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Denis Ouellet, CFA
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Denis Ouellet has been involved in the Financial sector since 1975. Now retired, he is a part-time blogger. Denis has been analyst and head of research for a brokerage company, equity manager for various investment organizations (pension, mutual and hedge funds), head of global equity... More
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    “Transitory”. Ben Bernanke and other Fed officials have recently been employing the word to qualify the surge in headline inflation stemming from commodity price increases and reassure investors that such inflation will be brief, fleeting and, as such, needs no special attention from neither central bankers nor investors.

    Obviously, Bernanke and Co. have more than a passing influence on economists. Most of them are now using the same word to qualify the recent deflation in economic news, sympathetically called the “soft patch”, reassuring investors that the slowdown is only transitory, being essentially caused by the supply disruptions from Japan, the spike in commodity prices, principally gasoline, and the volatile weather. Being non-core, all these deteriorating variables are thus not worrisome and need no special attention.

    Last week, an old friend passed away. At his burial, the priest offered the idea that this life is only transitory and that it leads to another, unknown, but presumably better lifePriests are versed in latin; they know that transitory comes from transit, “a passage from one place to another”, not merely a return to where we were before, unchanged and unscathed.

    Bernanke and his economist friends also can’t tell us what we are transiting to, what is this next economic life. The word transitory conveniently conveys faith and hope, something  Fed officials currently desperately need investors to have. Keeping the “next life” unqualified, they make us faithfully believe that the post transition state shall be just about where we were before. For Bernanke, that means just enough inflation to avoid deflation, keep interest rates low for an extended period and conclude QE2 smoothly. For many economists, that means that post transition(s) (Japan, commodities, oil and weather), we shall return to decent enough growth to sustain equity and commodity markets.

    Our economic priests are reassuring: there are no reasons to worry and grieve more than necessary. The afterlife shall be all right. Growth will soon enough resume its course (Larry Summers says that “it will be accelerating before too terribly long”), employment will continue its gradual recovery, commodity prices will be sustained but only transitory, corporate profits will keep rising, and interest rates will stay low almost forever. Close to heaven, isn’t it?

    Bernanke and Co’s afterlife is simply back to the future, when a few but economically important people enjoyed rising equity and commodity prices while most other ordinary people in the world stayed economically miserable. The idea was and still is that the wealth effect on the few will, eventually, save the miserable.

    But the afterlife remains mysterious, even for Saint Ben. How much faith and hope should we have? For her part, last Saturday morning, my friend’s widow was showing little hope that her transition would be painless and toward a better life.


    • Japan’s transition will necessarily be towards reconstruction. Although the exact timing is uncertain, Japan’s transition will be economy positive.
    • However, the reconstruction will sustain demand for many commodities, contributing to high prices for a longer period than Ben’s “transitory” might be assuming.
    • Japan’s reconstruction will itself be transitory but it could last long enough to offset China’s economic slowdown while the Communist Party deals with its own seemingly less transitory inflation problem.
    • Oil prices are another thing. Even Ben Bernanke is having doubts about the transitory nature of the recent oil spike(s). For starters, nobody can confidently predict what will happen in MENA countries where “transitory” is now a buzz word. Secondly, Saudi Arabia, faced with its own domestic challenges, is no longer acting as a swing producer for the West. Quite the opposite, in fact. But not to worry: according to many faithful economists, oil is far from having the impact it used to have.
    • The transitory volatile weather is very likely to remain…volatile and transitory. Hope is very appropriate in this case.


    Unfortunately, it seems that Japan does not explain everything as FT’s Gavyn Daviesclearly shows. Notice how the recent “slowdown” is much worse than that of 2010 when we got the double dip scare and QE2..

    Dismissing suggestions that the poor job data reflected transitory Japan and/or weather-related supply chain disruptions, Keith Hall, commissioner of the Bureau of Labor Statistics, told the FT that

    Bad US payrolls data for May appear to reflect a “general weakening in job growth” rather than any temporary distortion.

    As any boxer will tell you, hits received while you’re weak are more damaging than when they occur during healthier bouts. My belief is that the recent economic hits are significant setbacks, not jus a soft patch. Just peruse these charts and compare with the situation in the spring/summer of 2010:



    The US consumer has retreated, along with his real earnings. As a result, inventories have been rising dangerously.

    Housing is clearly double dipping, further eroding homeowners wealth and banks balance sheets. This spiral is just getting worse and worse. Here is how Michael Lewitt (The Credit Strategist) sees that mess:

    Lower prices are being driven by the inordinate number of bank owned
    (i.e. foreclosed) properties for sale. Sales of these properties comprised 34.5 percent of the market according to a survey by Clear Capital, a prominent real estate consulting firm, resulting in a nationwide price drop of 4.9 percent for 1Q11, 5 percent year-over-year in March 2011, and 11.5 percent over the past nine months. This is the sharpest rate of price deterioration since 2008. In 2008, however, the government (as usual) came to the rescue with housing tax credits, a program that had limited success. Another plan is (fortunately) not in the cards, which suggests that prices will fall further until the inventory of foreclosed and other distressed
    properties is absorbed.

