With no POMO on the calendar today and the WSJ suggesting that QE2 may be a couple of hundred billion over several months, but by most measures a disappointment for the bulls who were using it as an excuse to run up the market over the past two months, futures are looking down big this morning.
Yesterday, William Dudley, the president of the FRB NY said the central bank cannot fix the sluggish economy. If you recall from the special report I wrote on QE2, Dudley has been one of the largest advocates of loosening monetary policy. Perhaps with currency wars and protectionism, angry allies who have been forced into currency interventions of their own as a result of our actions, and an American electorate who has by now somewhat begun to understood the risks of more Fed action, Dudley has decided that it may be time to back it off a bit.
Wednesday, October 27, 2010
Tuesday, October 26, 2010
Market Update
Futures are pointing down this morning after disappointing earnings from ArcelorMittal (MT) and UBS. UBS beat estimates with the help of an 825M franc tax credit, but its investment banking unit posted a surprise pretax loss of 406M francs due to 'very low levels of client activity' and a charge on the bank's own debt.
Meanwhile, UK GDP grew twice as fast as expected in Q3 at 0.8% and S&P reaffirmed the U.K.'s AAA credit rating and revised its outlook to stable from negative. Interestingly though, this could pressure the BOE to delay additional bond purchases. Goodbye stimulus?
The U.S. will report 3Q GDP on Friday this week, just ahead of the FOMC meeting on November 3rd. If we posted a better than expected 3Q GDP (unlikely given the durable goods orders data, etc over the past few months) on Friday, would QE2 expectations have to come way down, and in the process, bring the market way down?
Another two signs that expectations for further monetary stimulus in the U.S. may be overdone include comments from Nissan COO Toshiyuki Shiga this morning, "we can't adequately express our concern about the sharp yen rise on our earnings by simply saying...we are worried about it. The company is now working with a sense of crisis."
And, a 5-year TIPS auction yesterday was done at a negative yield for the first time ever. Investors bought $10B at (0.55%) on expectations for higher inflation (monetary stimulus). It will end up being a shame if these investors end up paying the government to loan it money...
On today's economic calendar we will have the Case Shiller 20 city home index and Consumer Confidence.
We will also have another round of POMO. The target of which will be longer dated treasuries.
Remember that the market tends to see its apex on POMO days at 8:30 PST. So, if we sell of hard in the morning, you might buy a few beaten down names going into the POMO (if they be tech or materials names...with MT down 5% pre-market, that could be a decent candidate...) and cover your shorts.
Meanwhile, UK GDP grew twice as fast as expected in Q3 at 0.8% and S&P reaffirmed the U.K.'s AAA credit rating and revised its outlook to stable from negative. Interestingly though, this could pressure the BOE to delay additional bond purchases. Goodbye stimulus?
The U.S. will report 3Q GDP on Friday this week, just ahead of the FOMC meeting on November 3rd. If we posted a better than expected 3Q GDP (unlikely given the durable goods orders data, etc over the past few months) on Friday, would QE2 expectations have to come way down, and in the process, bring the market way down?
Another two signs that expectations for further monetary stimulus in the U.S. may be overdone include comments from Nissan COO Toshiyuki Shiga this morning, "we can't adequately express our concern about the sharp yen rise on our earnings by simply saying...we are worried about it. The company is now working with a sense of crisis."
And, a 5-year TIPS auction yesterday was done at a negative yield for the first time ever. Investors bought $10B at (0.55%) on expectations for higher inflation (monetary stimulus). It will end up being a shame if these investors end up paying the government to loan it money...
On today's economic calendar we will have the Case Shiller 20 city home index and Consumer Confidence.
We will also have another round of POMO. The target of which will be longer dated treasuries.
Remember that the market tends to see its apex on POMO days at 8:30 PST. So, if we sell of hard in the morning, you might buy a few beaten down names going into the POMO (if they be tech or materials names...with MT down 5% pre-market, that could be a decent candidate...) and cover your shorts.
Wednesday, October 20, 2010
France, Germany, Currencies, G20 and QE2
Reuters paraphrases Angel Merkel today as having said that 'the vulnerability of the euro has not yet been lastingly overcome and the currency is being shielded at the moment by the euro zone's safety net.' Relatedly, the German chambers of industry and commerce said today that if the Euro rises to $1.50 that the German economy will come under pressure.
This is a not so subtle demand for the US to cease devaluation plans.
Sarkozy is calling for currency manipuliaton to be on the docket at the G20.
Brazil is boycotting the events and has been forced recently to play vigorous defense to offset the impacts of USD moves on the Real.
The Yen is flying.
Those believing the Fed will still announce a full QE2 effort on November 3rd may be mistaken.
For the Fed to turn around only two weeks after the G20 and in defiance of an almost global insistence on stopping the dollar slide, I can't imagine we move forward with massive monetary stimulus. I'm not ruling out the possibility for a morsel of monetary stimulus to be announced, but even voting Fed governors (Dallas Fed's Fisher for ex) are starting to suggest they have questions about both the efficacy of another round of monetary stimulus and also the Fed's ability to implement it without taking extraordinary risks (hyperinflation, currency wars, increased protectionism, destroying purchasing power of American consumer who could be bogged down by high food and fuel costs, etc).
This is a not so subtle demand for the US to cease devaluation plans.
Sarkozy is calling for currency manipuliaton to be on the docket at the G20.
Brazil is boycotting the events and has been forced recently to play vigorous defense to offset the impacts of USD moves on the Real.
The Yen is flying.
Those believing the Fed will still announce a full QE2 effort on November 3rd may be mistaken.
For the Fed to turn around only two weeks after the G20 and in defiance of an almost global insistence on stopping the dollar slide, I can't imagine we move forward with massive monetary stimulus. I'm not ruling out the possibility for a morsel of monetary stimulus to be announced, but even voting Fed governors (Dallas Fed's Fisher for ex) are starting to suggest they have questions about both the efficacy of another round of monetary stimulus and also the Fed's ability to implement it without taking extraordinary risks (hyperinflation, currency wars, increased protectionism, destroying purchasing power of American consumer who could be bogged down by high food and fuel costs, etc).
Market Update: POMO
Today's POMO was a mere $660M (after Monday's massive $6.26B). Dow is up 120 at its completion.
Market Update: BAC Thoughts
Two hours into the trading session, the Dow is up 115 points, the S&P up 10, and the Nasdaq up 20. High beta stocks are off and running. This is a POMO day afterall.
Meanwhile, BAC is getting hammered on the threat of mortgage put-backs. Paul Miller at FBR says the amount of pushbacks might be nearly unquantifiable. Stifel Nicholas downgraded BAC this morning with an apologetic tone given it was downgrading one of the four horsemen at a time when the stock is trading below its just-announced TBV (BAC 11.39, -0.40, -3.5%) of 12.91. At some point, BAC is probably a buy for a trade, especially if the selling takes this even a little bit further. We are now at 0.9x TBV. At 10.30, we'd be at 0.8x. How much BV could the mortgages pushed-back actually consume....? No one knows, hence the sell-off. But, TBV is approx $128.673B. The market cap is now $114.74B. So, the market has already essentially sliced off $13.9B. The headline articles suggest BAC would be on the hook for put-backs on securitizations with total value of $46B. So, 30% of the loans in the securitizations being delinquent/fradulent, etc. has already been priced into the stock. I'd caution against trying to catch a falling knife, but at some point this becomes interesting. At 10.30, or at 0.8x TBV, we'd see ~$26B taken off (or 56% of the securitizations' total value).
Disclosures & Disclaimers: This post is intended for informational purposes only and is not a recommendation to buy or sell any security.
Meanwhile, BAC is getting hammered on the threat of mortgage put-backs. Paul Miller at FBR says the amount of pushbacks might be nearly unquantifiable. Stifel Nicholas downgraded BAC this morning with an apologetic tone given it was downgrading one of the four horsemen at a time when the stock is trading below its just-announced TBV (BAC 11.39, -0.40, -3.5%) of 12.91. At some point, BAC is probably a buy for a trade, especially if the selling takes this even a little bit further. We are now at 0.9x TBV. At 10.30, we'd be at 0.8x. How much BV could the mortgages pushed-back actually consume....? No one knows, hence the sell-off. But, TBV is approx $128.673B. The market cap is now $114.74B. So, the market has already essentially sliced off $13.9B. The headline articles suggest BAC would be on the hook for put-backs on securitizations with total value of $46B. So, 30% of the loans in the securitizations being delinquent/fradulent, etc. has already been priced into the stock. I'd caution against trying to catch a falling knife, but at some point this becomes interesting. At 10.30, or at 0.8x TBV, we'd see ~$26B taken off (or 56% of the securitizations' total value).
Disclosures & Disclaimers: This post is intended for informational purposes only and is not a recommendation to buy or sell any security.
BHP/POT and Meryvn King on Protectionism and Global Co-op on Policy
WFC reported record profits this morning as credit improved. $0.60 vs. $0.56 consensus on $20.9B of revenue. USB also reported this morning, and saw its 3Q profit rise 51% YoY, to post $0.45 vs. $0.43 expected. (Incidentally, these reports should bode well for Fairfax which owns large stakes in both banks.)
Bloomberg has a story out this morning detailing the deepest budget cuts in British history as Chancellor of the Exchequer, George Osborne, outlined austerity measures designed to virtually eliminate a $245B budget deficit. These plans include eliminating approx 490,000 public-sector jobs, putting a permanent maximum sustainable tax revenue on the financial services sector, cuts to the royal family's funding from the 'civil list', a 7.1% decrease in funds for local governments by 2015, a 24% cut to the Foreign Office budget, and a 6% cut to the Ministry of Justice. The pound is little changed this morning on the announcement.
BHP's offer to Saskatchewan of $360M for infrastructure investment was turned down by the province, as BHP's offer doesn't come close to offsetting the C$3B in revenue thed province would lose if BHP is successful in its attempted acquisition of POT. Saskatchewan Premier Brad Wall will lay out the province's position on the hostile offer in a speech today. Canada has until Nov. 3 to block the bid if it doesn't provide a net benefit to the country. (Bloomberg)
Bank of England Governor Mervyn King gave a speech yesterday ahead of this weekend's G20 meeting discussing the dire need for globally coordinated policy decisions in order to keep the level of protectionism from rising to a point where it would slow global output. “The risk is that unless agreement on a common path of adjustment is reached, conflicting policies will result in an undesirably low level of world output, with all countries worse off as a result,” King said. “The need to act in the collective interest has yet to be recognized, and, unless it is, it will be only a matter of time before one or more countries resort to trade protectionism.” Mr. King went on to discuss how countries with floating exchange rates are 'innocent victims' and how Brazil has had to retaliate and even how India is considering intervening in the market if the rupee appreciates past 43 to the dollar. His most troubling statement however was when he said that a real agreement at the G20 would require a "revolution". (Bloomberg)
Bloomberg has a story out this morning detailing the deepest budget cuts in British history as Chancellor of the Exchequer, George Osborne, outlined austerity measures designed to virtually eliminate a $245B budget deficit. These plans include eliminating approx 490,000 public-sector jobs, putting a permanent maximum sustainable tax revenue on the financial services sector, cuts to the royal family's funding from the 'civil list', a 7.1% decrease in funds for local governments by 2015, a 24% cut to the Foreign Office budget, and a 6% cut to the Ministry of Justice. The pound is little changed this morning on the announcement.
BHP's offer to Saskatchewan of $360M for infrastructure investment was turned down by the province, as BHP's offer doesn't come close to offsetting the C$3B in revenue thed province would lose if BHP is successful in its attempted acquisition of POT. Saskatchewan Premier Brad Wall will lay out the province's position on the hostile offer in a speech today. Canada has until Nov. 3 to block the bid if it doesn't provide a net benefit to the country. (Bloomberg)
Bank of England Governor Mervyn King gave a speech yesterday ahead of this weekend's G20 meeting discussing the dire need for globally coordinated policy decisions in order to keep the level of protectionism from rising to a point where it would slow global output. “The risk is that unless agreement on a common path of adjustment is reached, conflicting policies will result in an undesirably low level of world output, with all countries worse off as a result,” King said. “The need to act in the collective interest has yet to be recognized, and, unless it is, it will be only a matter of time before one or more countries resort to trade protectionism.” Mr. King went on to discuss how countries with floating exchange rates are 'innocent victims' and how Brazil has had to retaliate and even how India is considering intervening in the market if the rupee appreciates past 43 to the dollar. His most troubling statement however was when he said that a real agreement at the G20 would require a "revolution". (Bloomberg)
Tuesday, October 19, 2010
Dallas Fed's Fisher on Monetary Policy
"In my darkest moments, I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places."
Dow is down 200
Dow is down 200
Long Idea - Fairfax Financial
Fairfax Financial Holdings Ltd (FRFHF.PK)
Basic Company Overview
Fairfax Financial is a financial holding company that, through its subsidiaries, writes commercial property and casualty insurance and reinsurance. The company now operates in 100 countries worldwide through its wholly owned subsidiaires:
Northbridge - Canadian insurance underwriter
Crum & Forster - US P&C Insurance underwriter
Zenith National - US Workers' Compensation Specialist
OdysseyRe - Worldwide underwriter of P&C Reinsurance & Specialty Insurance
Advent - US Property Insurance
Fairfax Asia - Consists of two P&C insurers: First Capital, based in Singapore and Falcon Insurance which is based in Hong Kong.
Fairfax Brasil Seguros Corporativos S.A. - Brazil P&C Insurer, founded in March 2010
And JV Partners:
15% Interest in Alltrust Insurance Company of China (a leading Chinese insurer)
JV in India with ICICI Lombard General Insurance
Fairfax also owns a leading North American animal nutrition business, Ridley.
The float is managed by Hamblin Watsa Investment Council (HWIC). Hamblin has gained significant notoriety for betting against the subprime housing market through CDS positions with an $18.5B notional amount on 25-30 bond insurers and mortgage lenders. The net realized gain since inception has been $2.1B vs. original acquisition costs of $433.B. (Note: CEO and Chairman Prem Watsa is quick to note in his most recent letter to shareholders, "Our adventure with credit default swaps is over (Emphasis Mine)- but we will remember it as of one of the the more significant events in our history!" He also notes, "...it is highly unlikely we will ever repeat [these investment results] in the future!" Have to love this guy.)
HWIC has helped take the company from its original $30M in assets and $7.6M in common equity in 1985 to end 2009 with $28B in assets and $7.4B in common equity - an almost 1,000 fold increase. BVPS has compounded 26% per year, while the common stock has gained 22% per year.
Interest and Dividend Income has Grown Substantially As Well:
1985 - $0.70/share
1990 - $2.35/share
2000 - $40.54/share
2009 - $38.94/share
At the end of 2009, the combined float was $579/share. Combined with $370/share in BV and $115/share in net debt, there is approx $1,064 in investments per share.
Also, importantly, float actually increases as the dollar depreciates at no cost to Fairfax as a result of its foreign subsidiaries. Given the dollar depreciation in September, one would expect earnings from Fairfax on October 28th to show a very positive benefit in this regard.
Watsa is a disciple of Benjamin Graham and has been compared to Warren Buffett (largely because of the compound annual growth rates, the constant references to Security Analysis, his holding company structure, and his colorful letters to shareholders.) As a conservative, long-term oriented value-investor (ditto for HWIC), Watsa in my mind is probably as good an asset manager as any should the market begin to behave, shall we say, erratically.
HWIC has large positions in WFC, J&J, USB, and KFT. Watsa notes that KFT has 1,000 stores in India after its acquisition of Cadbury. This is the type of diversification into growing markets that I for one can be excited about.
HWIC hedges its equity exposure to a great extent through swaps and other derivatives. The net exposure to equities has been higher than in previous years, which actually should provide another tailwind into earnings.
Turning to Insurance
Compound Annual Growth Rates from 2001 - 2009 in its insurance subsidiaries:
Northbridge - 18.6%
Crum & Forster - 19%
OdysseyRe - 22.7%
Fairfax Asia - 24.8% (since 2002)
Brazil has just begun and the India and China joint ventures should also provide robust growth and additional diversification.
The consolidated combined ratio for YE09 was 99.8%. Watsa is focused on underwriting at a profit or not at all, causing net premiums written to shrink on a consolidated basis by 1.1% through YE09. The markets will eventually harden and cost of acquisition of new business will go down. It may take some time, but in the meantime, Fairfax can earn excellent ROEs on its existing float. Also, the underwriting environment especially in the US has been very difficult which may account for why Fairfax appears to be so undervalued at this time. To want to own this company however, you'd have to think like Watsa. If that is the case, the lumpiness in the insurance and investment businesses should not be a deterrent to ownership, but actually should be viewed as an opportunity to buy the company at a VERY reasonable 1.1x BV. Fairfax took sizable hits (6.2 combined ratio points) on insurance exposures to Deepwater Horizon and the Chilean Earthquake, without which, Fairfax's consolidated combined ratio in 1H10 would have been 98.4%. This is the natural result of writing insurance around the globe, but even these events did nothing to keep Watsa from his goal of compounding annual BVPS by 15% per annum over the long term. Additioanlly, Fairfax Asia's combined ratio of 82.6% at YE09 and the newly open for business Brazilian unit should provide not only nice additions in net premium growth but also make correspondingly high contributions to the size of the parent company float.
