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In cooperation with ACG Analytics in Washington: Impact Areas, Oil and European Elections

Tillerson Heading to Moscow on the 12th, for Now

Six months ago, if we told you Donald Trump will be elected President, and the first quarter of his administration would see calmest stock market ever?  Would you believe us?

Household and Small Business Sentiment has Surged the Trump Election:

1.  University of Michigan’s consumer sentiment index reached a 13-year high.

2. Last week the Conference Board’s index of consumer confidence rose to its highest level in 16 years.

3. The NFIB’s small business optimism index is at a 12-year high after having recorded its largest-ever two-month increase in November and December.

If we look at Q1 U.S. stock market volatility found in the S&P 500, the average VIX level was down at 11.74  That’s the lowest Q1 level on record, smallest quarterly average since Q4 2006.   Of course, this all changed in April.

U.S. Missile Strike: Syria Implications

If Assad falls, Syria will look like Libya. ISIS moves in for power grab. Proxy groups fight for power amongst themselves and v ISIS. Meanwhile the US consolidates in neighboring Iraq. In Syria, Russia will either pull or commit, US will likely do the opposite (Russia also likely knew about this as the U.S. warned them to leave, to avoid casualties, they told Assad so his air assets scrambled to avoid the strike. Bottom line: Assad has not fallen yet).

VIX Futures Curve Flattening, Speaks to Geopolitical Risk Surge

The 1 Month v 3 Month VIX futures curve, flattest since (Brexit / Trump election).  If hedge funds are paying up for near term protection, typically comes in front of some pain, lower equities.  Our model measures the speed of the flattening, it’s accelerating at an alarming rate. Cash is pouring into the front end, meaning market participants want insurance against a possible near term drawdown in stocks.  Bottom line: the cost of the April contract is nearly the same for three much insurance on the market.  Typically, as in most of this year – the front end is far cheaper than outer months, NOT today. 

Oil Futures Spike on U.S. Strike

Lets be Clear, Syria’s Oil Output is Less than 0.65% of Global Production 

Syrian production is not the entire story here. We think oil implications are meaningful, it is no secret Turkey would like close oil access. This could give Russia a mandate to take ISIS’ oil fields in the south and then deal with Turkey. Assad regime is also ISIS’s biggest customer in the blackmarket oil trade which is protected by Russian air assets, they still hold the oil fields,  Implications here point to the White House.  Trump must decide to commit in the region if Russia doesn’t or see where the dust settles and risk the power vacuum. Shifts in refugee flow could impact Europe – depending on Turkey’s reaction, it’s likely U.S. military action in the region will exacerbate anti-Islam nationalist sentiments in Europe as ISIS fragments move north.  Bottom line, the migration risk from Syria into Turkey and on to Europe is higher now than ever.  This gives populist candidates like Le Pen in France another argument for more aggressive border controls – the influx of refugees into Europe has already created collateral political stress.

Where’s the Trade?

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Trump Lessons in Europe

If there’s one lesson from the Brexit and Trump experience, its don’t listen to establishment (bias) tainted polls.

This time Last Year, we were Lectured by the Global Media:

“There’s No Trump path to victory.”

“We’re looking at an insurmountable blue wall.”

“Trump is polling at less than 7% with women and Latinos, he’s unelectable with those numbers.”

Next

Then Trump won 84% of America’s counties (2623 of 3112), and Michigan, Wisconsin and Pennsylvania for the first GOP win in 30 years in those states.  The lesson, don’t underestimate silent populism.

Today, the France – Germany two year bond spread at fresh five year wides, while final round polling data consistently is showing a 60-40 no contest, Le Pen loss.

Euro vs Le Pen, an Inverse Relationship

As you can see above, as odds markers see Le Pen bets on the rise – the Euro has been on the other side.  The Euro is off nearly 3% since March 27, around the same time Le Pen’s fortunes started to pick up.

With the first round of France’s presidential election less than three weeks away, Bloomberg is reporting the yield difference between the nation’s two-year bonds and similar-maturity German securities has widened to the most since 2012.

Trump’s victory was derived from states hit hardest by globalization, winning Ohio, Michigan, Indiana, Pennsylvania, Wisconsin.

From 2010-2016, wages in these states were off anywhere from 18% to 3%, BLS, Bloomberg data.

Le Pen in France is using the same playbook.

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Two Year Bond Yield Spread, 2013-2017

The latest move comes amid signs traders are starting to put election hedges back on as they enter the month of the election, even as polls continue to show euro-skeptic Marine Le Pen will lose in May’s second round. Per Bloomberg, French candidates are due to hold their second debate later today, with the first round of voting scheduled for April 23.

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March light vehicle sales equate to  16.62 million seasonally adjusted annualized rate of cars sold, this is the lowest pace in 25 months.  Today’s data is confirming a much feared negative trend for U.S. auto sales, they’ve declined on a year-over-year basis in nine of the last 13 months.