    By comparison, in 2010, US manufacturing was recovering, car sales were strengthening, consumer real earnings were growing, the US savings rate was above 6% vs 4.9% currently, house prices were above their lows and China’s economy was growing at double digit rates with inflation in the 3.0-3.5% range.


    China Economy by Numbers - April

    So where are we transiting to? Did I hear QE3?

    But what about the Fed’s transitory inflation bulge? In theory, the transition towards a weaker economy should help cool commodity prices, hence non-core inflation. The real problem may rest with core inflation which, at the present time, is no cause for concerns but, according to SocGen Albert Edwards, will soon become a headache:


    Also, Prieur du Plessis’ chart below reveals that US CPI is not quite yet disconnected from changes in oil prices:

    At least, deflation worries are not in the cards, yet, thank God, or whoever rules the afterlife.

    Next transition: earnings and earnings estimates.

    Be careful at all all crossings.

    Business Insider offers some hope:

    BofA’s David Bianco argues that the economy/market is in a soft patch, and not a sinkhole.

    His key points:

    • Business investment is likely to accelerate (!) due to higher oil costs. Watch for the manufacturing ISM to go back into the mid-50s.
    • A summer market swoon will increase repurchase activity.
    • The weak dollar will boost export activity.
    • S&P earnings estimates will hold up due to the above: exports, commodity prices, FX, and foreign operations.
    • 10-year Treasury rates around 3% are now predicting double dip, but rather record savings.

    Read again carefully: the US will be saved by foreigners. Yet, Europe is struggling while everywhere else there is growth, central banks are tightening to kill inflation. Who will save us in the afterlife?

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Jun 07 1:00 PM | Link | Comment!

    China’s Lunar New Year holiday has been mentioned by official Chinese agencies and many economists as the principal cause for some recent weaker economic data such ashouse sales and the manufacturing PMI. However, a closer analysis and other sources point to real weaknesses developing in the Chinese economy (see my Feb. 14 post CHINA’S INFLATION FIGHT THREATENS ECONOMY).

    The latest example is the services PMI. China’s official CFLP claims that the sharp contraction in its February’s non-manufacturing PMI is essentially due to the holiday.

    China’s non-manufacturing industries contracted in February for the first time in a year because of the week-long Lunar New Year holiday.

    The Non-Manufacturing Purchasing Managers’ Index (PMI) dropped to44.1 from 56.4 in January, the China Federation of Logistics and Purchasing said on its website on Thursday, falling below the 50 level that divides expansion and contraction.

    “The pullback is mainly due to seasonal factors,” Cai Jin, vice-president of the logistics federation, said in a statement. “Excluding that, the momentum of the indicator is still running at its normal trend.” The gauge published by the federation also dropped below 50 in February last year.

    Markit HSBC published its own, seasonally adjusted, services PMI for China yesterday, qualifying the trend as “lackluster growth”.

    Posting 51.9 in February, down slightly from 52.0 in the previous month, the seasonally adjusted HSBC Business Activity Index was at a level indicative of only a modest rate of activity growth in China’s service sector.

    New business received by Chinese service providers rose further in February. However, the rate of growth eased for the sixth successive month to the third-lowest in the series history. This, combined with a weaker expansion in manufacturing new orders, meant that growth of private sector new business weakened to the lowest since July 2010.

    Markit’s China Composite Output Index, which combines manufacturing and non-manufacturing activity, fell significantly from 54.6 to 51.9 in February, seasonally adjusted. The composite index also declined sharply in early 2010 before rebounding but recall that stimulus measures were still present then. The current situation is much different as the PBoC and the government are seriously fighting inflation.


    And the fight against inflation is far from over. The Markit survey reveals that cost pressures are still very strong and that businesses are not shy of passing them on to their clients. Core inflation is thus likely to keep rising in China.

    Output prices set by service providers rose again in February, with thepace of inflation quickening to the sharpest for a year. Similarly, output prices rose at an accelerated rate at the composite level, as charge 
    inflation at manufacturers’ factory gates quickened to a three-month high.

    Respondents to both the services and manufacturing PMI surveysmentioned passing on higher costs to customers through increased output charges. February data pointed to another marked rise in average input costs faced by Chinese service sector firms.

    However, the rate of cost inflation was much stronger in the manufacturing sector, where purchase prices rose at the fastest rate since last November Consequently, the overall rate of cost inflation quickened to a three-month high in February. 

