PPG Industries Warns of Intensifying Inflation Pressures and Weakening Demand

{Originally published on One-Twenty Two by Dr. Duru}

““As we look ahead, we currently do not anticipate any relief from inflationary cost pressures in the third quarter. We expect aggregate global economic growth to remain positive with end-use market activity comparable to the second quarter, adjusted for traditionally lower seasonal demand. However, uncertainties exist regarding global trade policies, which may create uneven demand by region and in certain industries. Specific to PPG, we expect that the previously announced architectural customer assortment change will lower our third quarter year-over-year sales volume growth rate by between 120 and 150 basis points. We remain confident that our leading-edge technologies and products, which are bringing value to our customers, will facilitate our growth going forward….

Currently the new tariffs are starting to add some modest cost to our raw materials. Based on the strength in the US dollar in the second quarter, we expect foreign currency exchange rates to have an unfavorable impact to our sales in the third quarter”

This was the essence of the guidance industrial paint company PPG Industries (PPG) provided in its 2nd quarter earnings report. I added the emphases because the warnings on inflation and international demand were clear precursors to the company’s pre-earnings warning tonight. The stock traded down about 10% in after market trading in response to significant cuts in revenue and earnings guidance. I was most interested in the explanation which made the second quarter’s caution come to life (emphases mine)…

““In the third quarter, we continued to experience significant raw material and elevating logistics cost inflation, including the effects from higher epoxy resin and increasing oil prices…These inflationary impacts increased during the quarter and, as a result, we experienced the highest level of cost inflation since the cycle began two years ago.

“Also, during the quarter, we saw overall demand in China soften, and we experienced weaker automotive refinish sales as several of our U.S. and European customers are carrying high inventory levels due to lower end-use market demand…Finally, the impact from weakening foreign currencies, primarily in emerging regions, has resulted in a year-over-year decrease in income of about $15 million. This lower demand, coupled with the currency effects, was impactful to our year-over-year earnings and is expected to continue for the balance of the year.”

Instead of moderating, inflationary pressures are mounting on PPG. The weakness in China is telling in the context of the trade war with the U.S. The lower “end-use market demand” points to the trickle-down impact of “peak auto.” These warnings are each important given PPG has a market cap of $26.5B and trailing 12-month revenue of $15.4B. I fully expect other industrial companies to deliver similar news this earnings season.

Interestingly, Credit Suisse downgraded the stock in late September and the market responded by taking PPG down 2.8% on relatively high trading volume. The gap down confirmed the end of PPG’s post-earnings run and breakout above 200-day moving average (DMA) resistance. Until the downgrade the stock finally looked ready to challenge its 2018 high.

PPG Industries (PPG) never quite recovered from the February swoon. The recent breakdowns below 50 and 200DMA supports now look like fresh warnings.
PPG Industries (PPG) never quite recovered from the February swoon. The recent breakdowns below 50 and 200DMA supports now look like fresh warnings.

Source: FreeStockCharts.comThe market is supposed to be a forward-looking mechanism, so it is natural to wonder why PPG was rallying so well in the first place. I do not put all the blame on investors. I assume the company itself was partially responsible through its sizable share repurchase program. For the first half of 2018, PPG spent $1.1B on its own shares: 4.1% of the company’s current market capitalization. With this kind of aggressiveness, PPG should quickly move in on the new 52-week low to add to take out even more shares.

As earnings season unfolds, I will be paying close attention to company commentary on trade woes and inflation. The stock market has spent most of the past several months ignoring risks, so there are a good group of over-priced stocks out there waiting their turn for a douse of realty. Collectively, these warnings could be the catalyst that delivers the oversold market conditions I am anticipating.

Full disclosure: no positions

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Acuity Brands: Wage and Tariff Inflation and Resulting Business Uncertainties

(Originally published on One-Twenty Two by Dr. Duru)

I last mentioned Acuity Brands (AYI), a lighting and building management solutions company with $3.7B in net sales in 2018, three months ago. At that time, I described a good risk/reward setup to go long the stock post-earnings. AYI shot nearly straight up from there. The stock broke through resistance at its 200-day moving average (DMA) and gained as much as 34.7% before peaking intraday in September. While I only participated in a portion of that run-up, I am glad I did not overstay my welcome. Fast forward to last week: AYI suffered a massive post-earnings gap down. The stock lost 16.3% and sliced right through 200DMA support after the 50DMA gap down. Sellers closed the week confirming the bearish breakdown. AYI has now almost erased its entire incremental gain from July earnings.

