ISM Index Release Will Provide First Glimpse into Earnings Season

The major economic data releases are relatively light in the first week of the new year.  Of the major releases that we follow, only six of them are on tap this week:

• Tuesday 10:00 - ISM Manufacturing Index
• Wednesday 14:00 - FOMC Minutes
• Thursday 08:30 - Jobless Claims
• Thursday 11:00 - EIA Petroleum Status Report
• Friday 08:30 - Employment Situation (AKA the "Jobs Report")
• Friday 08:30 - International Trade

Heading into the next round of earnings releases, starting on Monday, 9 January when Alcoa (NYSE: AA) reports before the open, we'll pay special attention to Tuesday's ISM Manufacturing Index.  This key release offers insight into whether manufacturing (and the economy as a whole) is growing or declining. To interpret the index, keep in mind these key levels:

Readings above 50 indicate that manufacturing and the overall economy are expanding.  It also indicates that the GDP (Gross Domestic Product) is also growing at a steady pace.

Readings below 50 but above 42.5 indicate that manufacturing is declining, however the GDP is continuing to grow, albeit slowly.

Readings below 42.5 indicate that both manufacturing and the GDP are in decline.  (Remember that the definition of a recession is two consecutive quarters of negative GDP growth.)

The ISM data being released tomorrow is for the month of December, 2016.  Consensus estimates for tomorrow's release is a reading of 53.8.  That follows a prior release of 53.2, so the consensus is for modest growth in both manufacturing and the economy as a whole.

ISM Manufacturing Index Histogram

The index is well off it's Third-Quarter 2014 highs, however since bottoming in January 2016 manufacturing and the GDP have demonstrated modest growth.  This trend is expected to continue in tomorrow's release.

The implications of a surprise away from the consensus estimates may well be in play through the entire earnings season this quarter.  Since it shows the health of manufacturing, a weaker than expected report will imply that earnings in general, especially for the industrial and transportation related industries may similarly disappoint.  Equities in general could retreat following a weak announcement.  On the flip side, the bond market will rally on the indication that the economy is weaker than perceived, and bond yields will retreat.

If, on the other hand, the index reports higher than consensus estimates, we may see some mixed results. The market is currently anticipating a June 2017 interest rate increase. March only shows a 20% chance of an increase, and May only shows a 29% chance. June, on the other hand, is at 47% - nearly 50:50, and the dates beyond June start to reflect the interest rate that will follow the next move.

If the Manufacturing Index is higher than the consensus estimate, this may incent the FOMC to increase interest rates in either the March or May meeting, and in anticipation of that, we may see equities retreat despite the positive economic data.  That will be especially true for companies with a high reliance on debt in their operating model, and will also be true for lower-yielding dividend stocks since the higher interest rates go, the more attractive bonds become for that level of income.  Bonds, on the other hand, will decline and their yields will increase.

Of course, the size of an Index surprise to the upside will determine whether equities advance or retreat.  Coming in at or just a point above consensus will not be taken as bad news for equities.  Several points above, however, the the support that provides to the more hawkish FOMC members will almost certainly be factored into market pricing.

When the Index is released at 10:00 AM EST (15:00 GMT) tomorrow, consider what it signals for corporate earnings, most of which are already in the books and awaiting release, and what it signals for potential shifts in the FOMC monetary policy posture.  This is one of the indicators that may generate tradeable setups, so pay close attention to what it portends.

Happy Trading.

Showing Only 1.2% Growth, GDP Is Still Anemic

Is there truly an economic recovery in progress?  You'd never know it from the GDP which increased by a mere 1.2% in the quarter ending June 30th.  It continues a very sluggish trend that started in 2014 following what had looked to be a promising post-Great Recession recovery.

Quarterly GDP Growth 2012 to Present

Economists generally consider a range of 2.5% to 3.5% GDP growth to be healthy for the economy.  Lower than 2.5% and corporate profits suffer and with them, job growth also suffers.  Higher than 3.5% and the economy starts to experience inflationary pressures.  Now, that last point is significant in this case since we've been in an extended period of under-inflation.  The Fed mandate to maintain inflation at 2% needs a boost in GDP well above what we're currently experiencing before that target grows within reach.

