and asset managers from investment banks, continue to say that earnings and the stock market will grow into and throughout 2019, and into 2020, because the economy is getting stronger and is growing.

Really? The economy is growing?

Some of the bullishness is starting to sound … well … like bull.

What is it in the economy that is growing? The GDP? Consumer spending? Real wages? Home values? A positive trade balance? Earnings and guidance?

No. No. No. No No. And- we’ll see.

Let’s review the actual data we’ve seen in recent months to see if the economy really is “growing”:

  1. The most recent PPI print came in lower than expected.
  2. The most recent CPI print came in lower than expected.
  3. The most recent consumer spending prints came in lower than expected.
  4. The GDP is expected by all to be lower than in the second quarter. So, it’s growing- less and less. It’s expected to grow, less and less, in each quarter following Q2 of this year.
  5. Interest rates are rising on all ends of the curve.
  6. Housing is slowing. Home-building permits dropped in August by the most in seven years.
  7. The S&P Supercomposite Homebuilder Index just had its biggest annual drop since 2008.
  8. Non-defense capital goods orders excluding aircraft, which is considered a proxy for business investment, fell in August.
  9. Copper is in bear market territory.
  10. The breadth of equities that are rising is narrow.
  11. The EU announced it is weaker than expected (slower than expected growth in a major U.S. export market).
  12. China’s numbers are slowing- by its own hand and due to the new tariffs (slower than expected growth in, and a trade dispute with, a major U.S. export market).
  13. EM currencies and equities have been sinking (Turkey, Argentina, The Philippines, and others), with possible contagion risks.
  14. We receive data and earnings from public companies. But, earnings and stresses of private companies, often having less scale than their public counterparts, and which are, thus, more susceptible to input cost pressures, are, largely, unknown.

Here are the things that are “growing”:

  1. Consumer debt is growing. In May of this year, when the GDP hit 4.2% growth, consumer debt rose to a six month high. Overall consumer debt is now $618 billion higher than the previous peak of $12.68 trillion in the third quarter of 2008 (how’d things go after that?).
  2. Interest rates for businesses and on credit cards are growing.
  3. Mortgage rates for home buyers are growing.
  4. Corporate debt, and debt to cash ratios, are growing.
  5. The federal deficit and debt keep growing.
  6. Jobs with dead-end wages keep growing.
  7. The trade deficit is growing.
  8. Treasury sales to fund the federal deficit are growing.
  9. Energy prices are growing.
  10. Taxes (tariffs) on consumer goods are growing.
  11. Risks to China’s financial stability- and contagion risks to other Asian markets- may be growing.
  12. Investments in riskier corporate debt obligations are growing.
  13. Trade uncertainty and the effects on the economy are growing.
  14. Loans by unregulated “alternative” or “hard money” lenders to businesses and for real estate are growing. It’s estimated that 80% of mortgages today are from alternative (non-bank) lending sources.
  15. Large corporations taking all the available labor and leaving small businesses across America short-handed is growing.
  16. Large businesses scaling so large that small businesses can’t compete on price or on service and going out of business are growing.
  17. Economic inequality in America is growing.

Here are examples of Wall Street’s denials of realities that keep “growing”:

  1. Higher gasoline prices won’t matter to consumers until oil is $100.00 per barrel.
  2. The messages of the yield curve are different this time.
  3. Tariffs are not high enough to affect consumers or businesses.
  4. Oil prices are rising because of global economic strength.
  5. Earnings are all that matter (true- but, those earnings come from somewhere- from the real economy).
  6. We’re not in the late stages of a business cycle. It’s different this time. We extended the cycle.
  7. Because EM economies are so weak- America’s economy is very strong. (Really? Is this how it works?)
  8. The consumer will remain strong because of low unemployment. (Really? Wages, gasoline prices, credit card interest rates, tariffs, and debt don’t matter?)
  9. Wages are rising. (Real wages are not rising.)
  10. Interest rates are historically low, so the economy and stocks will stay vibrant. (Really? So, interest rates in 1985 control business planning today? What do rates in 1985 or 1997 matter to rates rising on the debt on corporate books today, or to business forecasts that are based on present yields? History is immaterial to business planning. Also, rising Treasury yields compress stock multiples, as rising yields for less-risky Treasuries may offer similar returns to what can be expected from risk assets under present and future conditions. So, it has nothing to do with history.)
  11. Fiscal policy is a tailwind going forward that will offset all other challenges, like monetary policy, stagnant wages, and tariffs.
  12. Companies will be able to pass-through rising input costs to consumers, because consumers have jobs.
  13. Job growth proves that the economy is growing. (Job growth is an element of the economy, but large companies taking on cheap labor, while small businesses can’t find people does not prove overall economic growth. Amazon and Home Depot grow, while small retailers across America close their doors.)

Are earnings “growing”?

