Volatility Returns to the Markets 10/17/2014

As we stated earlier this week:  the recent selling seems to be based on fears of slowing global growth along with the negative news regarding Ebola, Russia, Hong Kong, etc.  The IMF lowered their global growth forecast and the ECB also lowered their guidance for the European Union.  However, the underlying macroeconomic fundamentals in the U.S. still suggest the U.S. economy is very strong.  We are seeing improvement in the labor market, manufacturing, business confidence and we expect corporate earnings will continue to remain strong.  The fear is that the slowdown in growth outside the U.S. will eventually hurt U.S. corporate profits as many U.S. companies have a global footprint. 

 

The selloff should not turn into a major reversal in our opinion because the data on U.S. earnings and economic activity remains positive which should offset the concerns described above.  We have summarized some of the key data below that provides ample evidence that the U.S. economy is strengthening and we should see this trend continuing into 2015.

 

Third Quarter Earnings Reports look very good thus far:

 

The estimated earnings growth rate for Q3 2014 is 4.5%.  The Telecom Services sector is expected to report the highest earnings growth for the quarter, while the Consumer Discretionary sector is the only sector expected to report a year-over-year decline in earnings.  The actual results for Q3 is likely to be in the 5% to 5.5% range based on the early reports.  We are watching the earnings announcements closely to get as much information as possible on earnings guidance for the fourth quarter.  It is likely that many CEOs will provide conservative guidance due to the global economic and geopolitical uncertainty. 

 

General Electric (GE) posted better than expected profits estimates as the company reduced its costs from the manufacturing units.  Operating margin in the industrial business, a gauge closely watched by investors, expanded by 0.9 percentage point in the third quarter.  Adjusted profit from continuing operations was 38 cents a share, exceeding the 37-cent average analyst estimate.

 

Wells Fargo (WFC) posted third-quarter results that disappointed investors as the bank again saw a key measure of lending profitability narrow and expenses climbed.  Wells Fargo’s net interest margin — a key profitability figure that measures the difference between what a bank makes on lending and what it pays depositors—had continued to disappoint investors, despite an uptick in loan growth.  In the third quarter, the margin narrowed to 3.06% compared with 3.39% a year earlier and 3.15% in the prior quarter.

 

Citigroup (C) reported Tuesday that third-quarter profit rose 6.6% from the same time last year, helped by stronger-than-expected trading results.  The company also stated it plans to retreat from some additional foreign retail-banking markets. When eliminating legal expenses, the bank’s profits were much better than expected.  However, as with other U.S. banks, legal expenses continue to weigh on the bottom line.

 

Bank of America (BAC) posted a small profit for the third quarter as the company reported stronger than expected trading revenue and showed progress in controlling expenses.  However, results were once again weighed down by large legal charges. Bank of America reported a profit of $168 million, compared with a profit of $2.5 billion a year earlier. The results include a litigation charge of $5.6 billion, about five times the year-earlier charge of $1.1 billion.  Like with Citigroup, Bank of America’s biggest headwind continues to be the legal expenses they are facing.

 

Falling Oil Prices set to provide a $1 Trillion boost to Global Economy:

 

The lowest oil price in four years will provide stimulus of as much as $1.1 trillion to global economies by lowering the cost of fuels and other commodities, according to Citigroup Inc.  Brent, the world’s most active crude contract, is recently trading in the range of $82.00 to $84.00 a barrel.  That’s more than 20 percent below its average for the past three years, amounting to savings of about $1.8 billion a day based on current output.  Savings will climb to $1.1 trillion annually as the slide cuts costs of other commodities, leaving consumers and businesses with extra cash to spend and bolstering growth.

 

Crude prices are plunging amid signs that OPEC, supplier of 40 percent of the world’s oil, won’t act to eliminate a surplus as global growth slows.  Combined supplies from the U.S. and Canada rose last year to the highest since at least 1965 as producers tapped stores locked in shale-rock formations and oil sands.  A reduction in oil prices also results in a reduction in prices across commodities, starting with natural gas, but also including copper, steel, and agriculture.  All commodities development require the use of billions of gallons of fuel and other forms of energy.

 

Regular gasoline prices averaged nationwide in the U.S. dropped to $3.163 a gallon — the lowest in more than three-and-a-half years.  The Bloomberg Commodity Index slumped to a five-year low, about 50 percent below its peak in July 2008.  Copper, natural gas, coal and iron ore are all far below their peaks.

