Markets find it tough to break the BTFD conditioning

Was the Friday rebound in equity markets another BTFD opportunity, or a possible suckers rally? Certainly, the wall of central bank liquidity over the past five years have reduced the market’s pricing mechanism to little more than a pavlovian response to the next turn of the central tap and where bad news can be good news for prices if it raises expectations of a bigger flow.  News however, whether good or bad that does stimulate more liquidity may just be bad news.  

Last week had a lot of ‘bad’ news. This however was not new bad news. The US continues to goad Russia, albeit now through bombing its ally Syria and getting its own ally Saudi Arabia to cut oil prices on which Russia also depends. Ebola continues to spread, which is bad for airlines, but good for pharma and security. Japan continues to struggle with radiation, a collapsing economy, rising real inflation and what should be an utterly discredited and failed QE policy.  Europe meanwhile continues to grind back into recession, but having approached the moment of truth may be shying away from the full QE programme that advocates were predicting after Draghi’s recent Jackson Hole speech.  Notwithstanding a partial attempt with an ABS programme, this fell short of expectations and so bad news was just bad news and markets reacted accordingly.

Unfortunately, market volatility is an inevitable consequence of the deliberate confusion about the nature of the ECB and Euro that has been sponsored by politicians and central bankers. At the centre of this has been Merkel who has been trying to ‘hunt with the hounds and run with the hares’.  EC treaties are clear and indeed have been paid lip service to by Draghi when he re-iterates that the EC is “not a transfer union”.  His actions however belie this, including advancing ECB liquidity to domestic banks who have used this to buy local sovereign debt in the secondary market to circumvent the ECB’s prohibition to fund primary debt. Notwithstanding the German constitutional court’s ruling in February (which had been sat on for around 9 months) that the ECB’s OMT plan “manifestly violates” the EU treaties, Merkel seems happy just to turn a blind eye while playing a ‘good cop, bad cop’ game with Bundesbank president Jens Weidmann.  This, together with Draghi’s “whatever it takes” and subsequent utterances have goosed the market into believing peripheral EU sovereign debt is now backstopped by the ECB and therefore German tax-payers. German tax-payers however have not been consulted and seem to be in no mood to comply, as today’s comments from a key Merkel ally, Hans Michelbach of the Christian Social Union (CSU) might suggest. Not only is Draghi accused of “endangering the stability of financial markets”, but more pertinently Herr Michelbach reminds us of the now largely ignored constitutional court ruling and that “The ECB needs to change its policies so that they come back within the terms of the treaties”

http://uk.reuters.com/article/2014/10/04/germany-ecb-draghi-idUKL6N0RZ07N20141004

So bad news in Europe may not be the ‘good’ bad news that markets have run with during the US QE programme, but ‘bad’ bad news for markets if the ECB is approaching that crisis point where it has to reveal whether it has any real bullets in its monetary pistol or has just been fooling us with blanks. Perhaps by taking Europe to the cliff, Draghi feels he can present the German tax-payers with a fait-accomplie from which they dare not refuse, as such a refusal would have devastating consequences to peripheral bond markets and banks. Germany’s decision however, will not be telegraphed to us muppets ahead of time. With peripheral Euros now invested back into peripheral bonds and banks, the creation of a hard currency Northern block at this stage would not be saddled with a mountain of peripheral euros in Germany which might have to be converted at par into the new Deutschmark. While the ‘soft’ Euro areas would then be free to monetise debt and devalue, yields would rise significantly and there would be no shortage of burnt positions amongst bond investors.

So what was the cause of Friday’s market euphoria, a cure for Ebola, peace on Earth? No, it seems a slightly better than expected monthly job growth figure in the US non-farm statistics for September.  To qualify as a ‘good’ figure for markets however would either be a really ‘bad’ number that would raise the prospect that Yellen would defer the QE tapering and keep the liquidity tap and low rate environment going indefinitely or a figure that was so good as to signal a serious acceleration in US GDP growth prospects. Unfortunately neither of these would apply to the September numbers. At +248k net new jobs (+236k private), US job growth was around +30k ahead of consensus and the trailing 12 month rolling average of approx. +213k, albeit in large part reflecting a +40k MoM swing in retail (from -4.7k in August to +35.3k in Sept).  While the numbers are ‘so..so’, they do not deserve the praise heaped on them by political spin doctors who focussed on the flawed unemployment ratio (-0.2ppts to 5.9%). 

