Friday, July 30, 2010

Morning Note...

Happy Friday…macro dominates this morning…  Futures are ~1% lower as U.S. Q2 GDP comes in weaker than expected at +2.4% vs. the +2.6% expectation and the +3.7% Q1 revision.  Thus markets now have concrete evidence that the rate of U.S. economic growth certainly slowed in Q2.  The GDP reading is also troubling for its make up:  personal consumption (70% of our economy remember) growth decreased while inventories built.  Obviously demand has not kept up with inventory… Also government spending increased from -1.6% to +4.4%... Overseas, European markets are weaker as Moody’s cautioned over Spain’s credit rating (and also made cautious U.S. comments):

Spain May Lose Rating, U.S. Needs Plan, Moody’s Says 2010-07-30 09:57:41.778 GMT
July 30 (Bloomberg) -- Spain will probably lose its Aaa credit rating after the country was put under review for possible downgrade in June, and the U.S. needs a “clear plan”
to tackle its deficit, Moody’s Investors Service said.  “Spain is very highly rated and I can’t say where that rating will end up, but it’s likely to go down a bit,” Steven A. Hess, senior credit officer at Moody’s, said in an interview in Sydney yesterday. In the U.S., slower growth may hinder government efforts to address the budget shortfall, he said. “We’re watching the government’s measures that they are implementing and we’ll probably try to put that rating at the level we think it should belong for some time to come,” Hess said. “We don’t see it moving down as many notches as Greece did.”
The U.S. faces a difficult task in trying to stimulate growth as its current debt trajectory would threaten the nation’s top rating in the years ahead, said Hess. “The U.S. certainly shouldn’t be trying to put more debt on its books, but we do have questions about the strength of the economic growth,” Hess said. “If economic growth is not there, then the government’s ability to fix its budget problem is less because the revenue will be less. So it can be counter- productive not to stimulate.”  Hess said the U.S. needs a strategy for curbing its budget deficit, which was 9.9 percent of GDP at the end of last fiscal year on Sept. 30. The fiscal shortfall is projected to reach a record $1.47 trillion this year.  “Having a clear plan certainly increases confidence and the U.S. doesn’t have that yet,” said Hess.
Note that next week is a very busy earnings week in Europe and – given recent moves – some desks feel that a “sell the news” type week may be in order there.  A bit further afield in Japan, unemployment data there was slightly worse than expected as was industrial production.  This took Asian markets down overnight, led by the Nikkei’s -1.6%.  Chicago PMI due at 9:45am and Consumer Confidence is due at 9:55am.  Note that today is the last trading day of the month and there is always “window dressing” chatter relative to some funds marking up positions on the bell in order to report better month-end numbers.  Of course, for some funds this would have been a few days ago considering trades settle on Trade Date + 3 business days.  But for others, today matters.  (I have never been able to figure out who does what and when…but if the market turns higher at about 3:40pm today, people will be saying “window dressing.”)  Relative to yesterday’s mid-day rally off the Bullard Fed comments, see the quote section below for an excellent summary from Mike O’Rourke.

For more cheerful news relative to equity markets, FBR is out this morning with a Washington Policy piece on taxes:

What Will Your Taxes Be Next Year?
At the end of the year, the Bush tax cuts will expire and taxes will increase. Congress’s response will have far-ranging impacts on the economy from consumer consumption and investment activities to general economic growth. Even with an end-of-the-year deadline looming, Congress has an even more pressing deadline—the November elections—and as of right now neither party has much political incentive to compromise. As a result, there is a growing risk that the tax rate on dividends, capital gains, estates, and high-income individuals will be allowed to increase. This is a highly fluid situation that could easily extend into next year.
            Key Points

·                     This highly fluid situation could have wide ranging sentiment impacts from wealth effects on consumer spending to allocation strategies between growth (capital gains taxes) and income (dividends). The automatically rising tax on dividends, for example, could inspire 4Q10 special dividend payments or it could raise the cost of capital in 2010.

·                     The most likely tax cuts to be extended are personal income taxes for individuals with less than $200,000 and families with less than $250,000 in taxable income. What is far less certain is the tax treatment for individuals and families above that level, the tax rate on dividends, capital gains, and the taxation on estates. The two biggest factors influencing the debate are the elections this fall and the difficulty finding other revenues necessary to offset the extension of many of these provisions. Below is a discussion of the current proposals before Congress and their likelihood for passage, detailed information on the tax rates in each category, and the potential impact to various sectors should Congress fail to act on certain provision.

·                     Our conversations with our Washington contacts suggest that a full extension of the 2001 and 2003 Bush tax cuts remains unlikely due to the expense in this tight budgetary environment. We believe that Democratic strategists consider opposition to tax cuts for the rich to be a winning campaign strategy. This likely means that a final decision will be postponed until after the November elections with some increase appearing to be the most likely outcome.

·                     Dividend taxes are 15% and are scheduled to revert to normal income in 2011 and President Obama has proposed reducing the increase to 20%. However, cost remains a hurdle. Preliminary estimates have the cost of maintaining the current rates at $99 billion over the next 10 years. We note the significant chance that the Democrats allow dividend rates to revert at the end of the year and attempt to return and extend lower rates retroactively in 2011.

·                     We do not expect to see any significant changes to the 20% capital gain taxes.

·                     Federal estate taxes are nonexistent this year, but are scheduled to reset to 55% on estates over $1 million next year, but we believe Congress will intervene. We view a tax rate in the 35% to 45% range with an exclusion of $3.5 million to $5 million as the most likely outcome.