Just be aware that earnings per share can be manipulated higher by companies repurchasing their shares or taking other measures to reduce their respective floats, making it look as if EPS has grown (Wall Street doesn’t like to talk about this too much). Share buybacks are at historical highs. Share buybacks can be good for shareholders (if such buybacks were the best uses of companies’ retained earnings and if no burdensome debt was incurred to make such buybacks) because they increase the values of the remaining shares. EPS has grown- but, this does not mean that the economy is strong, or even that that company has grown.

Even if revenues grow, remember that spending comes from income- as well as from debt. Consumers like to spend- but you also have to look at the debt they accumulate to achieve that spending and to cause those higher revenues.

Revenues of a business may show that consumers are spending, and such growth is not only by EPS growth due to share buybacks- it’s real growth. But, while sales revenues that come from debt is good for businesses (short term), it can be bad for consumers and the economy, and for everyone, in the long term (see 2007-2008).

The same goes for the GDP. GDP is a measure of spending, including by the government. The GDP can go higher and higher- it can grow and grow- the question is how much government debt-spending is in the number. Just ask China how this works. Ask the Soviet Union about its experience with this in the 1980’s. Or, just look at the Reagan-era deficits that had built up, leading to tax increases by Congress and the subsequent administration. Or, ask Greece.

In any event, with the PPI, the CPI, and consumer spending disappointments, and rising interest rates, tariffs, and higher gas and oil prices- let’s see how companies guide for future quarters. I expect that guidance, overall, will disappoint.

Semiconductor demand, or lack thereof, is a leading indicator for the economy- and memory chip demand is deteriorating.

Stocks’ sales-to-price ratios are at historical highs.

It’s rarely mentioned anymore that confidence surveys are often contrarian indicators.

Tight labor markets, rising energy prices, and a tightening Fed, all are markers of the late stages of a business cycle- so this tells us where we are in the cycle, and are signals not to be ignored. It can be argued that a low level of rising wages this late in the cycle would be less helpful to consumers than they would be damaging to businesses, as just another ding to margins- which could lead to layoffs. People have to realize that there is good inflation and bad inflation; and it’s not only the type of inflation it is that makes it good or bad- it’s also the timing of the inflation that matters. For example, wages rising early-on in a business cycle, as interest rates are low and as earnings and the GDP are growing, is a positive. Late in a cycle, wage inflation can do more harm than good, if, rather than being a demand side stimulus, it leads to layoffs as it accompanies other rising input costs and/or rising interest rates. (The cause of the inflation must also be understood. For example, increases in oil and gas prices can be due to economic growth, which, generally speaking, is good- or, price increases can be because of supply constraints, such as those due to sanctions or embargoes, which, at any point in a business cycle, is bad.)

The consumer and the S&P, which can track each other to a degree, have been strong this year- but interest rates were lower, gas prices were lower, and there were, relatively, few tariffs. All of that has changed.

And where is the trickle-down effect of the tax cuts? Analyses of capex investments are all over the map, but no significant capex has been proved- and certainly none that has led to higher real wages. Businesses certainly have invested in their own shares- but in the economy through capex? It’s not clear. Business investment is the most important element of GDP that we need to see grow right now- as opposed to more consumer and government spending on leverage. Trade disputes have no doubt hindered this endeavor for many companies.

Oil supply constraints due to sanctions on Iran at the same time as consumer product prices are likely to rise due to tariffs on Chinese products is too much for the economy to bear at a time when monetary policy is withdrawing liquidity from our economy and from the world through both target Fed funds rate hikes and quantitative tightening. Rising oil prices can be managed by an economy with low interest rates, an expanding GDP, and rising wages- but not with none of these. Oil prices and tariffs that are elevated due to policies will not alleviate with higher interest rates, as in a typical business and inflation cycle. Higher short term rates can collapse an economy experiencing rising consumer prices that are due to “non-growth” factors, by destroying demand, rather than steadily slowing the growth in prices to achieve price stability- because these aren’t demand issues.

We have been in a slow grind downward on the economic numbers, as challenged housing data, spending data, and political problems keep hitting the market. Stocks have been up-and-down, recently, while yields are on the rise all across the curve. China and the U.S.’s economic data have been slowing due to reductions in liquidity, per domestic policies, combined with trade concerns. Non-growth oriented inflation (tariffs and tight energy supplies due to sanctions) and higher interest rates are hitting world markets. Housing markets in China and the U.S. have slowed. Earnings and stocks have declined in China- and U.S equities are the Bulls’ last argument left to show anticipated economic growth. With all of the aforesaid, you’d have to be totally oblivious to economic matters to not see we are in the midst of an economic slowdown- solid growth in the S&P and FANG stocks this year, notwithstanding. That’s the past. Just as with the consumer- the headwinds are gathering, and the data show it.

I expect negative GDP growth to start (or, at the least, positive GDP growth to stop) during either the first quarter or the second quarter of 2019, unless there is a trade deal with China and significant capex- soon. Watch housing (because the Fed probably is), watch oil, watch for job cuts as input costs rise, watch consumer debt.