Perhaps a little perspective is needed for this political hot potato. First, the context. For the year to end September, US private sector employment increased by +2,588k/+2.25% to 117.524m versus a total civil non-institutional population that increased by +2,278k/+0.93% to 248.446m.  This is hardly spectacular given the government and central bank largesse over the period with private sector job growth only just exceeding population growth. But what about incomes?  Average hours have barely changed at 34.6 pw (vs 34.5 pw) while average hourly earnings are struggling to keep pace with inflation with a +2.0% YoY increase to $24.53 p hr (from $24.04 p hr) to take average weekly earnings from $830.07 pw to $848.74 pw, an increase of +2.2% YoY.  Multiply this by the increase in employment and this implies that private sector wages increased by +4.6%/+$225.8bn to approx. $5.2tn. Although this may seem ok, there are a couple of points one may need to consider. Firstly, don’t forget that the private sector ultimately has to support the entire working population and that these figures are nominal. Also, remember that the US economy is worth approx. $17bn pa, which means that the $225.8bn increase in private sector wages is equivalent to only +1.3% of GDP.  If consumption accounts for around two thirds of GDP in the US, clearly private sector wage growth alone will not be offering much of a boost this year!

So back to Friday’s market bounce. As the dog might utter, “Woof, Woof”

WPP FY14 interims: Tightening cost management belies the upbeat market forecasts

WPP :   The group is tightening the screw on hiring and staff costs to absorb slowing net sales growth while maintaining the public forecasts of rising GDP and advertising expenditure into 2015. The hitherto growth engine markets of BRIC however, are looking increasingly wobbly, while the contraction in margins at the digitally heavy specialist communications division suggests pressure from rising talent costs on the groups core growth areas. For the present, markets are un-fazed as long as Draghi follows through with the QE rumours and groups such as WPP increasingly resort to share buy-backs and lower tax provisions to create the veneer of value enhancement for investors. While the current financial repression engineered by central banksters can make most share buy-ins look attractive by enhancing EPS, this is just another example of the misallocation of capital when companies are being encouraged to overpay for growth, even when it is their own.

Trading H1 FY14: FY14: Revenues +2.7% to £5,459m (WYT +1.6% to £5,413m) with net sales +4.1% organic (WYT +4.1%), -8.3% fx and +2.3% Acqs. By region, organic net sales increased by +4.3% from N.Am (RoS +30bps to 14.9%), +6.9% from UK (but with RoS -20bps to 13.7%), +0.6% from W.Europe (Ros +10bps to 9.3%) and +5.5% from RoW (but RoS -60bps to 13.1%). By category, organic revenue growth was +5.9% for Advertising & Media (margins however flat at 14.7%), +1.2% for Data Inv mgt (margins +10bpts to 10.5%), +2.7% for PR (margins +180bps to 15.0%) and +3.8% for Branding & Identity, Healthcare & Specialist Comms (margins down -100bps to 11.2% however). Net New Business was $4.089bn, which was slightly below our $4.39bn forecast.

Costs: Against constant currency revenue growth of +6.4%, constant current currency cost growth was held at +6.2%, ergo, the +30bps constant currency margin uplift reported (vs reported margins flat at 13.0%). Within this number, staff costs as a proportion of net revenues edged up from 66.5% to 66.6%, notwithstanding cuts in cash incentives (from £78m to £54m) and modest increase in like for like FTE numbers; +1.7% YoY to period end and +1.5% average for H1.

OUTLOOK FY14: Group FY14 guidance remains at >+3% for lfl net sales and +30bps (at constant fx) for EBITA margins. On a macro perspective, WPP did not re-iterate its previous (at Q1) FY14 global GDP growth estimate of +3.6% (+5.7% nominal), although it continues to forecast global advertising expenditure growth of +4.5% for 2014, rising to +5.0% in 2015. The latter year estimate, includes an improved level of expenditure across every major market with the exception of LatAm, where the drop-off in the estimated rate of growth to +8.7%, vs +10.1% for 2014, is still relatively benign. Clearly, all’s well in someone’s garden, albeit they ought to go easy on the weed!

In many ways, WPP is a microcosm of the broader market; a diminishing capacity to raise margins against a faltering top-line growth proposition and thereby having to resort to levering cheap capital to drive acquisitions and buy-backs in order to sustain the EPS growth mantra.  Perhaps, there are still some optimists out there that believe that “it’ll be better next year”, notwithstanding  this has been pushed out each year, only to see the growth forecast crumble.  But who really cares? Sovereign debt yields across southern Europe have little connection to those countries ability to pay, unless the EU really is the "transfer union" that Draghi says it's not and the Karlsruhe judgement ruled would be illegal. As long as central banks flood financial markets with liquidity and depress returns, the game is not whether WPP et al are misallocating capital by over-paying for lower growth, but whether equities as an asset class remains attractive (by default) and if WPP shares remain an efficient proxy for this.  Of course, the madness won’t last, but until currency markets restore discipline, it seems to be the only game in town.