1H10, the company earned $29.64/share. If the company earns $60/share for 2010, then Fairfax is trading at 9x TTM and 1.11 TTM BV for long term 26% annual compounded growth. This company is one that I intend to own for the long term.
It was recently mentioned by Mohnish Pabrai of Pabrai Investment Fund and Zeke Ashton of Centaur Capital Partners at the Value Investors Conference (VIC) which should draw additional attention to the company in the coming weeks/months.
Disclosures & Disclaimers: This article should not be taken as advice to buy or sell any security. It is intended for informational purposes only. The author owns shares in FRFHF.PK and may choose to buy more or sell the current holding at any time without notice.
Basic Company Overview
Fairfax Financial is a financial holding company that, through its subsidiaries, writes commercial property and casualty insurance and reinsurance. The company now operates in 100 countries worldwide through its wholly owned subsidiaires:
Northbridge - Canadian insurance underwriter
Crum & Forster - US P&C Insurance underwriter
Zenith National - US Workers' Compensation Specialist
OdysseyRe - Worldwide underwriter of P&C Reinsurance & Specialty Insurance
Advent - US Property Insurance
Fairfax Asia - Consists of two P&C insurers: First Capital, based in Singapore and Falcon Insurance which is based in Hong Kong.
Fairfax Brasil Seguros Corporativos S.A. - Brazil P&C Insurer, founded in March 2010
And JV Partners:
15% Interest in Alltrust Insurance Company of China (a leading Chinese insurer)
JV in India with ICICI Lombard General Insurance
Fairfax also owns a leading North American animal nutrition business, Ridley.
The float is managed by Hamblin Watsa Investment Council (HWIC). Hamblin has gained significant notoriety for betting against the subprime housing market through CDS positions with an $18.5B notional amount on 25-30 bond insurers and mortgage lenders. The net realized gain since inception has been $2.1B vs. original acquisition costs of $433.B. (Note: CEO and Chairman Prem Watsa is quick to note in his most recent letter to shareholders, "Our adventure with credit default swaps is over (Emphasis Mine)- but we will remember it as of one of the the more significant events in our history!" He also notes, "...it is highly unlikely we will ever repeat [these investment results] in the future!" Have to love this guy.)
HWIC has helped take the company from its original $30M in assets and $7.6M in common equity in 1985 to end 2009 with $28B in assets and $7.4B in common equity - an almost 1,000 fold increase. BVPS has compounded 26% per year, while the common stock has gained 22% per year.
Interest and Dividend Income has Grown Substantially As Well:
1985 - $0.70/share
1990 - $2.35/share
2000 - $40.54/share
2009 - $38.94/share
At the end of 2009, the combined float was $579/share. Combined with $370/share in BV and $115/share in net debt, there is approx $1,064 in investments per share.
Also, importantly, float actually increases as the dollar depreciates at no cost to Fairfax as a result of its foreign subsidiaries. Given the dollar depreciation in September, one would expect earnings from Fairfax on October 28th to show a very positive benefit in this regard.
Watsa is a disciple of Benjamin Graham and has been compared to Warren Buffett (largely because of the compound annual growth rates, the constant references to Security Analysis, his holding company structure, and his colorful letters to shareholders.) As a conservative, long-term oriented value-investor (ditto for HWIC), Watsa in my mind is probably as good an asset manager as any should the market begin to behave, shall we say, erratically.
HWIC has large positions in WFC, J&J, USB, and KFT. Watsa notes that KFT has 1,000 stores in India after its acquisition of Cadbury. This is the type of diversification into growing markets that I for one can be excited about.
HWIC hedges its equity exposure to a great extent through swaps and other derivatives. The net exposure to equities has been higher than in previous years, which actually should provide another tailwind into earnings.
Turning to Insurance
Compound Annual Growth Rates from 2001 - 2009 in its insurance subsidiaries:
Northbridge - 18.6%
Crum & Forster - 19%
OdysseyRe - 22.7%
Fairfax Asia - 24.8% (since 2002)
Brazil has just begun and the India and China joint ventures should also provide robust growth and additional diversification.
The consolidated combined ratio for YE09 was 99.8%. Watsa is focused on underwriting at a profit or not at all, causing net premiums written to shrink on a consolidated basis by 1.1% through YE09. The markets will eventually harden and cost of acquisition of new business will go down. It may take some time, but in the meantime, Fairfax can earn excellent ROEs on its existing float. Also, the underwriting environment especially in the US has been very difficult which may account for why Fairfax appears to be so undervalued at this time. To want to own this company however, you'd have to think like Watsa. If that is the case, the lumpiness in the insurance and investment businesses should not be a deterrent to ownership, but actually should be viewed as an opportunity to buy the company at a VERY reasonable 1.1x BV. Fairfax took sizable hits (6.2 combined ratio points) on insurance exposures to Deepwater Horizon and the Chilean Earthquake, without which, Fairfax's consolidated combined ratio in 1H10 would have been 98.4%. This is the natural result of writing insurance around the globe, but even these events did nothing to keep Watsa from his goal of compounding annual BVPS by 15% per annum over the long term. Additioanlly, Fairfax Asia's combined ratio of 82.6% at YE09 and the newly open for business Brazilian unit should provide not only nice additions in net premium growth but also make correspondingly high contributions to the size of the parent company float.
1H10, the company earned $29.64/share. If the company earns $60/share for 2010, then Fairfax is trading at 9x TTM and 1.11 TTM BV for long term 26% annual compounded growth. This company is one that I intend to own for the long term.
It was recently mentioned by Mohnish Pabrai of Pabrai Investment Fund and Zeke Ashton of Centaur Capital Partners at the Value Investors Conference (VIC) which should draw additional attention to the company in the coming weeks/months.
Disclosures & Disclaimers: This article should not be taken as advice to buy or sell any security. It is intended for informational purposes only. The author owns shares in FRFHF.PK and may choose to buy more or sell the current holding at any time without notice.
Dollar to lose reserve status? Geithner, "Not in our lifetime"
The sad thing about this 4 word response is that it does a fabulous job of summarizing the current attitude of our policymakers and other officials. "Not in our lifetime." While I do not propose to argue with the veracity of that statement as forecasting such a thing is virtually impossible (and thus somewhat mitigating the strength of meaning of his off-the-cuff remark), it still strikes me that the focus on the short term by our leaders is going to have serious consequences for both my own and future generations. We haven't really begun fixing the systemic failures that have lead us into this morass. A great deal of the current and mounting frustration by the electorate is the direct result of the notion that the stop loss measures taken by the Fed, Treasury, Congress, etc were aligned more closely with protecting the wealth of the wealthy rather than ending a morally and financially bankrupt banking cartel, pushing into renewables to create jobs, improving the enforcement powers of the various federal agencies (see Deepwater Horizon, Bernie Madoff, etc), protect US jobs from moving overseas, etc, etc, etc.
We need to start considering the long term ramifications of allowing policy drift and generational favoritism to dominate our political landscape.
We need to start considering the long term ramifications of allowing policy drift and generational favoritism to dominate our political landscape.
"Geithner vows U.S. will not devalue dollar"
Reuters reports this morning that Treasury Secretary Tim Geitner told an audience of the Commonwealth Club of California in Palo Alto, "It is very important for people to understand that the United States of America and no country around the world can devalue its way to prosperity, to (be) competitive," Geithner added. "It is not a viable, feasible strategy and we will not engage in it."
These remarks come ahead of this weekend's G20 meeting in South Korea. China this morning raised its base lending rate 25 bps to try to curb lending and also perhaps to make a symbolic gesture re: the 'weak' remnimbi ahead of the G20.
Elsewhere this morning, various news agenies are reporting that Brazil has backed out of this weekend's G20 meeting, and tried to offset the rally in the real on Monday by raising taxes for foreigners buying local bonds to 6% from 4%.
Reuters also reports that, "Argentina's Minister of Economy and Public Finance Amado Boudou on Monday called on developed nations to focus on creating jobs rather than actions that weaken their currencies, saying a "true currency war" was underway."
Dow is down 150 pts after first 30 mins of trading. Sub-11,000. While I hate to say it, this sell-off should probably be bought. After all, its POMO tomorrow.
These remarks come ahead of this weekend's G20 meeting in South Korea. China this morning raised its base lending rate 25 bps to try to curb lending and also perhaps to make a symbolic gesture re: the 'weak' remnimbi ahead of the G20.
Elsewhere this morning, various news agenies are reporting that Brazil has backed out of this weekend's G20 meeting, and tried to offset the rally in the real on Monday by raising taxes for foreigners buying local bonds to 6% from 4%.
Reuters also reports that, "Argentina's Minister of Economy and Public Finance Amado Boudou on Monday called on developed nations to focus on creating jobs rather than actions that weaken their currencies, saying a "true currency war" was underway."
Dow is down 150 pts after first 30 mins of trading. Sub-11,000. While I hate to say it, this sell-off should probably be bought. After all, its POMO tomorrow.
IBM and AAPL reported yesterday after the market close.
AAPL reported fiscal Q4 revenue of $20.34B vs. estimates of $18.9B and EPS of $4.64 vs. expectations of $4.08. The company however did not sell as many iPad's as analysts predicted and its margins and guidance disappointed. AAPL is down $15.83 or 5% to $302.17 in pre-market trading.
IBM reported Q3 EPS of $2.82/share vs. $2.75 expected on revenue of $24.3B vs. $24.1B expected. The outsourcing business did not perform as well as expected, but the company did raise its earnings forecast for the rest of the year. IBM is down $4.84 to $137.88 pre-market.
BAC reported this morning before the open. The banking giant lost $7.65B or $0.77/share in the 3Q due to a charge related to credit and debit card reform legislation passed over the summer. Excluding the one-time charge, BAC earned $3.1B or $0.27/share vs. $0.16 expected. A lower provision (see JPM and C earnings) was a main driver of the beat, coming in at a $5.4B addition vs. $11.71B in 3Q09. Credit improved as NCOs were $2.4B lower than 2Q10. Capital levels also improved and TBV moved to $12.91.
GS will also report earnings this morning.
Futures are down with the Dow posting a 31 pt drop, Nasdaq down 24, and the S&P down 6. There is no POMO scheduled for today, but there is one tomorrow. Timothy Geithner said yesterday that the US would not pursue a weak dollar position and said we must work hard to ensure the strength of the USD. Shorts are covering and the dollar is up for the 3rd session in a row. This is also particularly bad for technology companies, so we could be in for a sizable sell-off today unless Goldman's numbers are really impressive.
On the economic front, we will have housing start and building permit reports today.
UPDATE: GS beat on both the top and bottom line as reported revenue came in at $8.9B vs. $7.9B expected ($12.37B in 3Q09) and EPS of $2.98/share beat the $2.32 expected and $5.25 for 3Q09. TBV increased about 3% to $116.23.
The futures are showing no improvement based on GS' earnings just yet...The weaker dollar, Geithner's comments, disappointing AAPL guidance, and the IMF warning of potential bubbles and slowing growth in East Asia seem to be enough for the market to take a breather this morning. We could firm up going into the close however, as another POMO is scheduled for Wednesday and earnings after the bell should look ok.
AAPL reported fiscal Q4 revenue of $20.34B vs. estimates of $18.9B and EPS of $4.64 vs. expectations of $4.08. The company however did not sell as many iPad's as analysts predicted and its margins and guidance disappointed. AAPL is down $15.83 or 5% to $302.17 in pre-market trading.
IBM reported Q3 EPS of $2.82/share vs. $2.75 expected on revenue of $24.3B vs. $24.1B expected. The outsourcing business did not perform as well as expected, but the company did raise its earnings forecast for the rest of the year. IBM is down $4.84 to $137.88 pre-market.
BAC reported this morning before the open. The banking giant lost $7.65B or $0.77/share in the 3Q due to a charge related to credit and debit card reform legislation passed over the summer. Excluding the one-time charge, BAC earned $3.1B or $0.27/share vs. $0.16 expected. A lower provision (see JPM and C earnings) was a main driver of the beat, coming in at a $5.4B addition vs. $11.71B in 3Q09. Credit improved as NCOs were $2.4B lower than 2Q10. Capital levels also improved and TBV moved to $12.91.
GS will also report earnings this morning.
Futures are down with the Dow posting a 31 pt drop, Nasdaq down 24, and the S&P down 6. There is no POMO scheduled for today, but there is one tomorrow. Timothy Geithner said yesterday that the US would not pursue a weak dollar position and said we must work hard to ensure the strength of the USD. Shorts are covering and the dollar is up for the 3rd session in a row. This is also particularly bad for technology companies, so we could be in for a sizable sell-off today unless Goldman's numbers are really impressive.
On the economic front, we will have housing start and building permit reports today.
UPDATE: GS beat on both the top and bottom line as reported revenue came in at $8.9B vs. $7.9B expected ($12.37B in 3Q09) and EPS of $2.98/share beat the $2.32 expected and $5.25 for 3Q09. TBV increased about 3% to $116.23.
The futures are showing no improvement based on GS' earnings just yet...The weaker dollar, Geithner's comments, disappointing AAPL guidance, and the IMF warning of potential bubbles and slowing growth in East Asia seem to be enough for the market to take a breather this morning. We could firm up going into the close however, as another POMO is scheduled for Wednesday and earnings after the bell should look ok.
Monday, October 18, 2010
Despite the industrial production and capacity utilization declines (both large red flags regarding the state of the recovery), the Dow is up 40+ pts and the Nasdaq and S&P 500 each currently sport a small gain. One must assume this is the result of a demand for stocks ahead of AAPL's earnings release after the market close today, and also a belief that worsening economic data virtually guarantees Fed action.
The US dollar is up 0.3% this morning from a 10 month low against a basket of currencies after Fed Chairman Bernanke's comments on Friday softened views re: the possible size and implementation of QE2.
Citigroup (C) reported $0.07/share vs. $0.06 expected this morning. Citi was just a bit light on the top line, coming in at $20.7B vs. the $21B consensus expectation. Much of this bottom line beat is attributable to a $1.99B drop in provisions for loan losses.
Industrial production fell 0.2% in September which was the first time IP fell since the 'recession ended'. This seems to confirm the thesis that much of the ramped production over the past year or so was not being absorbed by consumers.
Capacity utilization came in at 74.7% in September, down 0.1% from August. This is also the first decline in utilization since June 2009.
NAHB issues October housing market index at 7 am PST. 14 is expected vs. 13 in September.
"This multicultural approach, saying that we simply live side by side and live happily with each other has failed. Utterly failed," Angela Merkel said regarding Turks and other immigrants living in Germany. It's both unfortunate and frightening to see xenophobia on the rise around the globe.
China's new five-year plan has been issued, but will await final approval early next year. The Chinese economy is forecast to grow 50% in the next five years to $7.5T. A key focus of the Plan will be to shrink the income gap by improving the distribution of the national income in order to drive long term domestic consumer demand for goods and services. "Expanding domestic demand is the guiding long-term strategy of our country's economic and social development," said Zhang Ping, head of the National Development and Reform Commission. Meanwhile a NYT article from this weekend entitled, "Income Inequality: Too Big to Ignore" states, "The share of total income going to the top 1 percent of earners, which stood at 8.9 percent in 1976, rose to 23.5 percent by 2007, but during the same period, the average inflation-adjusted hourly wage declined by more than 7 percent." When will US policy makers and economists address the rising income gap in the U.S.?
AAPL and IBM report after the close.
The US dollar is up 0.3% this morning from a 10 month low against a basket of currencies after Fed Chairman Bernanke's comments on Friday softened views re: the possible size and implementation of QE2.
Citigroup (C) reported $0.07/share vs. $0.06 expected this morning. Citi was just a bit light on the top line, coming in at $20.7B vs. the $21B consensus expectation. Much of this bottom line beat is attributable to a $1.99B drop in provisions for loan losses.
Industrial production fell 0.2% in September which was the first time IP fell since the 'recession ended'. This seems to confirm the thesis that much of the ramped production over the past year or so was not being absorbed by consumers.
Capacity utilization came in at 74.7% in September, down 0.1% from August. This is also the first decline in utilization since June 2009.
NAHB issues October housing market index at 7 am PST. 14 is expected vs. 13 in September.
"This multicultural approach, saying that we simply live side by side and live happily with each other has failed. Utterly failed," Angela Merkel said regarding Turks and other immigrants living in Germany. It's both unfortunate and frightening to see xenophobia on the rise around the globe.
China's new five-year plan has been issued, but will await final approval early next year. The Chinese economy is forecast to grow 50% in the next five years to $7.5T. A key focus of the Plan will be to shrink the income gap by improving the distribution of the national income in order to drive long term domestic consumer demand for goods and services. "Expanding domestic demand is the guiding long-term strategy of our country's economic and social development," said Zhang Ping, head of the National Development and Reform Commission. Meanwhile a NYT article from this weekend entitled, "Income Inequality: Too Big to Ignore" states, "The share of total income going to the top 1 percent of earners, which stood at 8.9 percent in 1976, rose to 23.5 percent by 2007, but during the same period, the average inflation-adjusted hourly wage declined by more than 7 percent." When will US policy makers and economists address the rising income gap in the U.S.?