Low inflation, in this case, translates to lower interest rates.  Following Friday's GDP report, the Fed Funds Futures market reacted sharply, reducing the probability of a September Fed interest rate hike to only 12%, and a December probability dropped to 30%.  As we discussed two days ago, interest rates will be depressed likely right through 2017.

Yesterday's announcement made mention of a slight increase in trade, saying it added about 0.2 percentage points to overall growth.  I've read some analysts point to that figure as evidence that the impact of the strong US dollar has stabilized, however I don't believe that to be the case.  Rather, what's driving the trade growth is a drop in US imports, not an increase in exports.  (Imports are subtracted from the figure, so if imports decline, it has a net positive effect on the trade number.)  Given the strength of the dollar, a reduction in imports is a very bearish signal, indicating a decrease in demand for materials and finished products.

Along those same lines, a major factor in yesterday's anemic announcement was continued reduction in inventory restocking by businesses in the US.  This is the fifth consecutive quarter in which inventory levels have dropped, and it's a further indication that there are strong downward pressures on consumer demand and on corporate sales.  Unlike analysts that are predicting a rapid end to that trend, I see just the opposite.  Until there is a healthy increase in the hourly wage statistics and a healthy increase in the Labor Force Participation Rate, I don't see any major driver for a change in inventory stocking behavior that would add anything of significance to the GDP.

When I consider the economic warnings hidden in the Schlumberger and Union Pacific earnings calls earlier this month, I begin to see a general underlying pattern of slowing growth, slowing demand for commodities and raw materials, and a potential crack in the expected rate of consumer spending over the second half of the year.  For that pattern to reverse, we need to see a weakening of the US Dollar, a dramatic reduction in the number of Americans that are out of work, and a return to a price of oil that provides healthy growth across a wide range of industries.  None of those appear to be on the short-term horizon, which leaves me pessimistic about future growth prospects in 2016 and into the first half of 2017.

Greek / EU Agreement in Principle - Almost, Sort of, Maybe

According to the various financial news wires, sources in Brussels have reported that Greece and the EU have reached an "agreement in principle" related to the outstanding debt issues that have dominated the news for the past month.  These sources state that the details are still being worked out, but are expected to be finalized and signed on Monday following an agreement that Greece would remain under the terms of the EU bailout program.

You could hear the FX, Bond, and Equity markets all breathe a tremendous sigh of relief following that breaking news.  Treasury bond yields improved, equities futures improved, and the Euro gained against the US Dollar all on the word of an unnamed source that an agreement - minus the details - had been reached.

Is the market setting itself up for disappointment and the significant drop that always follows?  Quite possibly.  Barring other news, there's a high likelihood that equity markets will surge, especially in Europe, and that may well flow into the morning session in the US tomorrow.  The greater the surge, though, the greater the potential for a significant drop heading into the weekend or on Tuesday if an actual agreement fails to manifest.

Such a failure is very possible.  Despite the optimism coming from this unnamed source, both Greece and the EU were very quick to dismiss any such agreement in principle.  Other sources involved in the negotiations stated that no agreement had been reached, which, barring any details, is certainly true, however they floated the idea that the existing terms of the bailout could be extended.  It's very likely that that is indeed one of the offers on the EU side of the table, and given the hard-line stance taken by Germany in recent weeks, that could be viewed as a concession.  The likelihood of Greece accepting it, however, is very slim.

It's important to remember the results of the recent Greek election.  There was a very clear mandate from the people in support of the Syriza platform, and the fledgeling coalition government will be under extreme political pressure not to accept terms that are in direct opposition to that platform.  In fact, an unnamed representative of the Greek government was very quick to dismiss the bailout extension idea as a non-starter. 

So how optimistic should we be regarding the "agreement in principle" news?  Without any details surfacing, I'd be very cautious.  As additional information comes out of Brussels, there's a high potential for significant volatility, at least until there is word from both sides that they have truly reached an agreement.  Remember, Monday is a holiday in the US and the equities markets are closed.  I will be keeping my trades very short term, and will look to close my short-term open positions before the weekend.  The true deadline to settle the Greek debt issue is still two weeks away, which leaves plenty of opportunity for political brinksmanship from both sides of the bargaining table.  Be sure to factor in that volatility when you line up your trades tomorrow.