Acuity Brands (AYI) looks set to reverse all its previous post-earnings gains after a disastrous earnings report that sent the stock crashing through its 50 and 200DMAs
Acuity Brands (AYI) looks set to reverse all its previous post-earnings gains after a disastrous earnings report that sent the stock crashing through its 50 and 200DMAs

Source: FreeStockCharts.com 

This moment is critical for the stock. AYI hit an all-time high in August, 2016 and sold off pretty steadily from there (on a monthly basis) until reaching a 4-year low in May, 2018. If AYI completes a full reversal of its gains from July earnings, then the stock greatly increases its risk of resuming the downtrend from the all-time high.

AYI’s earnings report was interesting for a lot more than the technical disaster. The company also delivered some telling remarks about today’s inflationary environment. The company begain its conference call by launching right into the bad news. From the Seeking Alpha transcript:

“While our results for the fourth quarter and the full year were records, we had higher expectations coming into 2018. Market conditions for growth were far more subdued than most had originally anticipated, especially for larger commercial projects and deflationary pricing persisted throughout the year, while cost pressures were far more significant than most had forecast, particularly in the fourth quarter.”

The general market environment hindered the business:

“Based on the information from various data collection and forecasting organizations, we believe the overall growth rate for the fourth quarter as measured in dollars for lighting in North America was flat to slightly down, continuing the sluggish trend over the last several quarters…

We believe the lighting industry will continue to lag the overall growth rate of the construction market, primarily due to continued product substitution to lower priced alternatives for certain products sold through certain channels.”

For the fourth quarter and full-year, the company sported record revenues and diluted earnings but significantly lower operating profit and margin. The cost pressures came from multiple inflationary fronts including tariffs and wages. Emphasis mine…

“Another significant factor impacting our adjusted gross profit and margin was higher input cost for certain items, including electronic and certain oil-based components, freight and certain commodity-related items, particularly for steel. Many of these items experienced dramatic increases in price in the fourth quarter due to several economic factors including enacted tariffs and wage inflation due to the tight labor markets.

We estimate the inflationary impact of these items reduced our adjusted gross profit in the quarter by more than $20 million, lowering our adjusted gross profit margin by 200 basis points and reduced adjusted earnings per share this quarter by $0.38…

…we expect employee-related costs will continue to rise as we enter fiscal 2019 as markets for certain skills remain tight contributing to a rise in wage inflation…”

AYI also explained that it sources from China about 15% of its components and finished goods which are subject to the new import tariffs.

Freight costs are an increasing burden. The combination of rising oil prices and the rising wages that come from a severe shortage of truck drivers are driving freight rates skyward. Shipping a lower-value product mix is exacerbating the shipping burdens.

As we would expect, AYI is scrambling to mitigate these costs by finding alternative suppliers and production sources, improving productivity, and increasing prices. The company announced price hikes last month and new price increases go into effect on October 15th. Assuming the new 25% bump in tariffs on Chinese imports goes into effect on January 1, 2019, AYI will raise prices yet again. IF AYI makes these price hikes stick without losing much demand, then the stock could represent a great buying opportunity. Better margin numbers should start appearing by the second fiscal quarter 2019.

AYI cautioned that a lot uncertainty surrounds the potential impact of the cost pressures. For example, the inflationary pressures from tariffs caught the general industry by surprise as participants have experienced a deflationary environment for a “handful of years.” The demand impacts are hard to assess: “It is not possible for us to precisely determine what the potential impact tariffs will have on demand as it is a very complex situation impacted by numerous factors including currency fluctuations and political outcomes.”

As the inflationary adjustments unfold, I will watch the technicals for signs of renewed buying interest. The company itself is one source of buying. AYI repurchased 2M shares at a cost of $298.4M in its fiscal year 2018. AYI still has 5.2M shares left under its repurchase authorization. I have to assume the company will aggressively buy shares in the coming months given the current stock price of $130.99/share is well below the average cost basis of $149.20/share of the to-date repurchased shares.