If we’re not going to see more growth at or near the same rate as heretofore, why has the 10-yr. Treasury yield been rising of late? The 10-yr. yield has, in fact, been climbing in the past week (something it has neglected to really do following earlier Fed hikes). Capital flows being re-directed from bonds into oil, energy stocks, and/or bank stocks and bank ETFs, as oil prices and interest rates rise, is more likely the reason (or much of the reason) for the rising yield than are any risk-on sentiments. These are, likely, inflation trades, rather than growth trades- perhaps compounded by concerns over increased Treasury offerings in the future, while the economy slows, combined with quantitative tightening. Investors may also be seeking equities of companies with pricing power that can benefit from, or at least shield themselves from rising prices. Finally, China’s holdings of 10-yr. Treasuries are shrinking. I would hesitate to conclude that rising yields are due to a wide belief in on-going organic earnings and economic growth in the U.S. or abroad. How can organic earnings rise while energy costs, labor costs, prices on consumer products from China, and the cost of money rise- all as consumer spending is in decline? Any inflation we are seeing in oil and interest rates and consumer products is U.S. policy-driven, and not demand-driven. It’s a distinction that makes all the difference- especially as the Fed raises rates.

It’s not demand-driven or growth-oriented inflation and higher interest rates that threaten the economy (i.e. typical inflation)- it’s rising political-oriented inflation (oil sanctions, tariffs) combined with rising rates, that will cause lessening of demand (and layoffs), or deflation. A sort-of stagflation (especially if the dollar weakens). (If these political-oriented inflation points reverse, or are effectively counteracted, my thesis of the timing of a slowdown or recession would be extended-out.)

If supply-constrain induced inflation (rather than growth-induced inflation), due to U.S. policy, is, in fact, the cause of curve steepening, the steepening should, eventually, reverse, due to demand destruction, or, in the case of oil, due to more supply coming online- or from risk-off re-asserting itself, moving investors from energy back to bonds (though, the movement from bonds to the energy sector by investors in order to protect against or benefit from policy-driven inflation is not what I would call risk-on). This said, the combination of quantitative tightening and growing Treasury auctions to fund the budget deficit could cause the curve to remain steep. This would be very bad news for the economy if rates on longer term obligations should remain elevated due to the deficit- rather than due to growth- when the economy needs them to decline, due to slowing.

To that latter point, how would the federal budget be funded if and when tax receipts to the government begin to decline? With interest rates so low, the Fed would have little room to help on the monetary side (which is probably why the Fed looks for any scintilla of inflation as a reason to raise rates). Certainly, fiscal stimulus has reached a high-water mark. We can’t keep selling bonds to fund the budget, and send longer term yields higher and higher. The budget has to be funded, largely, by tax income.

Such a scenario of tax receipts declining while the deficit keeps growing would leave only one option …

… Our tax rates would start growing.

_________________________________

endnotes

  1. Fed Chairman Powell was asked today what he and the Fed are “buying” by raising interest rates. As usual, the Chairman refuses to even mention the word “housing” in his statements or Q&A sessions as a consideration of the Committee in raising the target funds rate- even as it’s perfectly clear to everyone how sensitive housing is to interest rates (he did address mortgage origination standards). For me, his silence on this topic has been deafening. I believe he’s been reticent to discuss anything even remotely related to a housing bubble for fear of causing panic.
  2. A few things to note about advice from people on “Wall Street” (analysts, CEOs, and asset managers from the large investment banks) to keep in mind as you evaluate markets and the economy:
  • They either didn’t see or didn’t warn us about the 2007 housing crisis (while some investment banks were selling housing-related securities short).
  • They touted a “global synchronized growth” story for months in 2017 and 2018 that never panned out- it’s been quite the opposite.
  • They spent the latter part of 2017 and early 2018 recommending emerging market stocks and bonds to everyone. Great call!
  • You never see calls from investment banks about shadow banking risks (even China had enough sense … and transparency … to try to acknowledge, address, and reel theirs in). The whole shadow banking issue is addressed only by “Wall Street” when brought up by others (such as by Bloomberg’s first class anchors), and gets glossed-over by many financial industry interviewees. The alternative lending/hard money lending risks percolate below the surface, along with other non-regulated, high-return debt investments.

In light of the above, when “Wall Street”, over and over, stresses a 2020 slowdown in the economy and stocks – you can be sure that investment funds and asset and portfolio managers will not be waiting until 2020 to do something about it. In 2019- not in 2020- they will be getting themselves and their clients out of the market or diversified into risk-off assets long before “you” are out. So, don’t wait until the so-called “professionals” call the slowdown and alert you about it on TV. It will be too late. Look at the CPI, the PPI, expected GDP, consumer spending, consumer debt, copper, the federal deficit, interest rate trajectories, housing permit applications, energy prices and their effect on businesses and consumers … the slowdown is upon us.

3. Any PPI, CPI, or PCE increases from here would result from tariffs (higher consumer product prices) and sanctions (higher product prices resulting from higher energy costs)- rather than from organic economic growth and demand.

 

NEIL S. SISKIND, ESQ., PRESIDENT
The Siskind Law Firm
Tel: 646.530.0006

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