Financial Review

And Its Discontents

…Wall Street rallies. Waiting on earnings. Consumer borrowing spikes. Buybacks spike. US-China trade war, history suggests pain. Soft v hard Brexit triggers resignations. The state of oil.

Financial Review by Sinclair Noe for 07-09-2018

DOW + 320 = 24,776
SPX + 24 = 2784
NAS + 67 = 7756
RUT + 10 = 1704
10 Y + .03 = 2.86%
OIL + .21 = 74.01
GOLD + 2.70 = 1258.20

Wall Street is enjoying a hot start to the month of July. Still, the Dow has just barely managed to move into positive territory for the year to date. And the S&P 500 is up about 3.2% year-to-date. The Russell 2000 index of small caps stocks has posted solid gains of nearly 9% for 2018.

 

Bank stocks rose at least 2.5 percent, led by Bank of America, Citigroup, Goldman Sachs and J.P. Morgan Chase. The SPDR S&P Bank ETF (KBE) rose 2.3 percent and posted its best day since March 26, when it gained 3.3 percent. JPMorgan Chase, Wells Fargo and Citigroup are scheduled to report results on Friday, kicking off the second-quarter earnings season in earnest.

 

Consumer borrowing picked up in May. According to the Federal Reserve, total consumer credit increased $24.6 billion in May to a seasonally adjusted $3.9 trillion. That’s an annual growth rate of 7.6%. This is the fastest pace of credit growth since November. Credit grew a revised $10.3 billion in April, up from the prior estimate of $9.3 billion. Revolving credit, like credit cards, surged in May, rising by 11.4% after a 1.3% gain in April. This is the biggest increase since November. Meanwhile, nonrevolving credit, typically auto and student loans, rose 6.3% in May, up from 3.9% in the prior month. The data does not include mortgages.

 

U.S. companies are buying back record amounts of stock this year, but their shares aren’t getting the boost they bargained for. S&P 500 corporations have bought back a record $433 billion in stock in the second quarter at the same time that investors dumped a record amount in stock market-focused funds. S&P 500 companies are on track to repurchase more than $800 billion in stock this year, a record that would eclipse 2007’s buyback bonanza. Among the biggest buyers are companies like Oracle, Bank of America and JPMorgan Chase. But 57% of the more than 350 companies in the S&P 500 that bought back shares so far this year are trailing the index’s 3.2% increase. Buybacks don’t last forever. What happens when buybacks dry up?

 

The trade war with China is four days old. The question is when it will start to hurt profits or maybe the better question is how much it will hurt earnings. Several major companies are set to report earnings next week, starting with PepsiCo on Tuesday. Delta is scheduled for Thursday, and Citigroup, JPMorgan Chase, PNC and Wells Fargo are all planning to report on Friday. Tariffs on steel, aluminum, solar panels and washing machines kicked off retaliatory tariffs from around the world. On Friday, the Trump administration enacted 25% tariffs on $34 billion worth of Chinese goods, and the Chinese government responded in kind. Tariffs have already had an immediate impact, largely through disruption of the supply chain. The tariffs’ impact probably won’t be reflected in second-quarter earnings for most businesses. But we’ll hear a lot about them — particularly when CEOs give guidance for the third quarter. Overall, profit for S&P 500 companies in the second quarter is expected to be up 20% from a year earlier. Those are lofty expectations. It would be difficult to beat those numbers in the third quarter – which raises the question of whether the market is now seeing peak earnings.

 

History suggests that a cycle of tariffs and retaliations can eventually choke economic growth. But for now, employers, investors and US consumers are weighing the perils of a prolonged rift between the world’s two largest economies against a far more positive backdrop. The economy is strong. The labor market is soaking up the slack; jobs are plentiful. The tariff gamble is that the US economy is so strong that foreign countries have no choice but to trade with us. And any damage done can be absorbed without a crushing blow. Nearly all roads lead to at least some permanent tariffs. The French government insisted on Sunday that Washington should expect united retaliation from Europe to further tariff increases after Germany signaled it was prepared to negotiate. With Germany’s powerful car industry facing the threat of higher U.S. duties, Chancellor Angela Merkel said she would back a lowering of European Union levies on imports of U.S. cars. And at some point, you might wonder why is this happening? What is the point, and if we win, what will winning look like? Each escalation raises the stakes by increasing the chances of miscalculation on all sides. So even if you assume that Trump is entirely motivated by political concerns, it’s possible that China could do something drastic enough that the fallout would force the administration to start thinking in terms of markets and economics. And while markets look good now, never forget that markets are fickle.

