Financial Review

Beneath the Surface

…Stocks fall again. October turns nasty. Boeing takes trade war hit. UK to tax big tech. Italy dodges downgrade. Merkel lame duck. Jair Bolsonaro elected president of Brazil. Earnings season offers few rewards.

Financial Review by Sinclair Noe for 10-29-2018

DOW – 245 = 24,442
SPX – 17 = 2641
NAS – 116 = 7050
RUT – 6 = 1477
10 Y + .01 = 3.09%
OIL – .90 = 66.69
GOLD – 4.20 = 1229.60


Today was a microcosm of the month’s trading activity: started strong, faded, turned negative, never really recovered. Today, the fade was significant, more than 900 points from intraday high to intraday low, and almost 600 points from intraday high to close. After a series of sharp sell-offs in recent weeks, the US indices are on track for their worst month since the financial crisis. A sell-off like this one can be unnerving, in part because they suggest all is not well with the broader economy.


Boeing shares fell more than 8 percent today, heading for their worst daily performance since January 2016. Much of Boeing’s decline came after a report that the United States is preparing to add tariffs to all remaining Chinese imports if trade talks between Trump and Xi Jinping fail. Trump is preparing to place tariffs on all remaining Chinese imports if proposed talks with Beijing next month fail. That came hours after the World Trade Organization was scheduled to hear a complaint Washington filed against Beijing, accusing Chinese companies of violating international intellectual property rules.


Boeing exports about 80 percent of what they build and they build 90 percent of that in the United States. A brand-new Boeing 737 MAX 8 jet operated by Lion Air crashed into the Java Sea off Indonesia on Monday, the first accident of its kind for the variant of the top-selling plane. Indonesian transportation and safety officials are searching for voice and data recorders and other clues to determine the cause of the crash. There were 189 people on board the flight.


British finance minister Philip Hammond held out the prospect of an end to Britain’s long running austerity programs provided the government secures a Brexit deal with the EU, putting pressure on the divided Conservative Party to back Prime Minister Theresa May. Delivering an annual budget speech that sought to change the tone about tax and spending a decade after the financial crisis, Hammond announced tax cuts for households and the easing of welfare curbs for poorer working families. He also took aim at big tech firms such as Google, Facebook and Amazon with a new sales levy.


Hammond says several tech companies make substantial profits in the UK but pay no tax on that income. Big internet companies, which say they follow tax rules, had previously paid little tax in Europe, typically by channeling sales via countries such as Ireland and Luxembourg which have light-touch tax regimes. Both Google and Facebook have changed the way they account for their activity in Britain. In 2016, Facebook started recording revenue from its UK customers supported by local sales teams and subjecting any taxable profit on the income to UK corporation tax. Hammond wants to tax profitable companies 2 percent on the money they make from UK users from April 2020, and the measure was expected to raise more than $512 million a year, such as search engines, social media and online marketplaces. The tax would only apply to large tech companies with more than $500 million in global revenue.


Italy dodged a credit downgrade by S&P, easing fears about public spending plans that have brought its populist government head to head with Brussels. Last week, Moody’s cut Rome’s credit rating to one level above junk.


Angela Merkel has been Germany’s chancellor for 13 years. She will not seek re-election. Merkel will  serve her full term as chancellor until 2021. A lame-duck Merkel – or her successor – may be less tolerant of countries, such as Italy, who flout the European Union’s budget rules.


On Sunday, Brazil’s Jair Bolsonaro — a far-right congressman who has expressed fondness for his country’s past military dictatorship — won Brazil’s presidential election. Bolsonaro, has exalted the country’s military dictatorship, advocated torture and threatened to destroy, jail or drive into exile his political opponents. Bolsonaro is further to the right than any president in the region, where voters have recently embraced more conservative leaders in Argentina, Chile, Peru, Paraguay and Colombia. Reeling from the deepest recession in the country’s history, a corruption scandal that tarnished politicians across the ideological spectrum, and a record-high number of homicides last year, Brazilians picked a candidate who not only rejected the political establishment but at times also seemed to reject the most basic democratic tenets. Bolsonaro plans to appoint military leaders to top posts and said he would not accept the result if he were to lose. He has threatened to stack the Supreme Court by increasing the number of judges to 21 from 11 and to deal with political foes by giving them the choice of extermination or exile. And he has stated that he would like to go straight to a military dictatorship. Some of Bolsonaro’s remarks were so offensive the country’s attorney general earlier this year charged him with inciting hatred toward black, gay and indigenous people. He said that he’d rather his son die than be gay and that women don’t deserve the same pay as men – but for all the bluster,  Bolsonaro’s legislative record is quite thin on accomplishments. And now that the election is over, Bolsonaro is threatening to banish members of the just-defeated Workers’ Party.