    One way to alleviate inflation problems is to “accept” higher inflation. Li Zhaoxing, the spokesman for the National People’s Congress, China’s top legislature, said on Friday that China may set the inflation target for 2011 at around 4% from 3% in 2010. As a Chinese proverb says: “One may tolerate a bulging carpet, one could still trip on it.”

    Coming back to the official services PMI survey, it should be noted that the February 2010 reading was 46.4, down 8.7 points from 55.1 in January. The non-seasonally adjusted figure for February 2011 is thus 2.3 points lower than last year, 12.3 points below its January 2011 level and, at 44.1 is a mere 2.2 points above the index all time low of 41.9 reached in February 2009. That certainly does not sound like an indicator that “is still running at its normal trend” as the official statement asserts.

    Lastly, the official survey notes that

    (…) the sub-index for consumption-related businesses dropped to 46.5 in February from 62.6 the previous month. The gauge for new property orders declined to 39.7 in February from 42 in January, the fifth monthly decline, the federation said.

    Seasonal factors or not, that sounds weak to me.

    滞涨 (stagflation in Chinese).

    Mar 07 2:49 PM | Link | Comment!
     Much is being written these days on the US corporate margin squeeze developing from rising commodity prices. Zero Hedge’s Tyler Durden first wrote about that in December:

    Today’s Philly Fed current activity index came at what at first glance appears to be a healthy 24.3 in December from 22.5 in November on expectations of 15.0. Great right? Nope. (…) what was most notable is the absolute explosion in the Prices Paid index which followed mortgage yields in going parabolic. From 34 in November, the Price Paid index surged to 51.2! Recall David Rosenberg discussing the mother of all margin squeezes yesterday… It’s here. From the index: “Price increases for inputs as well as firms’ own manufactured goods are more widespread this month. Fifty-two percent of the firms reported higher prices for inputs, compared with 38 percent in the previous month. The prices paid index, which increased 17 points this month, has increased 41 points over the past three months. On balance,  firms also reported a rise in prices for manufactured goods: More firms reported increases in prices (21 percent) than reported decreases (10 percent), and the prices received index increased 13 points, its first positive reading in eight months.” Add to this the earlier comments from Fedex that the main reason for the EPS miss (not so much revenue) was due to a spike in labor costs, and one wonders: Quo Vadis Deflation?

    David Rosenberg got back to the same theme yesterday:

    We saw more evidence that companies are facing an intense profit margin squeeze with the recent macro data. The chart below is the spread between Philly Fed prices paid (input costs) and received (prices charged). The last time the spread was at 46.2 was in June 1979 … that was not a good foreboding: the four-quarter EPS trend swung from +21% to -9% a year later. The producer price index data told the same story on margins — the ratio of PPI at the crude stage to PPI at the final gate just broke above 1.3x … there were only three other episodes where this ratio was above 1.3 … in each case, EPS growth slowed substantially all three times in the next year.

    But if one starts digging and uncover a potential problem, one should not stop digging and just cry wolf. Let’s keep digging this margin call.

    US corporate profit margins are high and, as such,  vulnerable, something the bears happily point out. One pundit wrote:

    When corporate profit margins are shrinking, profits grow more slowly than revenues, and stock multiples usually contract.

    He kind of stopped there, leaving the seemingly obvious conclusion up in the air without bringing any tangible support.

    I used his chart which clearly demonstrated a decline in profit margins as per the GDP accounts but I checked what happened to S&P 500 EPS and the index itself while the margins were being squeezed.


    In 3 of these 4 “mothers of all margin squeezes”, S&P 500 EPS kept growing. Shrinking margins do mean profits grow more slowly than revenues but, as the chart above shows, not necessarily that multiples “usually”contract. In fact, based on the evidence from the chart, the jury is about evenly split on multiple movements when margins contract meaningfully from current high levels. History convincingly shows that PE multiples are primarily a function of interest rates, therefore of inflation rates and trends thereof (seeS&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years).

    It is also important to note that often margins did not go straight down, staying elevated for periods of 9-15 months after peaking. Furthermore, in all four instances, equities did rather well, at least in the early part of the margin contraction period.

    I then looked at the Philly Fed “Prices Paid Minus Prices Received” Index. Rather than using David Rosenberg’s chart which only goes back to 1990, I used Doug Short’s which goes back to 1968.

    I transposed on a semi-log earnings chart the 7 instances when the Philly Fed “Margins” index reached extreme levels. The “R” on the chart indicates US recession periods. S&P 500 profits have, in fact, declined after the “Margins” index rose smartly but only when there was a US recession, negating the usefulness of the indicator.


    So, simply saying or implying that elevated profit margins are bearish is incomplete analysis to say the least.

    Feb 27 8:20 AM | Link | Comment!
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