Listen to Credit Markets, Not Polls in Europe

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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

Le Pen vs Euro

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.

FrANCE ELECTION

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

France 2sThe 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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The Inequality Decade Rolls On

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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

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

some car companies

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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What’s Credit Telling Us Now?

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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

IG v HYHigh 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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Earnings Season, How High is the Bar?

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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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On Borrowed Time

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Updated 4/5/17 at 7:10AM ET

In his just released annual letter to shareholders, the CEO of the largest bank in America repeats a warning heard in recent months across this great land.

“It is Clear that Something is Wrong with the U.S.”

When a political novice wins the U.S. Presidential Election with 84% of U.S. counties (2623 of 3112), it’s important to dig deeper than Russian hacking, there’s far more here than meets the eye.

“It is understandable why so many are angry at the leaders of America’s institutions, including businesses, schools and governments. This can understandably lead to disenchantment with trade, globalization and even our free enterprise system, which for so many people seems not to have worked.”

Jamie Dimon, CEO J.P. Morgan

U.S. Credit Deterioration is Picking Up Steam, Fastest Since Lehman

Hardly anyone has noticed, but in the fourth quarter of 2016 there was a surge in financial stress across America, a shift in financial conditions that may have had a hand in the election outcome.

Am I more Likely to Default on a Loan Payment in the Next 12 Months*

Age 35-46 Years Old: 21% vs. 16%
Age 21-36 Years Old: 37% vs 24%

*Data looking at Q4 2016 vs Q4 2015

UBS Evidence Lab

The cycle is turning, right before our very eyes.  In recent months, we’ve found a substantial amount of evidence in capital markets pointing to credit formation reaching a saturation point.

December 2016, a Turning Point

Prime MBS

If you look at high quality prime loans, there’s more evidence of a credit event in December 2016.  Across the board in consumer credit we witnessed spikes in credit card charge offs, auto loans gone bad, sour commercial real estate, student loans and an uptick (above) in Prime Mortgage Delinquencies.

We’re seeing surging defaults in commercial real estate securitization pools, credit card receivables and even prime auto loans.  The icing on the credit cake is margin debt’s historic rise.  Equity bears have been talking up this leverage class since 2014, but this time there’s far more collateral evidence of easy credit “saturation.”

Credit Rolling Over Faster than anytime Since Lehman Brothers

File_001 (96)

Every day, December 2016 is looking more and more like December of 2007.  The credit deterioration has been sharp and swift.  After auto loans, credit card receivables and commercial real estate; Commercial and Industrial loans is another area we have our eye on.  This $2T segment of the U.S. financial system hit an air pocket during the last three months of 2016 with non-residential property financing in a 5.5% plunge, a rate of change to the downside not seen since 2008.  Special thanks to the Telegraph for this chart.

Corporate lending is in meaningful contraction as the U.S. Federal Reserve has finally initiated their rate hiking cycle.  The Fed hiked rates for the third time in two years in March.  Once again, central bankers are smoking in the dynamite shed, they’ve waited far too long to  raise rates.  They’re clearly tightening monetary policy into ugly credit deterioration.

Listen to Economists or Data?

Data vs Sentiment

In many spots around the economy, data is rolling over but the survey sentiment remains strong? 

“While the Fed is worried about the economy overheating, bank loans and leases continue to slowdown on a year over year basis. Part of the reason we think the economy is actually losing steam is because of this precipitous fall in lending (credit contraction) over the past year.”

The Bear Traps Report, March 10, 2017

Equity market’s hopes are pinned high on a economic shot of adrenalin from Washington, but a fumble (Paul Ryan’s Health Care Repeal and Replace failure) up on Capitol Hill has fiscal stimulus well over a year away in our view.  This is looking more and more like a bridge too far.

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Atlanta Fed Q1 GDP Forecast in the Month of March

2017: 1.0%
2016: 0.6%
2015: 0.2%
2014: 0.7%

Do you think there’s a seasonal GDP problem here with the Atlanta Fed reading?  For sure, Q1 has consistently been an under-performer over the last four years. 