Auto sales were sluggish DESPITE BIGGEST INCENTIVES IN 8 YEARS, over $3500 per vehicle for U.S. automakers.

We view this as a sure sign of credit saturation, they’ve reached the last warm body to shoe horn into a new Honda or GMC Sierra.

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The Inequality Decade Rolls on in Ferrari

While the subprime, easy money gravy train (funded by the Federal Reserve) is propping up U.S. auto sales, the Big Winner is found in companies which are inequality’s rage like Ferrari.  With their 2017 high end sales coming in over $400,000 sticker price per car, Ferrari has been a colossal indirect recipient of central bank asset purchases.  The company has thrived in the QE (quantitative easing) / ZIRP (zero interest rate policy) era.   While middle class Americans struggle to make ends meet, Ferrari car sales are up nearly 50%.   In the election that shocked the world, President Trump’s victory was derived from states hit hardest by globalization, winning Ohio, Michigan, Indiana, Pennsylvania, Wisconsin.  From 2010-2016, wages in these states were off anywhere from 18% to 3%, BLS, Bloomberg data.  What’s Ferrari’s stock price and car sales telling us about global inequality and populism’s surge?

While the market attempts to digest the weakness in motor vehicle sales, it is worth pointing out, not all companies seem to be struggling.  Weakness in subprime auto loans along with bloated inventory totals, sent the share prices of GM and Ford much lower in today’s trading. The current weakness in consumer durables that we have also seen in retail, does not paint a very strong picture of how the economy is really doing. However, while excess debt and inventory buildups burden households and large auto makers, some car companies seem to be doing just fine.

Inequality Showing up in the Auto Market

While the big three car companies (GM, Ford, FCA) showed year over year declines in car sales, and other more mainstream brands such as Toyota and Hyundai, also displayed weakness, Ferrari and Maserati did not have much of the same issues. Of course, the numbers for luxury automakers are much more volatile as they sell only a fraction of the cars, but to us it is noteworthy to see Ferrari’s sales rise by almost 50%, while the majors struggle.

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Lessons 2008-16

Redistribution focused Fiscal Policy + $4.5T of Monetary Policy = the largest surge in Inequality in 100 years

Inequality Ratio, USA Leads the World

U.S. 7.8
Germany: 4.3
U.K. 2.7
France: 2.2
Japan: 1.8

*Mean to median wealth per adult, CSFB data

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One of the most reliable risk indicators in our 21 Lehman Systemic Index is the rate of change found in credit spread contagion.

If a fire is spreading quickly, it’s far more deadly.  As we often share with clients, rule number one – credit leads equities.  Since the financial crisis, nearly every significant drawdown in the stock market has witnessed meaningful (accelerated) credit deterioration in the weeks before.  Our model measures this rate of change and quantifies its significance. 

When compared to U.S. Treasuries – junk bond yield spreads have widened nearly 70 basis points since late February, reversing a long run of positive “risk on” spread compression.  Looking back over the last seven years, the S&P 500 declined anywhere from 3.8% to 20.3% in the 11 plus examples of this contagion.

Looking back over the last 10 years, U.S. high yield finished Q1 in its 94 percentile in terms of expensiveness, now that’s rich.

CCC Love

Even worse, the junk of the junk smells like six day old fish but this month has a market embrace resembling a young bride holding on to fresh flowers.

Central Bank Induced Yield Chase, Created a Toxic Cocktail

If we Look at the CCC Rated Bond Universe

Annualized Returns

2008-2017:  16.8%
1996-2008: 1.4%

Bear Traps Report, Bloomberg data

CCC is a very speculative grade assigned to a debt obligation by a rating agency. Such a rating indicates default or considerable doubt that interest will be paid or principal repaid.

Moral Hazard in Energy Lending

Covenant standards in energy lending are at all time lows.  The Bear Traps Report Team reviewed 15 oil and gas producers that have used 72%+ of their borrowing-base credit lines during spring redeterminations by lenders.

The Most Leveraged

Credit-line use exceeds 85% Abraxas Petroleum, Approach Resources, Mid-Con Energy Partners and Rex Energy.

Of course, crude oil price curves declining through 2021 may influence bank decisions on cutting credit lines.

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High Yield vs. Investment Grade Bond Spread

High yield has underperformed investment grade bonds by 25bps over the last 30 days.

2017’s “Junk” Bond Prices

% of Bond’s Market Value

100-115: 73%
95-100: 15%
Below 95: 12%

Bloomberg TRACE, Citi Index data

It’s nothing short of crack smoking insanity.  This month over 88% of high yield bonds were trading north of 95 cents on the dollar. Bloomberg / Bear Traps Report data.

High Yield Gross Leverage

2017: 4.6x
2016: 4.4x
2015: 4.2x
2014: 4.0x
2013: 3.7x
2012: 3.2x
2011: 3.9x
2010: 4.5x
2009: 4.4x
2008: 4.3x (Credit Crisis)
2007: 4.1x
2006: 3.6x
2005: 3.1x
2004: 4.1x
2003: 4.5x (Credit Crisis)

Bloomberg, Bear Traps Report Data, Capital IQ

We’re sorry, the high yield market is not on crack, it’s actually smoking crystal meth.