AAPL and IBM report after the close.
Friday, October 15, 2010
Bernanke Speech Spooks Market, Brian Sack Rides to the Rescue
The Dow is down 50 points, S&P down 3, and the Nasdaq is, of course, showing a gain of 8. This afterall being a POMO day, you didn't think that a GE top and bottom line miss or Bernanke throwing cool water on QE2 expectations could actually take down AAPL...did you? No, no. The primary dealers are busy using taxpayer dollars to bid up makers of hyper-discretionary electronic gadgets. Anyone who believes we need a formal QE2 announcement to continue this charade is being fooled. As long as the prospect is on the table and POMO actions inject liquidity into the PDs, the market will remain buoyant.
The real unwind in this Fed driven environment of coerced malinvestment would need to come from:
1) An external shock, such as military aggressions between sovereign nations. The flight to quality into the dollar would likely occur faster than anyone anticipates (given how oversold the dollar is ahead of a QE2 expectation) and would likely destroy risk appetite (at least in the short term.)
2) The couple of days sell-off we'd have with no QE2 announcement in November. In my opinion, it would likely give short-biased funds the opportunity to pick up some return before the end of the year, but then the mentality of, 'well if not now, then in Dec' will likely prevail and the market will resume its run higher.
3) A unexpected rise in the risk premium that indirect buyers of Treasury securities demand given the now universal understanding that the Fed intends to monetize US debt. If the 10 year started to march higher despite POMO/QE2, etc then we'd likely see a big unwind in risk as the Fed would lose both international credibility and domestic confidence in its ability to control all aspects of a globally interconnected market.
Things that will not, and have not taken the market down:
1) The technically overbought nature of the market.
2) The very high concentration of investors who are bullish.
3) The sub 20 VIX.
4) The rapidly weakening economic fundamentals.
5) The uncertain outcomes of FX wars and Smoot Hawley style protectionism.
6) European Sovereign Debt Crisis. Afterall, the ECB has stepped in to ensure that every bond auction coming out of the PIIGS gets filled.
7) The uncertainty surrounding US elections. If we have stalemate in Congress, then we obviously don't get any more of the fiscal stimulus (the job creating kind of stimulus, not the crush the middle class monetary kind...). But this fact doesn't seem to give anyone pause for thought.
8) Foreclosuregate. The financials are getting crushed this morning on heightened uncertainty surrounding liabilities related to fradulent foreclosure activity. The financials led us down in Fall 2008 and took us higher in spring 2009. Will we be back down in Fall 2010 on concerns over Financials? They tend to lead the market, and BAC, JPM, C, etc are down 5% this morning. No matter. Have no fear, Mr. Sack is here!
All of the above being said, it should be understood that the sheer size and type of challenges currently facing not just the US, but also pretty much the entire planet, virtually guarantee that:
1) No one is smart enough to reasonably handicapp all possible known unknowns and unknown unknowns. The world is awash in excess risk appetite right now. If you get one of the tails wrong, you could get slaughtered unless you are the first out the door...unlikely...
2) Policy decisions, decisions of the electorate, decisions of foreign dictators, decisions of buyers of assets and sellers of assets, etc are all the emotionally driven decisions of human beings. History has proved that human beings are falible and also at times irrational, self-destructive, short tempered, etc. When the 'fog' and confusion reaches these types of levels, people are bound to panic or do irrational things that they wouldn't do otherwise. The survivor is one who keeps a clear head when the shooting starts. Unfortunately it is very difficult to predict when the shooting will start or what will be the catalyst. It is because of this that it seems now that the most rational decision is to hold cash and wait for absolute home-runs. If we have a Black Monday (tues, whatever) then maybe its time to deploy some cash in blue chip dividend paying equities. If the S&P rises to 1350 on sustained expectation of a QE2 announcement that just isn't coming (the ultimate communication strategy...The Great Bernanke Bluff) then maybe its time to purchase a boatload of SPY puts. If gold pulls back sharply on a dollar run, then maybe its time to portfolio some of the shiny (non-cash-flowing-impossible-to-determine-appropriate- valuation) metal. If the EUR/USD goes to 1.50 maybe its time to buy the EUO. You get the point. But otherwise, unless certain special situations arise, why gamble in a HFT driven, volume-lite, government produced rally while your super ego screams for you to pay heed to reality?
In the meantime, enjoy the show.
The real unwind in this Fed driven environment of coerced malinvestment would need to come from:
1) An external shock, such as military aggressions between sovereign nations. The flight to quality into the dollar would likely occur faster than anyone anticipates (given how oversold the dollar is ahead of a QE2 expectation) and would likely destroy risk appetite (at least in the short term.)
2) The couple of days sell-off we'd have with no QE2 announcement in November. In my opinion, it would likely give short-biased funds the opportunity to pick up some return before the end of the year, but then the mentality of, 'well if not now, then in Dec' will likely prevail and the market will resume its run higher.
3) A unexpected rise in the risk premium that indirect buyers of Treasury securities demand given the now universal understanding that the Fed intends to monetize US debt. If the 10 year started to march higher despite POMO/QE2, etc then we'd likely see a big unwind in risk as the Fed would lose both international credibility and domestic confidence in its ability to control all aspects of a globally interconnected market.
Things that will not, and have not taken the market down:
1) The technically overbought nature of the market.
2) The very high concentration of investors who are bullish.
3) The sub 20 VIX.
4) The rapidly weakening economic fundamentals.
5) The uncertain outcomes of FX wars and Smoot Hawley style protectionism.
6) European Sovereign Debt Crisis. Afterall, the ECB has stepped in to ensure that every bond auction coming out of the PIIGS gets filled.
7) The uncertainty surrounding US elections. If we have stalemate in Congress, then we obviously don't get any more of the fiscal stimulus (the job creating kind of stimulus, not the crush the middle class monetary kind...). But this fact doesn't seem to give anyone pause for thought.
8) Foreclosuregate. The financials are getting crushed this morning on heightened uncertainty surrounding liabilities related to fradulent foreclosure activity. The financials led us down in Fall 2008 and took us higher in spring 2009. Will we be back down in Fall 2010 on concerns over Financials? They tend to lead the market, and BAC, JPM, C, etc are down 5% this morning. No matter. Have no fear, Mr. Sack is here!
All of the above being said, it should be understood that the sheer size and type of challenges currently facing not just the US, but also pretty much the entire planet, virtually guarantee that:
1) No one is smart enough to reasonably handicapp all possible known unknowns and unknown unknowns. The world is awash in excess risk appetite right now. If you get one of the tails wrong, you could get slaughtered unless you are the first out the door...unlikely...
2) Policy decisions, decisions of the electorate, decisions of foreign dictators, decisions of buyers of assets and sellers of assets, etc are all the emotionally driven decisions of human beings. History has proved that human beings are falible and also at times irrational, self-destructive, short tempered, etc. When the 'fog' and confusion reaches these types of levels, people are bound to panic or do irrational things that they wouldn't do otherwise. The survivor is one who keeps a clear head when the shooting starts. Unfortunately it is very difficult to predict when the shooting will start or what will be the catalyst. It is because of this that it seems now that the most rational decision is to hold cash and wait for absolute home-runs. If we have a Black Monday (tues, whatever) then maybe its time to deploy some cash in blue chip dividend paying equities. If the S&P rises to 1350 on sustained expectation of a QE2 announcement that just isn't coming (the ultimate communication strategy...The Great Bernanke Bluff) then maybe its time to purchase a boatload of SPY puts. If gold pulls back sharply on a dollar run, then maybe its time to portfolio some of the shiny (non-cash-flowing-impossible-to-determine-appropriate- valuation) metal. If the EUR/USD goes to 1.50 maybe its time to buy the EUO. You get the point. But otherwise, unless certain special situations arise, why gamble in a HFT driven, volume-lite, government produced rally while your super ego screams for you to pay heed to reality?
In the meantime, enjoy the show.
Thursday, October 14, 2010
Market Update
The market is treading water this morning, for while the economic data was not what you might call 'encouraging', we have our first installment of the next round of POMO tomorrow. Thus anyone thinking of shorting or taking a profit has come to the conclusion that today is not the day. Volume is extremely light and gold continues to climb higher. The VIX is higher this morning in the mid 19's. I have postulated since last Spring that if the VIX goes sub-17 then one should look to buy long dated calls (22's, 23's, etc) and prepare for a market pullback. Complacency is definitely on the rise. 'The market will go up forever, because the economic data will improve or Ben Bernanke will drop a trillion dollars out of a helicopter...' While it may be wishful thinking on my part, something tells me that such arrogance almost always gets punished by the market. Stay tuned.
On to the day's economic data.
Initial claims rose for the first time in 3 weeks to 462K vs. 450K expected and 449K prior (revised up from 445K). Continuing claims fell to 4399K from 4511K prior (up from 4462K) and 4450K expected. As the figures are still hovering around the 450K mark, this doesn't come as too much of a surprise. Its obviously still bad, but not outrageously so versus the running average.
PPI came in at 0.4% vs. 0.2% exp'd and 0.4% prior. Core PPI was in-line at 0.1% vs. 0.1% prior and expected. The non-core PPI was higher due to increased prices for food and fuel. It would appear that Bernanke's inflationary regime is working...to at least drive up prices on consumer non-discretionaries. It doesn't take a genius to understand that this is a strong negative for the health of the American consumer.
The trade deficit widened to $46.3B in August, with the deficit with China at an all-time high. The deficit is running at an annual rate of $502.B, up 34% from last year's $374.9B, which of course was much lower than usual due to the ongoing recession. The higher than expected trade deficit suggests an even lower 3Q GDP and more rhetoric surrounding a revaluation of the remnimbi.
Nothing in the above comments should be taken as a recommendation to buy or sell any security.
On to the day's economic data.
Initial claims rose for the first time in 3 weeks to 462K vs. 450K expected and 449K prior (revised up from 445K). Continuing claims fell to 4399K from 4511K prior (up from 4462K) and 4450K expected. As the figures are still hovering around the 450K mark, this doesn't come as too much of a surprise. Its obviously still bad, but not outrageously so versus the running average.
PPI came in at 0.4% vs. 0.2% exp'd and 0.4% prior. Core PPI was in-line at 0.1% vs. 0.1% prior and expected. The non-core PPI was higher due to increased prices for food and fuel. It would appear that Bernanke's inflationary regime is working...to at least drive up prices on consumer non-discretionaries. It doesn't take a genius to understand that this is a strong negative for the health of the American consumer.
The trade deficit widened to $46.3B in August, with the deficit with China at an all-time high. The deficit is running at an annual rate of $502.B, up 34% from last year's $374.9B, which of course was much lower than usual due to the ongoing recession. The higher than expected trade deficit suggests an even lower 3Q GDP and more rhetoric surrounding a revaluation of the remnimbi.
Nothing in the above comments should be taken as a recommendation to buy or sell any security.
POMO Schedule: $32B through Nov 8th
Tentative Outright Treasury Operation Schedule
Across all operations in the schedule listed below, the Desk plans to purchase approximately $32 billion. This is the amount of principal payments from agency debt and agency MBS expected to be received between mid-October and mid-November.
October 15, 2010 Outright Treasury Coupon Purchase
October 18, 2010 Outright Treasury Coupon Purchase
October 20, 2010 Outright TIPS Purchase
October 22, 2010 Outright Treasury Coupon Purchase
October 26, 2010 Outright Treasury Coupon Purchase
October 28, 2010 Outright Treasury Coupon Purchase
November 1, 2010 Outright Treasury Coupon Purchase
November 4, 2010 Outright Treasury Coupon Purchase
November 8, 2010 Outright Treasury Coupon Purchase
Across all operations in the schedule listed below, the Desk plans to purchase approximately $32 billion. This is the amount of principal payments from agency debt and agency MBS expected to be received between mid-October and mid-November.
October 15, 2010 Outright Treasury Coupon Purchase
October 18, 2010 Outright Treasury Coupon Purchase
October 20, 2010 Outright TIPS Purchase
October 22, 2010 Outright Treasury Coupon Purchase
October 26, 2010 Outright Treasury Coupon Purchase
October 28, 2010 Outright Treasury Coupon Purchase
November 1, 2010 Outright Treasury Coupon Purchase
November 4, 2010 Outright Treasury Coupon Purchase
November 8, 2010 Outright Treasury Coupon Purchase
Wednesday, October 13, 2010
Market Update
JPM 3Q results came in at $1.01 vs. $0.90 consensus on lower provision in both the mortgage and credit card portfolios. Revenue missed at $24.3B vs. $24.6B expected which is 15.4% less than 3Q09. Loan losses remain high but are no longer growing at the pace they did during the recession. Provision remains high at 5.1%. Retail banking and credit card business improved, while investment banking and trading softened. Looking up this morning pre-market.
Intel beat forecasts on both the top and bottom lines. INTC had warned of a slowdown in PC sales in August, but the numbers looked strong and the fears of a slowdown are off the table from now. I find this all very curious. Did they sandbag the quarter on purpose?
The FOMC minutes released yesterday supported market speculation that a second round of QE will be coming soon. As expected, the committee cut its growth expectations for the remainder of 2010 and 2011. The minutes did indicate however that a return to recession is viewed as unlikely by the committee members (...why the stimulus then???)
The economic calendar is a bit light today. We have MBA Mortage Applications, Import/Export Prices, Treasury Budget, a speech from Bernanke after the close, and a speech by Lacker this evening.
Dow Futures are up 74 points and S&P is looking up 8.75 points.
Lastly, a reminder that we will get the POMO schedule for the next four weeks at 11 am PST today.
Intel beat forecasts on both the top and bottom lines. INTC had warned of a slowdown in PC sales in August, but the numbers looked strong and the fears of a slowdown are off the table from now. I find this all very curious. Did they sandbag the quarter on purpose?
The FOMC minutes released yesterday supported market speculation that a second round of QE will be coming soon. As expected, the committee cut its growth expectations for the remainder of 2010 and 2011. The minutes did indicate however that a return to recession is viewed as unlikely by the committee members (...why the stimulus then???)
The economic calendar is a bit light today. We have MBA Mortage Applications, Import/Export Prices, Treasury Budget, a speech from Bernanke after the close, and a speech by Lacker this evening.
Dow Futures are up 74 points and S&P is looking up 8.75 points.
Lastly, a reminder that we will get the POMO schedule for the next four weeks at 11 am PST today.
Tuesday, October 12, 2010
Market Update
Futures are looking down this morning as San Francisco Fed President, Janet Yellen, warned that excessively easy monetary policy could create bubbles in the future. "It is conceivable that accomodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking." Since the Fed has been involved in nearly every US bubble, it is probably a bit more concrete than it is merely 'conceivable' but I'm glad to see someone on the FOMC express concern.
Also weighing on the markets this morning is India's August industrial production miss that came in at 5.6% (a 15 month low.) The number is very volatile due to the lumpy nature of capital goods orders, but certainly a 5.6% print vs. expectations of 10%+ is something to keep an eye on.
China's auto sales slowed in September as tax breaks and subsidies began to roll off. Sales rose 17 percent YoY to 1.56M, down a bit from 18% in August. But July was 16% growth, and June was 21% growth so while the auto industry in China is being described as normalizing, it must be pointed out that a.) they are still selling more cars than we are domestically in the U.S. and b.) the absolute growth in China continues to be tremendous with sales of 13.6M vehicles in 2009 (45% growth) and on pace to do about 17M vehicles in 2010 (30% growth.) Of note, Ford saw sales in China rise 26%, up from 24% in August. Ford sales in China were up 40% in the first nine months of the year at 419,073 units. GM on the contrary rose 15%, down from 19% growth in August. For the first 9 months of the year, GM sold a record 1.78M vehicles.
Goldman Sachs reports that it has heard from bank employees in China who say that the government has told its largest banks that they must increase reserves to 17.5% (up 50 bps) in order to cool inflation and housing prices. There has been no formal announcement from the government in Beijing. Estimates suggest that this latest reserve hike would remove approx 200B yuan or $29B out of the lending pool. Banks will be allowed to lend a total of 7.5T yuan ($1.1T) this year vs. 9.6T yuan ($1.4T) in 2009.
Despite all the bad economic news this morning (summarizing...signs of slowing growth in China and India, INTC reporting after the close today after negatively pre-announcing a few weeks ago, Fed warning that QE2 expectations for November may be a bit premature, etc) there is nothing that will change the fact that until investors are disappointed by either earnings or the Fed fails to announce QE2 on November 3rd, the market will hold its level. That being said, I do expect earnings to be somewhat disappointing especially for the banks and brokers. We have JPM reporting earnings on Thursday. With a bad print possible, I wonder that when the Fed releases its POMO schedule for the coming weeks on Wednesday, if it doesn't include a healthy dose of Thursday and Friday this week???
FOMC minutes are due out at 11 am PST.
