3 Reasons Why Company Earnings Have Been Weak

The trend of weakness in corporate earnings is likely to continue in 2016. The most recent corporate earnings report from the Bureau of Economic Analysis for the first quarter showed after-tax profits down 3.6% from the first quarter of 2015. A negative 3.6% comparable growth rate puts the economy on track for lower earnings growth in 2016, which could potentially lead to an even slower year than 2015. In 2015, corporate earnings growth was 3.3%; in 2014, earnings growth was 0.1%.

A few factors have been significant across the board, while sector-specific risks are also occurring. The main macro trends include weaker global revenue from a strengthening dollar, slowed growth specifically in goods over services, and lower oil prices.

Strengthened Dollar
The dollar has been strengthening globally, which leads to a decrease in corporate profits for American companies. When looking at May 2016 exchange rates, you can see the effects from a strengthened dollar inflated against other currencies. For example, the dollar receives 1.30 Canadian dollars, 18.46 Mexican pesos, 110.27 Japanese yen and 0.9 euros in the current trading environment. Given competitive global pricing, translating this to dollars for corporate earnings thus results in lower revenue.

Additionally, an expected rate increase from the U.S. Federal Reserve, which is likely to occur in the second half of the year, could strengthen the dollar further. A rate increase would draw more foreign investment, increasing demand for the dollar and strengthening it against other currencies.

Goods and Services
The breakdown of goods versus services in the industry has also been a factor for corporate profits. Goods-producing companies grew production by a slow 0.4% in the first quarter of 2016, while services gained 2.6%. The goods sector continues to be a weak spot for the economy, with the 0.4% growth rate down significantly from the fourth quarter's 1.6% and the third quarter's 5%. Within the goods sector, durable goods were reportedly down the most, with a growth rate of negative 1.2% for the first quarter of 2016, down from 3.8% in the fourth quarter of 2016 and 6.6% in the third quarter of 2016.

Energy Prices
Energy prices are also a significant factor affecting corporate earnings. With oil prices low at nearly $50 a barrel for West Texas Intermediate crude oil, the sector overall has significantly been reporting losses, and there are few signs of relief in the second half of the year. The lost revenue from lower oil prices has caused a major decline in revenue for energy companies and has been a factor filtrating through other sectors as well. As a result, commodity-producing companies are reporting lower revenue. Industrial companies, with slowed manufacturing of durable goods for the sector, have also been reporting lower earnings. These energy sector factors have caused widespread weakening in corporate earnings for U.S. companies.

Overall, corporate earnings growth has been trending lower, with no significant signs of a rebound in the near term. The slowed growth in goods-producing companies continues to be a focus, as durable goods trend lower and services remain flat. Energy prices, while showing some small signs of recent improvement, are still projected to remain flat at their current low levels, which has a broadly negative effect on corporate earnings overall. Meanwhile, a rate increase expected for the second half of the year is likely to strengthen the U.S. dollar even further. The strengthened dollar has been the main factor, causing lower corporate earnings growth as inflated dollar values abroad translate to lower domestic earnings. An additional increase from the Federal Reserve is likely to cause further strengthening, which also keeps the near-term corporate outlook weak.
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Why PIMCO Says China's Growth Is Capped

PIMCO's forecasts call for 5.5 to 6.5% growth in Chinese gross domestic product (GDP) in 2016. This figure is above the global average but substantially lower than China's performance over the preceding decade. China's real estate and capital markets experienced deceleration and volatility between 2014 and 2016, with concerns about insufficient demand and fiscal overstimulation causing investor discomfort. PIMCO's modest view for China's GDP growth in 2016 is limited to the upside by concerns over the real estate market, rising sovereign debt, growing nonperforming loans, equity volatility and policy overextension.

Real Estate Market
The Chinese real estate industry has been an important factor in the country's economic growth, rising above 15% of GDP in 2014, fueled by high domestic investment. Strong real estate performance stimulates other industries such as construction and basic materials, so the knock-on effects of rising demand for housing and commercial space are substantial. The Chinese real estate market has been heavily supported by a government that has ensured low interest rates and accommodative lending standards. Unoccupied ghost cities in various parts of the country have been well documented, and concerns about excess capacity have threatened the outlook for the real estate market and the entire economy.

Property prices fell in 2015 but rebounded in early 2016 in China's top-tier cities. The slide continued in smaller cities. Some analysts have suggested real estate investments are being funded by capital flowing out of China's equity markets, though occupancy data suggests much of the strength in surging geographies is not being driven by speculation. In PIMCO's view, sluggish performance in smaller cities and inventory overhang are sufficient to limit real estate's potential to modest positive growth. This creates a drag on GDP growth relative to historical performance, because real estate is such an important part of the Chinese economy.

