Earnings Recession And Low/Negative GDP Growth Versus QE, Who Will Win?

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Includes: QQQ, SPY
by: David White

Summary

The April 19, 2016 Atlanta Fed forecast for US Q1 2016 GDP Growth was +0.3%. However, the trend is downward.

The US is in an Earnings Recession with 4-5 consecutive quarters of declines in both earnings and revenues.

Countering this, the BOJ and the ECB have recently increased their QE programs. Some of this extra liquidity will make its way to the US Equities Markets.

The US stock markets are in a very uncertain place. The April 19, 2016 Atlanta Fed forecast for US Q1 2016 GDP Growth was +0.3%. However, the trend is downward (see chart below).

That is a steep trend. The US economic news since April 19, 2016 has been more negative than positive (see below).

  • Existing Homes Sales were up seasonally in March 2016 month over month from 5.07 million to 5.33 million. This beat expectations of 5.30 million by a small amount.
  • Initial Claims for April 16, 2016 were down slightly at 247K versus the prior week's 253K. They were also below the expectation of 263K.
  • Housing Starts (1089K) and Building Permits (1086K) for March were both down from February 2016 numbers of 1194K and 1177K respectively. They also both missed their expectation numbers of 1170K and 1200K respectively by a good margin. This doesn't bode well for the 2016 Q1 GDP Growth number.
  • The April 2016 Philly Fed Index was -1.6. This was far below the March reading of +12.4. It was far below the market expectation of +9.9. This does not bode well for the 2016 Q1 GDP Growth number.
  • The Leading Economic Indicators for March 2016 were +0.2%. This was up from the previous month's -0.1%. However, it was below the market expectation of +0.4%. This doesn't bode well for the 2016 Q1 GDP Growth number.

The US has seen an earnings and revenues recession for the last 4-5 quarters. The revenues declines have been slight; but they were declines. The blended revenue decline for the S&P 500 in Q1 2016 is expected to be -1.2% (the April 22, 2016 FactSet estimate). The blended earnings decline is expected to be -8.9%. Ouch! This is lining up as by far the biggest EPS decline of the last four quarters. It will be the first time the S&P 500 has seen four consecutive quarters of earnings declines since Q4 2008 through Q3 2009. The forward 12-month PE ratio is 16.9. The forward 12-month EPS for the S&P 500 is $124.70. The April 20, 2016 close for the S&P 500 was $2102.40. If you look on a chart with these two axes, the S&P 500 appears to be approximately 20% over priced. All of the above are negative indicators for the US economy and the US Equities markets.

Some people like to explain the above with the phrase, "multiple expansion". However, neither the S&P500 EPS and revenue decline trends would seem to justify a "multiple expansion". Usually the justification is that the economy is about to expand nicely. One of the purposes of this article is too try to determine whether that might be the case. Certainly the downtrends in both EPS and revenues for the S&P 500 do not indicate that expansion is about to occur.

As an opposing force to the above, the newly expanded QE programs of the ECB and the BOJ (and many other central banks) might logically be expected to push US equities markets upward. Ditto for the Chinese easing measures. These will all add further liquidity to global markets. These programs had not necessarily been expected. Hence they are new stimuli.

What exactly are these new stimuli?

On March 10, 2016 the ECB announced:

  • It would cut its main refinancing rate to 0.0% (a -5 bps decrease) -- effective March 16, 2016.
  • It would decrease the interest rate on the marginal lending facility by 5 bps to +0.25% -- effective March 16, 2016.
  • It would cut its main deposit rate by -10 bps to -0.4% -- effectively charging the banks to deposit money -- effective March 16, 2016. The hope is that this will make them more likely to put the money to use.
  • It extended its monthly asset purchases to €80B per month from €60B per month -- starting in April.
  • Starting near the end of Q2 2016, it will add investment grade, Euro-denominated corporate bonds from non-bank corporations to the assets it can buy.
  • It will launch a series of four targeted longer term refinancing operations with maturities of four years -- starting in June 2016. At the least the LTROs should act to stabilize the EU banks, which had begun to come under pressure in 2016.

This will mean at first €20B more in liquidity from the ECB. The more negative deposit rates should add further to the liquidity. The upcoming LTROs should add still further to the liquidity. I won't try to estimate the new liquidity exactly. However, it will be significantly in excess of an additional €20B. With the negative deposit rate for the ECB, an increased amount of the liquidity will make its way to US equities and fixed income markets.