Greek Market Action Impact is Slowing

Several conflicting news reports came out in the overnight hours and during the morning trading session, and both reports created some minor fluctuations in the US market.  Of interest, though, is that the fluctuations truly were minor.  The first report provided some hope of compromise on the Greek Debt situation, and indeed the US market was up a solid 100+ points in early trading.  Reports had surfaced that Greece would get a six-month extension to pay off its debt, and that provided a bit of market optimism given the looming February 28th deadline for compliance.

Mid-way through the morning session, however, German Finance Minister Wolfgang Schaeuble threw a large barrel of ice-water on that notion, stating that any claims of an extension are false.  The market reacted by pulling back all of its gains since the open, and briefly traded flat.  Very briefly.  Almost immediately, in fact, the market started to trend back towards its early highs.

As of this writing, however, the market is back up nearly 100 points, despite WTI Crude being down 4.25% for the morning.  To all appearances, the market is now shrugging off both the Greek situation and the very volatile price of oil.  What is likely is that the impact of both have already been factored into a market dealing with these issues for the last several months.

Specific to Greece, there will almost certainly be a compromise brokered at the last minute.  With a GDP the size of the state of Missouri - there are 22 states with a higher GDP than Greece - there's relatively little concern that Greece alone can have a significant impact.  Rather, the true concern is how Italy and Spain will respond should Greece ultimately leave the the Eurozone.  Compared to Greece's $283 Billion GDP, Spain weighs in at $1.358 Trillion, and Italy tips the monetary scales at $2.071 Trillion.  Their economies are significant, and there's a very real concern that, should Greece leave the Eurozone, they could soon follow.

Greek Defence Minister Panos Kammenos outlined a "Plan B" yesterday, although it's doubtful that this is truly a viable plan.  According to Kammenos, if no compromise is reached, Greece would seek financial aid elsewhere.  "It could the United States at best, it could be Russia, it could be China or other countries," he said.  The phraseology suggests that he has not yet explored these options with the countries in question, so for the moment it's pure speculation - and possibly political rhetoric - on his part.

It's doubtful the US would jump into this mix, potentially antagonizing European allies, and Russia is in no financial position to bail out anyone.  Stronger ties between Russia and Greece would be interesting politically, but it's doubtful that Russia would be willing or able to open their already strained coffers to purchase those closer ties.  China is a possible financier that does have the ability to bail out Greece, but would they be willing to do that when there is so little potential gain from the deal?  China is heavily dependent upon exports, primarily to Europe and the US. Greece adds little to that mix, and a Chinese bailout could be perceived as a slap to France and Germany - the two primary antagonists in the current Greek saga.

Wednesday is the day where it should get interesting.  European finance ministers are meeting in Brussels tomorrow to review the situation, and Greece is expected to put new proposals on the table at that meeting. 
Greek Finance Minister Yanis Varoufakis is expected to detail what's being called "10 surprise reforms" which are expected to replace many of the austerity measures that were part of the original agreement.  (The new government was elected on a platform that included the elimination of the current austerity measures.)  He is also expected to request a bridge program that would keep the government solvent while they work on a revised debt deal.  So far, that has been rejected by Germany, but it's possible it could gain traction when all of the finance ministers meet tomorrow.

It appears that the new government is simply asking for time to assess the mandate of the latest election and reconcile that with their obligations under the current bailout agreement.  It's not an unreasonable request, and it would appear that the actions in today's stock market agree that some type of compromise is highly likely.  Tomorrow should prove interesting, especially if Germany continues to take a hard-line no-compromise stance.  In the end, though, I do expect a solution that reworks the terms of Greece's bailout, implements the new reforms, and allows Greece to remain in the Eurozone.  Anything short of that benefits neither Greece nor the Eurozone.

LMCI Comes in Weak at 4.9

The Fed released the January Labor Market Conditions Index this morning.  The LMCI, as we discussed yesterday, is comprised of 19 separate economic indicators that provide insight into the health of the job market.  With Unemployment continuing to fall and with optimism in last month's non-farm payroll index, expectations were high that today's LMCI number would continue to show improvement.  In yesterday's post, I said that I was looking for a value of 6.8 or higher to demonstrate strength in the labor market.  Well, we fell far short of that value.