 

Cheaper oil is an advantage for both consumers as well as industrial and manufacturing operations, especially as winter approaches.  As lower energy prices help reduce commodity costs, they can also push down the inflation rate.  While freeing up more money for consumers, outsized declines could become a concern in places like Europe, where policy makers are trying to stave off deflation, which can exacerbate an economic slump.

 

The International Energy Agency reiterated this point in a report on October 14th stating that lower prices, for most economies, reduce the cost of doing business and support economic growth and offer a cushion against any vulnerable macroeconomic issues. 

 

U.S. Infrastructure Investment could Rise Dramatically:

 

A major theme that could add significant economic growth in the U.S. over the next few years is rebuilding the U.S. infrastructure of roads, bridges, water and sewer systems.  The political dysfunction in Washington has done nothing to address the decrepit American highways, bridges and waterways. The pressure is mounting to not only pass legislation funding infrastructure projects, but to also ignite private investment in this area.

 

Fixing those roads and bridges also boosts employment. Every $1 billion in new infrastructure investment creates about 18,000 jobs, according to a 2009 report by economists at the University of Massachusetts’ Political Economy Research Institute.

 

Institutional investors such as Pension funds and Insurance Company funds have capital and want to invest in U.S. infrastructure because it meets their long-term objectives.  There hasn’t been more investment because the U.S. is behind other countries in tapping private capital.  We are hopeful we will see better receptivity to private investment in the U.S. infrastructure in 2015.

 

U.S. Economic Data shows continued strengthening:

Jobless Claims fall to 14 Year Low in October:

The number of Americans filing new claims for jobless benefits fell to a 14-year low last week, a positive signal for the labor market that could counter doubts over whether the economy is shifting into a higher gear.  Initial claims for state unemployment benefits dropped 23,000 to a seasonally adjusted 264,000, its lowest level since 2000, for the week ended October 11th, the Labor Department said on Thursday. 

 

U.S. Housing Starts rise in September:

U.S. housing starts and permits picked up in September, as groundbreaking rose 6.3 percent to an annual 1.02 million-unit pace from a 957,000 pace in August.  Builders started work on more homes in September and American consumers this month were the most optimistic in seven years, signaling the U.S. economy will ride out a global slowdown.  

 

Gains in residential construction will help underpin the economic expansion as the recent drop in mortgage rates lifts home sales and gives builders reason to take on more projects.  Other figures showing factory production rebounded last month and claims for jobless benefits dropped last week to the lowest level in 14 years added to evidence that the turbulence in global markets has yet to depress the world’s largest economy.

 

Global central banks to take more action:

 

European Central Bank is likely to announce additional action to stimulate the Eurozone economic activity in the near future.  The ECB cut interest rates to a record low, offering banks new cheap loans and wrapping up a review of bank balance sheets.  Such steps have helped drive down the euro, providing another source of stimulus if it bolsters demand for exports.  They announced last month it would buy private-sector assets as soon as this month to provide the region with new liquidity in the hope of easing credit further, it has now agreed on a legal framework for buying so-called covered bonds, according to two euro-area officials.  

 

The ECB’s Governing Council signed off this week on two acts to officially establish the program and detail its implementation. Policy makers still need to agree on issues including accounting. Draghi set the end of this month as a deadline for purchases to start. 

 

The pressure is mounting on the ECB to unleash full blown quantitative easing program but Germany has resisted this action thus far.  With inflation less than a quarter of the ECB’s goal of just below 2 percent and investors betting it will deteriorate further, such qualms might look misplaced.  The theory is that QE would provide a kick-start to growth by pumping enough cash into the economy to ease credit, extend the euro’s slide and boost confidence in equity markets.

 

China’s central bank is said to plan the injection of about 200 billion yuan ($32.7 billion) into some national and regional lenders as Premier Li Keqiang steps up stimulus to support economic growth.  The People’s Bank of China is providing funds to joint-stock banks to help them prepare for year-end liquidity needs, said a government official familiar with the matter, who asked not to be identified because an official announcement hasn’t been made. Joint stock banks are mid-size national banks with mixed ownership.  The injection comes after the central bank provided 500 billion yuan of liquidity to China’s five biggest banks last month, a government official familiar with the matter said at the time.  Premier Li has refrained from using broad-based stimulus and expressed a preference for reform to boost an economy weighed by a property slump.

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