Finally, it is possible tariffs could HELP AYI although the company did not specifically say so. In the conference call AYI pointed out that the Chinese government is subsidizing lighting companies who are undercutting price for lower-value fixtures. This competitive pressure is important because, as noted earlier, some of AYI’s customers are downshifting to these lower-valued products. AYI is determined to compete – “We will not yield this space for many strategic reasons” – and this competition represents one more important risk factor for the business.

Overall, AYI is one more cautionary tale about the unanticipated impacts of today’s new inflationary environment. Given that financial markets are generally ignoring most potential fallouts from the expanding trade war between the U.S. and China, this earnings season should deliver many more surprises like AYI’s.

Be careful out there!

Full disclosure: no positions


Inflation Washes Ashore

Ever since the election of Donald Trump as U.S. President, the stock market has gone into a “Trumpflation” mode of trade. The early evidence of inflation may have finally washed ashore.

U.S. January prices rose 0.6% and core prices rose 0.3% month-over-month. Both were slightly higher than expected, and the rise was the highest since February, 2013. Year-over-year the Consumer Price Index (CPI) rose 2.5%, the highest since march, 2012. The CPI incorporated some particularly strong price hikes:

“Clothing prices jumped 1.4 percent, the most since February 2009. Men’s apparel surged by the most on record. New vehicle prices climbed 0.9 percent in January, the biggest advance since November 2009.”

The price hikes were enough to push real hourly wages down by 0.5% form December and unchanged year-over-year.

This is just one month of data, yet it precedes any of the policy changes or fiscal stimulus measures which promise to introduce inflationary pressures into the U.S. economy. InflationWatch is officially back on alert for the U.S.!

https://www.bloomberg.com/api/embed/iframe?id=f020e8cd-257d-4519-85a0-ddbdd3bf1339


On the Ground Measuring Inflation

Ever wondered exactly how the government measures inflation via individual products? Planet Money ran a segment explaining the process in 2010 that was rebroadcast last year. I caught “The Price Of Lettuce In Brooklyn” sometime early last year. I was absolutely amazed to learn that the government actually sends surveyors into the field to sample prices from various stores on very specific goods. The surveyors have to exercise particular care to measure prices for the exact same goods over time. That basket of goods is then aggregated across products and locations into what we know as the Consumer Price Index (CPI).

I highly recommend this 15-minute podcast for anyone who wants an introduction to inflation monitoring at the ground level.

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Source: NPR Planet Money


Cross-Post: The Canadian Dollar’s Rapid Devaluation Presents An Inflation Predicament for the Bank of Canada

(This is a cross-post from my blog One-Twenty Two)

A year ago, the Bank of Canada (BOC) delivered the first of two rate cut surprises for the year. So with oil still cratering ever lower, I can understand why the market seemed braced for yet another rate cut last week. Instead, the BOC not only stood still on rates, but also it expressed an implied reluctance to reduce rates any further unless absolutely necessary. The result was an immediate jump in the Canadian dollar (FXC) featuring a drop in USD/CAD. USD/CAD continued to sell off right into the week’s close.

Going into the Bank of Canada January, 2016 decision on monetary policy, speculators were ramping up net short positions against the Canadian dollar.

Going into the Bank of Canada January, 2016 decision on monetary policy, speculators were ramping up net short positions against the Canadian dollar.


Source: Oanda’s CFTC’s Commitments of Traders

USD/CAD printed topping action just ahead of the Bank of Canada decision. The currency pair has shot nearly straight down ever since.

USD/CAD printed topping action just ahead of the Bank of Canada decision. The currency pair has shot nearly straight down ever since.


Source: FreeStockCharts.com

The Canadian dollar has been weaker but the PACE and extent of the weakening is nearly without recent precedent.

The Canadian dollar has been weaker but the PACE and extent of the weakening is nearly without recent precedent.


Source: Board of Governors of the Federal Reserve System (US), Canada / U.S. Foreign Exchange Rate [DEXCAUS], retrieved from FRED, Federal Reserve Bank of St. Louis, January 23, 2016.

Here is the key quote from Governor Stephen S. Poloz’s opening statement:

“It is fair to say, therefore, that our deliberations began with a bias toward further monetary easing.”

The on-going collapse in oil and all its destructive consequences for the Canadian economy still justify further easing. BUT…

“First, the Canadian dollar has declined significantly since October, which means that the non-resource sectors of our economy are receiving considerably more stimulus than we projected then. Let’s remember that it typically takes up to two years for the full effect of a lower dollar to be felt.