The LMCI for January dropped to 4.9, a decline of 1.2 points off December's 6.1 value.  That drop confirms what we've been saying for some time, that the labor market is not as healthy as the unemployment number would lead us to believe.  In fact, the decline in January confirms the falling Participation Rate which is now at its worst level since the late 1970s.

What the low values in the LMCI are telling us is that, despite a drop in the Unemployment Rate - which I've already categorized in previous posts as a meaningless number - the other aspects of the job market are in terrible shape.  Hours worked per week continue to drop.  Wages continue to drop and annual merit increases are barely keeping pace with inflation.  Benefits, especially health care benefits, continue to skyrocket in costs to the worker.  The number of workers that are leaving the workforce prior to age 65 continues to increase.

Now, it's doubtful that the LMCI is having much of an impact on today's market decline.  As of this writing, we're trading near the lows of the day, but the entire day has been down due almost entirely to the standoff between the Eurozone and Greece coupled with the extremely poor trade numbers released by China last night.  Those two global constraints are having a far greater impact than the little known LMCI is likely to cause.

What we as traders need to take from this, though, is the warning that the labor market is not at all healthy.  We need to keep a very close eye on Average Weekly Hours, Average Hourly Earnings, Hiring Rate and Quit Rate, and Hiring Plans.  These will give us a much clearer view as to the conditions of the average worker in the US.  I'm expecting all of them to continue to worsen in the short term.

An Economic Look Ahead to the Week of February 9

As we near the end of this quarter's earnings season, focus will once again turn to geopolitical news and the numerous economic releases that are spread throughout the month.  Here's what we're following for the week of February 9th.  As a reminder, the following Monday is a holiday in the US and markets will be closed.

Greece vs the Eurozone

On the geopolitical front, the big news continues to be the standoff between Greece and the Eurozone.  No progress was cited this weekend in settling the issue of Greek debt, and one official noted that it truly was a case of 1 versus 18 in the negotiations.  The two sides remain extremely far apart in their positions, indicating that the crisis will continue for the foreseeable future.  The current bailout expires February 28th, and there is nothing to suggest that the standoff won't continue through to the 11th hour.

Essentially, Greece is requesting authority to issue additional short-term debt and to receive profits from the ECB and other central banks that were gained by holding Greek debt.  Greece is, in effect, requesting a bridge agreement to keep the government running while they detail a new debt and reform program.  The Eurozone is having none of it, however, with even leftist France and Italy taking a hard-line stance against any concessions to Greece.

While a compromise by the end of February is likely, the interim will see continued volatility due to the uncertainty surrounding Greece's financial future as well as its future in the Eurozone.  Now, its not in anyone's best interests to see Greece leave the Eurozone, so some compromise is extremely likely before push comes to shove later this month.  Don't expect logic to prevent wild market swings in the meantime, however.

China

Switching continents from Europe to Asia, the economic news coming out of China continues to worsen.  This evening, China released their import and export numbers, and both were extremely below the market consensus estimates.  Chinese exports in January came in at -3.3% versus a projected 6.3%.  Imports were just as bad, coming in at -19.9% versus a projected -3%.  These two dismal numbers will fuel fears that the Chinese economy is slowing at an even greater rate than anticipated.  The import number is especially troubling since it suggests a slow-down in the Chinese industrial sector.  The government is expected to reduce their GDP forecast for 2015 to 7%, however given the new data, it's possible the forecast will be even lower.  The translation for us, of course, is increased market volatility.

Ukraine vs Russia

Finally, news out of the on-going Ukraine and Russia squabble continues to degrade.  I'm skeptical, however, that this will drive much market action, however, since the effects of the conflict appear to already be factored in.  More likely, news of an agreement would spur some positive market action, however, continued conflict appears now to be the accepted status quo.  I'm keeping an eye on reports that the US is considering arms shipments to Ukraine since that may produce short-term trading opportunities, but beyond that I don't see this situation adding much to the economic picture in the near future.

With the geopolitical backdrop now in focus, let's take a look at what economic releases are coming this week.