This all seems to have had the effect of strengthening the Euro against the USD in the short term. In other words, the idea that the European economy will be overall stronger due to these actions has pushed the Euro up versus the USD. It is not clear that this effect will be lasting. The lower rates and increased liquidity may start to weigh on the Euro versus the USD exchange over time. This could push the USD up longer term. I will call the currency effect a wash for now. However, short term it probably bolstered US exports to Europe (see EUR/USD chart below).

The yellow arrow in the chart above indicates the day of the announcement, March 10, 2016.

While the ECB actions were only one of the big central bank actions worldwide, most if not all actions amounted to easing. These seem to have had a positive effect on the three month S&P 500 chart (see below).

Notably the S&P500 uptrend has started to wane as the Euro has started to wane against the USD.

The Bank of Japan also decreased rates on a fraction of deposits to -0.1%. It introduced a tiered approach to deposit rates ranging from +0.1% to -0.1% with the bulk of deposits earning +0.1%. The diagram below depicts this tiered approach.

The BOJ took this approach in order not to undermine the profitability of the financial sector.

"BoJ says that this new mechanism will succeed in reducing money market rates into negative territory, because these rates are determined by the policy rate paid on marginal increases in bank assets, not on the entire aggregate of these assets accumulated in the past. They presumably expect this to impact the foreign exchange and bond markets." (Financial Times)

As investors can see in the JPY/USD (black line) chart below with the Nikkei 225 index (red line) and the S&P500 Index (green line), this has had the effect of increasing the value of the yen versus the USD. Again as the Yen has recently started to wane against the USD, the S&P 500 (green line) has also started to wane.

The BOJ is as of March 2016 considering expanding its QE (or QQE) program from ¥80T to ¥100T mainly by increasing its JGB purchases. It is also considering pushing negative deposit rates from -0.1% to -0.5%. We will have to wait to see how this develops.

China does not have QE; but it does have easing. For instance on February 29, 2016 the PBOC cut its banks reserve ratio requirement by -0.5%. This is the fifth cut in the last year. It means big banks in China will have to have a reserve ratio of 17%. It also means that they can lend more with this now lower reserve ratio requirement. This action along with the many others China has implemented in the last year are expected to decrease the rate of "slowing" in the Chinese GDP Growth. This could be good news for China in that sense. However, it also means that the Chinese banks will be making an increasing number of "risky" loans. It means when the Chinese credit crisis hits, the Chinese will have a bigger problem than many are envisioning. It means there is a limit to how much the Chinese can get out of this kind of easing. For instance, at what point do you decide that the reserve ratio requirements are too low?

The above action has stabilized the yuan for now; but yuan seems likely to come under increased pressure in the near future. The Financial Times reported April 24, 2016 that Chinese debt had reached 237% of its GDP (about $25T). This is more or less inline with the US and European debt. However, China has gotten to this point much more quickly. Chinese debt was only 148% of GDP at the end of 2007 (and the GDP was smaller). The rapid rise in Chinese debt means there has to be a far larger ratio of bad debts. Many are expecting a credit crisis to hit China in the near future due at least partially to this situation.

Adding to China's problems, net outflows from China are expected to be $530B in 2016. This expectation is lower than the $675B of outflows in 2015. That lowered expectation has added a bit to the stabilization of the yuan. However, it is hard to see how China's economy can be growing at a roughly 6.9% rate with those kind of net outflows. With a 2015 GDP of approximately $11T, the $530B in net outflows amounts to almost -5% of its GDP. How can an economy grow dramatically when money is flowing out of its economy to this large an extent? Clearly this situation is unsustainable. When you take into account the multiplier effect of the negative stimulus due to the net outflows, you would think the Chinese economy has to be shrinking (or will soon be).

I have tried to give some flavor to the Chinese economic situation above. However, it would take many articles of significant length to really do the Chinese situation justice. Suffice it to say that China has significant economic problems. The new borrowing increase of Rmb6.2T ($955B) in the first three months of 2016 should help offset the $530B in outflows mentioned above; but large increases in amounts loaned by banks ultimately mean the rapid proliferation of questionable loans. It means China is rapidly increasing the amount of the bad loans it will have to write off in its credit crisis. This credit crisis seems to be looming on the near horizon.

"Jonathan Anderson, principal at Emerging Advisors Group, warns that banks driving the huge credit expansion since 2008 rely increasingly on volatile short-term funding through sales of high-yielding wealth management products, rather than stable deposits. As Lehman and Bear Stearns proved in 2008, this kind of funding can quickly evaporate when defaults rise and nerves fray." (Financial Times)

A few have estimated the current level of bad Chinese debts at about $6T-$8T (including myself). This is roughly twice the US and the EU estimated bad debts ($4T apiece) during their Great Recession credit crises. No one is really sure when this situation is going to explode; but it merits careful watching by all investors. It could easily trigger a worldwide recession, especially since the US and EU economies are already weak. Some years ago I estimated that the Chinese credit crisis would ensue when Chinese GDP growth slowed to the 5%-6% range. That estimate is appearing ever more accurate as China approaches that level.

