Friday, November 19, 2010
Another Friday, another Reuters screw up. Team Macro Man found the misreporting of China's Reserve Ratio Hike as an actual rate hike by the newswires somewhat farcical. We are sure there was no sub-plot in announcing it at the same time as The Beard was trying to explain to the Germans why he is trashing the Dollar! Perhaps it's time to go Long AUD vs. short Thomson-Reuters. But for now, it certainly feels as though "that is it" for the day, with no US data this afternoon and expiries likely to see us pinned around current levels.
So TMM thought they'd take a look at something they've been following for the past year as an indicator of when (or if) the corporate investment story is likely to ramp up and morph into a private sector hiring cycle.
Over the years, we have found that the 6m ahead CapEx expectations component of the Philly Fed survey to be a pretty good predictor of non-residential investment. The trouble with survey data is that it is pretty noisy, as sentiment whips around with the equity market. But on a 6m moving average basis, it is a little clearer. The below chart shows the 6m moving average of the said CapEx component (blue line, lagged 6m), non-residential investment growth (YoY, red line, lagged 3m) and year-on-year Non-Farm Payroll growth (green line). From what TMM can tell, corporates appear to have undergone a similar sort of CapEx plan as the early-1990s, when it fell sharply, then recovered, and then looked as though it would double dip (in late-1993), before re-accelerating in 1994 as the outlook became more certain. And it looks like they have done pretty much the same thing this time around, just over a shorter time scale. Their CapEx expectations have recovered back to their post-recessionary highs with it looking like the double-dip danger over.
One of TMM's strongly-held theories is that most trading desks are staffed with guys that, prior to 2008/9, had only experienced one recession - that of the early 2000s, and that this is their playbook for how recoveries develop. But that recession was followed by a very atypical recovery, driven by credit growth, interest cuts and housing-financed consumption.
The early-1990s recovery was very different - it was slow to start with as the output gap was pretty large, but eventually, corporates began to invest and private employment growth followed with a lag (as can be seen in the chart above), and gradually the unemployment rate came down (see chart below: white line - YoY employment growth, orange line - unemployment rate, lagged 6m). Back in the 1990s, Japanese Households and Corporates both had to repair their balance sheets, but in the US today, Corporate balance sheets have never been in such great shape. For this reason, while we buy into the idea that things are going to be slow, we certainly don't think we are turning Japanese. With US employment growth having finally turned positive and the recent upward revisions to private hiring over the past six months, TMM are starting to find themselves itching to get long of equities.
Indeed, it surprises many to find that earnings have nearly recovered their fall since peaking in August 2007 (see chart below), only 9.5% below, and are expected to breach their peak mid-next year. It seems to us that absent a double dip these expectations are very likely to be realised given the position Corporates are in. As far as TMM can see, this has never been a better time for corporates to invest:
- With a split House, there is more clarity on regulation.
- QE2 is keeping real rates very low.
- They have been terming their debt out at record low yields, and not bothering to swap it to floating, resulting in lower funding costs for the years to come.
- Free Cash Flow yields are sitting above the cost of debt.
- The recent economic data has suggested a double dip is not on the cards.
Given all the above, it is pretty hard for management to justify to shareholders either not investing that cash in new enterprises or returning it to shareholders. As we've seen over the past few months, the return of multi-billion Dollar M&A and share-buybacks has ramped up significantly. We expect organic growth through investment to follow...
...and with the S&P500 trading at just 12.4x 2011's earnings, and looking nearly as cheap as it has done since Spring-2009 (see chart below, trailing earnings yield minus 10yr real yields - although, admittedly, this is as much a result of real bond yields being so low as anything) it seems to us that both the valuation and newsflow has turned for the better.
Finally, given the post-QE2 positioning washout and falls in bullish sentiment it appears that positioning is not an obstacle. If yesterday's renewed optimism can hold, then there appears little to stop a melt-up into year-end.