As bond bulls in a sea of bears in 2015, we made a stand.  Back then, Wall Street (consensus estimate from economists) was calling for ten Fed rate hikes in 2016-17.  We argued, because of the colossal debt build 2006-2015, a small 25bps hike has the destructive power of three interest rate hikes.

One Hike = Three Hikes

“One of the most popular bond indices, the Barclay’s U.S. Aggregate, has a market value of $17.9 trillion today. This compares to a market value of $8.3 trillion at the time of the last Fed rate hike on June 29, 2006. A look around the world is an eye opener; the Barclay’s Global Aggregate has a market value of $42.2 trillion versus $21.9 trillion on June 29, 2006. Some of this is already priced in of course, but the quick and dirty calculation tells you that for the U.S. Agg, a 25bps hike has 2.53x the impact of a 2006 era move and for the Global Agg, the impact is around 2.36x a 2006 era move in terms of the value of immediately repriced assets. This gives the adage “interest rates up, bond prices down” profound new meaning.  Put another way, the amount of losses by global bond investors in percentage terms for a given hike in rates is around 2.5x as powerful as it was the last time the Fed hiked rates over nine years ago. So might 25bps act a bit more like 62.5bps.  We’re bond bulls, NOT bears, Wall St. has rate hikes wrong.”

Quote from The Bear Traps Report, September 2015

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M1 Money Supply Growth Rolls BEFORE Recessions

Chart 1970-2017

M1

Above, the red line and circles represent recessions and the white line shows us M1 money supply growth.  As banks pullback from lending M1 contracts, typically out in front of recessions.  As you can see above, M1 has been trending lower since October’s 10.8% growth rate, to 8.1% in February.  The good news is we’re far from the real danger zone for M1 growth.  Ahead of the 2008, 2000 and 1990 recessions, each time M1 was negative 6-9 months prior to real economic stress.  On the other hand, the U.S. economy heading in that direction, our model will be focused here in the months to come.

Stocks and Borrowed Cash: Margin Debt Surged to 58-Year High at Trump Rally’s Peak

Margon Debt Load“A record $530 billion was extended as credit by brokerages for stock buying at the end of February as the post-election rally peaked, according to data released Wednesday by the New York Stock Exchange. While some investors interpret such speculative buying as signals of imminent market reversals, Michael Shaoul, chief executive officer of Marketfield Asset Management, says that’s not the case. He notes that the current pace in equity credit growth is nowhere near where it was in 2000, and the cost to borrow only slightly exceeds the 1.97 percent yield that S&P 500 companies offer as dividends.”

Bloomberg

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Stocks Bought with Borrowed Money

March 2017: $530B*
2007: $390B
2000: $285B

*58 year high

Bloomberg data

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Consumer Credit Deterioration and Subprime Auto Loan Defaults touch highest level since Financial Crisis

U.S. subprime auto lenders are losing money on car loans at the highest rate since the aftermath of the 2008 financial crisis as more borrowers fall behind on payments, according to S&P Global Ratings.  Losses for the loans, annualized, were 9.1% in January from 8.5% in December and 7.9% in the first month of last year, S&P data released March 10, 2017.

Motor Vehicle Loans Owned & Securitized

Auto LoansSo, lets get this straight.  We have an economy near full employment in what every economist on Wall St. calls a strong jobs market, with surging auto loan defaults?  This is moral hazard gone bad, the Fed has kept interest rates so low for so long – the net result?  We have an ugly, smelly pile of bad loans on our hands.  In 2006, clueless economists lectured us “we cannot have a surge in home mortgage defaults with the labor market as strong as it is.”  That was their “blind spot.”  Trying to manage risk while looking at stale, traditional economic metrics, it’s pathetic.

Supply of Automobiles at 30 Year High, Outside 2008-9 Recession

File_000 (158)

This is an eye opener, record supply level vs sales.  It speaks to credit market saturation, sellers simply cannot find more “qualified” buyers.  They’re reaching deeper into the risk spectrum. 