However, in the shorter term China is easing; and that easing is stabilizing the RMB (see chart below).

The above three month chart of the RMB versus the USD looks very promising. However, the one year chart of the RMB versus the USD looks much less so (see below).

This chart looks like a strong downtrend. There seems to be a fairly strong correlation between falls in the RMB (black line) and falls in the S&P500 Index (red line). Thus far the S&P500 index seems to be rebounding nicely; but it seems inevitable that at some point it will not. The US is a major importer of Chinese Goods. If they get dramatically cheaper due to a cheaper RMB, that will put downward pressure on the US economy. It will cost the US many jobs.

The timing of a looming economic disaster for China is in question. However, the ultimate outcome does not seem to be. In fact credit risk is already spiking in China (see chart below detailing the Corporate Bond Sale Cancellations in China in the first two weeks of April 2016 versus April 2015).

I could go on. However, China seems to be implementing delaying tactics that seem destined to lead to an ever bigger explosion (or implosion as the case may be) when some unknown event finally triggers the Chinese credit crisis.

The US and Europe are sure to suffer when this happens. Some say China will be able to engineer a "soft landing". I don't know what they are considering a "soft landing"; but I see little way that China gets out of its current predicament without substantial pain.

I cannot predict exactly what will happen when. However, if the EUR/USD and JPY/USD keep falling as they have been just recently, that will hurt US exports. It will push the US import to export ratio upward. It will increase the trade deficit. That will decrease GDP growth. In March 2016 Chinese exports were up 18.7% year over year. The US Trade Deficit with China was $3.08B in March 20015; and it rose to $29.86B in March 2016. That nearly $27B in extra US March trade deficit with China will hurt the US Q1 2016 GDP Growth number. It makes the likelihood of a US GDP Growth decline in Q1 2016 that much more likely.

The old saying, "sell in May and go away" may be very appropriate to this year's US equities markets. The risks seem huge. The extra QE by the ECB and the BOJ with tend to push US equities upward; but will that be enough? That is a question that I would not want to risk a lot of money on. If you do, perhaps you will be rewarded with gains. The ECB already has €20 extra in liquidity pouring in each month. It will start the LTROs in June. The BOJ may add another ¥20T per year in liquidity soon? It is hard to bet against all of that liquidity. The BOJ may soon raise its ETF buying from ¥3.3T to a much higher number.

I admit I am confused. The world has never seen the like of these central bank programs. Thus far the mantra, "bet on the central banks" has proven fruitful for investors. It may again; but the amount of worry involved in following the central banks is increasing. It also appears that Janet Yellen does not want to follow the other central banks into this equities markets inflationary spiral, especially when the US is seeing revenues and EPS equities recessions. Not following may be a prudent decision by Yellen. If it is for her and the US Fed, then not following may prove to be a prudent decision for US investors.

I would rate the SPDR S&P500 ETF (NYSEARCA:SPY) a hold under the current circumstances. However, I would be very wary of a significant move downward. I might consider selling just to be able to sleep better at night. The two year chart below of the SPDR S&P500 ETF shows the precariousness of the technical position.

One could interpret the above as a triple top formation. That would be a very negative technical indicator. Some would argue that they see a triple bottom. Unfortunately the triple bottom broke downward though in its last fall. The triple top is still intact. The situation is uncertain. The new ECB and BOJ QE and the China easing are temporarily pushing things upward. However, even with that the non-US currencies are flagging recently. That seems to be negatively affecting the US equities markets. Watch the movement of those major currencies against the USD. If the USD goes up in relation to them, the market will likely go downward. The price of oil might go downward too, which would also have a negative impact on the S&P500 ETF.

Of course, the summer driving season is coming; and the hurricane season starts in June. Perhaps those will prop up oil prices and the S&P500 ETF . The SPY is heavily energy weighted. After the recent poor results by Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), and others, the PowerShares QQQ ETF (NASDAQ:QQQ) seems even more likely to fall. The currencies again should play a significant role in the performance in the near term and midterm. Watch them carefully.

NOTE: Some of the fundamental fiscal data above is from Yahoo Finance.

Good Luck Trading Investing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.