Also weighing on the markets this morning is India's August industrial production miss that came in at 5.6% (a 15 month low.) The number is very volatile due to the lumpy nature of capital goods orders, but certainly a 5.6% print vs. expectations of 10%+ is something to keep an eye on.
China's auto sales slowed in September as tax breaks and subsidies began to roll off. Sales rose 17 percent YoY to 1.56M, down a bit from 18% in August. But July was 16% growth, and June was 21% growth so while the auto industry in China is being described as normalizing, it must be pointed out that a.) they are still selling more cars than we are domestically in the U.S. and b.) the absolute growth in China continues to be tremendous with sales of 13.6M vehicles in 2009 (45% growth) and on pace to do about 17M vehicles in 2010 (30% growth.) Of note, Ford saw sales in China rise 26%, up from 24% in August. Ford sales in China were up 40% in the first nine months of the year at 419,073 units. GM on the contrary rose 15%, down from 19% growth in August. For the first 9 months of the year, GM sold a record 1.78M vehicles.
Goldman Sachs reports that it has heard from bank employees in China who say that the government has told its largest banks that they must increase reserves to 17.5% (up 50 bps) in order to cool inflation and housing prices. There has been no formal announcement from the government in Beijing. Estimates suggest that this latest reserve hike would remove approx 200B yuan or $29B out of the lending pool. Banks will be allowed to lend a total of 7.5T yuan ($1.1T) this year vs. 9.6T yuan ($1.4T) in 2009.
Despite all the bad economic news this morning (summarizing...signs of slowing growth in China and India, INTC reporting after the close today after negatively pre-announcing a few weeks ago, Fed warning that QE2 expectations for November may be a bit premature, etc) there is nothing that will change the fact that until investors are disappointed by either earnings or the Fed fails to announce QE2 on November 3rd, the market will hold its level. That being said, I do expect earnings to be somewhat disappointing especially for the banks and brokers. We have JPM reporting earnings on Thursday. With a bad print possible, I wonder that when the Fed releases its POMO schedule for the coming weeks on Wednesday, if it doesn't include a healthy dose of Thursday and Friday this week???
FOMC minutes are due out at 11 am PST.
Monday, October 11, 2010
Market Trading on a Policy Expectation Which No One Understands
Seeking Alpha contributor, Jeff Miller, whose 'Weighing the Week Ahead' piece I enjoy reading for its typically unique outlook on the coming weeks' events, wrote the following this morning:
"Before anyone is allowed to pontificate about the merits of quantitative easing, the pundit would have to demonstrate a minimal level of knowledge. Let us try the following:
In three sentences, please explan what quantitative is, how it is implemented, and what it is intended to accomplish. (slogans like "printing money" do not constitute an acceptable answer.)
This would probably eliminate nearly everyone, and confront CNBC with a major problem. How would they do any interviews if they could not ask people questions about things where they had no knowledge?
Meanwhile, the market continues to trade on expectations for Fed action, a policy which hardly anyone understands."
And this guy is bullish...?
He cites Art Hogan, chief market analyst at Jeffries, who recently mimicked David Tepper's comments, as most thoughtfully expressing his thesis. Art:
"The concept of a double-dip recession has been replaced with slow and steady improvement, and even if we don't get it, we have a Federal Reserve that's ready to step in and support the rally,"
Mr. Miller's reponse, "For me, this was hardly fresh news, but it is nice to see people joining in."[Emphasis Mine]
Does anyone else see this bubble for what it is? Has governing one's actions with a thoughtful prudence become a relic, a dinosaur? Perhaps the process of blowing and popping bubbles is something we've gotten comfortable with. At least it is dramatic, I suppose...
"Before anyone is allowed to pontificate about the merits of quantitative easing, the pundit would have to demonstrate a minimal level of knowledge. Let us try the following:
In three sentences, please explan what quantitative is, how it is implemented, and what it is intended to accomplish. (slogans like "printing money" do not constitute an acceptable answer.)
This would probably eliminate nearly everyone, and confront CNBC with a major problem. How would they do any interviews if they could not ask people questions about things where they had no knowledge?
Meanwhile, the market continues to trade on expectations for Fed action, a policy which hardly anyone understands."
And this guy is bullish...?
He cites Art Hogan, chief market analyst at Jeffries, who recently mimicked David Tepper's comments, as most thoughtfully expressing his thesis. Art:
"The concept of a double-dip recession has been replaced with slow and steady improvement, and even if we don't get it, we have a Federal Reserve that's ready to step in and support the rally,"
Mr. Miller's reponse, "For me, this was hardly fresh news, but it is nice to see people joining in."[Emphasis Mine]
Does anyone else see this bubble for what it is? Has governing one's actions with a thoughtful prudence become a relic, a dinosaur? Perhaps the process of blowing and popping bubbles is something we've gotten comfortable with. At least it is dramatic, I suppose...
The Week Ahead: 10/11-10/15
The Dow closed above 11,000 for the first time since May on Friday on a soft Unemployment report that indicated to some market participants that the Fed will commence QE2 on November 3rd. The dollar was weaker, and gold made new highs at $1,350.
With no already scheduled POMOs this week, we may have a chance to trade on economic data, earnings, etc (but we are the Smith Report aren't holding our breath!)
The schedule for the coming week's events is posted below.
Monday - Dudley and Bernanke speak Today. Both publicly in favor of QE2, so this should give the bulls a chance to run. We will likely hear things along the lines of, "more monetary stimulus appears necessary" and "inflation below mandate."
Tuesday - FOMC minutes from Sept 21st meeting. Everyone will be looking for clues re: QE2.
Wednesday - MBA Mortgage Applications, Export and Import Prices, Crude Inventories, and Treasury Budget, China Trade, Eurozone Industrial Production, POMO SCHEDULE FOR COMING MONTH out at 11 am PST. (Could anything be more important???).
Thursday - Initial and Continuing Claims, PPI, Trade Balance. PPI likely to continue to support deflationary trends or at least 'below mandate inflation' providing the Fed to continue to perpetuate idea that QE2 is acceptable because of low inflation. Ditto for the CPI report on Friday.
Friday - CPI, Retail Sales, NY Fed - Empire Manufacturing Survey, Michigan Sentiment, Business Inventories. Retail sales likely to come in fairly solid as both the most recent auto sales and chain store sales reports beat expectations.
With no already scheduled POMOs this week, we may have a chance to trade on economic data, earnings, etc (but we are the Smith Report aren't holding our breath!)
The schedule for the coming week's events is posted below.
Monday - Dudley and Bernanke speak Today. Both publicly in favor of QE2, so this should give the bulls a chance to run. We will likely hear things along the lines of, "more monetary stimulus appears necessary" and "inflation below mandate."
Tuesday - FOMC minutes from Sept 21st meeting. Everyone will be looking for clues re: QE2.
Wednesday - MBA Mortgage Applications, Export and Import Prices, Crude Inventories, and Treasury Budget, China Trade, Eurozone Industrial Production, POMO SCHEDULE FOR COMING MONTH out at 11 am PST. (Could anything be more important???).
Thursday - Initial and Continuing Claims, PPI, Trade Balance. PPI likely to continue to support deflationary trends or at least 'below mandate inflation' providing the Fed to continue to perpetuate idea that QE2 is acceptable because of low inflation. Ditto for the CPI report on Friday.
Friday - CPI, Retail Sales, NY Fed - Empire Manufacturing Survey, Michigan Sentiment, Business Inventories. Retail sales likely to come in fairly solid as both the most recent auto sales and chain store sales reports beat expectations.
Friday, October 8, 2010
St. Louis Fed President James Bullard on QE2 Today
"This upcoming FOMC meeting is going to be a tough call, because the economy has slowed but it hasn't slowed so much that it's an obvious case to do something."
"I do think the risk of a double-dip recession has probably receded some in the last six to eight weeks."
"I do think the risk of a double-dip recession has probably receded some in the last six to eight weeks."
Loss of 95K Jobs, Unemployment Rate Unchaged at 9.6%
The unemployment rate held steady at 9.6%, despite the net loss of 95,000 jobs in the month of September. The unemployment rate has now topped 9.5% for 14 consecutive months, which makes it the longest stretch since the 1930s.
Of course the market has rallied on the expectation of QE2. We broke the Dow 11,000 barrier this morning, but much like yesterday, have faded back below the line as the S&P can't seem to break above its 1163 resistance.
Volume is non-existent this morning as the last intelligent people still remaining are finally beginning to give up. Its an odd paradox to be bearish right now. For perhaps the first time in history, to be bearish means to hope for an economic recovery that develops organically. I was hoping for a good jobs number this morning, not just for the health of my PA, but for the health of the global economy, the economic security of my fellow countrymen, and the off-hand chance that Bernanke might not decide to destroy the purchasing power of the middle class. To be bullish on the market, you had to hope for the jobs number to be god-awful (which it was) so that we could rally above 11,000 on hopes that the rich get richer and the poor get shafted as the Fed launches round 2 of the currency wars.
Of course the market has rallied on the expectation of QE2. We broke the Dow 11,000 barrier this morning, but much like yesterday, have faded back below the line as the S&P can't seem to break above its 1163 resistance.
Volume is non-existent this morning as the last intelligent people still remaining are finally beginning to give up. Its an odd paradox to be bearish right now. For perhaps the first time in history, to be bearish means to hope for an economic recovery that develops organically. I was hoping for a good jobs number this morning, not just for the health of my PA, but for the health of the global economy, the economic security of my fellow countrymen, and the off-hand chance that Bernanke might not decide to destroy the purchasing power of the middle class. To be bullish on the market, you had to hope for the jobs number to be god-awful (which it was) so that we could rally above 11,000 on hopes that the rich get richer and the poor get shafted as the Fed launches round 2 of the currency wars.
Thursday, October 7, 2010
QE2 Special Feature: Exploring Hopes, Wishes, Dreams, and Realities
FOMC Members
Ben Bernanke
William Dudley, NY, Vice Chairman
James Bullard, St. Louis
Elizabeth Duke, BoG
Thomas Hoenig, Kansas City
Sandra Pianalto, Cleveland
Sarah Raskin, BoG
Eric Rosengren, Boston
Daniel K. Tarullo, BoG
Kevin M. Warsh, BoG
Janet L. Yellen, BoG
Alternate Members
Charles Evans, Chicago
Richard Fisher, Dallas
Narayana Kocherlakota, Minneapolis
Charles Plosser, Philadelphia
Christine Cumming, New York
Fed Opinions on QE2:
In Favor:
William Dudley: "Currently, my assessment is that both the current levels of unemployment and inflation and the timeframe over which they are likely to return to levels consistent with our mandate are unacceptable. In addition, the longer this situation prevails and the U.S. economy is stuck with the current level of slack and disinflationary pressure, the greater the likelihood that a further shock could push us still further from our dual mandate objectives and closer to outright deflation.
We have tools that can provide additional stimulus at costs that do not appear to be prohibitive. Thus, I conclude that further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long."
Charles Evans (Non-Voter, But will be a voter in 2011): "The unemployment rate is very high. Inflation is low. To me that means we need an accommodative stance of monetary policy."
"We need more accommodation. A lot of people respond that their take on monetary policy depends on the data coming in from here on out. For me, the data have spoken very clearly. As I stared at the forecast even before the August FOMC meeting, I had come to the conclusion that things were very different than what I had been expecting in previous meetings. This is a far grimmer forecast than we ought to have. So yes, I’m in favor of more accommodation."
On Bullard's idea of a contingent program, "I'm favorably disposed toward the approach that JIm has mentioned...I just think that far more accomodation is required."
Bullard (Voter): Believes we should have a contingent asset purchase program that has incremental purchases as the situation evolves, rather than a program which either pumps all the money into the system at once or that announces the full amount at the start of the program. That way changes can be made.
Against:
Thomas Hoenig (Voter): "I am convinced that the time is right to put the market on notice that it must again manage its risk, be acountable for its actions, and cease its reliance on assurances that the Federal Reserve, not they, will manage the risks they must deal with in a market economy." (April 7th in Sante Fe.)
Narayana Kocherlakota (Non-voter, but will vote in 2011): "I do not see why they [banks] would suddenly start to use the new ones [excess reserves] if they weren't using the old ones."
Charles Plosser (Non-voter, but will vote in 2011): "It is difficult, in my view, to see how additional asset purchases by the Fed, even if they move interest rates on long term bonds down by 10 or 20 bps, will have much impact on the near-term outlook for employment."
Reasons to Believe QE2 is not coming in November:
1. If economy went into double-dip recession, what then could the Fed do? They'd be literally out of ammunition.
2. Don't know the impact of additional asset purchases. This point has been repeatedly admitted by none other than the Fed members themselves.
Reasons to Hope QE2 is not coming:
1. Bubbles are forming in unproductive asset classes such as gold.
2. Companies are using excess liquidity for M&A which reduces employment.
3. Paul Volcker, the former Fed Chairman, and master stagnation fighter has said that just as a woman can't be a little bit pregnant, the Fed cannot create a little bit of inflation without running the risk of inflation becoming out of control.
4. Soaring commodity prices. $8/gallon gasoline. Heating oil and food prices rise. Americans have even less disposable income. The 70% of GDP that is consumer spend will be be negatively impacted. Recovery will be even weaker as a result. Possible class wars. A broken political system. Both larger and more frequent Tea Party-like political groups forming populist/anarchist/libertarian/mob-like coalitions.
5. New York Fed estimates that the Fed would need to purchase an additional $2T in Treasuries to push down the yield on the 10 year by 100 bps. So, if the worst happens and QE2 ends up being about $1T or 50% growth on our currently $2T monetary base, we will get a mere 50 bps decrease in the 10 year yield. This will have a virtually non-existent effect on the demand for credit, but will certainly provide a hefty blow to the value of the USD.
6. The Fed (along with HFTs, dark pools, etc) is destroying the ability for the market to trade based on fundamentals. With announcements of hiring freezes at Morgan Stanley, 22 straight weeks of equity outflows, rapidly diminishing volume, etc, it is becoming clear that a rigged market will destroy the credibility of what was once (I believe anyway...) a lawful, efficient market system, which in turn will result in job losses in the financial sector which in boom times accounted for some 20+% of GDP.
7. Growing concern over possible (partial-)loss of reserve currency status.
8. On the mere suggestion of possible QE2, the trade-weighted dollar has lost approximately 6% of its value in September alone. This could wreak havoc on global financial markets. The euro has been rising against the dollar, hitting multi-month highs this morning around $1.40. This will be very bad for the eurozone's recovery. Germany, an export led economy, will soon need to increase its rhetoric against competitive currency devaluations or suffer from weaker forward GDP growth. The Japanese look as though the nation could fall back into recession. Their QE2 impacted the Yen positively for all of two days when attempted in the face of US currency destruction. China will become increasingly less interested in purchasing soon to be monetized US Treasuries and in fact, ironically, will see the value of the remnimbi continue to fall as the USD falls.
Dreams regarding QE2
1. That a lower US dollar will increase US exports, assisting in domestic job creation, and leading the US out of slumping economic conditions. This might be true if our economy were not based 20% on manufacturing and 80% on services. Manufacturing might pick up, but not materially so, and again, the American consumer faced with higher commodity prices will see an offsetting drop in demand for discretionary items, further hurting actual export driven nations like China. Probably unwise to kick the stool out from under the emerging markets. For if we hope China, India, and Brazil to lead the world out of economic purgatory, we'd better not up the odds against them.
2. That a lower dollar, and higher stock prices will raise consumer optimism, and thus spending via the wealth effect. WRONG. Higher stock prices, bigger bonuses for executives, etc only create further divisions between the citizenry of the United States. The rich getting richer has been shown over the last thirty years to do nothing to help the poor get richer. If costs rise and quality of life for the bottom 80% starts to take a hit, then expect increased violent crime, theft, calls for secession, etc to begin to boil over. This may over a longer horizon provide an opportunity, as did the Civil War in the 19th Century, to create a more perfect union. But first, we'd have to suffer through a lot of unpalatable changes, especially given the level of 'me-ism' our population (especially amongst our young people) supports and nurtures. There is the possibility that many rude awakenings await our over-fed, under-read citizenry.
3. That lower rates will increase aggregate credit demand. US Households have been de-levering for the past 9 consecutive quarters. QE1 did not have an effect on credit demand, why should QE2?
4. That QE2 is a given. Bernanke was clear that it was on the table, but I think many overstate their talent for clairvoyance. Bernanke in the same comments at Jackson Hole mentioned that much of what the Fed was considering would be the Fed's communication strategy. And he was dead-on in his belief in the efficacy of spoken/written Fed communiques. He mentioned the possibility for QE2, the dollar got absolutely hammered in September, a worldwide currnecy war broke out, the stock market went up, and gold rallied. Probably not all of these consequences were intended (let that be a lesson to you Ben!) but just the suggestion of its possibility seemed to have a rather dramatic effect! Much of the supporting rhetoric driving the belief in QE2 has come from non-voting members of the FOMC including Brian Sack and Goldman Sachs, neither of which have an un-vested interest if you get my drift...?
