Chinese Economy Driving U.S. Market

FactSet released its updated aggregate quarterly earnings report. They broke down firms with a large amount of Asian exposure in the chart below. As you can see, the firms with over 40% of sales in Asia outperformed those who only have 20% exposure to Asia. The group with 20% of sales in Asia did better than the entire S&P 500. It would be interesting to see how bad the firms with less than 20% exposure to Asia did. The implication based on these metrics is that group would have even worse performance. This relative performance makes sense based on the improved economic performance of China and Japan. It also shows how weak the rest of the world is. The declining estimate in the GDP Now report is a good representation of American economic weakness.

(Click on image to enlarge)

As you can see from the chart below, the Chinese Yuan has had a turnaround. It has been rallying versus the dollar for a few months. The chart above might be slightly biased because in the past few days we’ve seen a minor correction in the Yuan. It’s interesting that the potential nuclear war with North Korea didn’t affect the Yuan or stocks with Asian exposure given that Trump threatened a trade war with China if it didn’t get tougher on North Korea. It shows how the market is ignoring that risk and focusing on the Chinese rebound. With some good economic numbers, analysts are projecting another boom. In August Chinese exports were up 5.5% and imports were up 13.3%. The excavating machinery part of the Chinese Construction Machinery Association stated its excavator sales were up 111.1% year over year in the first 8 months of the year. Industrial profits in were up 21.2% in the first seven month of the year. GDP growth was 6.9% in the first half of the year. After years of deceleration, there’s a renewed optimism that the soft landing is over and a new boom is here.

(Click on image to enlarge)

Q3 Earnings Expectations Crash

We are getting back to the same old situation the market and earnings have been in for most of this recovery. As you can see from the chart below, the Q3 earnings estimates fell in the past few days. Year over year earnings growth is expected to be 4.9% which is down from 7.5% on June 30th. The full year earnings are now expected to grow 9.7% instead of 10.0%. This is while stocks hit a record high Monday. The S&P 500 was up 1.08% to 2,488.11 on Mondaybecause hurricane Irma wasn’t as bad as expected. That’s not a great reason to rally because stocks never fell on the anticipation of the storm. The Shiller PE is now at a cycle high. It’s at 30.45, inching closer to the 32 handle which was seen before the Great Depression.

(Click on image to enlarge)

Corporate leverage to GDP is near its all-time high as low interest rates allow firms to take on more debt than ever before. The debt only becomes a problem when interest rates rise. The chart below gives you an example of how the corporate leverage has increased. As you can see, in Q4 2012 16% of firms had gross leverage of 0-1 times. Now only 2% have that low leverage ratio. The percentage of firms with a gross leverage of 4-5 times has risen from 4% to 11%. The exposure to interest rates rising is higher than it was in 2012. I don’t think there’s a tipping point where there’s too much leverage. There needs to be a catalyst to make this situation reverse course. The credit cycle needs to be stressed. With the Chinese economy improving and the Fed staying relatively easy, no catalyst is coming by the end of the year.

(Click on image to enlarge)

Labor Market Stats

Now let’s look at some of the latest macro trends in the labor market. As you can see in the first chart below, those aged 25-34 years old are seeing more median wage growth than those 55 years or older. The one negative in this chart is that the trend for both segments is lower. It’s tough for millennials to get a job, but for the past few months they are at least getting a boost in median earnings. Millennials aged 25 to 29 have just passed those aged 50 to 54 in the workforce. I wouldn’t necessarily celebrate from that because 26 is the most common age followed by 25. There are more people in that younger age group, so it makes sense there are more workers that age. That doesn’t take away from the fact that fewer millennials have jobs than all the other generations when they were younger.

(Click on image to enlarge)

Another interesting trend in the labor market is that low-skilled workers have had more of a pay raise than high and middle skilled workers this year. This goes hand in hand with the fact that the slack in the manufacturing labor market has been tight. Many firms have discussed not being able to find qualified workers to fill entry level positions. I previously discussed the fact that you’d think there would be a lot of workers will little experience. The problem is that there’s also a lot of entry level jobs. Many millennials would rather work in the service sector than manufacturing, taking away from the labor pool. If the labor force for highly skilled and middle skilled workers starts to tighten, we will see a tight labor market and expansive wage inflation.

(Click on image to enlarge)

Conclusion

The Chinese economy held up the U.S. stock market in August showing itself to be the global economic powerhouse that it used to be. The Q3 earnings estimates have been tumbling, making the all-time highs in the major indices look ridiculous. The one optimistic catalyst which occurred recently is that hurricane Irma wasn’t as bad as projected. This caused the hurricane trade, which was short Travelers and long Home Depot, to unwind. The labor market is showing a glimmer of hope for millennials.