China added $21 trillion in debt between 2007 and 2015. While the sovereign-debt-to-GDP ratio climbed from 32% in 2006 to 43.9% in 2015, GDP growth fell from 15.4% to 6.7%. Government spending has become an important element of GDP growth as the Chinese economy experiences cyclical slowdown, so the country would have to take on roughly 15% more sovereign debt to achieve its GDP targets at the current rate. Leverage is not high enough to represent a serious threat to economic well-being, but the expanding role of government and diminishing marginal returns limit upside potential.

Nonperforming Loans
Nonperforming loans (NPL) in Chinese banks more than doubled in 2015, bringing the reported NPL ratio to 1.4%. PIMCO expects this figure to increase over the medium term, and stress tests suggest this figure could climb as high as 6%. If these downside scenarios are realized, it could require recapitalization of Chinese banks. NPLs are long-term problems and do not represent an imminent threat in the current cycle, but could influence policy in the short term. This lingering threat can also inhibit investment, which is important for sustained growth.

Equity Market
Chinese equities were highly volatile in 2015 and 2016, and corrective policy often lacked efficacy in response. Stock market volatility can be harmful in the real economy when it impacts investor confidence or consumer sentiment. Uncertain investors can withdraw their assets from an economy, resulting in capital flight, which limits growth potential. Poor consumer sentiment reduces aggregate demand and can be a drag on economic growth. Poorly conceived policy designed to address equity volatility can also impact currency and stifle business investment.

Policy Efficacy
Monetary and fiscal policy have already both been heavily used by China to address economic and capital market inadequacies, and the marginal effects of additional actions are diminished. Sweeping currency depreciation measures led to capital outflow and pushed interest rates closer to theoretical efficacy thresholds. Fiscal stimulation contributed to excess capacity in some manufacturing or real estate categories, and there are fears that true demand from businesses and consumers cannot be simulated indefinitely.
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Did the G20 Agree on a New Plaza Accord in Shanghai?

A burning question that arose in the aftermath of the February 2016 G20 meetings in Shanghai is whether the G20 members secretly instituted a "Plaza Accord" agreement to intervene and stem the rise of the U.S. dollar, and perhaps even to reverse its overall trend from the upside to the downside versus other major world currencies.

"Plaza Accord" refers to an agreement made at the Plaza Hotel in 1985, between the United States and its primary economic allies, to engage in massive selling of the dollar in the foreign exchange market at a time when the dollar had skyrocketed in value against other currencies. At the time, the U.S. dollar index (USDX) versus major currencies had soared from under 100 to nearly 150 in the space of just a few years.

The Plaza Accord was the first major, internationally-coordinated currency intervention since the abandonment of the gold standard in 1971 in favor of fiat money, currencies that are not backed by any physical commodity such as gold or silver, and lack any intrinsic value. Following the Plaza agreement, the U.S. dollar declined 40% over the next three years.

The Dollar's Recent Bull Run
The U.S. dollar has been on a tear versus most other major currencies since mid-2014 when the dollar index reached a low around 79. Since then, it has risen to a high just above 100, scored in late 2015. In June 2014, GBP/USD stood at 1.7191; as of May 2016 it is down to 1.4527. EUR/USD fell from a 2014 high of 1.3993 to 1.1134 in May 2016. Even though the Chinese yuan remains officially pegged to the U.S. dollar, the yuan has depreciated almost 7% against the dollar in less than a year. Overall since 2011, the U.S. dollar has risen more than 30% versus major currencies.

Part of what leads analysts to suspect that some sort of agreement on currency policy may have been crafted at the Shanghai meetings is the belief that a continuing rise of the U.S. dollar against, specifically, the yen and the euro may have negative effects on the global economy as a whole. Additionally, a stable U.S. dollar is seen as one key component in reducing any financial pressure that China policymakers may be feeling to initiate a further significant devaluation of the yuan.

The Nature of a Possible Accord
Joachim Fels, global economic advisor at Pacific Investment Management Company (PIMCO), thinks that at least an informal, tacit agreement may have been reached in Shanghai between the heads of state and central bankers from the G20 economies. In Fels' opinion, such an agreement is likely one to stifle the dollar's advance primarily by using monetary policy rather than by means of active intervention in the form of selling the dollar in the forex market.