Realities regarding QE2
1. It is likely that the Fed will take a wait and see approach, which in my mind probably amounts to the start of QE2 sometime late in the year, but in small increments so as not to draw too much populist ire and also to allow for the Fed to change its mind and keep at least some amount of its remaining ammunition on the sidelines, in case of negative GDP in 2011 (for example.)
2. The rhetoric coming from the Fed over the intermediate term will likely continue to show that the Bernanke Put, even if not fully in use, is at the ready.
3. No one knows what exactly will result from QE2. It is not a given that it will have all of even its positive intended consequences. Foreigners may see its very possibility as a need to begin demanding higher rates, otherwise we may begin to see indirect buyers fall as a percentage of Treasury buyers, leaving only the Fed to finance our debt.
Pop quiz: Where does the Fed get the funds it uses to monetize US Treasury debt???
Ben Bernanke
William Dudley, NY, Vice Chairman
James Bullard, St. Louis
Elizabeth Duke, BoG
Thomas Hoenig, Kansas City
Sandra Pianalto, Cleveland
Sarah Raskin, BoG
Eric Rosengren, Boston
Daniel K. Tarullo, BoG
Kevin M. Warsh, BoG
Janet L. Yellen, BoG
Alternate Members
Charles Evans, Chicago
Richard Fisher, Dallas
Narayana Kocherlakota, Minneapolis
Charles Plosser, Philadelphia
Christine Cumming, New York
Fed Opinions on QE2:
In Favor:
William Dudley: "Currently, my assessment is that both the current levels of unemployment and inflation and the timeframe over which they are likely to return to levels consistent with our mandate are unacceptable. In addition, the longer this situation prevails and the U.S. economy is stuck with the current level of slack and disinflationary pressure, the greater the likelihood that a further shock could push us still further from our dual mandate objectives and closer to outright deflation.
We have tools that can provide additional stimulus at costs that do not appear to be prohibitive. Thus, I conclude that further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long."
Charles Evans (Non-Voter, But will be a voter in 2011): "The unemployment rate is very high. Inflation is low. To me that means we need an accommodative stance of monetary policy."
"We need more accommodation. A lot of people respond that their take on monetary policy depends on the data coming in from here on out. For me, the data have spoken very clearly. As I stared at the forecast even before the August FOMC meeting, I had come to the conclusion that things were very different than what I had been expecting in previous meetings. This is a far grimmer forecast than we ought to have. So yes, I’m in favor of more accommodation."
On Bullard's idea of a contingent program, "I'm favorably disposed toward the approach that JIm has mentioned...I just think that far more accomodation is required."
Bullard (Voter): Believes we should have a contingent asset purchase program that has incremental purchases as the situation evolves, rather than a program which either pumps all the money into the system at once or that announces the full amount at the start of the program. That way changes can be made.
Against:
Thomas Hoenig (Voter): "I am convinced that the time is right to put the market on notice that it must again manage its risk, be acountable for its actions, and cease its reliance on assurances that the Federal Reserve, not they, will manage the risks they must deal with in a market economy." (April 7th in Sante Fe.)
Narayana Kocherlakota (Non-voter, but will vote in 2011): "I do not see why they [banks] would suddenly start to use the new ones [excess reserves] if they weren't using the old ones."
Charles Plosser (Non-voter, but will vote in 2011): "It is difficult, in my view, to see how additional asset purchases by the Fed, even if they move interest rates on long term bonds down by 10 or 20 bps, will have much impact on the near-term outlook for employment."
Reasons to Believe QE2 is not coming in November:
1. If economy went into double-dip recession, what then could the Fed do? They'd be literally out of ammunition.
2. Don't know the impact of additional asset purchases. This point has been repeatedly admitted by none other than the Fed members themselves.
Reasons to Hope QE2 is not coming:
1. Bubbles are forming in unproductive asset classes such as gold.
2. Companies are using excess liquidity for M&A which reduces employment.
3. Paul Volcker, the former Fed Chairman, and master stagnation fighter has said that just as a woman can't be a little bit pregnant, the Fed cannot create a little bit of inflation without running the risk of inflation becoming out of control.
4. Soaring commodity prices. $8/gallon gasoline. Heating oil and food prices rise. Americans have even less disposable income. The 70% of GDP that is consumer spend will be be negatively impacted. Recovery will be even weaker as a result. Possible class wars. A broken political system. Both larger and more frequent Tea Party-like political groups forming populist/anarchist/libertarian/mob-like coalitions.
5. New York Fed estimates that the Fed would need to purchase an additional $2T in Treasuries to push down the yield on the 10 year by 100 bps. So, if the worst happens and QE2 ends up being about $1T or 50% growth on our currently $2T monetary base, we will get a mere 50 bps decrease in the 10 year yield. This will have a virtually non-existent effect on the demand for credit, but will certainly provide a hefty blow to the value of the USD.
6. The Fed (along with HFTs, dark pools, etc) is destroying the ability for the market to trade based on fundamentals. With announcements of hiring freezes at Morgan Stanley, 22 straight weeks of equity outflows, rapidly diminishing volume, etc, it is becoming clear that a rigged market will destroy the credibility of what was once (I believe anyway...) a lawful, efficient market system, which in turn will result in job losses in the financial sector which in boom times accounted for some 20+% of GDP.
7. Growing concern over possible (partial-)loss of reserve currency status.
8. On the mere suggestion of possible QE2, the trade-weighted dollar has lost approximately 6% of its value in September alone. This could wreak havoc on global financial markets. The euro has been rising against the dollar, hitting multi-month highs this morning around $1.40. This will be very bad for the eurozone's recovery. Germany, an export led economy, will soon need to increase its rhetoric against competitive currency devaluations or suffer from weaker forward GDP growth. The Japanese look as though the nation could fall back into recession. Their QE2 impacted the Yen positively for all of two days when attempted in the face of US currency destruction. China will become increasingly less interested in purchasing soon to be monetized US Treasuries and in fact, ironically, will see the value of the remnimbi continue to fall as the USD falls.
Dreams regarding QE2
1. That a lower US dollar will increase US exports, assisting in domestic job creation, and leading the US out of slumping economic conditions. This might be true if our economy were not based 20% on manufacturing and 80% on services. Manufacturing might pick up, but not materially so, and again, the American consumer faced with higher commodity prices will see an offsetting drop in demand for discretionary items, further hurting actual export driven nations like China. Probably unwise to kick the stool out from under the emerging markets. For if we hope China, India, and Brazil to lead the world out of economic purgatory, we'd better not up the odds against them.
2. That a lower dollar, and higher stock prices will raise consumer optimism, and thus spending via the wealth effect. WRONG. Higher stock prices, bigger bonuses for executives, etc only create further divisions between the citizenry of the United States. The rich getting richer has been shown over the last thirty years to do nothing to help the poor get richer. If costs rise and quality of life for the bottom 80% starts to take a hit, then expect increased violent crime, theft, calls for secession, etc to begin to boil over. This may over a longer horizon provide an opportunity, as did the Civil War in the 19th Century, to create a more perfect union. But first, we'd have to suffer through a lot of unpalatable changes, especially given the level of 'me-ism' our population (especially amongst our young people) supports and nurtures. There is the possibility that many rude awakenings await our over-fed, under-read citizenry.
3. That lower rates will increase aggregate credit demand. US Households have been de-levering for the past 9 consecutive quarters. QE1 did not have an effect on credit demand, why should QE2?
4. That QE2 is a given. Bernanke was clear that it was on the table, but I think many overstate their talent for clairvoyance. Bernanke in the same comments at Jackson Hole mentioned that much of what the Fed was considering would be the Fed's communication strategy. And he was dead-on in his belief in the efficacy of spoken/written Fed communiques. He mentioned the possibility for QE2, the dollar got absolutely hammered in September, a worldwide currnecy war broke out, the stock market went up, and gold rallied. Probably not all of these consequences were intended (let that be a lesson to you Ben!) but just the suggestion of its possibility seemed to have a rather dramatic effect! Much of the supporting rhetoric driving the belief in QE2 has come from non-voting members of the FOMC including Brian Sack and Goldman Sachs, neither of which have an un-vested interest if you get my drift...?
Realities regarding QE2
1. It is likely that the Fed will take a wait and see approach, which in my mind probably amounts to the start of QE2 sometime late in the year, but in small increments so as not to draw too much populist ire and also to allow for the Fed to change its mind and keep at least some amount of its remaining ammunition on the sidelines, in case of negative GDP in 2011 (for example.)
2. The rhetoric coming from the Fed over the intermediate term will likely continue to show that the Bernanke Put, even if not fully in use, is at the ready.
3. No one knows what exactly will result from QE2. It is not a given that it will have all of even its positive intended consequences. Foreigners may see its very possibility as a need to begin demanding higher rates, otherwise we may begin to see indirect buyers fall as a percentage of Treasury buyers, leaving only the Fed to finance our debt.
Pop quiz: Where does the Fed get the funds it uses to monetize US Treasury debt???
NFP Number Tomorrow, QE2 Expectations, AA after the market close
Markets are down somewhat this morning ahead of two very critical events over the next 24 hours.
1. Alcoa reports earnings today after the close.
2. Tomorrow morning we will get the Nonfarm Payroll Number for September.
With virtually the entire market fixated on how soon the Fed will launch QE2, tomorrow's NFP number will be a critical factor for determing the market's direction over the coming weeks. The consensus is for no change in jobs on the aggregate from the prior month, but with jobs coming from the private sector to see an increase of 74K, with the unemployment rate to tick up 0.01% to 9.7%.
What is going to be fascinating however, is seeing how the market reacts to this number. If the report is better than expected, will the market necessarily have to sell-off on good news? Surely a good number must be read as a mitigating factor against the current Goldman Sachs (and therefore market consensus) expectation of a Nov. 3rd launch of QE2.
If the number is bad, we will likely rally through Dow 11,000 as it will be assured that Bernanke will officially declare war on the middle class on election day.
If the number is in-line, then we will likely trade off of Alcoa's numbers from this afternoon.
Alcoa is expected to report EPS of $0.05 on revenue of $4.95B. The consensus ranges are $0.01-$0.12 and $4.52B-$5.36B. The stock has risen from $10 to $12 in September. With the stock already up 20%, investors appear nervous heading into earnings with good news already somewhat priced-in, AA trading down $0.14 or 1.21% at the time of this writing. Also creating anxiety is an article on Bloomberg this morning which notes that Alcoa's profits may drop 20% as the weak dollar offsets the higher realized spot aluminum prices. Alcoa's revenue is in USD but pays costs in its non-US operations in local currencies. The largest source of revenue after the US is Australia, whose currency is up 14% against the USD this quarter alone. Alcoa also has sizable operations in Brazil, and the real has climbed 7% this quarter (Thanks BB!)
1. Alcoa reports earnings today after the close.
2. Tomorrow morning we will get the Nonfarm Payroll Number for September.
With virtually the entire market fixated on how soon the Fed will launch QE2, tomorrow's NFP number will be a critical factor for determing the market's direction over the coming weeks. The consensus is for no change in jobs on the aggregate from the prior month, but with jobs coming from the private sector to see an increase of 74K, with the unemployment rate to tick up 0.01% to 9.7%.
What is going to be fascinating however, is seeing how the market reacts to this number. If the report is better than expected, will the market necessarily have to sell-off on good news? Surely a good number must be read as a mitigating factor against the current Goldman Sachs (and therefore market consensus) expectation of a Nov. 3rd launch of QE2.
If the number is bad, we will likely rally through Dow 11,000 as it will be assured that Bernanke will officially declare war on the middle class on election day.
If the number is in-line, then we will likely trade off of Alcoa's numbers from this afternoon.
Alcoa is expected to report EPS of $0.05 on revenue of $4.95B. The consensus ranges are $0.01-$0.12 and $4.52B-$5.36B. The stock has risen from $10 to $12 in September. With the stock already up 20%, investors appear nervous heading into earnings with good news already somewhat priced-in, AA trading down $0.14 or 1.21% at the time of this writing. Also creating anxiety is an article on Bloomberg this morning which notes that Alcoa's profits may drop 20% as the weak dollar offsets the higher realized spot aluminum prices. Alcoa's revenue is in USD but pays costs in its non-US operations in local currencies. The largest source of revenue after the US is Australia, whose currency is up 14% against the USD this quarter alone. Alcoa also has sizable operations in Brazil, and the real has climbed 7% this quarter (Thanks BB!)
Wednesday, October 6, 2010
Guest Post: Duoyuan Global Water (DGW): Chinese Water (Long idea)
Duoyuan Global Water (DGW): Despite concerns, a cheap pure play on water and Chinese urbanization
By Josh Rowe
Introduction
On September 13, American depository shares of Duoyuan Global Water (DGW) were cut in half on worries over an accounting scandal at DGW’s sister company, Duoyuan Printing (DYP). Duoyuan Water and Printing share a chairman, Wenhua Guo, but have separate management teams; the CEO and CFO of DYP have been replaced. DYP also fired its auditor, Deloitte, and instituted an internal review of possible irregularities in its filings to the SEC. At the time of writing, it was not clear which numbers were in question, or whether, as some have speculated, DPY withheld information such as bank statements, distributor contracts, or expense accounts from its auditor. Notwithstanding the meltdown in the stock, there is nothing to link the controversy at DPY to Duoyuan Global Water, apart from Mr. Guo’s role as chairman of both companies. DGW is undertaking a preemptive third-party review of accounting standards, which may entail future headline risk. Regardless, with its market cap cut in half, fears are likely overblown.
The scandal is the third shock to weigh on investor sentiment regarding DGW since its listing in 2009. The first was of its own making; following a run up to $45, the company announced a secondary offering of 3.5 million shares (increasing the float some 11%), to which investors reacted negatively. The second was the slowdown in Chinese stocks as the PBOC raised deposit reserve requirements for lenders, putting the brakes on the credit-fueled bull market of 2009. I believe that neither of these first two negatives poses a serious obstacle to the long-term performance of DGW’s shares. Water is a secular bull market in China, dependent less on the global business cycle than on internal demographics. DGW’s secondary was not as dilutive as the subsequent share price drop would suggest, and is not necessarily a token of future dilution. $211 million in cash ($8.50 share diluted) lends ample room for expansion of capacity without tapping the equity market.
The third concern represents an “unknown unknown.” Due to Western investors’ persistent uncertainty about standards of transparency and corporate governance in the People’s Republic, the mere whiff of an accounting scandal is sufficient to seriously impact the credibility of a Chinese firm’s financial reports. Because DGW is listed in America and subject to the reporting requirements of the Securities Exchange Act of 1934, and because its relationship with its auditor, Grant Thornton, appears to remain solid, these sorts of risks should be less worrisome than in stocks traded only on Mainland Chinese exchanges. If the accounting irregularities are confined to Duoyuan Printing, and if a prospective investor is willing to accept the increased volatility of a Chinese-originated ADR, DGW represents compelling value over a several year horizon. Though we must acknowledge concerns over slowing growth in China and DGW’s potentially dilutive capital markets strategy, my conclusion is that these risks should not greatly affect long-term holders of the stock. The following paragraphs present the bull case for shares of DGW, predicated on its highly competitive market position in an area of secular and state-supported growth.
Reasons for optimism
Above all, market dynamics support a rising demand for DGW’s products, both within the PRC, and potentially outside. As a rapidly industrializing, urbanizing economy, China’s water needs should grow far in excess of cheap, reusable supply. According to a recent series of reports in The Economist, China has 21% of the world’s population yet only 6% of its renewable fresh water. In the water-poor North and West, conditions are particularly problematic—80% of the country’s water is in the more developed South, and the North China Plain that sustains much of the country’s agriculture is currently in drought. 67% of Chinese cities are in deficit; this is a large and growing problem, as China currently has over 150 cities with greater than 1 million in population. The average Chinese citizen subsists on only one quarter of the water per person of the world average.
Market research cited by DGW indicates that demand for water treatment products is expected to grow 15.5% per annum to 2012, and faster thereafter. DGW should benefit from increases in demand for water for personal consumption, industrial use, agriculture, and municipal water treatment alike. At present, 38% of the company’s revenues come from circulating water treatment products used in cooling and refrigeration, 22% from water purification (drinking water, food processing, the electronics and pharmaceutical industries), and 41% from wastewater treatment and reuse (municipal sewage, petroleum, paper).
This last segment should see the most robust growth. The company itself projects 45.5% increases in sales due to increased urban demand, government regulations mandating water treatment, and tougher enforcement of environmental protection laws. The latter are becoming a higher priority in state policy as newly wealthy Chinese consumers awake (as did Americans in the 1950s and 1960s) to aesthetic and health consequences of environmental laxity. DGW’s ambitious projections are supported by a number of political considerations and by the secular dynamic of urbanization. The current national budget allocates more than ¥150 billion for mandatory water conservation. This number should form a minimum baseline in future years. DGW’s expanded production capacity reflects its anticipation of at least a robust upgrade cycle.
