European Auto Sales (and Next Week's PMI)

New car registrations in the EU slowed to just 4.5%yoy in April, down from a growth rate of more than 13%yoy in December:



Interestingly, while new car registrations grew by more than 50%yoy in Portugal and more than 30%yoy in Spain, many of the Nordic countries--as well as Germany-- recorded declines in the rate of vehicle purchases:



Given a decent correlation between the two variables, the muted rise in overall vehicle sales suggests that next Thursday's release of Manufacturing PMI data for Europe, France, and Germany might not impress the markets:

Bond are Signaling P/E Compression for the Stock Market

Bonds have had a great last few days as yields have fallen by the largest three-day amount since April of 2013. But, this rally in treasury bonds began at the start of the year and the ten-year now yields about 50bps less than it did then. This has created a divergence we are closely monitoring, which is the deteriorating relationship between ten-year treasury bond yields and the S&P 500 forward P/E ratio. Usually rising bond yields are accompanied by a higher stock multiple and vice verse. So far this year the relationship has not held and over the last few days the gap between the red line (yields) and blue line (forward P/E) in the chart below has grown wider. We suspect this relationship will reassert itself with either multiples falling or yields rising.  

In Spite of Weak Earnings and Internals, European Markets Continue Higher

As we noted a couple of days ago (here), MSCI Europe appears to be the region with the weakest Q1 earnings results so far this reporting season.  Meanwhile, European stock market indices have continued higher and, in some cases, are making new all-time highs:




Individual stocks, however, are NOT making new highs:




And the number of advancing stocks has fallen back quite a bit over the last couple of months:



Fewer European equities are outperforming the World Index:




And the number of stocks in European sectors that are above their respective moving averages is declining:



Regular readers will not be surprised by most of this data-- a common theme leading up to and since our most recent quarterly call.

Despite Stronger Q1 GDP Growth, Japan is Not Out of the Woods

Japan's GDP grew at a 5.9% annualized rate in Q1, beating expectations for growth of 4.2% and bringing hope that Japan will be able to avoid a tax-increase-induced slowdown in Q2 and beyond (1st chart). Indeed, the main drivers of the QoQ growth were private consumption and private non-residential fixed investment, which is a nice change from government-spending-led growth for the last year (2nd chart). However, we would caution about being overly optimistic on Japan's growth prospects for the next few quarters. For one, the increase in private consumption and investment is likely largely driven by demand being brought forward ahead of the April consumption tax increase. This tailwind will turn to a headwind in the Q2 GDP numbers. Secondly, the retreat in government investment (the grey bar below), is set to continue to detract from GDP in the coming quarters as stimulus spending winds down. We've noted all this in the past here and here.

Further, recent data don't yet reveal the foundations for the accelerating growth story. Real wages are falling and look set to continue on that course as the weaker yen feeds through to the real economy (3rd chart), consumer confidence has been falling since the middle of 2013 (chart 4), and business survey data (like the headline manufacturing PMI and the new orders components of the manufacturing PMI in charts 5 and 6) weakened handily in April.

30-Year Treasuries Are Having the Largest 3-day Drop In Yields Since April 2013

Despite (or because of?) the taper and some better economic numbers coming out of the US today, treasury bond yields are down for the 3rd day in a row. If the 30-year closes at 3.33% today (the current yield), the 3-day percent change in yield will be the most negative in about 13 months. Needless to say, the bond and stock markets are telling two different stories about growth and inflation prospects.

In Japan It's Going to Take Another Round of QE to Weaken the Yen

Last week we analyzed here one reason why the yen has not fallen more, despite all the QE and investor expectations for a much weaker yen. In that post we argued that in a world of zero interest rates and low inflation it's the relative size of central bank balance sheets that seem to be the main factor driving the level of currency pairs. When one compares the relative size of central bank balance sheets and a logical forecast for the relative size for 2014 and 2015, it becomes clear that the JPY/USD cross, at 102, is already discounting further monetary debasement in Japan.

In this post, instead of analyzing the relative size of central bank balance sheets, we'll look at the relative size of the monetary bases in the US and Japan. We also incorporate into our analysis a low and high forecast for the relative monetary bases. Our low forecast assumes the BOJ continues to create base money at a rate of roughly ¥70tn per year for the remainder of 2014 and 2015. Our high forecast assumes the BOJ doubles its base money creation starting in November of this year and so begins to create money at a rate of ¥140tn per year. In both cases we assume the Fed concludes its tapering process by the end of the year.

What we notice is that the JPY/USD cross discounted almost immediately the entirety of the BOJ's current QE program and at the current level the cross actually appears to be discounting even more easing than the current level of relative monetary bases would imply. To us, this means that since the market has already more than fully discounted the effect of the taper and the BOJ's planned asset purchases, it's going to take even more easing by the BOJ to push the yen lower. If the relationship between relative monetary bases and the JPY/USD  holds, then a doubling of the BOJ's bond buying program would put the yen at 120.

Should We Worry More About The US Economy Or The International Economy?

The KBW Bank index is an index of 24 commercial banks in the US.  It is considered a good proxy of the banking sector.  Commercial banks tend to draw most of their profits from the local market, so the performance of the KBW Bank index is a decent proxy for profit expectations of the domestic sectors of the US.  Likewise, the S&P 600 small cap index is an index of small cap companies, and small cap companies tend to derive more of their profits from the domestic economy (rather than international operations).  So, if there are concerns about domestically generated profits in the US, likely the KBW Bank index and the S&P 600 small cap index will underperform the S&P 500.  This is exactly what is happening now.  In the chart below we compare the relative performance of the KBW Bank index to the S&P 500 and the relative performance of the S&P 600 small cap index to the S&P 500.