 

Meanwhile, there is a big political fight in the UK over Brexit. In the last 24 hours, three members of British Prime Minister Theresa May’s cabinet — Foreign Minister Boris Johnson, Brexit Minister David Davis, and the minister for the Department for Exiting the EU, Steve Baker — quit the government in protest over May’s handling of negotiations with the European Union. In June of 2016, British voters approved a referendum to exit the EU. May came to power shortly after the Brexit vote, promising to be a steady hand in the negotiations. She even brought into her government pro-Brexit politicians, including Johnson, Baker, and Davis. Over time concern grew that May would agree to a “soft Brexit.” That’s the nickname for a model based on Norway’s relationship with the EU: It isn’t in the union but still has access to Europe’s single market. To follow that model, the UK must mostly allow the free flow of goods, services, money, and people.That’s a no-go for the pro-Brexit crowd, who prefer a “hard Brexit,” like Canada’s relationship with Britain. Under that model, the UK-EU relationship would be governed by international law — not EU law — and Britain could restrict immigration. Basically, the UK would be just another country with no special ties to the EU, just like Canada.

 

May’s cabinet is deeply divided between those two camps, and time is running out for her to present her terms to the EU. Last Friday May sequestered her entire cabinet to hammer out a compromise. After a 12-hour meeting, May emerged with a plan the group “collectively” agreed on: The UK would seek a “free-trade area” with the EU for industrial and agricultural goods, preserving its access to EU markets and governed by a “common rule book.” But there wasn’t a consensus: For Johnson and other hardcore Brexiteers, the plan was too soft. “It seems to me we’re giving too much away, too easily,” Davis said. Johnson wrote: “We are truly headed for the status of colony—and many will struggle to see the economic or political advantages of that particular arrangement.” Considering British history of colonization, that would be funny, if it weren’t for Britain’s history of colonization. So they quit in protest. Now there is some question whether May can retain power. The bigger problem is that the Euro Union is in the drivers’ seat on negotiations. May acknowledged this on Monday, telling members of Parliament to brace for the possibility of Britain leaving the EU without any agreement, which would create serious problems for the movement of goods and people between the U.K. and its nearest trading partners. Gee, who could have guessed?

 

Consumer staples rallied to begin July as the first round of tariffs between the U.S. and China went into effect and hopes for a quick trade resolution faded. The XLP consumer staples ETF is up more than 1 percent this month after a nearly 4 percent rise in June.

 

US airlines are aiming to convince investors that surging fuel costs won’t knock a record stretch of profitability off course. Some investors say airlines won’t be able to raise prices fast enough to cover a roughly 55% increase in fuel costs from a year ago. Look for carriers to commit to schedule cuts to address the rising costs when they report quarterly earnings this month. Delta Air Lines is the first to report, on Thursday. Over the 4th of July holiday, Trump tweeted for OPEC to REDUCE PRICING NOW. He used all caps, so it must have been serious. He’s worried that higher prices at the pump will eat away at the savings he imagines are accruing to U.S. consumers as a result of the tax cuts.

 

Goldman Sachs analysts responded to the tweet with a note that does a nice job of explaining the current oil market: “Actual and likely production losses are adding up: (1) production is most at risk in Iran, with the US administration targeting a significant drop in exports that could threaten more than 1 mb/d by year-end, (2) Venezuela production continues to decline at a pace of c. 170 kb/d per quarter, (3) Libya production has also been disrupted following violence in the east of the country leaving exports suspended from Eastern ports, with flows currently down by 600 kb/d, and (4) Canadian production will likely be down by 360 kb/d through July because of an outage at the Syncrude Canada plant. On aggregate, this far exceeds the 1 mb/d proposed increase in OPEC+ production, with these issues able to quickly exceed our estimate of short-term available spare capacity of c. 2 mb/d”

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