56% of China’s population still lives in rural communities, often constrained by a hereditary registration laws that define residency as rural or urban, and determine land allotments. These laws are likely to be further liberalized, and the standards of living and social mobility offered by urban life continue to attract young Chinese to the many fast-growing cities. The Ministry of Housing estimates that between 2010 and 2025 some 300 million Chinese will move from rural areas to urban. Residential property markets in Hong Kong and Shanghai have recently come under scrutiny as high-end properties have traded at spectacularly high valuations. In second and third-tier cities, however, property price rises continue unabated, driven on by a strong fundamental demand dynamic. Most China watchers believe that urban migration is a process that has not approached its peak; as it grows, demands for water treatment and reuse will as well. This is not a bubble; it is a powerful, sustainable trend.
Appealingly, municipal water treatment is also a high-margin business for DGW. All of its products in this segment earn over 40% gross (frequently more) and technological developments in quality and efficiency drive pricing power. DGW’s microporous aerator, a new product in 2009 that has seen high rates of adoption, is one example. Using oxygenation to kill more than 98% of germs in wastewater, the microporous aerator competes at the high-end of the market. One of the beneficiaries of DGW’s equity offering, projected 50% sales growth rates in this product should provide adequate returns on capital. In recent years, R&D has shrunk somewhat as a share of revenue, but has grown significantly in absolute terms (net sales have increased by more than 32% each of the past three years). Particularly among its domestic competitors, the company is a technology innovator, and links its future strategy to remaining such. In the medium term, DGW is exploring licensing agreements with Israeli and American firms to bring highly efficient drip irrigation and membrane-based desalinization technology to its product portfolio. Though it is not discounted in the stock price, management recognizes that agriculture represents an enormous untapped growth market. There has also been some preliminary talk of partnerships with distributors in India. I would adopt a “wait and see” approach.
DGW has several competitive advantages in all of its business segments. Compared to international offerings from Veolia, Suez, or Thames, DGW (thanks to cheap labor) is the low cost producer. Domestic competitors cannot offer the same diversity and complementarity of product offerings. RINO, which provides water to the iron and steel industries, was a popular name with Western smart money in 2009. By contrast, the wide range of DGW’s businesses make it a less cyclical, more secular play. Unlike niche manufacturers leveraged to growth in particular industries, DGW is a WalMart-like “one-stop shop.”
DGW evidently believes its U.S. listing give it better access to capital and more brand prestige than its Chinese rivals. One of its largest expenses is a 12 million RMB CCTV 4 advertising campaign to convince distributors of its superior product quality. Selling costs have risen slowly and steadily on the back of this and other campaigns. DGW operates with a network of over 80 regionally diverse independent distributors; international competitors are often limited to one. By agreeing with distributors to yearly contracts, DGW is highly flexible to regional demand shifts, and maintains tighter control over working capital. Like an industrial company, DGW’s vertical integration permits volume discounts on raw material, and improved workflow from standardized practices across segments. Like a high-tech company, its relative small size and investments in R&D give it an edge in energy efficient and non-chemical water treatment technologies.
Financial analysis
An analysis of DGW’s financial position (if it can be believed) reveals a pristine balance sheet, a strong platform for growth, and an excellent cash flow yield. I have attached a discounted cash flows model, with conservative assumptions, that can easily generate valuations at a 50 to 100% premium to the current price. The model is fairly rough and unconventional in places, but fairly self-explanatory. Thus, here, I will merely highlight some of DGW’s financial results that speak its compelling value at current levels. Full financial data are only available from 2009, at the time of DGW’s New York listing; still, this business is steady enough that a reliable picture can be drawn. As of Q2 2010, DGW carried no debt on its balance sheet. It has financed itself entirely through equity, which it has redeployed as capital expenditure, primarily to bring online a new manufacturing facility at Langfang, where many of its higher-margin products are made. This significant investment should reduce mandatory CAPEX in the near future. Elsewhere, the balance sheet has expanded at a rate above 50% for the last several years, though without significant growth in working capital. Inventory turn came down from 96 to 78 days over the previous FY. The company has weathered the rise in raw material costs since 2006 admirably, increasing gross margin from 35% in 2005 to 48% in 2009. Operating margin improved from 14% to 24% over the same time, and is on track to hit 32% for FY2010. A 2008 change in PRC corporate tax policy eliminated DGW’s privileged status and applied a standard rate of 25%, equity-financed CAPEX, reflected in long term asset growth, appears to be in the neighborhood of 10% of revenue. These charges have not materially harmed the bottom line; free cash flow is on track to grow 70% in 2010.
From a cash flow perspective, the company is doing even better than its statement of operations might indicate. In June 2009, in accordance with FASB rule 123r, DGW expensed the award of $12.6m in ordinary shares (2 are redeemable for 1 ADS) at par to its employees, making up a significant proportion of SG&A cost. This share-based compensation was a sub-CFO level award for services already rendered. Rather than an ongoing compensation expense, shareholders should view the award as a one-off, a reward made possible by the company’s American listing. Management claims, “Going forward, we anticipate employee share-based compensation expense to be minimal.” The effect was a large, non-cash hit to net income. The award was not tax deductible; excluding the impact of share-based compensation, net income would have risen pro forma 55.7% in 2009. Instead it declined 12.5%. Cash flow growth in 2009 was in excess of 30%.
Assuming flattening growth across all four business segments (circulating water treatment, purification, wastewater treatment, and spare parts), with wastewater gradually increasing its share of operations, it is reasonable to expect total sales growth over the next decade to range between 15% and 35% per annum. If we also assume that the company can maintain its recent operating averages both on the cost side and in stewarding its capital, it is likely that we will see consistent double-digit cash flow growth for the foreseeable future. There is a risk that management will find, as technology leaps forward, or as competitors enter the market, that this level of performance is more capital intensive than it has currently estimated. Duoyuan may take on debt; more likely there may be further dilution of existing shareholders. Further, the cost of being a market leader is increased competition. DGW may lose pricing power, or may be forced to invest more of the proceeds of growth in marketing. Fluctuating raw material costs pose another challenge; the company targets 40% or greater gross margin on all new products, but with most hard commodities in secular bull markets, this may be unattainable. Nevertheless, DGW has a number of structural advantages in sourcing, distribution, technology, and in its (so far) cozy relationship with the state. Economies of scale should mitigate some of the headwinds to profitability.
All told, assuming historical operating averages remain intact or decline somewhat (a fairly conservative assumption, in my view), a discounted cash flows analysis generates a ADR value of $28.55, more than a 100% premium to mid-September 2010 levels. If current growth and profitability trends persist, the value could be much higher. I have used a 10% (marginally below DGW’s WACC) discount rate that I believe is at least a fair opportunity cost of owning equities in a global slump. Chinese equities may deserve a higher discount rate; if so they probably deserve a perpetual growth rate above the 2% I have employed.
Catalysts
Besides being substantially oversold, there are a number of catalysts that make DGW an attractive play into the end of 2010. Firstly, because of the impact of 2009’s share-based compensation, net income for 2010 will have a relatively easy comp. The stock is not heavily covered; thus when the December 31 10K reports earnings growth of 120%, some heads on the Street may turn. DGW has beaten the EPS consensus three of the last five quarters. If there is to be any material appreciation in the renminbi (which looks unlikely at present), input costs at PPP will come down and the dollar value of American-listed shares will increase. At minimum DGW is insulated from adverse currency fluctuation. Finally, water is a theme that is attracting more and more institutional money managers as global shortages (this summer’s Russian fires being a key illustration) become more acute. Duoyuan is the clearest pure play on water in the PRC.
More compellingly, it is likely that the heft of political mandates for investment in wastewater treatment will increase in late 2010. Wastewater, now the largest revenue driver for DGW is the most important variable in cities’ water conservation efforts, and is an important health consideration. China’s 12th five-year-plan, to be released this year, is expected to heighten focus on efficient water use and environmentally sensitive development. Environmental protection occupies a new significance in the minds of China’s planners, who see leadership on environmental issues as critical to China’s economic development, the quality of life of a growing middle-class, and to its diplomatic position in the world. DGW stands to benefit from any explicit mention of water use in the forthcoming plan.
Conclusion
My bull position on DGW rests on the view that the market has mispriced the risk of owning a Chinese ADR listing, and views DGW as a higher beta play on the Chinese business cycle than it actually is. Its balance sheet is clean, its finances are conservative, and ROIC on the development of the manufacturing facility in Langfang (as well as R&D facilities planned near the Daxing headquarters) funded by IPO should be positive. Investors scared by the surprise and relative opacity of management’s share-based compensation award should not expect a repeat. The stock shows a cash flow yield of greater than 6% with respect to enterprise value, and FCF multiple of only 15 times based on my 2010 projections. Compare this to a 130x multiple for the Shanghai Composite, per Bloomberg in August 2010. Its enterprise multiple is below 3, while the Shanghai Composite averages near 7. If Duoyuan Global Water were not tarred by the brush of scandal at DPY, or by the froth of what Jim Chanos calls “the greatest credit excess of all time,” I believe value investors would be taking heed. The risk of an unknown unknown in Chinese stocks is always great. The perception of that risk, however, represents much of the downside, as rumors lead investors to fly to the exits. This has already happened in DGW. I would explore a small, non-core position, occupying no more than a few percentage points of my portfolio, at an entry below $14. It seems unlikely that a question over expense accounts at a separate company could shave 50% of the value off a name that was already cheaply valued. If the scandal blows over, and DGW’s numbers can be believed, the stock could trade in high twenties by early 2011.
DCF Model:
https://docs.google.com/leaf?id=0B_ipU5WJf9sJNGE1Yjc4NmUtYTg3Mi00YjZlLWFhYzQtZTc5NGQwODQ1MDc3&hl=en&authkey=CLOxhv8B
Disclosures and Disclaimers: This long idea should not be taken as a recommendation to buy or sell any security. This is an informational posting only. Both the author and the proprietor of this site have been and will cotinue to be invested in DGW at various points in time.
About the author: Josh Rowe is currently in the final stages of earning his PhD from Princeton University and will soon be looking for buyside employment in San Francisco.
By Josh Rowe
Introduction
On September 13, American depository shares of Duoyuan Global Water (DGW) were cut in half on worries over an accounting scandal at DGW’s sister company, Duoyuan Printing (DYP). Duoyuan Water and Printing share a chairman, Wenhua Guo, but have separate management teams; the CEO and CFO of DYP have been replaced. DYP also fired its auditor, Deloitte, and instituted an internal review of possible irregularities in its filings to the SEC. At the time of writing, it was not clear which numbers were in question, or whether, as some have speculated, DPY withheld information such as bank statements, distributor contracts, or expense accounts from its auditor. Notwithstanding the meltdown in the stock, there is nothing to link the controversy at DPY to Duoyuan Global Water, apart from Mr. Guo’s role as chairman of both companies. DGW is undertaking a preemptive third-party review of accounting standards, which may entail future headline risk. Regardless, with its market cap cut in half, fears are likely overblown.
The scandal is the third shock to weigh on investor sentiment regarding DGW since its listing in 2009. The first was of its own making; following a run up to $45, the company announced a secondary offering of 3.5 million shares (increasing the float some 11%), to which investors reacted negatively. The second was the slowdown in Chinese stocks as the PBOC raised deposit reserve requirements for lenders, putting the brakes on the credit-fueled bull market of 2009. I believe that neither of these first two negatives poses a serious obstacle to the long-term performance of DGW’s shares. Water is a secular bull market in China, dependent less on the global business cycle than on internal demographics. DGW’s secondary was not as dilutive as the subsequent share price drop would suggest, and is not necessarily a token of future dilution. $211 million in cash ($8.50 share diluted) lends ample room for expansion of capacity without tapping the equity market.
The third concern represents an “unknown unknown.” Due to Western investors’ persistent uncertainty about standards of transparency and corporate governance in the People’s Republic, the mere whiff of an accounting scandal is sufficient to seriously impact the credibility of a Chinese firm’s financial reports. Because DGW is listed in America and subject to the reporting requirements of the Securities Exchange Act of 1934, and because its relationship with its auditor, Grant Thornton, appears to remain solid, these sorts of risks should be less worrisome than in stocks traded only on Mainland Chinese exchanges. If the accounting irregularities are confined to Duoyuan Printing, and if a prospective investor is willing to accept the increased volatility of a Chinese-originated ADR, DGW represents compelling value over a several year horizon. Though we must acknowledge concerns over slowing growth in China and DGW’s potentially dilutive capital markets strategy, my conclusion is that these risks should not greatly affect long-term holders of the stock. The following paragraphs present the bull case for shares of DGW, predicated on its highly competitive market position in an area of secular and state-supported growth.
Reasons for optimism
Above all, market dynamics support a rising demand for DGW’s products, both within the PRC, and potentially outside. As a rapidly industrializing, urbanizing economy, China’s water needs should grow far in excess of cheap, reusable supply. According to a recent series of reports in The Economist, China has 21% of the world’s population yet only 6% of its renewable fresh water. In the water-poor North and West, conditions are particularly problematic—80% of the country’s water is in the more developed South, and the North China Plain that sustains much of the country’s agriculture is currently in drought. 67% of Chinese cities are in deficit; this is a large and growing problem, as China currently has over 150 cities with greater than 1 million in population. The average Chinese citizen subsists on only one quarter of the water per person of the world average.
Market research cited by DGW indicates that demand for water treatment products is expected to grow 15.5% per annum to 2012, and faster thereafter. DGW should benefit from increases in demand for water for personal consumption, industrial use, agriculture, and municipal water treatment alike. At present, 38% of the company’s revenues come from circulating water treatment products used in cooling and refrigeration, 22% from water purification (drinking water, food processing, the electronics and pharmaceutical industries), and 41% from wastewater treatment and reuse (municipal sewage, petroleum, paper).
This last segment should see the most robust growth. The company itself projects 45.5% increases in sales due to increased urban demand, government regulations mandating water treatment, and tougher enforcement of environmental protection laws. The latter are becoming a higher priority in state policy as newly wealthy Chinese consumers awake (as did Americans in the 1950s and 1960s) to aesthetic and health consequences of environmental laxity. DGW’s ambitious projections are supported by a number of political considerations and by the secular dynamic of urbanization. The current national budget allocates more than ¥150 billion for mandatory water conservation. This number should form a minimum baseline in future years. DGW’s expanded production capacity reflects its anticipation of at least a robust upgrade cycle.
56% of China’s population still lives in rural communities, often constrained by a hereditary registration laws that define residency as rural or urban, and determine land allotments. These laws are likely to be further liberalized, and the standards of living and social mobility offered by urban life continue to attract young Chinese to the many fast-growing cities. The Ministry of Housing estimates that between 2010 and 2025 some 300 million Chinese will move from rural areas to urban. Residential property markets in Hong Kong and Shanghai have recently come under scrutiny as high-end properties have traded at spectacularly high valuations. In second and third-tier cities, however, property price rises continue unabated, driven on by a strong fundamental demand dynamic. Most China watchers believe that urban migration is a process that has not approached its peak; as it grows, demands for water treatment and reuse will as well. This is not a bubble; it is a powerful, sustainable trend.
Appealingly, municipal water treatment is also a high-margin business for DGW. All of its products in this segment earn over 40% gross (frequently more) and technological developments in quality and efficiency drive pricing power. DGW’s microporous aerator, a new product in 2009 that has seen high rates of adoption, is one example. Using oxygenation to kill more than 98% of germs in wastewater, the microporous aerator competes at the high-end of the market. One of the beneficiaries of DGW’s equity offering, projected 50% sales growth rates in this product should provide adequate returns on capital. In recent years, R&D has shrunk somewhat as a share of revenue, but has grown significantly in absolute terms (net sales have increased by more than 32% each of the past three years). Particularly among its domestic competitors, the company is a technology innovator, and links its future strategy to remaining such. In the medium term, DGW is exploring licensing agreements with Israeli and American firms to bring highly efficient drip irrigation and membrane-based desalinization technology to its product portfolio. Though it is not discounted in the stock price, management recognizes that agriculture represents an enormous untapped growth market. There has also been some preliminary talk of partnerships with distributors in India. I would adopt a “wait and see” approach.
DGW has several competitive advantages in all of its business segments. Compared to international offerings from Veolia, Suez, or Thames, DGW (thanks to cheap labor) is the low cost producer. Domestic competitors cannot offer the same diversity and complementarity of product offerings. RINO, which provides water to the iron and steel industries, was a popular name with Western smart money in 2009. By contrast, the wide range of DGW’s businesses make it a less cyclical, more secular play. Unlike niche manufacturers leveraged to growth in particular industries, DGW is a WalMart-like “one-stop shop.”
DGW evidently believes its U.S. listing give it better access to capital and more brand prestige than its Chinese rivals. One of its largest expenses is a 12 million RMB CCTV 4 advertising campaign to convince distributors of its superior product quality. Selling costs have risen slowly and steadily on the back of this and other campaigns. DGW operates with a network of over 80 regionally diverse independent distributors; international competitors are often limited to one. By agreeing with distributors to yearly contracts, DGW is highly flexible to regional demand shifts, and maintains tighter control over working capital. Like an industrial company, DGW’s vertical integration permits volume discounts on raw material, and improved workflow from standardized practices across segments. Like a high-tech company, its relative small size and investments in R&D give it an edge in energy efficient and non-chemical water treatment technologies.