 

As a double check, let's bring into the analysis some other proxies for domestic and foreign strength.  Lumber is used primarily for housing and so serves as a good proxy for the health of the housing market narrowly, but of the domestic economy more broadly.  Copper tends to be used in infrastructure and durable goods, so it serves as a good proxy for the health of the international market (especially given the huge infrastructure spending in the emerging markets).  By making a lumber-to-copper ratio, we can then broadly measure the relative strength of domestically oriented sectors compared to more internationally oriented sectors.  Interestingly, the lumber/copper ratio has flatlined for the last year and appears to be starting to roll over.  Below, we compare the lumber/copper ratio to the S&P600/S&P500.  The message here seems to be one of a growing relative concern of the domestic economy over the international economy.

Chinese Economic Data Just Continues to Disappoint

Despite the fact that Chinese private sector debt is growing at nearly twice the rate of overall GDP growth, as we highlighted here, Chinese economic data continues to miss expectations to an extent not seen since 2008-2009 (first chart below). Last week it was trade and today it's industrial output and retail sales, both of which remained at levels indicative of weak and slowing growth in the world's second largest economy (second and third charts below). So, as one would expect, economic growth forecasts just keep coming down with the weaker data (fourth chart below).

Earnings Update and Highlights

In the Asia-Pacific region, about two-thirds of companies have reported Q1 earnings.  Of those companies, about 57% have surprised on the upside, versus just 42% that have disappointed expectations.  The Health Care sector has generated positive surprises in 85% of its earnings releases so far.  With nearly all of the companies in the Information Technology sector having reported results, the number of constituents in the sector with positive growth in earnings is more than twice the number with negative earnings growth.



With just over half of the companies in the MSCI Europe index having reported Q1 earnings thus far, the majority of results have been neutral (~3.5%) to positive (~52.5%).  The Information Technology sector has generated the greatest number of positive surprises while the Energy sector has surprised by the widest margin on the upside.  While growth in earnings has been positive for more Industrials, it has been below expectations and has so far resulted in the most negative surprises for any sector.  The Consumer Staples sector has seen the largest positive price impact as a result of generally better than expected results.



Turning to the North American region, where nearly 90% of the constituents have reported earnings, we find the largest percentage of positive surprises (68.5%) of any MSCI World region, led by the Information Technology sector.  Companies with positive earnings growth outnumber those with earnings declines by nearly five-to-one in the Utilities sector; conversely, more than half of the companies in the Materials sector reported negative earnings trends.  In spite of 77% of the Health Care sector companies having beaten estimates, the impact on share prices has mostly been negative.

The US Dollar Still Looks Undervalued

So far in 2014 we have seen the dollar lose ground on a Purchasing Power Parity basis against most major currencies in the world. By our count, the dollar is undervalued against 15 major currencies and overvalued against just 3 (Hong Kong Dollar, Japanese Yen, & Taiwanese Dollar).  The Dollar looks to be the most undervalued against the New Zealand Dollar (32.6%), Australian Dollar (27.4%) and the Czech Koruna (20.8%). The Euro is about 10% overvalued versus the Dollar. Perhaps most interesting is that we are now seeing the British Pound overvalued against the Dollar for the first time since 2008. This relationship flipped at the very end of 2013 and has steadily moved further in favor of the British Pound. Charts below:

Valuations Mattered Last Week In North America

Everyday we decompose the performance of all stocks, sectors and regions within the MSCI World index to understand what fundamental forces are driving price changes.  We divided every aggregate into deciles to rank order and calculate the relationship with each fundamental variable.  We then calculate the coefficient of determination (R^2) to understand how much each, single variable explained changes in equity prices.

Last week, in North America, the strongest relationship was with price-to-book value.  About 87% of the performance last week of the MSCI North America index can be explained by price-to-book value. The lowest P/BV decile was up .1% on average, while the heighest P?BV decile was down 1.9% on average.

Below are the biggest losers from last week in North America, led by Whole Foods.

Below are the stocks in the MSCI North America index with highest book value.  Should last week's factor performance trend continue into this week, these companies would be at the most risk.

Every New Yuan of Chinese Debt Creates About .5 Yuan in Nominal Growth

The Chinese nominal GDP growth rate has fallen by about 66% since the peak in 2007, from 22.9% to 7.8% in Q1 2014. Meanwhile, total loan growth has basically remained flat aside from the surge in 2009. The logical deduction is that it's taking ever more debt to create a lower level of nominal growth. For example, the multiplier on new debt is now well below 1, and probably closer to .5. In other words, every yuan of new debt obligation creates about .5 yuan in nominal growth.

Now Is Probably Not The Time To Be Buying Telecom Stocks

Telecom valuations seem to be either in the penthouse (as they are now and as they were in 2005-2007) or in the outhouse (as they were from 2001-2003 and 2008-2010). The charts below show the percent of Telecom stocks that are trading within 25% of their 3-year, 5-year and 7-year max valuation. We look at P/E, P/CF, P/S and P/B on each chart.

The 3-year chart shows the most extreme valuations with 100% of stocks trading within 25% of their 3-year max valuation based on P/S. This is the highest level since November 2006. Looking at the other three valuation metrics, we see they are at even more extended historical valuation levels. 95% of stocks are trading within 25% of their 3-year max P/B level. This is the highest level since February 2002. 88% of stocks are trading within 25% of their 3-year max P/CF level which is the highest since April 2002. And finally, 71% of stocks are trading within their 3-year max P/E level which is the highest since March 2002. Anyone that remembers the TMT bust may shutter looking at these valuation levels.

The absolute level are lower looking at it from a 5-year or 7-year perspective. The trends, however, remain in place. Regardless of how you slice it Telecom valuations look stretched.