Tuesday 17 July 2018

A fine line between the American dream and creative accountancy

Spin and duplicity are ubiquitous these days - and it is getting harder for investors to separate fact from fiction, writes Paul Sommerville

Divisive figures like Donald Trump have emerged
Divisive figures like Donald Trump have emerged

Paul Sommerville

Janet Yellen is to central banking what Cinderella is to the happy ever after. Everybody wants to believe the fairy tale - but when examined closely, the narrative doesn't add up.

The US economy is portrayed as being strong and recovering, but held back by a sluggish world economy. After raising interest rates last December for the first time in seven years, the Fed has already had to row back on its intentions to increase rates further, fearing a measly extra quarter point rise could derail the whole recovery.

Yellen's musings on the state of the US economy at Fed press briefings have been reduced to incoherent babblings.

The US's first quarter GDP is scheduled for release this Friday, and estimates are sliding fast. We were told that by 2016 the US would be firing on all cylinders with 3pc-plus GDP rates - but of course that was just empty rhetoric to justify the printing of trillions of dollars. The majority of analysts now expect sub-1pc growth - and that is after 1.4pc for the previous three months. Bank of America has cut its forecast to zero. Please note these numbers are annualised.

This as we pass seven years since the worst point of the Great Recession and seven years into the most radical easing of monetary policy in history. A dismal return.

Already we are hearing the usual chorus of "don't worry, the weak numbers are temporary." In the world of financial spin, all bad numbers are "temporary" and a buying opportunity. No doubt the slant on the data will be that the first quarter is traditionally weak, even though the numbers are seasonally adjusted, and last year they decided to seasonally adjust them twice - I'm not making this up!

It is never instructive to focus on any one data point to gauge the health of an economy, so let us look at some others.

Across a broad spectrum the picture is deteriorating. Retail sales fell 0.3pc in March and have fallen for three straight months. The inventory-to-sales ratio has spiked to the highest level since the last financial crisis. (This tracks how long inventory sits around unsold, in relationship to sales completed.) Inventory corrections tend to have an unpleasant impact on the overall economy.

Total business sales are also struggling, including sales by manufacturers, retailers and wholesalers of all sizes across the US economy. This measure is far broader than the aggregate sales of publicly-traded companies, which have also been falling. US factory orders have declined on a year-over-year basis for 16 months in a row. These are clear recessionary signals.

One statistic constantly used to promote the US recovery story is the low and falling unemployment rate. Firstly, the number simply does not reflect the reality - it is purely for marketing. A record number of 18 to 35-year-olds are not working, and if you apply the 2005 participation rate to 2016, unemployment is above 9pc.

More importantly, the jobs being created are lower wage occupations, so do not produce income needed to spur faster GDP growth. (For those with a more optimistic bent, I would urge you to pay close attention to the participation rate. Any sizable uptick in this number, even if the headline unemployment rate is rising, would suggest things are improving and would be a possible signal that the US economy is past its worst and potentially a buying opportunity. I believe this point to be some time away.)

The real fun - and duplicity - comes with US corporate earnings. Earnings season has just begun and it is likely the worst quarter for earnings since 2009. As revenues fall, companies are increasing their debt and using the money for share buybacks, dividend increases and other financial trickery - in order to maintain lofty share prices.

Aggressive central bank monetary policies have created artificial demand for corporate debt. Such usage of debt does not support economic growth, productivity growth or employment, but is likely to weaken future growth if interest rates rise.

Accountancy deception - always a feature of US corporates - is becoming more pronounced. Companies are increasing the use of non-GAAP 'earnings' to make the numbers. It is estimated 33pc of Q1 earnings will be non-GAAP - that suggests that if they were not taken into account, the S+P would be trading nearly 1,400 rather than the 2,100 it is today, on a 17 times P/E multiple (Translation: they are cooking the books.)

If profit margins revert to historical averages, the earnings-based valuation measures that investors are using to justify investment in equities today could quickly evaporate - making stocks appear much more expensive than they do currently.

It is not wise for investors to employ long-term capital to a US equity market with sky-high valuations and falling revenues and earnings. It is possible your long-term returns will be good - but not probable.

For shorter-term investors the picture is more nuanced. It is clear that central banks have decided the best way to avoid recession is to re-inflate colossal asset bubbles. Pricing in all markets has very little to do with fundamentals and much more to do with sentiment and positioning of large hedge funds and speculators.

Take, for example, the mining sector and China. This sector - despised by the majority of analysts coming into 2016 - has just had the most extraordinary rally. Large mining stocks such as BHP Billiton and Rio Tinto have doubled in value in the past few months (albeit from beaten down levels).

Similarly with oil and gold. The yellow metal universally loved when trading at $1,900 but shunned and written off when trading at $1,050 has just had a 20pc rally. Oil is up 50pc in the last three months, and, with it, oil stocks. Conversely, banking stocks (tipped as a safe bet for 2016) have fallen precipitously - for example Barclays is down 50pc in the last nine months. Remember, sentiment indicators are always reverse indicators at extremes.

High-risk investors are likely to be better rewarded by taking a contrarian approach. For this reason investors may need to contemplate that, in the short-term, the negative sentiment regarding China/emerging markets and the positive sentiment regarding the US could easily reverse. Iron ore has just rallied 50pc, suggesting views on China are becoming less bearish as those betting against China are forced out of positions. I would not be surprised to see similar moves in soft commodities, for example.

The price action in all markets is likely to show precipitous falls followed by gut-wrenching rallies as the various authorities step in to arrest falls. The S+P 500 has had two falls greater than 10pc in the last nine months, and I would expect more of such price action, but maybe after those bearish from February have been forced out of positions.

Conversely, the German Dax is still some 20pc lower than a year ago and could (along with other EU stocks) easily benefit from an improved sentiment towards China if it occurs. Also, we expect oil prices to come under further pressure once this bounce is exhausted.

The fable that the US economy is strong while others drag it down is simply fantasy. The US economy is on the precipice and a recession is a distinct possibility. More probable is a continuation of torturous slow growth and a hollowing out of the economy. The narrative put forward by financial media bears no relation to reality and it is for this reason that divisive figures such as Donald Trump emerge.

The vast majority of US citizens are struggling just to maintain their current living standard. It is a very fine line between the American dream and the American nightmare.


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