Financial analysis
An analysis of DGW’s financial position (if it can be believed) reveals a pristine balance sheet, a strong platform for growth, and an excellent cash flow yield. I have attached a discounted cash flows model, with conservative assumptions, that can easily generate valuations at a 50 to 100% premium to the current price. The model is fairly rough and unconventional in places, but fairly self-explanatory. Thus, here, I will merely highlight some of DGW’s financial results that speak its compelling value at current levels. Full financial data are only available from 2009, at the time of DGW’s New York listing; still, this business is steady enough that a reliable picture can be drawn. As of Q2 2010, DGW carried no debt on its balance sheet. It has financed itself entirely through equity, which it has redeployed as capital expenditure, primarily to bring online a new manufacturing facility at Langfang, where many of its higher-margin products are made. This significant investment should reduce mandatory CAPEX in the near future. Elsewhere, the balance sheet has expanded at a rate above 50% for the last several years, though without significant growth in working capital. Inventory turn came down from 96 to 78 days over the previous FY. The company has weathered the rise in raw material costs since 2006 admirably, increasing gross margin from 35% in 2005 to 48% in 2009. Operating margin improved from 14% to 24% over the same time, and is on track to hit 32% for FY2010. A 2008 change in PRC corporate tax policy eliminated DGW’s privileged status and applied a standard rate of 25%, equity-financed CAPEX, reflected in long term asset growth, appears to be in the neighborhood of 10% of revenue. These charges have not materially harmed the bottom line; free cash flow is on track to grow 70% in 2010.
From a cash flow perspective, the company is doing even better than its statement of operations might indicate. In June 2009, in accordance with FASB rule 123r, DGW expensed the award of $12.6m in ordinary shares (2 are redeemable for 1 ADS) at par to its employees, making up a significant proportion of SG&A cost. This share-based compensation was a sub-CFO level award for services already rendered. Rather than an ongoing compensation expense, shareholders should view the award as a one-off, a reward made possible by the company’s American listing. Management claims, “Going forward, we anticipate employee share-based compensation expense to be minimal.” The effect was a large, non-cash hit to net income. The award was not tax deductible; excluding the impact of share-based compensation, net income would have risen pro forma 55.7% in 2009. Instead it declined 12.5%. Cash flow growth in 2009 was in excess of 30%.
Assuming flattening growth across all four business segments (circulating water treatment, purification, wastewater treatment, and spare parts), with wastewater gradually increasing its share of operations, it is reasonable to expect total sales growth over the next decade to range between 15% and 35% per annum. If we also assume that the company can maintain its recent operating averages both on the cost side and in stewarding its capital, it is likely that we will see consistent double-digit cash flow growth for the foreseeable future. There is a risk that management will find, as technology leaps forward, or as competitors enter the market, that this level of performance is more capital intensive than it has currently estimated. Duoyuan may take on debt; more likely there may be further dilution of existing shareholders. Further, the cost of being a market leader is increased competition. DGW may lose pricing power, or may be forced to invest more of the proceeds of growth in marketing. Fluctuating raw material costs pose another challenge; the company targets 40% or greater gross margin on all new products, but with most hard commodities in secular bull markets, this may be unattainable. Nevertheless, DGW has a number of structural advantages in sourcing, distribution, technology, and in its (so far) cozy relationship with the state. Economies of scale should mitigate some of the headwinds to profitability.
All told, assuming historical operating averages remain intact or decline somewhat (a fairly conservative assumption, in my view), a discounted cash flows analysis generates a ADR value of $28.55, more than a 100% premium to mid-September 2010 levels. If current growth and profitability trends persist, the value could be much higher. I have used a 10% (marginally below DGW’s WACC) discount rate that I believe is at least a fair opportunity cost of owning equities in a global slump. Chinese equities may deserve a higher discount rate; if so they probably deserve a perpetual growth rate above the 2% I have employed.
Catalysts
Besides being substantially oversold, there are a number of catalysts that make DGW an attractive play into the end of 2010. Firstly, because of the impact of 2009’s share-based compensation, net income for 2010 will have a relatively easy comp. The stock is not heavily covered; thus when the December 31 10K reports earnings growth of 120%, some heads on the Street may turn. DGW has beaten the EPS consensus three of the last five quarters. If there is to be any material appreciation in the renminbi (which looks unlikely at present), input costs at PPP will come down and the dollar value of American-listed shares will increase. At minimum DGW is insulated from adverse currency fluctuation. Finally, water is a theme that is attracting more and more institutional money managers as global shortages (this summer’s Russian fires being a key illustration) become more acute. Duoyuan is the clearest pure play on water in the PRC.
More compellingly, it is likely that the heft of political mandates for investment in wastewater treatment will increase in late 2010. Wastewater, now the largest revenue driver for DGW is the most important variable in cities’ water conservation efforts, and is an important health consideration. China’s 12th five-year-plan, to be released this year, is expected to heighten focus on efficient water use and environmentally sensitive development. Environmental protection occupies a new significance in the minds of China’s planners, who see leadership on environmental issues as critical to China’s economic development, the quality of life of a growing middle-class, and to its diplomatic position in the world. DGW stands to benefit from any explicit mention of water use in the forthcoming plan.
Conclusion
My bull position on DGW rests on the view that the market has mispriced the risk of owning a Chinese ADR listing, and views DGW as a higher beta play on the Chinese business cycle than it actually is. Its balance sheet is clean, its finances are conservative, and ROIC on the development of the manufacturing facility in Langfang (as well as R&D facilities planned near the Daxing headquarters) funded by IPO should be positive. Investors scared by the surprise and relative opacity of management’s share-based compensation award should not expect a repeat. The stock shows a cash flow yield of greater than 6% with respect to enterprise value, and FCF multiple of only 15 times based on my 2010 projections. Compare this to a 130x multiple for the Shanghai Composite, per Bloomberg in August 2010. Its enterprise multiple is below 3, while the Shanghai Composite averages near 7. If Duoyuan Global Water were not tarred by the brush of scandal at DPY, or by the froth of what Jim Chanos calls “the greatest credit excess of all time,” I believe value investors would be taking heed. The risk of an unknown unknown in Chinese stocks is always great. The perception of that risk, however, represents much of the downside, as rumors lead investors to fly to the exits. This has already happened in DGW. I would explore a small, non-core position, occupying no more than a few percentage points of my portfolio, at an entry below $14. It seems unlikely that a question over expense accounts at a separate company could shave 50% of the value off a name that was already cheaply valued. If the scandal blows over, and DGW’s numbers can be believed, the stock could trade in high twenties by early 2011.
DCF Model:
https://docs.google.com/leaf?id=0B_ipU5WJf9sJNGE1Yjc4NmUtYTg3Mi00YjZlLWFhYzQtZTc5NGQwODQ1MDc3&hl=en&authkey=CLOxhv8B
Disclosures and Disclaimers: This long idea should not be taken as a recommendation to buy or sell any security. This is an informational posting only. Both the author and the proprietor of this site have been and will cotinue to be invested in DGW at various points in time.
About the author: Josh Rowe is currently in the final stages of earning his PhD from Princeton University and will soon be looking for buyside employment in San Francisco.
POMO - Fed is now #2 holder of US debt
Today's POMO came in at $2.069B, vaulting the Fed into the Number 2 spot for largest holders of U.S. debt, passing Japan's $821B (as of July 2010) at $821.128B.
Notes on Soros' speech on Ignoring Economic History
The principal of fallibility: People base their decisions not on actual reality but on what they perceive to be reality. The extent of the divergence varies from time to time and from person to person.
The principle of reflexivity: Market participants' misconceptions as reflected in market prices affect the so-called fundamentals.
"The extent and degree of uncertainty is itself uncertain and variable."
Soros states that he believes that the market trends towards near-equilibrium or far from equilibrium rather than hovering around some mean.
Most Succinct History of European Sovereign Debt Crisis I've Seen:
"The euro was an incomplete currency to start with. The Maastricht Treaty established a monetary union without a political union. The euro boasted a common central bank but it lacked a common treasury.
"So even though member countries share a common currency, when it comes to sovereign credit they are on their own. Unfortunately, this fact was obscured until recently by the willingness of the European Central Bank to accept the sovereign debt of all member countries on equal terms at its discount window. This allowed the member countries to borrow at practically the same interest rate as Germany and the banks were happy to earn a few extra pennies on supposedly risk-free assets by loading up their balance sheets with the government debt of the weaker countries. For instance, European banks hold more than a trillion euro’s of Spanish debt of which more than half is held by German and French banks. The large positions came to endanger the creditworthiness of the European banking system, depriving them of the capacity to add to their positions.
Although it was the inability of the banks to continue accumulating the government debt of the heavily indebted countries that precipitated the crisis, but it was the introduction of the euro and ECB’s willingness to refinance sovereign debt that got the banks weighed down with these large positions in the first place. It led to a radical narrowing of interest rate differentials and that, in turn, generated real estate bubbles in countries like Spain, Greece, and Ireland. Instead of the convergence prescribed by the Maastricht Treaty, these countries grew faster and developed trade deficits within the eurozone, while Germany reigned in its labor costs, became more competitive and developed a chronic trade surplus. The discount facility of the ECB allowed the deficit countries to continue borrowing at practically the same rates as Germany, relieving them of any pressure to correct their excesses. So the introduction of the euro was indirectly responsible for the development of internal imbalances within the eurozone."
Notes that Germany has been 'traumatized by two episodes of runaway inflation" and so was originally "adamanatly opposed to any bailout." See Weimar republic. At least one country seems to have learned from history. Although it should be noted that Germany's citizenry possesses a stronger nationalist vibe if not outright xenopohobia than that of most developed nations. Its also understandable that hard-working savers running chronic surpluses do not enjoy coming to the aid of reckless speculators (imagine that!).
The crisis forced the creation of the 750B European Financial Stabilization Fund, 500B Euro from the member states, and 250B Euro from the IMF. The Stabilization Fund is, according to Soros, "very far from a unified fiscal policy, but it is a step in that direction...So the crisis has passed its high water mark and the euro is here to stay. But it is far too early to celebrate because the emerging common fiscal policy is dictated by Germany and Germany is wedded to a false doctrine of macro-economic stability which recognizes only the threat of inflation and ignores the possibility of deflation."
Maastricht criteria has no adequate enforcement mechanism.
Deficit reduction by a creditor country such as Germany is in direct contradiction of the lessons learnt from the Great Depression of the 1930s. It is liable to push Europe into a period of prolonged stagnation or worse. That may, in turn, produce social unrest and, since the unpopular policies are imposed from the outside, turn public opinion against the European Union. So the euro, with its aysemmetric directive, may endanger the social and political cohesion of Europe."
"...And the policies [Germany] is imposing on the eurozone are liable to send the eurozone into a deflationary spiral."
On the United States:
"By contrast, interest rates on US government bonds have been falling and are near record lows. This means that financial markets anticipate deflation not inflation."
"Consumption still needs to fall as a percentage of the GDP and fiscal and monetary stimulus are still needed to keep the GDP from falling and to prevent a deflationary spiral."
"I believe there is a strong case for further stimulus. Admittedly, consumption cannot be sustained indefinitely by running up the national debt. The imbalance between consumption and investment needs to be corrected. But to cut back on government spending at a time of large-scale unemployment would ignore all the lessons learned from the Great Depression."
An allusion to his oft commented on reflexivity, "...A quarter century of agitation calling the government bad has resulted in bad government."
"The Obama administration has in fact been very friendly to business."
"I do not believe that monetary policy can be successfully substituted for fiscal policy." AGREED. This has been a theme expressed in previous posts. Why QE2 and not real infrastructure spending, etc? Create jobs, don't destroy the dollar.
"Quantitative easing is more likely to stimulate corporations to devour each other than to create employment. We shall soon find out."
The principle of reflexivity: Market participants' misconceptions as reflected in market prices affect the so-called fundamentals.
"The extent and degree of uncertainty is itself uncertain and variable."
Soros states that he believes that the market trends towards near-equilibrium or far from equilibrium rather than hovering around some mean.
Most Succinct History of European Sovereign Debt Crisis I've Seen:
"The euro was an incomplete currency to start with. The Maastricht Treaty established a monetary union without a political union. The euro boasted a common central bank but it lacked a common treasury.
"So even though member countries share a common currency, when it comes to sovereign credit they are on their own. Unfortunately, this fact was obscured until recently by the willingness of the European Central Bank to accept the sovereign debt of all member countries on equal terms at its discount window. This allowed the member countries to borrow at practically the same interest rate as Germany and the banks were happy to earn a few extra pennies on supposedly risk-free assets by loading up their balance sheets with the government debt of the weaker countries. For instance, European banks hold more than a trillion euro’s of Spanish debt of which more than half is held by German and French banks. The large positions came to endanger the creditworthiness of the European banking system, depriving them of the capacity to add to their positions.
Although it was the inability of the banks to continue accumulating the government debt of the heavily indebted countries that precipitated the crisis, but it was the introduction of the euro and ECB’s willingness to refinance sovereign debt that got the banks weighed down with these large positions in the first place. It led to a radical narrowing of interest rate differentials and that, in turn, generated real estate bubbles in countries like Spain, Greece, and Ireland. Instead of the convergence prescribed by the Maastricht Treaty, these countries grew faster and developed trade deficits within the eurozone, while Germany reigned in its labor costs, became more competitive and developed a chronic trade surplus. The discount facility of the ECB allowed the deficit countries to continue borrowing at practically the same rates as Germany, relieving them of any pressure to correct their excesses. So the introduction of the euro was indirectly responsible for the development of internal imbalances within the eurozone."
Notes that Germany has been 'traumatized by two episodes of runaway inflation" and so was originally "adamanatly opposed to any bailout." See Weimar republic. At least one country seems to have learned from history. Although it should be noted that Germany's citizenry possesses a stronger nationalist vibe if not outright xenopohobia than that of most developed nations. Its also understandable that hard-working savers running chronic surpluses do not enjoy coming to the aid of reckless speculators (imagine that!).
The crisis forced the creation of the 750B European Financial Stabilization Fund, 500B Euro from the member states, and 250B Euro from the IMF. The Stabilization Fund is, according to Soros, "very far from a unified fiscal policy, but it is a step in that direction...So the crisis has passed its high water mark and the euro is here to stay. But it is far too early to celebrate because the emerging common fiscal policy is dictated by Germany and Germany is wedded to a false doctrine of macro-economic stability which recognizes only the threat of inflation and ignores the possibility of deflation."
Maastricht criteria has no adequate enforcement mechanism.
Deficit reduction by a creditor country such as Germany is in direct contradiction of the lessons learnt from the Great Depression of the 1930s. It is liable to push Europe into a period of prolonged stagnation or worse. That may, in turn, produce social unrest and, since the unpopular policies are imposed from the outside, turn public opinion against the European Union. So the euro, with its aysemmetric directive, may endanger the social and political cohesion of Europe."
"...And the policies [Germany] is imposing on the eurozone are liable to send the eurozone into a deflationary spiral."
On the United States:
"By contrast, interest rates on US government bonds have been falling and are near record lows. This means that financial markets anticipate deflation not inflation."
"Consumption still needs to fall as a percentage of the GDP and fiscal and monetary stimulus are still needed to keep the GDP from falling and to prevent a deflationary spiral."
"I believe there is a strong case for further stimulus. Admittedly, consumption cannot be sustained indefinitely by running up the national debt. The imbalance between consumption and investment needs to be corrected. But to cut back on government spending at a time of large-scale unemployment would ignore all the lessons learned from the Great Depression."
An allusion to his oft commented on reflexivity, "...A quarter century of agitation calling the government bad has resulted in bad government."
"The Obama administration has in fact been very friendly to business."
"I do not believe that monetary policy can be successfully substituted for fiscal policy." AGREED. This has been a theme expressed in previous posts. Why QE2 and not real infrastructure spending, etc? Create jobs, don't destroy the dollar.
"Quantitative easing is more likely to stimulate corporations to devour each other than to create employment. We shall soon find out."
Today's Outlook - Ireland Downgrade, Huge ADP Emp Miss, and POMO
Yesterday the market surged higher as the Fed purchased $5.19B of 2016-2020 Treasuries and the primary dealers drove BIDU, NFLX, and AMZN up 5% or more. The dollar sank to an 8-month low against the euro as market participants continue to believe that the Fed will launch a $1 Trillion asset purchased program (QE2) on November 3rd, on top of the $400B or so of expected POMO over 2011. Also helping the market was the ISM Services Index which came in at 53.2 vs. the 51.8 that had been expected. Gold was up 2% to a new all-time high of $1340.60/ounce, and oil reached 82.48. Lastly of major note was Japan announcing plans for a 5 trillion yen fund to purchase bonds and ABS securities. So QE announcement out of Japan, and as we are not going to lose the race to hyperinflationary-causing currency debasement, it looks all the more likely that we will see QE2 sometime over the next few months.
The Dow finished at a fresh 4-month high at 10,944 up 193.45 points. The S&P closed at 1,160.75, and the Nasdaq at 2,399.