Monday, February 9.

12:00 EST 15:00 GMT - US Labor Market Conditions Index.  I'm looking for a value in excess of 6.8 to indicate continued growth in the job market.  The Participation Rate is hovering in the 62.7 range, and unemployment is in the 5.6% range, so I'm looking to this number (currently at 6.1) to paint a broader picture of the overall health of the labor market.

20:30 EST  01:30 GMT - China's Consumer Price Index and Producer Price Index.  These two numbers are a good measure of inflation in the Chinese economy.  The CPI is forecast to be 1.0 (down from1.5) and the PPI is forecast to be -3.8, down from -3.3.  If that holds, they will confirm the continuing belief of an economic slowdown in China.

Tuesday, February 10.

01:45 EST 06:45 GMT - Swiss Unemployment. 

03:15 EST 08:15 GMT - Swiss CPI.   Normally we wouldn't pay much attention to the Swiss Unemployment or CPI numbers, however in light of recent action by the Swiss Bank and the resulting market volatility here in the States, we'll watch these numbers and pay attention to any reaction here as a result.  Unemployment is forecast to hold steady at 3.2% and the CPI is expected to drop to -0.6%, down from -0.3%. 

08:20 EST 13:20 GMT - Jeffery M. Lacker Speech.  The President of the Richmond Fed is the featured speaker at the 30th Annual Emerging Issues Forum, Innovation Reconstructed in Raleigh, North Carolina.  His speech is entitled "Education, Innovation, and Economic Growth." His comments are being watched as a signal for volatility in the strength of the US Dollar.

12:00 EST 15:00 GMT - US Wholesale Inventories.  This number is expected to drop to 0.1% down from 0.8%.  Wholesale Inventories are used as a means of predicting the GDP for the quarter and the year.  In effect, a lower number signals a growing economy and a higher number signals a weakening economy.  This one will move the markets if it does not come in at the consensus value.

Wednesday, February 11.

08:00 EST 13:00 GMT - Richard Fisher Speech.  The President of the Dallas Fed is the featured speaker at a breakfast being held at the Economic Club of New York.  He is expected to discuss how the Fed currently views the US economy and the value of the US Dollar.  Fed watchers will be dissecting his comments to ascertain when the Fed will begin interest rate hikes.

Thursday, February 12.

02:00 EST 07:00 GMT - Eurozone Harmonized Consumer Price Index.  Germany will release their CPI at the same time.  The German number will show the rate of inflation in Germany, and the Harmonized number will show the rate of inflation using a methodology incorporated across the entire Eurozone.  The German CPI is expected to drop to -0.3% and the Harmonized CPI is expected to drop to -0.5%.  Both demonstrate a deflationary trend that further confirms the weakness in the European economy.

05:00 EST 10:00 GMT - European Industrial Production.  This number shows the volume of production of industries such as factories and manufacturing.  Increased production is indicative of a growing economy whereas decreased production is indicative of a slowing economy.  Interestingly, the number is forecast to increase to .3%, up from -0.4% last month.

08:30 EST 13:30 GMT - US Jobless Claims.  This is a weekly number and reflects the number of new unemployment claims.  There's no consensus number published, however the previous week's number was 278K.  In general, a larger number indicates weakness in the economy and a smaller number indicates strength.

08:30 EST 13:30 GMT - US Retail Sales.  Here's the big release in the US for the week.  This number is widely used as an indicator for consumer spending.  The consensus is for the number to improve to -0.5%, up from -0.9%.  Any deviation from the consensus will drive the markets accordingly. 

Friday, February 13.

01:30 EST 06:30 GMT - France and Germany's GDP.  Of the two, the German number is the one that's expected to move the market.  The Quarter-over-Quarter number is forecast to grow to 0.3%, up from 0.1%. 

05:00 EST 10:00 GMT - Eurozone GDP.  The Year-over-Year GDP for the Eurozone is the number being closely watched, and is expected to hold steady at 0.8%.  Weakness in this number will have an adverse effect on the US markets heading into the long weekend.  The Quarter-over-Quarter number is also expected to hold steady at 0.2%.  Something to watch will be divergence between the two numbers with the QoQ value being treated as an indicator for the year ahead.