As evidence of such an agreement, Fels and other analysts point out that, after the G20 summit, officials from China, Japan, the European Union, the United Kingdom and, finally, the U.S. have all made policy moves designed to stabilize the overall economy and currency markets. China's central bank eased its reserve ratio requirement by 50 basis points, and the European Central Bank (ECB) shifted its focus to credit markets. The U.S. Federal Reserve Bank finished up the round of central bank statements and actions by announcing a likely slower rise in interest rates. Fed Chairman Janet Yellen explained the more cautious policy with references to global economic risk and the recent volatility in equity markets.

There are plenty of analysts who are skeptical of any Plaza-type accord having been made. Julian Jessop, global economist at research firm Capital Economics, argues that neither the Bank of Japan (BOJ) nor the ECB would see an advantage in their currencies appreciating against the U.S. dollar.

The February meetings in Shanghai concluded with G20 officials openly pledging, for the first time in history, to maintain close communications in regard to currency exchange rates.

Market Action Following the G20 Meeting
Whether or not any agreement was reached in Shanghai to reverse the dollar's bull run, market action since the summit has been characterized by a notable decline in the dollar. Following the conclusion of the G20 meetings, the dollar index fell from 98 to 92, although it recovered some of that ground to trade around 95 to 96 in late May 2016. In contrast, both the yen and the euro have enjoyed rallies. It's unlikely that the G20 group actually wants to see a major U.S. dollar sell-off. A more probable goal is simply stabilization and putting something of a cap on the dollar's rise.

The recent market action may reflect a sort of self-fulfilling prophecy, a reluctance on the part of forex traders to buy the dollar if they fear that central banks may be making a concerted effort to sell short. If it influences traders to favor the short side against the dollar, then just the rumor of a possible agreement may be sufficient to prevent the dollar from advancing significantly higher.
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Yellen to Consider Brexit Repercussions At Fed Meeting

Federal Reserve chair Janet Yellen has gone on record saying that a British vote to leave the European Union (or, Brexit) would have consequences that will ripple through the global economy and financial markets. Moreover, in a speech last week, Yellen confirmed that the fallout from a Brexit "leave" vote would indeed be considered during the upcoming FOMC meeting to be held June 14 and 15, which will culminate in an interest rate decision, saying, "A UK vote to exit the European Union could have significant economic repercussions." As of now, polls show the U.K. voters split fairly evenly with 50% saying they will vote in favor of a British exit and the other 50% saying they will vote to remain in the EU. (See also: Brexit is Gaining Momentum.)

Earlier this year, the Fed raised its target Fed Funds Rate for the first time since the Great Recession, and many had anticipated a slow and steady series of rate increases, which have not actually materialized. In her speech last week, Yellen said, "If incoming data are consistent with labor market conditions strengthening and inflation making progress toward our 2% objective, as I expect, further gradual increases in the federal funds rate are likely to be appropriate." Currently, futures markets at the CME predict that there is a 98.1% probability that the Fed will leave interest rates unchanged at 0.50% in June and just a 1.9% chance of a 25 basis point hike to 0.75%. Futures markets are not pricing in any chance of a rate cut at the moment. If the Fed does not raise rates this month, its next opportunity to do so will be at its July 27 meeting. (See also: U.S. Labor Participation Rate at Record Lows. )

Brexit's Impact on a U.S. Rates Decision
While economic data in the U.S. has pointed to a modestly improving economy, with the headline unemployment figures clocking in below 5%, and with GDP growing steadily, some economists have warned that a Brexit could have an adverse effect here in the United States. Yellen has also remarked that a Brexit could change expectations and the appetite for risk among U.S. investors. Fed governor Lael Brainard has echoed Yellen's sentiment saying, "Because international financial markets are tightly linked, an adverse reaction in European financial markets could affect US financial markets, and, through them, real activity in the United States." (See also: 3 Brexit Doomsday Scenarios.)

Some predict that a Brexit will spur a recession in the U.K. accompanied by high unemployment. The U.S. firms with large operations in Britain, and especially those in the financial sector are bound to see their stock prices negatively impacted as a result. In 2014 for example, U.S. companies invested more than $588 billion into the British economy. The Ford Motor Company (F) and Goldman Sachs Group (GS) have already announced contingency plans to scale back U.K. operations should Brexit occur. European markets could also feel a sting as a Brexit may undermine the stability and perceived robustness of the common economic zone, and encourage fringe countries such as Greece, Cyprus or Portugal to follow suit and leave as well.