Futures are slightly lower this morning on ADP Employment Change data which came in at -39K vs. +10K prior and +20K forecast. Ouch. We'd probably be looking a lot lower, but we will have another batch of POMO at 7:15 a.m. PST. Judging by its effects yesterday, and also given that it is the last installment of POMO for a number of days, its likely to be as robust as yesterday's.
Ireland was downgraded to A+ from AA- and put on negative outlook by Fitch. "The downgrade of Ireland reflects the exceptional and greater-than expected fiscal cost associated with the government's recapitalization of the Irish banks, especially Anglo Irish Bank." Fitch said this morning.
The FT reports this morning that IMF chief Dominique Strauss-Kahn has said that governments are risking a currency war if they try to manipulate exchange rates to solve domestic problems.
The IMF also has a report out this morning lowering its US growth forecast to 2.6% and 2.7% for 2010 and 2011, respectively. These revisions are -0.7% and -0.6%. IMF Chief Economist Olivier Blanchard told a press conference, "But it is an unbalanced recovery, sluggish in advanced countries, much stronger in emerging and developing countries."
Dow +100 today? Why not?
The Dow finished at a fresh 4-month high at 10,944 up 193.45 points. The S&P closed at 1,160.75, and the Nasdaq at 2,399.
Futures are slightly lower this morning on ADP Employment Change data which came in at -39K vs. +10K prior and +20K forecast. Ouch. We'd probably be looking a lot lower, but we will have another batch of POMO at 7:15 a.m. PST. Judging by its effects yesterday, and also given that it is the last installment of POMO for a number of days, its likely to be as robust as yesterday's.
Ireland was downgraded to A+ from AA- and put on negative outlook by Fitch. "The downgrade of Ireland reflects the exceptional and greater-than expected fiscal cost associated with the government's recapitalization of the Irish banks, especially Anglo Irish Bank." Fitch said this morning.
The FT reports this morning that IMF chief Dominique Strauss-Kahn has said that governments are risking a currency war if they try to manipulate exchange rates to solve domestic problems.
The IMF also has a report out this morning lowering its US growth forecast to 2.6% and 2.7% for 2010 and 2011, respectively. These revisions are -0.7% and -0.6%. IMF Chief Economist Olivier Blanchard told a press conference, "But it is an unbalanced recovery, sluggish in advanced countries, much stronger in emerging and developing countries."
Dow +100 today? Why not?
Monday, October 4, 2010
Brian Sack, Head of FRBNY Desk (POMO), Regarding QE2
Notes from Brian Sack's remarks at the 2010 CFA Institute Fixed Income Management Conference, Newport Beach, California
Most FOMC members expect the unemployment rate to remain above 8.25 percent through 2011 and the inflation rate to remain below its mandate-consistent level through 2012.
The economy remains vulnerable to downside surprises that could take both output and inflation further away from the FOMC's objectives.
Fed used to maintain a 'relatively simple portfolio' of between $700B and $800B of Treasury securities.
Announced in November 2008 the purchase of up to $600B of agency debt and agency MBS.
In March 2009 it expanded the program to include cumulative purchases of up to $1.75T of agency debt, agency MBS, and longer-term Treasury securities.
Domestic securities held in the System Open Market Account (SOMA) reached a peak in June 2010 at $2.1T.
At that point this amount started to shrink as agency debt and agency MBS held in the SOMA were allowed to run off as they matured or were repaid.
At August Fed meeting, the decision was made to hold the size of the SOMA portfolio steady.
At this time, 'the Desk' was projecting that approximately $340B of the Fed Reserve's MBS holdings would be paid down from that time until the end of 2011. Another $55B would mature by the end of 2011. So expected shrinkage of $395B (~$400B).
Decision is to purchase longer-term Treasury securities.(As we've witnessed in Permanent Open Market Operations over the past few weeks.)
"The effect of asset purchases on the economy remains a point of ongoing debate..."
"My own perspective is aligned with the view expressed by Chairman Bernanke in Jackson Hole-that the effects arise primarily through a portfolio balance channel. Under that view, our asset holdings keep longer-term interest rates lower than otherwise by reducing the aggregate amount of risk that the private markets have to bear. In particular, by purchasing longer-term securities, the Federal Reserve removes duration risk from the market, which should help to reduce the term premium that investors demand for holding longer-term securities. That effect should in turn boost other asset prices, as those investors displaced by the Fed's purchases would likely seek to hold alternative types of securities."
[WOW, not that it wasn't previously obvious to anyone paying attention, but did Mr. Sack just admit that the Fed's real mandate isn't of full (un)employment and stable (bubble-like) asset prices but really about boosting prices of other 'securities' such as....well, stocks??? If that's the case, is the Fed, or at least Mr. Sack, admitting that the Fed is using taxpayer dollars to provide an opportunity to allow insiders to overwhelming liquidate their equity positions in their own companies (as has been shown by the weekly data.)??]
Value of the SOMA portfolio just ahead of the August meeting was $2.054 T.
"We are running at a pace of $27B in purchases this month, and we expect that pace to bump up to around $30B for the next several months."
"We currently project that cumulative amount of principal payments on agency debt and agency MBS through 2011 will be somewhat higher than the estimates provided at the August FOMC meeting."
So...call it $450-$500B in additonal purchases through YE11. If that is the case, and we are done on $27, and running at $30B for perhaps the next 3 months, then the average monthly purchase through 2011 will be approx. $23.583B.
Focus will be on Treasury securities with remaining maturities between 2 and 10 years, although some will occur outside this segment.
Avg duration of 5 years.
Reminds us that the reinvestment strategy, of course, involves a reallocation of the portfolio from agency debt and MBS into Treasury securities.
Mr. Sack believes that Treasuries and agency MBS purchases operate similarly to remove duration risk from the market. Concern however is that as MBS purchases reomve prepayment risk from the market and Treasuries do not, spreads on MBS to Treasuries could widen. If so, Fed would proably again buy agency paper.
Notes the qualitative policy approach of the Fed (the FOMC's communique's) have, "generated a sizable market response."
On Aggregate Demand and the Effect of QE on the Greater Economy (ex-the markets):
"Some observers have argued that balance sheet changes, even if they influence longer-term interest rates, will not affect the economy because the transmission mechanism is broken. This point is overstated in my view. It is true that certain aspects of the transmission mechanism are clogged because of the credit constraints facing some households and businesses, and it is true that monetary policy cannot directly target those parties that are the most constrained. Nevertheless, balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be. It seems highly unlikely that the economy is completely insensitive to borrowing costs and wealth, or to other changes in broad financial conditions."
So admits that QE is a tool to maintain artificially inflated asset prices even though this approach does not assist those who most desparately need equilibrium to return to the markets for wages, assets, necessities, etc. He believes it is very unlikely that 1) high stock prices and 2) wealth preservation for the top 20% don't have a trickle-down effect for the average citizen. Well, judging by recent data which suggests all-time record domestic income inequality (that has gone parabolic over the last thirty or so years), I'm not sure anyone puts much credence in Reaganomics anymore...except the Fed, of course.
Costs of balance sheet expansion:
"...an important operational consideration is whether the Federal Reserve purchases would strain the functioning of financial markets and cause an erosion of market liquidity." CHECK!
"This issue was present during the first asset purchase program, especially when the pace of weekly purchases reached a peak of about $40B in the middle of last year. The pace of those purchases at times put pressure on liquidity in the MBS market, leading the desk to take mitigating actions when possible."
Says there is more room to expand without issue as the SOMA holds about 12% of outstanding Treasury coupon securities. Treasury supposed to issue around $1.2T of securities over the next year, so plenty of supply. [GOOD-BYE DOLLAR]
He ends with a discussion of how to design a purchase program in a balance sheet expansion is desired. The key element in this portion of the speech seemed to be the idea that rather than announce the amount and type of purchases in advance that it might be wise to allow for some flexibility given the unknown effects such expansion might have. The important part about this is that it suggests that investors will have little clarity regarding the intermediate term actions of the Fed regardless of near term announcements. The market will therefore be incapable of operating under fundamental assumptions for some time...
http://www.newyorkfed.org/newsevents/speeches/2010/sac101004.html
An afterthought:
Last night, while visiting a friend at his rural home, I witnessed a most unusual scene. A raccoon (Procyon lotor) had become trapped in a neighborhood garbage bin. Another raccoon looking over a second bin filled with corn cobs, chicken bones, and various other sundries, decided against his initial selfish impulse and went to the aid of his fellow raccoon rather than having a feast all to himself. I gazed in wonder that these eye-masked marauders of the night were capable of feeling empathy for their fellow creature and acting to assist one another at the expense of their own personal interest. If only those in charge of monetary policy could experience a similar feeling of empathy while destroying the purchasing power of not just the current, but also the future generations of the American middle class...
Most FOMC members expect the unemployment rate to remain above 8.25 percent through 2011 and the inflation rate to remain below its mandate-consistent level through 2012.
The economy remains vulnerable to downside surprises that could take both output and inflation further away from the FOMC's objectives.
Fed used to maintain a 'relatively simple portfolio' of between $700B and $800B of Treasury securities.
Announced in November 2008 the purchase of up to $600B of agency debt and agency MBS.
In March 2009 it expanded the program to include cumulative purchases of up to $1.75T of agency debt, agency MBS, and longer-term Treasury securities.
Domestic securities held in the System Open Market Account (SOMA) reached a peak in June 2010 at $2.1T.
At that point this amount started to shrink as agency debt and agency MBS held in the SOMA were allowed to run off as they matured or were repaid.
At August Fed meeting, the decision was made to hold the size of the SOMA portfolio steady.
At this time, 'the Desk' was projecting that approximately $340B of the Fed Reserve's MBS holdings would be paid down from that time until the end of 2011. Another $55B would mature by the end of 2011. So expected shrinkage of $395B (~$400B).
Decision is to purchase longer-term Treasury securities.(As we've witnessed in Permanent Open Market Operations over the past few weeks.)
"The effect of asset purchases on the economy remains a point of ongoing debate..."
"My own perspective is aligned with the view expressed by Chairman Bernanke in Jackson Hole-that the effects arise primarily through a portfolio balance channel. Under that view, our asset holdings keep longer-term interest rates lower than otherwise by reducing the aggregate amount of risk that the private markets have to bear. In particular, by purchasing longer-term securities, the Federal Reserve removes duration risk from the market, which should help to reduce the term premium that investors demand for holding longer-term securities. That effect should in turn boost other asset prices, as those investors displaced by the Fed's purchases would likely seek to hold alternative types of securities."
[WOW, not that it wasn't previously obvious to anyone paying attention, but did Mr. Sack just admit that the Fed's real mandate isn't of full (un)employment and stable (bubble-like) asset prices but really about boosting prices of other 'securities' such as....well, stocks??? If that's the case, is the Fed, or at least Mr. Sack, admitting that the Fed is using taxpayer dollars to provide an opportunity to allow insiders to overwhelming liquidate their equity positions in their own companies (as has been shown by the weekly data.)??]
Value of the SOMA portfolio just ahead of the August meeting was $2.054 T.
"We are running at a pace of $27B in purchases this month, and we expect that pace to bump up to around $30B for the next several months."
"We currently project that cumulative amount of principal payments on agency debt and agency MBS through 2011 will be somewhat higher than the estimates provided at the August FOMC meeting."
So...call it $450-$500B in additonal purchases through YE11. If that is the case, and we are done on $27, and running at $30B for perhaps the next 3 months, then the average monthly purchase through 2011 will be approx. $23.583B.
Focus will be on Treasury securities with remaining maturities between 2 and 10 years, although some will occur outside this segment.
Avg duration of 5 years.
Reminds us that the reinvestment strategy, of course, involves a reallocation of the portfolio from agency debt and MBS into Treasury securities.
Mr. Sack believes that Treasuries and agency MBS purchases operate similarly to remove duration risk from the market. Concern however is that as MBS purchases reomve prepayment risk from the market and Treasuries do not, spreads on MBS to Treasuries could widen. If so, Fed would proably again buy agency paper.
Notes the qualitative policy approach of the Fed (the FOMC's communique's) have, "generated a sizable market response."
On Aggregate Demand and the Effect of QE on the Greater Economy (ex-the markets):
"Some observers have argued that balance sheet changes, even if they influence longer-term interest rates, will not affect the economy because the transmission mechanism is broken. This point is overstated in my view. It is true that certain aspects of the transmission mechanism are clogged because of the credit constraints facing some households and businesses, and it is true that monetary policy cannot directly target those parties that are the most constrained. Nevertheless, balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be. It seems highly unlikely that the economy is completely insensitive to borrowing costs and wealth, or to other changes in broad financial conditions."
So admits that QE is a tool to maintain artificially inflated asset prices even though this approach does not assist those who most desparately need equilibrium to return to the markets for wages, assets, necessities, etc. He believes it is very unlikely that 1) high stock prices and 2) wealth preservation for the top 20% don't have a trickle-down effect for the average citizen. Well, judging by recent data which suggests all-time record domestic income inequality (that has gone parabolic over the last thirty or so years), I'm not sure anyone puts much credence in Reaganomics anymore...except the Fed, of course.
Costs of balance sheet expansion:
"...an important operational consideration is whether the Federal Reserve purchases would strain the functioning of financial markets and cause an erosion of market liquidity." CHECK!
"This issue was present during the first asset purchase program, especially when the pace of weekly purchases reached a peak of about $40B in the middle of last year. The pace of those purchases at times put pressure on liquidity in the MBS market, leading the desk to take mitigating actions when possible."
Says there is more room to expand without issue as the SOMA holds about 12% of outstanding Treasury coupon securities. Treasury supposed to issue around $1.2T of securities over the next year, so plenty of supply. [GOOD-BYE DOLLAR]
He ends with a discussion of how to design a purchase program in a balance sheet expansion is desired. The key element in this portion of the speech seemed to be the idea that rather than announce the amount and type of purchases in advance that it might be wise to allow for some flexibility given the unknown effects such expansion might have. The important part about this is that it suggests that investors will have little clarity regarding the intermediate term actions of the Fed regardless of near term announcements. The market will therefore be incapable of operating under fundamental assumptions for some time...
http://www.newyorkfed.org/newsevents/speeches/2010/sac101004.html
An afterthought:
Last night, while visiting a friend at his rural home, I witnessed a most unusual scene. A raccoon (Procyon lotor) had become trapped in a neighborhood garbage bin. Another raccoon looking over a second bin filled with corn cobs, chicken bones, and various other sundries, decided against his initial selfish impulse and went to the aid of his fellow raccoon rather than having a feast all to himself. I gazed in wonder that these eye-masked marauders of the night were capable of feeling empathy for their fellow creature and acting to assist one another at the expense of their own personal interest. If only those in charge of monetary policy could experience a similar feeling of empathy while destroying the purchasing power of not just the current, but also the future generations of the American middle class...
POT Update - C$2B cost to Saskatchewan
Reuters is reporting that the BHP takeover of Potash is estimated by an independent report commissioned by the Saskatchewan government to cost the province at least C$2B over 10 years in royalties and taxes.
POT is trading up this morning to approx 144.30 (or +1.2%), presumably because the report suggests little or no change in the employment landscape in Saskatchewan as a result of the takeover (thus making gov't approval more likely). Also this morning, BHP asked the US court to dismiss the lawsuit filed by Potash.
I continue to believe that it is unlikely that BHP will be successful in its bid for Potash. The bid has turned hostile and so has the protectionist rhetoric coming from Brad Wall and the Canadian province's government.
POT is trading up this morning to approx 144.30 (or +1.2%), presumably because the report suggests little or no change in the employment landscape in Saskatchewan as a result of the takeover (thus making gov't approval more likely). Also this morning, BHP asked the US court to dismiss the lawsuit filed by Potash.
I continue to believe that it is unlikely that BHP will be successful in its bid for Potash. The bid has turned hostile and so has the protectionist rhetoric coming from Brad Wall and the Canadian province's government.
S&P Earnings Forecasts Revised Down
Analysts cut 2011 S&P earnings forecasts for the first time since June 09. New estimates for $95.17 vs. August high of $96.16. (Bloomberg). While this doesn't surprise anyone, and doesn't represent a material drop, it shows that those arguing that the market is undervalued based on forward earnings expectations need to remember that as margins may (or may not) have peaked, we will need to see an increase in aggregate demand (not likely while household sector continues to delever and/or remain jobless) to continue to drive higher earnings. Should final demand fail to improve, we will most certainly see deeper revisions to these forward earnings numbers that have always struck us as being a bit optimistic.
Bloomberg quotes Robert Doll, vice chairman of New York-based BlackRock Inc. "You need pretty fancy GDP numbers to get to $95/share in earnings next year. Our view is that they're still a little too high, and that nobody believes them." Well said.
Equity strategists are at $87.34 in 2011, less sanguine than company analysts.
Bloomberg quotes Robert Doll, vice chairman of New York-based BlackRock Inc. "You need pretty fancy GDP numbers to get to $95/share in earnings next year. Our view is that they're still a little too high, and that nobody believes them." Well said.
Equity strategists are at $87.34 in 2011, less sanguine than company analysts.
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