No good deed is going unpunished this earnings season. Third-quarter results are in from nearly half of the companies in the S&P 500. Of those, 77% reported earnings per share above the mean estimate — topping the five-year average of 71%. Those earnings, in aggregate, have exceeded expectations by 6.5%, above the five-year average of 4.6%. Companies that reported positive earnings surprises have seen prices fall, on average, 1.5% from the period two days ahead of the release of their third-quarter results through two days after. Over the past five years, companies that have beaten estimates have seen an average increase of 1% over that four-day period, the data showed. If that figure holds up, it would mark the biggest average price decline over the four-day window for companies beating expectations since a 2.1% fall in the second quarter of 2011. Companies that report weaker-than-forecast earnings, meanwhile, are getting punished more than usual, falling an average of 3.8% over the four-day window versus the five-year average of 2.5%


The price/earnings (P/E) ratio of the companies in the S&P 500 index is now 40% higher than its historic average. Its rise reflects the very low interest rates that have prevailed since the Federal Reserve cut the federal funds interest rate to near zero in 2008. As long-term interest rates rise, however, share prices will be less attractive to investors and will decline. The economy seems to be in good shape but stocks still look over-valued but most analysts believe the recovery is long in the tooth and a downturn is inevitable. But if a recession begins as soon as 2020, the Fed will not be in a position to reduce the federal funds rate significantly. Indeed, the Fed now projects the federal funds rate at the end of 2020 to be less than 3.5%. In that case, monetary policy would be unable to combat an economic downturn.


Amazon reported third-quarter revenue last week that trailed analysts’ estimates and also provided a fourth-quarter outlook that was below expectations. Amazon shares closed down 6.3 percent today and down 7.8 percent on Friday, and is trading at its lowest price since April, down 23 percent over the past month. The 13.7-percent drop over two days is the biggest decline since February 2014, when the shares plummeted 14.1 percent. The FANG stocks have been getting clobbered. FANG stocks, including Facebook, Amazon, Apple, Netflix and Google’s Alphabet, fell 4.7 percent last week. They were down 3.6 percent on Friday alone, and are also among the 10 most shorted U.S. stocks. In total, short positions on FANG shares are just over $30 billion. I don’t know whether the shorts or the longs will win this trade, but the safe bet is added volatility.


IBM is making a $34 billion move to bring more software developers under its wing by acquiring Red Hat, the largest distributor of the open-source operating system Linux. With the deal for Red Hat, IBM is trying to position itself as a kind of corporate “Switzerland” in cloud computing — a trusted partner of businesses that are moving to the cloud, but are leery of becoming dependent on one major cloud supplier.


In the cloud model, software developers write applications that run on remote data centers. The advantage can be lower costs and faster development of new business software. IBM is a champion of a hybrid approach to cloud computing. That means some crucial data and applications run on cloud technology inside a company’s data centers, while other computing tasks run on the clouds of tech companies. The major third-party cloud platforms are Amazon, Microsoft and Google. Businesses complain that these cloud suppliers include proprietary technology that makes it difficult to switch from one cloud to another. The IBM cloud strategy is to supply both hardware and software for companies to build their own private clouds, and it also has a third-party public cloud offering. IBM, struggles to compete with the hyperscale cloud companies — Amazon, Microsoft and Google — which tap their deep coffers to spend many billions of dollars a year to build more giant data centers. IBM and Red Hat say they are well placed to be leaders in helping corporations make the transition to cloud computing without getting locked into the technology of an internet giant.


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