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.
Wednesday, October 6, 2010
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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