Deleveraging Since the Financial Crisis?  It’s Leverage on Leverage

c loans

U.S. auto loans in the fourth quarter reached about 9.2% of all household debt, the highest share in data going back more than a decade.  the average amount used to finance a new-car loan also reached a record $29,469, according to Bloomberg. To support sales growth and keep monthly car payments affordable, lenders have been lengthening the terms of loans to consumers — in many cases as long as seven years.  It’s pure comedy, an asset that depreciates faster than a summer vacation is receiving longest term financing ever?!

The Great Enabler that is the Federal Reserve

FF Rate

As central banks suppress the natural level of the cost of capital, a moral hazard oozes through capital markets.  The bottom line, money ends up in places it just shouldn’t be as investors reach and reach and reach for yield.  Interest rates should be used to price risk, today the risk-pricing mechanism hasn’t simply collapsed, it’s toxic.

Ally Pain, Ally Financial Inc.

“As you’ve heard from many lenders, we’re closely watching the environment, and we’ve seen some more noticeable shifts recently…

Consumer losses have also been drifting higher, and most notably in lower credit tiers. You’ve heard back from others as well. We have seen some additional deterioration in the first quarter, and we believe that the delayed tax refunds may have had an impact here.”

Jeffery Brown, Ally Financial CEO, March 21, 2017

U.S. Credit Card Delinquencies

2016: +9%
2015: -9%
2014: -15%
2013: -21%
2012: -30%
2011: -38%
2010: -11%
2009: +38%
2008: +30%
2007: +6%

Four quarter, rolling % change

Thomson Reuters Data

Nearly $1.3T of Subprime Debt in the USA

Here’s the Breakdown

File_001 (97)We’ve come full circle since “A Colossal Failure of Common Sense” (our 2009-10 global best selling book, now published in 12 languages).   Over the last 100 years, after each financial crisis there’s a spectacular metamorphosis.   It’s a transformation into another serpent, another beast and it’s powerfully depicted above.   The mortgage market has “found religion,” only 6.8% of financing for new homes is subprime.  Flowing down hill (thanks to Central Banks – Ben and Janet), the water has simply found its way to another location.  Nearly nine years after Lehman’s failure, we’re seeing a substantial increase in risky lending in places like student loans, credit card and auto loans. 

Q4 Data, U.S. Credit Card Charge-off Quarterly 

2016: $8.5B
2015: $6.6B
2014: $6.5B
2013: $6.9B
2012: $7.8B

Fitch, Fed data

Once again, credit card delinquencies should NOT be going up with the economy at full employment.  Any first year economist out of college can tell you that, BUT they are.  At some point when the Fed’s easy money policy reaches the saturation level in the economy, even with a decent jobs market, credit quality deteriorates.  This is clearly happening now in our view.

Defaults on Student Loans

2016: 4.2m
2015: 3.6m
2014: 2.9m

Roughly 1.1. million borrowers entered default on their Direct Loans, a type of federal student loan, last year, about the same as the previous year, according to an analysis of publicly available government student loan data by Rohit Chopra, a senior fellow at the Consumer Federal of America, a network of more than 250 nonprofit consumer groups. Overall, there were 4.2 million borrowers in default in 2016, up 17% from 3.6 million the year before, as some borrowers exited default while others remained in the red. – Marketwatch data

Non-Housing U.S. Consumer Debt Load*

2017: $3.8T
2007: $2.5T

*Auto, credit card, student loans, other

NY Fed, Equifax Data

From Our Friend Chris Whalen

An early voice heading into the 2008 credit crisis, Chris Whalen is a man to listen to.  He’s one of the best bank credit analysts from Wall St.  We recap a section of his blog “Citigroup: Canary in the Coal Mine” below.