09:55 EST 14:55 GMT - US Reuters/Michigan Consumer Sentiment. This is a measure of how likely consumers are to spend money, based on their feelings about the overall economy.  The forecast is for the number to hold steady at 98.1.

Labor Market Conditions Index (LMCI) - A One Size Fits All View of the Labor Market

A quick glance at the economic calendar for any month makes it clear that there are numerous data elements that detail aspects of the labor market.  Frequently, these elements directly contradict each other, which increases the difficulty in truly assessing the overall health and the overall trends that impact the workforce.  Take, for example, the two most popular measures of the health of the job market, the Unemployment Rate (currently 5.6%) and the Participation Index (currently 62.7%.)  The former has been trending downward for the past couple of years and is an indication of a healthy and growing workforce.  The latter, however, has also been trending downward since 2010, and is an indication of a large number of eligible workers leaving the workforce.  Both statistics are accurate to what they are intended to indicate, but neither accurately depict the health of the labor market in totality.

In an attempt to reconcile all the various economic indicators that touch some aspect of the labor market - and there are 19 such indicators - the Federal Reserve Board implemented a new index in mid-2014 that incorporates all of them.  The Labor Market Conditions Index (LMCI) provides a single at-a-glance number that factors in such diverse measures as the number of hours worked, wages, hiring rates, hiring plans, jobs that are hard to fill, and the rate at which workers transition between unemployed to employed.  There is a heavy weight placed on indicators that correlate well to each other, while those that diverge from other indicators are given less of a weight in the calculation of LMCI. Therefore, the jury is still out as to the effectiveness of this single Indicator of Indicators.

Indicators Included in LMCI

The LMCI for December - reported in January, 2015 - sits at 6.1, and it has been trending upward since August.  As you can see from the following chart, however, the health of the labor market is not accurately portrayed by the Unemployment Rate, which has been improving steadily for two years.  Neither is it accurately portrayed by the Participation Index which has been degrading steadily for four years.  Rather, the correlation of the wide range of indicators gives a much more meaningful view of the overall health of the labor market.  At least, that's the message it seems to portray looking at the graph of the last two years.  To put the current graph in perspective, LMCI reached a maximum value of 28.6 in September, 1983.  Its worst value was -43.3 in May, 1980.

LIMC - January 2013 to December 2014

The Labor Market Conditions Index for January, 2015 will be released on Monday, February 9 at 12:00 EST (15:00 GMT).  While the data that comprise the indicator go back to the early 1970s, the indicator itself is still in its infancy.  It remains to be seen how much of an influence LMCI will have on the overall market.  With this being the only economic indicator of significance being announced on Monday, however, expect it to have some influence over afternoon trading, barring any geopolitical developments coming out of Greece, Germany, Ukraine, or Russia.  While no consensus estimate has been released, I'm looking for a value of 6.9 or higher to indicate healthy growth in the labor market.  A lesser value would indicate that factors other than the Unemployment Rate are taking a heavier toll on the job market than is currently factored into the economic outlook.

IMF Paints Dismal Picture for 2015

In what is sure to spook investors in companies with high global exposure, the International Monetary Fund (IMF) has lowered their global growth forecasts for 2015.  The big hit was in their forecast for China, lowering their forecasts to a 6.8% growth rate.  That's 0.8% lower than China experienced in 2014, and last year was already down from 2013.

That 6.8% growth rate is still almost double the anticipated growth rate world-wide, which the IMF is forecasting to decline to 3.5%.  While Chief Economist Olivier Blanchard acknowledged that the declining price in oil was providing a bit of an economic boost, he does not believe that it will be enough to stem the amount of global economic weakness that is forecast.

Interestingly, the IMF only cut their forecast for the Eurozone to by 0.2% to 1.2%.  From what we've seen to date, it's optimistic to assume that growth will be positive as Europe appears poised for recession.  They also cut Japan drastically, and with a consumer confidence level under 40 and falling, that appears more than justified.  In fact, the 0.6% growth level they are projecting may even be optimistic.