Second, past exchange rate depreciation is already adding around 1 percentage point to our inflation rate. This is a temporary effect, and is currently being offset by lower fuel prices—another temporary effect. However, we must be mindful of the risk that a further rapid depreciation could push overall inflation higher relatively quickly. Even if this is temporary, it might influence inflation expectations.”

In other words, financial markets have pounded the Canadian dollar so thoroughly that most of the BOC’s goals for easing have been accomplished already. The potential 2-year lag in impact means that the BOC must proceed with extreme caution when deciding to add more kindling to the raging fire of currency devaluation.

Moreover, this devaluation is now exerting inflationary pressures on the Canadian economy – to the tune of an incremental 1 percentage point. While current inflation may still be within tolerance, the pace of the increase could be strong enough to send future inflation expectations soaring past the BOC’s comfort zone. Given the lagging impact of the devaluation, the BOC could find itself fighting stubbornly high inflation expectations for an uncomfortably long time. During the press conference, Poloz clarified that the BOC does not think this process is underway. The Bank is simply keeping an eye on this potential – which is clearly enough to give them caution about doing anything that further drives down the value of the Canadian dollar.

Given these cautionary caveats, the BOC decided to leave rates just where they are. From the press release:

“The Bank of Canada today announced that it is maintaining its target for the overnight rate at 1/2 per cent. The Bank Rate is correspondingly 3/4 per cent and the deposit rate is 1/4 per cent…

…All things considered, therefore, the risks to the profile for inflation are roughly balanced. Meanwhile, financial vulnerabilities continue to edge higher, as expected. The Bank’s Governing Council judges that the current stance of monetary policy is appropriate, and the target for the overnight rate remains at 1/2 per cent.”

As usual, the BOC is cautiously optimistic about economic prospects. Despite a disappointing 2015, the BOC still expects the global economy to resume “gradual strengthening” in 2016. Expectations incorporate an assumed transition to a 6% annual GDP growth rate for China, and continued “solid” performance from the U.S. Even with weak exports to the U.S. in the fourth quarter, the BOC expects export activity to turn right around in 2016. While downgrading its forecast for Canada’s GDP growth in 2016 to 1.4%, the BOC emphasized that year-over-year, growth should be 1.9% for the fourth quarter of this year.

Even though the BOC did not cut rates in this last meeting, make no mistake about its bias. The BOC thinks it could take up to three years for the Canadian economy to fully adjust to the complex structural changes wrought by the collapse of the oil complex. The Canadian economy may not absorb excess capacity in the economy until late 2017. The BOC also acknowledged the growing magnitude of the shock from this collapse. The BOC called this reality a “significant setback compared with our October projection.” During the press conference, Poloz also admitted that the odds of a recession are higher than they have been in a very long time. All these realities imply a notable bias toward weakness for the Canadian dollar for quite some time.

When I wrote about the Canadian dollar’s fresh milestone of weakness, I described a small counter-trend bet that USD/CAD would return to 1.40. As the chart above shows, the USD/CAD just continued to spring higher after the 1.40 breakout. The Bank of Canada’s stasis on rates combined with the forex response was my signal to finally add to that bet. Without a promise to cut rates again, I fully expect USD/CAD to reverse most if not all of recent gains assuming oil does not resume its rapid plunge in the interim.

I will continue to try holding out for that return to 1.40, but I am perfectly fine bailing on the position if renewed strength shows up ahead of this week’s Federal Reserve’s meeting. On a technical basis, the counter-trend momentum in USD/CAD looks like it could easily retest the uptrending 50-day moving average (DMA). At the current pace, this would happen around 1.39. After I close out this short position, I will be quite eager to get back to trading with the trend.

During the press conference, Poloz would not commit to a specific level past which weakness in the Canadian dollar will no longer help the Canadian economy. He would only say that the assessment depends on the nature of the decline. If the currency is declining “on its own,” then there is a problem. An adjustment from economic realities makes sense – the current decline is mostly about the collapse in the oil complex. However, trends beget trends, and I can see several scenarios of overall financial turmoil and volatility that could send USD/CAD hurtling ever higher even independent of a fresh plunge in oil prices.