Credit Divergence: Citi vs JP Morgan

CDS Citi Divergence

“Even today, the relatively elevated credit profile of Citi’s customer base is reflected in a gross loan charge-off profile that at 126bp at the end of 2016 is more than a standard deviation higher than the average for the large bank peer group.  Loss given default (LGD) for Citi is almost 80%, again far higher than large cap asset peers like JPMorgan (NYSE:JPM) and Bank of America (NYSE:BAC). Indeed, Citi in credit terms is really more comparable to below-prime lenders such as CapitalOne (NYSE:COF) and HSBC (NYSE:HSBC).   The 126bp of default reported by Citi in 2016 maps out to roughly a “BB” credit profile for its portfolio, again reflecting a deliberate business model choice that has selected a below-prime business as the bank’s model.  COF, by comparison, reported 265bp of gross defaults at year-end 2016, roughly a “B” credit profile.  COF’s loan loss rate is more than three standard deviations above the large bank peer group with an LGD of 77%, according to the TBS Bank Monitor.  Of note, COF showed a risk-adjusted return on capital of just 1.6% at year end ‘16 while Citi reported a RAROC of 3.8%. Since the nominal cost of capital for most large banks is well into double digits, you may be wondering why these banks are still here.  Indeed, most large banks don’t earn their cost of capital, either in nominal or risk adjusted terms.  But it is only when you look at these banks based on RAROC that you understand that the big zombie banks are perennial value destroyers. Smaller regional and community banks, by comparison, routinely earn double digit real, risk-adjusted returns on capital.”

From our friend Chris Whalen

Back to Auto Loans, Prime Starting to Creep Higher

File_000 (156)

The final stage of credit deterioration’s saturation point is found in the shift over to “prime” or high quality borrowers.

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Consumer Confidence in Trump Fiscal Plan Soars

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Consumer Confidence in March rose to 125.6 vs. 116.1 prior Month

– Forecast range 110.0 to 118.0 from 69 estimates.
– Present situation confidence rose to 143.1 vs. 134.4 last month.
– Consumer confidence expectations rose to 113.8 vs. 103.9 last month.

Why are Consumers So Confident?

CC newWe’ve heard so much about record low approval rating for the Trump White House, but Consumers are singing a different tune.

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Tax Reform and Sky High Market Expectations, Why Should You Care?

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Blog Updated, Monday March 27, 2017 at 7:50am ET

Minutes after their hopes of undoing Obamacare unraveled, the White House and top Republicans shouted from the rooftops (in careful coordination); they’re moving on to another ambitious goal — overhauling the U.S. tax code for the first time since 1986.

S&P Futures Sunday Night, March 26, 2017

S&P Fut new

The S&P futures ES1 opened down at 2331.75, just through last week’s low.  Look for the bulls to defend this level overnight as the White House shifts gears on fiscal policy initiatives. 

“We will probably start going very, very strongly for the big tax cuts and tax reform, That will be next.”

President Donald Trump, after the House bill was pulled from a scheduled floor vote on Friday, March 25, 2017

Stocks in the U.S. suffered their worst week since the November election of Donald Trump.  Investors turned to bonds as U.S. Treasuries rallied for the second week.

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Wall St. was All Beared Up on Bonds Heading into 2017

Bonds Election

Since early March, the S&P 500 is off 2.6% while bonds are nearly 4% higher in recent weeks.  Coming into 2017, the policy execution bar was too high for the White House, equity markets are starting to price in a reality check on expectations.  After the monster bond rally, the yield on the U.S. 10 year Treasury bond is down near 2.37%, while Wall St’s year end yield target is 3.25%.

Near Record U.S. Treasury Shorts

CFTC Shorts

They’re piling out of U.S. Treasury shorts this morning as the “reflation trade” unwinds in a big way. 