One major challenge related to validating the IMF's gloomy view of China is the lack of confidence in numbers produced by the Chinese government.  Instead, we'll need to rely on forward guidance from some of the larger US corporations with high exposure in that region.  Alcoa, for example, provided a stronger view of 2015 Chinese growth than is predicted by the IMF.  Caterpillar reports next Tuesday (01/27) and it will be most beneficial to compare their forecasts with Alcoa's.  Between CAT and AA, I trust their assessment of global economic conditions far more than I trust the judgement of either the Chinese government's reporting, or the somewhat pessimistic view of the IMF.

Despite my overall skepticism related to numbers coming out of China, there is one release this week that does warrant watch.  The HSBC Manufacturing Purchasing Managers Index for China is released at 01:45 GMT on Friday (8:45 PM EST on Thursday.)  The December number was 49.6, so there's a bit of interest in the direction it takes for January.  A reading above 50 signals economic expansion, whereas a number below 50 signals contraction.  It has been slowly - very slowly - trending down since 2009.

It's no exaggeration to say that China will make or break global economic health as we navigate a troubled period in Europe and Japan.  A strong US dollar is not helping there since the Chinese Yuan is pegged to the dollar.  The strong dollar is adding downward pressure on the health of their currency, which raises the prospect that they could decouple from the dollar for added relief.  That may provide a needed boost by improving their export market.

There's a lot to consider related to China and it's interaction with other markets.  For now, pay attention to the PMI number on Friday, but pay even closer attention to the guidance from companies with extreme exposure overseas.  You can count on them being far more forthcoming than the numbers coming out of any government release.

The Significance of Copper's Current Price Moves

As if the plunging prices of oil weren't enough to worry about, pundits are now citing a "crash" in copper prices as further confirmation that the health of the global economy is deteriorating rapidly.  I've heard some question whether copper is signalling a global recession, or if it's signalling significant weakness in the US and China at the very least.  Well, before we start forecasting impending doom, let's take a step back and look at this "crash" from a broader perspective.  Here's the weekly chart of copper prices from 1/3/2000 to the present.

$COPPER EOD Price

As you can see from the chart, Copper has a tendency to follow global economic health.  Whether or not we can call it a leading indicator is somewhat doubtful, though, and in my view it would be a stretch of the imagination.  The two shaded green areas on that chart show the extreme market crashes that followed the September 11 attacks in 2001 and the financial crisis in 2008. 

Nobody will argue that any market indicator could have foreseen the market crash following a major terrorist attack, so there were no leading indicators that would have foreshadowed the post 9/11 crash.  Yet, as you can see from this chart, Copper started heading down following a peak over a year earlier.  Conclusion: there was no correlation between the two.

Look at the 2008 scenerio.  Again, Copper was trading in a very gradual incline until the financial crisis hit, and it then followed global markets down, just like every other commodity.  The key is, it followed, but it didn't lead.  Benefiting from a plunging dollar and a surge in economic growth in China, Copper surged from mid-2008 until the Commodity Bubble burst in 2011. 

The 2011 burst of that bubble was inevitable, since it was not possible for China to continue the level of growth it had sustained for the prior three years.  As China slowed, so did the demand for copper, and the prices gradually declined.  You can see from the chart, in fact, that the price managed to find some support around the 61.8% Fibonacci Retracement line, until it finally penetrated that line for good in November, 2014.

In the past two months, we've seen a significant drop in price back to the 50% Fibonacci line, but before we panic, let's stop and thing about what drives the price of copper.  There are three factors:

1.  Demand, primarily in China.  Well, that demand appears to be holding steady.  It's not growing, but neither is it dropping at any significant rate.  In fact, some of the early guidance we're hearing out of companies with exposure to China seem to indicate modest growth there for 2015, so I don't think weakening demand is driving the price down.

2.  Supply.  Well, it's definitely possible that there's an increase in supply.  There was speculation last week coming out of Morgan Stanley's commodities analysts that a drop in oil prices would encourage mining companies to increase their production of commodities such as copper.  It's possible, but I doubt that's what we're seeing in the current price drop.

3.  Strength of the US Dollar.  Here, folks, we have the winner.  The price of commodities, including copper, carries an inverse relationship to the value of the dollar.  As the dollar increases, commodities prices fall. What we've had in the last few months is a very sharp increase in the value of the US Dollar, culminating with Friday's 10-year high against the Euro.  This factor alone fully accounts for the sharp drop in copper prices last week.