So, the Canadian dollar presents a precarious predicament for the Bank of Canada. Its devaluation is a necessary part of the Canadian economy’s adjustment to lower oil prices. The potential inflationary impact of this rapid decline could constrain the Bank’s ability to provide more assistance to a wobbly economy. Yet, without this assistance, the weakness of the economy could drive even more weakness in the currency. Currency traders will easily seize upon the trend above all else.

In coming weeks I will be reviewing the Monetary Policy Report (MPR) and a soon-to-be-released BOC paper on the complex impact of the oil shock to find any additional (tradeable) insights.

Be careful out there!

Full disclosure: long FXC, short USD/CAD


Housing Bubbles: An Ounce of Prevention is Worth a Pound of Cure

Prescription for preventing housing bubbles from the IMF…

iMFdirect - The IMF Blog

By Kevin Fletcher and Peter Kunzel

The main features of boom-bust cycles in housing markets are by now all too familiar.

During booms, conditions such as lax lending standards and low interest rates help drive up house prices and with them mortgage debt.

When the bust arrives, over-indebted households find themselves underwater on their mortgages— owing more than their homes are worth.

Feeling the pinch of reduced wealth and access to credit, households, in turn, rein in consumption. At the same time, lower house prices cause investment in new houses to tumble.

Together, these forces significantly depress output and increase unemployment. Non-performing loans increase, and banks respond by tightening credit and lending standards, further depressing house prices and adding to the vicious cycle.

View original post 753 more words


The Persistence of Deflationist Psychology

Seven and a half years after the financial world as we know it almost completely blew up, deflation remains the biggest fear across the land. Some major central banks across the globe have had to double down on their efforts to fight deflation. For those like me who expected central bank activism to quickly lead to rampant inflation, this world of persistent deflationist psychology is a wonder to behold.

Along this vein comes a fascinating article in the New York Times called “A Prediction Market for Inflation, or Deflation” by Justin Wolfers, a a senior fellow at the Peterson Institute for International Economics and professor of economics and public policy at the University of Michigan. Wolfers warns that the Fed’s focus on hiking rates runs counter to declining expectations for inflation:

“Something unusual is happening to prices right now: They are falling.

The recent sharp decline in gas prices is part of the story, but there is now growing fear that the Federal Reserve will undershoot its own 2 percent inflation target, hindering the economic recovery. There’s also a small but worrying risk that the economy could enter a deflationary rut.”

Incredulous, I read on….

The majority opinion marginally expects the Fed to miss its 2% inflation target in the next 5 years

Opinion is skewed to a Fed miss of its 2% inflation target in the next 5 years

After seeing this chart, I feel that Wolfers far over-stated the case for a “deflationary rut.” This chart shows that 49% of the prediction market expects the Fed to deliver. That is a pretty good percentage although we of course would prefer higher. Wolfers focuses in on the skew of expectations; that is, the people who think the Fed will miss the mark on inflation are predominantly expecting an undershoot. Note that only 1% of the prediction market currently expects deflation in the next 5 years. I do NOT equate an expectation of missing the 2% the target as a deflationary risk.

The main lesson for those of expecting Fed policy to lead to excessive inflation is that we remain a distinct minority. Very few people are worrying about inflation in financial markets.

Wolfers provides this good caveat on interpreting prediction markets:

“Of course, the specific probabilities inferred from market prices should be taken with many grains of salt. In particular, traders may not be betting that prolonged deflation is probable, but rather be buying insurance against such a grim occurrence. Thus, prediction market prices might overstate the probability of bad outcomes. Nonetheless, these prices embed a powerful message for policy makers: Just as people buy flood insurance when they’re concerned that a storm might do terrible damage, traders might be buying deflation insurance because they fear the risk of vast economic damage if the economy were to enter a deflationary rut.”

And a nice message for those of us expecting problems with inflation in the near future:

“Next time people tell you that higher inflation is coming, remind them that they can get rich in the derivatives markets if they’re willing to put their money where their mouth is.”

In the end, seeing Wolfers turn relatively mild data into a warning on deflationary risks is yet one more example of how deflationist psychology persists in economic thinking despite years of accommodative Fed policy, lots of money printing, and more printing to come…

It's a wonder sometimes that gold has been able to hold on as high as it is...

It’s a wonder sometimes that gold has been able to hold on as high as it is…

Full disclosure: long GLD