Since December 15, 2016

Gold Miners $GDX +21.2%
Mexican Equities $EWW: +16.1%
Emerging Markets $EEM: +13.1%
Dow Jones Utilities: +11.1%
S&P Consumer Staples $XLP: +8.8%
Nasdaq 100 $QQQ: +8.2%
Long Term Zero Coupon Bonds: +6.1%
Long Term Treasury Bonds: +4.5%
S&P 500 $SPY: +2.5%
Financials $XLF: +0.5%*
Russell 2000 $IWM: -2.1%*
Regional Banks $KRE: -4.5%*

Dow Jones Transports: -4.8%
Oil Producers $XLE -12.1%

Bloomberg data

*Consensus Wall St’s “Overweight” Sectors for 2017’s Reflation Trade

Year after year we witness the same story.  Wall St. crowds their clients into glorious theme trades.  Each year, the road less traveled captures the honey pot.  When you hear a heavily bought in consensus from this mob, run – don’t walk – the other way.   Nearly all of Wall St’s “overweight” sectors for 2017 are underperforming this year.  The much heralded “reflation trade” has been put on hold as markets rethink the upside of Washington policy’s impact. 

U.S. 10s Touch 2.37%, Sunday March 26, 2017

10s new 15U.S. 10 year Treasury yield is through its hundred day moving average (see the green line above), the first time since October 4, 2016. 

Fed Rate Hikes?

Futures Market Probability

Rate Hike In?

June: 51%
September: 114%
December: 155%
Fed Dots: Two More Hikes in 2017

The futures markets are currently pricing in 50% probability of a move by June, 115% probability of a move by September, and 155% probability of a move by the end of the year.   A look at the Fed’s “Dots” (Fed governors public forecasts for interest rate direction) are currently projecting two additional moves this year, 31% more than what’s currently priced in.

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Q1 Returns of the iShares 20+ Year Treasury Bond $TLT ETF*

2017: +5.2%
2016: +13.5%
2015: +12.8%
2014: +7.3%

*from the December low to the Q1 high.

It’s nothing short of pure comedy, Wall St’s been the gang that can’t shoot straight on bonds year after year.  Each December, they’ve obnoxiously lectured investors about reasons to get out of bonds.  They come up with pathetic themes to corral the masses; the “great rotation,” the “reflation trade” and “life after liftoff” focused on Fed policy and “higher interest rates.”   This year it was Trump’s growth agenda, wrong again.  Every year it’s been a different excuse to get out of fixed income securities.  But so far in 2017, bonds, utilities, and defensive stocks have been the place to be.

Euro’s Dominance in 2017, Came After a Pan from Wall St.

Euro vs bbdxyWall St. was confident in December, they argued the ECB is in the middle of a $2.5T asset purchase program, while the Fed is hiking rates 3-4x, stay long the dollar.  Wrong again.  The dollar is at the same level is was during the week of the election of President Trump, it has given back all its gains.

We’re Hosting a Policy Call for Clients

Join Our Team in Washington, ACG Analytics and the Bear Traps Report will host a policy call on Monday, March 27, 2017 at 10:00am ET.

Implications of ACA Healthcare: Repeal Failure on the Trump Agenda:  Our team will analyze what the future holds for Healthcare and Tax Reform and how competing interests in the GOP will affect the legislative environment of Trump’s first term.

Join us here:

There’s a Colossal Tax Reform Earnings’ Premium Built into the S&P 500

S&P new

Some Wall St. analysts say corporate tax reform is now a happy meal not a big mac.  In other words, only a much smaller plan will be able to get through Congress now as revenue neutral ambitions are far more challenging.  As Washington policy execution stumbles, there’s an uneasy feeling creeping through in markets.  The hole just got deeper, now up to $2T with the border adjustment tax BAT in trouble & ACHA savings gone.  Bottom line, without key tax revenue offsets we’re looking at a corporate tax cut near 30-28%, not 20-15%.

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“There is a disconnect between the Trump stimulus execution risk and how far we’ve come in terms of expectations. An actual fiscal boost is more than 12 months away in reality, Obamacare took well over 300 days to land on the President’s desk while the Dems controlled the House, Senate and the White House. As much as well all want to believe Mr. Gridlock is dead, he’s still breathing.  As we head into 2017, gold miners, consumer staples, bonds and utilities are our favorite options as the street has unanimously bought into the crowded ‘reflation trade’ narrative.”

The Bear Traps Report, January 8, 2017

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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.

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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.

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.

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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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