Foreign exchange markets will also bear the brunt of a Brexit, with the U.S. dollar probably seeing an unwanted increase in value versus the British Pound, and some have also speculated that the euro could also fall in relation to the dollar as foreign capital from the UK and Europe alike flow into the U.S. A stronger dollar hurts exporters and might be seen as a countervailing force to the broader economic recovery. Higher domestic interest rates will only make the dollar look even more attractive as a place to stick foreign funds. (See also: British Pound Tumbles on Potential ‘Brexit’.)

The Bottom Line
The upcoming vote for Britain to leave the EU, in a so-called "Brexit" is fast approaching with polls showing a near 50/50 split in the outcome. If a Brexit does occur, however, it may force Janet Yellen to put the curbs on future interest rate increases in the U.S. To be sure, she and other Fed members have voiced concerns over the repercussions a Brexit could have on global financial markets and the U.S. economy due to changes in sentiment and expectations - but also due to currency movements and fallout from a British recession. With futures markets showing a very high probability of no rate hike during this June's FOMC meeting, a 'Yes' outcome for Brexit may already be factored in.
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5 Reasons Why Currency Manipulation Matters for Average Investors

The U.S. Treasury Department released a semi-annual report in April 2016 in which China, Japan, Korea, Taiwan and Germany were placed on a monitoring list as potential violators of fair currency practices. Countries on the list warrant enhanced scrutiny to determine if they are engaged in currency manipulation, which is monetary policy that provides an unfair trade advantage. Trade penalties could ensue if it is determined that a major trade partner violates fair practice guidelines and does not rectify any of these policies.

Currency manipulation occurs when monetary policy is implemented specifically to alter a currency in global foreign exchange markets. These policies are considered unfair trade practices when they are designed to maintain an artificial competitive advantage for a certain industry in the offending country. The most common incidence involves artificially raising the supply of an economy's tender to support its export industry. All else being equal, currency devaluation makes the exports from an economy cheaper in all other economies, thereby increasing demand for these products abroad. This can stimulate sectors such as manufacturing or basic materials, sending positive results throughout the wider domestic economy.

U.S. Corporate Financial Results
The financial results of corporations based in the United States can be impacted significantly by currency manipulation. When foreign countries devalue their currencies unfairly, exporters in the U.S. become less competitive in foreign markets, and foreign exporters gain an advantage in U.S. markets. American companies find it increasingly difficult to compete with foreign peers on a price basis. These factors also threaten business fundamentals, even if a competitive advantage is maintained.

The proportion of foreign-denominated sales tends to be higher than the proportion of foreign-denominated expenses for multinational corporations based in the U.S. Currency manipulation creates a scenario in which corporate operating profits are reduced, because the same volume of sales will now result in lower top-line results without a corresponding decrease in expenses. Such conditions also prompt corporate management teams to publish unofficial adjusted figures that control for fluctuations.

Retail investors suffer as a result. American investors hold roughly more than 75% of U.S. equity shares, so investors are jeopardized when American companies lose their competitive advantage. Lost profitability due to currency headwinds dampens earnings yields, limits cash flows and creates downward pressure on dividends and dividend growth. Adjusted figures and large currency distortions can complicate the fundamental research process, creating additional barriers for non-professionals.

U.S. Economic Well-Being
The same forces that impact corporate financial results can snowball into general economic problems. Chinese currency devaluation inflated the average annual U.S. trade deficit by several hundred billion dollars throughout the early 21st century, which had a negative effect on employment. The Economic Policy Institute estimates that Chinese currency devaluation cost 3.2 million American jobs between 2001 and 2013. Manufacturers and suppliers of basic materials tend to expand slowly or even contract due to currency manipulation, because they are at a competitive disadvantage against their foreign counterparts. This can also impact the growth of wages and disposable income, which are essential to healthy economic growth in developed economies.

A weak economy can stifle investment and reduce the investable income earned by Americans, as investors tend to become more conservative in times of uncertainty. Threats to economic stability contributed to the Federal Reserve's decision to delay interest rate moderation early in 2016. Low rates impact bond prices, and retirement savers continue to be pushed toward higher-risk fixed-income securities to achieve desirable yields for retirement income.

Capital Flows
Global capital markets are impacted by currency manipulation, so the impacts extend beyond trade balance and export competitiveness. When foreign currencies depreciate relative to the dollar, investors often seek better returns in other markets, and U.S. equities markets are popular destinations for that displaced capital. Some economists have noted that the Japanese yen is a leading indicator of U.S. equity market peaks and troughs, with improving yen strength indicating repatriation of gains. The proportion of U.S. equities owned by foreign entities rose steadily from 1995 to 2015, and foreign holdings of U.S. corporate debt securities also trended upward during that period. Depreciation of foreign currency influences demand for American assets, which can cause bubbles in U.S. markets.
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