·                     We believe the most likely scenario is a two-year increase in the exemptions level allowed to avoid the AMT to keep the number of individuals affected at the same level as 2008.

·                     We believe that a value added tax (VAT) is a political non-starter.

BERN ups UBS, cuts BIIB.  ALU higher on earnings.  CRL and WX terminate merger agreement and CRL announces buyback.  CSTR -8% on earnings.  GNW -2% on earnings.  MET +2% on earnings.  NTRI -3% on earnings.  SWIR beats by 6c and trades higher.  UFS beats on earnings and revs.  WFR misses by 3c.  WYNN beats by 10c. 

Asia lower overnight.  Europe ~1% lower.  Oil -160bps.  Gold +22bps.  EUR/USD 1.3021. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 
MEMC ELEC MATER        9.92      -11.9 % 330269
GENWORTH FINANCI      14.70    -6.9 %  12714
ITT CORP                      46.96    -5.93%  4300
TELLABS INC                  7.04      -4.74%  32501
EASTMAN CHEMICAL      62.15    +4.0 %  3400
FORTUNE BRANDS          44.79    +3.25% 1925
DR HORTON INC             10.54    -3.13%  450
PACTIV CORP                30.60    -2.98%  64600
ABERCROMBIE & FI        35.35    -2.94%  2000
TERADYNE INC               10.75    -2.89%  5000
NOVELLUS SYS              27.70    +2.78% 600
HALLIBURTON CO           29.30    -2.69%  28488
TEREX CORP                  18.93    -2.62%  700
WHIRLPOOL CORP          82.01    -2.5 %  100

Today’s Trivia:  Name the first U.S. state that allowed women to vote. 
Yesterday's Answer:  1 in 20 people have an extra rib.   

Best Quotes:  “When the Federal Reserve Bank President authors a paper with a title that sounds like a Stephen King novel, it is certainly going to garner some attention and rightfully so.  “Seven Faces of ‘The Peril’” is the title of St. Louis Fed President James Bullard’s latest research.  Bullard did not pull any punches in the abstract, he states “I emphasize two main conclusions: (1) The FOMC’s extended period language may be increasing the probability of a Japanese-style outcome for the U.S., and (2) on balance, the U.S. quantitative easing program offers the best tool to avoid such an outcome.”  The importance of these statements is remarkable.  This is a relatively new (2 years into the post) Regional Bank President producing research concluding that the current trajectory of FOMC policy may increase the likelihood of an outcome that we all know we don’t want.  If you read between the lines, it sounds like he is really saying, “Ben, I think you are wrong, and now that I have called you out on it, if you don’t adjust policy you will be subject to very serious hindsight risk.”  We are accustomed to hearing Richmond Fed President Jeff Lacker and Kansas City Fed President Thomas Hoenig dissent on FOMC policy all of the time, almost always simply in favor of being more hawkish, and usually provide some balance to the debate.  Bullard appears to be staking out the ultra-dove ground with his conclusions.  If we wind up in a Japan scenario, regardless of the cause, this research will be used to blame the Fed.

The policy Bullard is advocating and the stance he is taking is not new. As early as last November he advocated using Quantitative Easing (asset purchases and sales) to administer monetary policy much in the same way the Fed has traditionally used the Fed Funds rate.  He was opposed to allowing the Fed’s asset purchase program sunset in March.   Bullard wanted to leave the program open in order to buy and sell assets as deemed necessary by the state of the economy.  He was unsuccessful in his attempt, now it appears he has gone back done additional homework and is re-opening the debate backed by research. 

This is an attempt to overcome the debate surrounding the zero bound of interest rate policy.  The essence of Bullard’s work is that the zero interest rate policy “would also be consistent with the low nominal interest rate steady state in which inflation does not return to target but instead both actual and expected inflation turn negative and remain there.”  In that scenario the policymaker risks being perceived as running out of ammunition because they are locked into the perception that interest rates are the primary tool of monetary policy.  Here in 2010 we have witnessed a good example of the dilemma Bullard highlights.   When the market was rallying early in the year, everyone was discussing when would the Fed begin the exit strategy. As the economy hit a soft patch and the market sold off over the past few months up prior to last week there was little conversation about what the Fed would/could do.  When the topic emerged the debate centered around the Fed being out of bullets.  Case in point for Bullard.  His proposed solution is as follows. “To avoid this outcome for the U.S., policymakers can react differently to negative shocks going forward. Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”

You have to give Bullard credit for creativity while remaining within the realm of reality.  Simultaneously, we can imagine the German’s at  the Bundesbank thinking this is heresy in the almost cavalier way Bullard talks about adding liquidity to the system. “We can double the monetary base one day, and return to the previous level the next day, and we should not expect such movements to have important implications for the price level in the economy. Base money

can be removed from the banking system as easily as it can be added, so private sector expectations may remain unmoved by even large additions of base money to the banking system.”  A statement like that alone should fuel an uptick in inflation expectations.  Nearly everyone fears the slippery slope of creating money seemingly at a whim.  On some level it is a fear of the unknown , but sometimes that is a good thing.  In this age of transparency we believe one of the largest threats out there is predictability of policy. Bullard’s approach prevents the FOMC policy from becoming what he calls “passive,” a euphemism for inconsequential.  It allows carry traders to lever and permits investors to put on marginal positions where the risk does not match the reward.   A little uncertainty keeps the market honest, and if you have a position it is because you like it and not simply because the Fed is not tightening until 2012 or vice versa because rates can’t go any lower.  We can’t wait to see where Bernanke weighs in.” 

BTIG’s Mike O’Rourke