Is the global economy weakening?  I'd certainly say Europe's is weakening, but China appears to be holding steady, as is the economy in the US.  Growth is weaker than I'd like it to be, but there's nothing out there indicating an imminent recession.  So when we look at the plunging prices of commodities in general and copper in particular, let's not forget that it's more than a supply and demand equation.  Factor in the value of the dollar and we have a perfectly good explanation for the behavior without resorting to a doom and gloom economic forecast.

Schlumberger Hints at Global Growth, Oil Pressures in 2015

Schlumberger Limited's (NYSE: SLB) earnings conference call yesterday provided some interesting insight into the global growth potential for 2015 as well as a detailed view of the changing dynamics we are witnessing within the oil industry.  For those not familiar with this global company, Schlumberger provides technology, project management, and information solutions to global oil and gas exploration and production (E&P) corporations.  Their clients operate in over 80 countries, giving them a unique view into the health of the economy both domestic and global.

Despite currency weakening both in Russia and Europe, Schlumberger foresees healthy growth in the global economy, surpassing the growth seen in 2014.  They see demand for oil increasing by about one million barrels per day by 2016.  This is matched by the one million barrels per day increase being supplied by the global oil market.

The dramatic drop in prices that we've seen is primarily being driven by a significant increase in supply coming out of North America and Saudi Arabia.  Globally, Saudi Arabia has shifted their strategy from one in which they sought to protect the price of oil via a manipulation of the supply to one in which they seek to protect their market share via an increase in supply regardless of the impact on price.  It's a fundamental shift in philosophy, and it's one to which the rest of the world has yet to fully react.

The impact of this strategy shift and resulting price drop is already being felt.  Exploration and Production (E&P) are down significantly, and are projected to drop by 25% to 30% in the US next year, coupled with a 10% to 15% drop globally.  Already, some 400 oil rigs have been taken offline, due to profitability issues relative to the new oil price point.

Hydraulic Fracturing technologies in the US and Canada have made a significant contribution to the oversupply of oil coming out of North America.  In the realm of cost, however, this technology is one of the highest - much higher than the cost of traditional oil wells that have both a lower start-up cost and a longer life span per site.  (Production from fraked sites declines 45% per year as compared to 5% per year from traditional wells.)  The Arabian oil companies have the lowest production costs and can therefore ride out this wave of low prices to the detriment of all competitors. The break-even point on some Arabian wells is a mere $10 per barrel.  Average break-even in the Gulf-States is $27 per barrel.  US Shale, on the other hand, has a break-even point optimistically at $50 per barrel, and some of the newer sites are even in the $80 per barrel range.  Clearly, the Saudis have the price advantage and can win the market share game simply by holding prices below $50 per barrel indefinitely. 

The impact is being felt beyond North America.  In the North Sea, both UK and Norwegian oil-rig counts are lower today and are projected to be even lower in 2015.  Those wells are simply not profitable at the current price point.  Not only are rigs being taken offline worldwide, but applications for new wells are down over 50%, and Cap-Ex spend projections for next year are being lowered tremendously.  Financing for new exploration and drilling is expected to be difficult to obtain, again due to profitability.  That will be exacerbated by rising interest rates should that happen.

What this means in the medium to long term is two-fold.  At the moment, Saudi Arabia is antagonizing one of the largest industries in their largest global political ally.  Expect the petroleum lobby to begin to apply political pressure in the White House and in Congress, if that hasn't already started.  This will change the politics between US and Saudi relations, and anytime you have a changing political dynamic in the Middle East, events can become very volatile very fast.

The second outcome will be tightening of supply, which will result in a rise in oil prices.  Nobody is willing to predict when that will occur, but it's definitely on the horizon for sometime in 2015.  Even if it's not an overt action taken by the industry, it will be a de facto result as the more expensive drilling operations either go offline until prices rise, or they go bankrupt in the face of insurmountable losses.  A look at the overall break-even points for the various producers will provide an excellent investment opportunity since they are the ones most able to survive this downturn in price, and they are the companies that will reap the harvest when prices inevitably resume their climb.