Total Leveraged Debt Outstanding*

2017: $2.5T
2007: $1.2T
1997: $310B

*subordinated bonds high yield, senior secured high yield bonds, senior unsecured bonds, first lien bank debt, second lien bank debt

Bloomberg, Barclays Credit Agg

Outflows

U.S. corporate high-yield funds posted $248.5m of outflows for the week ended March 29 after seeing an inflow of $736m last week, according to Lipper US Fund Flows data released this week.

Corporate investment grade funds saw inflows fall to $3.97b from $5.24b the week prior.

Investments in fixed-income exchange-traded funds declined 80 percent in the past week. Inflows to ETFs that invest in corporate bonds slowed and high-yield funds saw outflows.

Inflows to U.S.-listed bond ETFs totaled $1.14 billion in the week ended March 28, compared with $5.75 billion in the previous period, according to data compiled by Bloomberg.

Our Larry McDonald ran a $600m high yield and distressed credit business at Lehman Brothers, and is the NY Times bestselling author of a Colossal Failure of Common Sense.

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Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here

Q1 Earnings Season

We’re already through the first quarter of 2017, can you believe it?  More importantly, how high in the bar for earnings seasons?

S&P 500 Earnings Expectations from Wall St.

2018 Street Consensus: $148.10
2017 Street Consensus: $131.45
2016 Operating Earnings: $106.45
2016 GAAP, Real Earnings: $95.35

The Road Ahead

Tax reform legislation climbs a far different mountain than the health bill. In December, we recommended clients overweight U.S. Treasuries, Utilities and Consumer Staples with a focus on “the high probability of political fumbles in Washington.”

Wall St. is Heavily Bought in to Tax Reform’s Success

We noted in December in our Bear Traps Reports, the difficulty congressional Republicans have had in reaching consensus on the health legislation can very easily lead to a pullback from their lofty ambitions on tax reform. Bottom line: the more extreme reform ingredients of the House Republican plan on tax reform are more at risk today.   Hot topics like the border adjustment and interest expense provisions that make up the destination based cash flow tax (DBCFT), will have far more uphill battle passing in an environment where near-unanimous support in the Senate will be necessary.

Expectations from Wall St., Numbers You Need to Know
 
Tax Reform = S&P Earnings Boost Corp*
 
Earnings Premium: New Corporate Tax Bracket vs Earnings Addition to S&P 500 from Tax Reform

32% v 0% (earnings boost)

30% v +3.5% (earnings boost)

25% v +6.5% (earnings boost)

20% v +9.5% (earnings boost)

15% v +12.5% (earnings boost)

Bear Traps Report Data

*This is on top of the Street’s assumed 14% earnings growth based on economic, stock buy back and dividend payout forecasts.

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S&P 500 Earnings

2017: $142*
2016: $116**

*Street’s forecast including successful tax reform
**Actual latest year (trailing four quarters to December 2016) GAAP earnings was $95.35,  latest year “operating” earnings (removes “unusual” items) was $106.45 per Bear Traps and Bloomberg.

 S&P 500 Twelve Month Forward Earnings Per Share Estimate

2017: $134.50
2016: $126.75
2015: $129.90
2014: $131.20

The forward 12-month P/E ratio for the S&P 500 is 17.5. This P/E ratio is based on Wednesday’s closing price (2348.45) and forward 12-month EPS estimate ($134.50).  Of the 111 companies that have issued EPS guidance for the first quarter of 2017, 79 have issued negative EPS guidance and 32 have issued positive EPS guidance.- Factset

As you can see, there’s 200-250 S&P handles tied to tax reform’s MEANINGFUL success.  Without the “expected” earning growth from tax reform, the current 18 PE on the S&P is far higher, well above 20 in our view.

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Wall St’s S&P 500 Targets for 2017

Best Case with Full Fiscal Policy Option: 2810*
Base Case with Partial Fiscal Policy Option: 2510
Worst Case with No Fiscal Policy Execution: 2090**
S&P 500 Today: 2343

We went through 12 different research reports from Wall St’s analysts, these are their best and worst case fiscal policy scenarios.

**Assumes no fiscal policy action (tax reform, repatriation, infrastructure) and a reversion to the mean in near record high CEO, small business and consumer confidence.

*Assumes full fiscal policy execution over the next 12 months (tax reform, repatriation, infrastructure, deregulation).

S&P 500 Sales Growth

2012-2016: 1.9%
2003-2007: 7.5%
1995-1999: 7.2%

Factset, Barclays

On the positive side, you can see why markets are so pumped up on Trump.  Sales growth found while looking at S&P 500 companies only grew at 1.9% during the mature years of the Obama economic recovery.  This data is well below normal levels and speaks to substantial upside if “animal spirits” are fully embraced in the years to come.

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