Wednesday, August 25, 2010

Morning Note...

Futures are down ~65bps this morning as the 8:30am U.S. Durable Goods Orders release came in below expectations and essentially outweighs a surprising business confidence reading in Germany.  Europe is also lower on a Moody’s downgrade of Ireland to AA- (its lowest rating since 1995, sparking sovereign debt default concerns yet again – see MSCO fixed income research piece in quote section below), and Asia was weaker overnight while the Yen weakened on intervention comments from the Japanese Finance Minister.  Regarding Durable Goods, July orders were +0.3% month-over-month, versus the +3.0% expectation and the -0.1% prior reading.  MBA Mortgage Applications grew 4.9% for the week ending August 20th, with represents a slow down from the prior 13% gain.  Note that Initial Jobless Claims are due tomorrow and 490k are expected.  (Recall that we broke the headline-round-number of 500k last week.)  Q2 GDP data will be released Friday.  In Germany, the Ifo Business Sentiment Index unexpectedly rose to a 3-year high.  Bond prices continue to rally, and ten-year yields now stand at 2.44%.  Oil -65bps.  Gold +40bps.  EUR/USD 1.2638 and USD/JPY 84.30. 

In case you missed it yesterday (and I ran out of room…), GSCO put out a cautious macro piece that is worth a look ahead of Friday’s GDP release (bold is mine):

Forecasters Need to Cut GDP Estimates a Lot Further (Hatzius)

·        Over the last few months, the US economic indicators have shown a broad-based slowdown.  Such a slowdown around the middle of 2010 has long seemed likely given the dependence of growth over the prior year on the boost from the inventory cycle and fiscal policy.  Our forecast is that real GDP will grow at a 1½% (annualized) rate in the second half of 2010 and in early 2011, and the risks to it are tilted to the downside.

·        But the forecasting community has only partially caught up with the deterioration in the numbers.  Last week’s FOMC statement suggests that Fed officials still expect the economy to grow at a slightly above-trend rate over the next year or so.  Likewise, most private forecasters predict that GDP will grow at roughly a trend rate in the second half of 2010 and a somewhat above-trend rate in 2011.  If our view is correct, substantial further downward revisions are coming.  In turn, these are likely to trigger downgrades to consensus earnings forecasts toward our strategists' more cautious views, as well as a return to large-scale asset purchases or other forms of "unconventional" monetary policy by the Fed.

·        Will the economy in fact return to a technical recession, marked by declines in real GDP?  We think the odds are still against such an outcome, but the risk is a substantial 25%-30%.  In our view, this exceeds the likelihood of the trend/above-trend growth scenario envisaged in the consensus forecast.

            Over the last few months, the US economy has shown signs of slowdown across a broad range of indicators:

1. GDP and its components.  We estimate that the Commerce Department will announce on Friday that real GDP grew just 1.1% (annualized) in the second quarter.  We do not yet have much “tracking” information for the third quarter, but we believe that the sparse data released so far are consistent with our forecast of a 1½% growth.

2. Business surveys.  At present, the ISM surveys for the manufacturing and nonmanufacturing sector—at 55.5 and 54.3, respectively—are still consistent with trend or above-trend growth.  However, other indicators such as the NFIB small-business survey and regional surveys such as the Philly Fed index look a lot softer.  We expect the ISM indexes to fall sharply in coming months, to around 50 in the manufacturing sector and to the low 50s in the nonmanufacturing sector.

3. Labor market indicators.  Both the establishment survey and the household survey of employment have shown a sharp slowdown in underlying job growth over the past few months (see US Views,  Moreover, initial jobless claims have crept up in recent week and hit 500,000 in the latest week, with only some of this increase attributable to temporary factors.  Although we do not have a forecast for the August employment report yet, the early indications are that private sector job growth may have stalled (or possibly gone into reverse) in the last month.

A slowdown around the middle of the year has long seemed likely given the dependence of GDP growth since mid-2009 on the boost from the inventory cycle and fiscal policy.  Over the last four quarters, the swing from inventory liquidation to accumulation has contributed 1.9 percentage points to real GDP growth, and overall fiscal policy—federal, state, and local—has contributed a little over 1 percentage point to real final demand growth.  These two numbers are additive, which implies that almost all of the 3.2% growth in real GDP over the past year was due to temporary factors, and that final demand excluding the impact of fiscal policy grew by less than ½% over the past year.  (Final demand excluding the impact of federal fiscal policy but including the impact of state and local policy has declined slightly.)

Given these relatively easy-to-measure factors—and given that it is difficult to tell a compelling story for why underlying final demand growth should accelerate sharply from here—we find forecasts that do not look for GDP growth well below trend quite implausible.  If the inventory and fiscal effect in combination are zero, which is a relatively generous assumption in our view, underlying final demand growth would need to accelerate by more than 1 percentage point to reach even our 1½% growth pace for real GDP growth.

Nevertheless, most official and private forecasters still expect trend or above-trend growth.  Last week’s FOMC statement noted that “…the Committee anticipates a gradual return to higher levels of resource utilization…,” which we interpret as growth of around 3% coupled with a modest decline in the unemployment rate to 9% or a bit below over the next year.  And according to the August 2010 survey by Blue Chip Economic Indicators, Inc., the average private-sector forecaster still expects real GDP growth of 2.4% in the third quarter, 2.7% in the fourth quarter, and 3% in 2011 (on a Q4/Q4 basis), as well as a drop in the unemployment rate from 9.5% now to 8.8% at the end of 2010.  We believe that the GDP forecasts will need to fall by at least 1 percentage point and the unemployment rate forecast will need to rise by at least 1 percentage point.  As we discussed recently, such GDP revisions are likely to trigger downward revisions to the consensus forecast for corporate earnings toward our strategists' more cautious views (see Andrew Tilton, "Reconciling 'Micro' Strength with 'Macro' Weakness," US Economics Analyst, 10/32, August 13, 2010).  They are also likely to persuade the Federal Reserve to resume large-scale asset purchases or engage in other forms of "unconventional" monetary policy.

Will the economy in fact return to a technical recession, marked by declines in real GDP?  As explained recently, we think the odds are still against such an outcome (see Ed McKelvey, “Private-Sector Insurance against a Double Dip,” US Daily, August 12, 2010).  This is mainly because several components of economic activity that usually help drag the economy down during recessions have already suffered large hits and are unlikely to fall much further, if at all.

Despite this, we continue to believe that the risk of a renewed technical recession—defined as a return to quarter-on-quarter declines in real GDP—is an uncomfortably high 25%-30%.  In our view, this exceeds the likelihood of the trend/above-trend growth scenario envisaged in the consensus forecast.

Looking a bit further afield and toward mid-term elections, I liked the following summary from FRBC.  Bold is again my own emphasis.  (And it’s also worth wondering if last night’s Democratic primary win for Kendrick Meeks here in South Florida over billionaire Jeff Green foreshadows a coming theme…the victory of a “Main Street” Democrat over a guy many view as a “Wall Street” fatcat…)

            Election Preview: Seeds of a Revolution?

For the first time, President Obama’s job approval dipped into the “low 40s,” which we view as the threshold at which Republicans have a greater-than-50% likelihood of retaking control of the House of Representatives. Investors are increasingly beginning to consider the possibility that Republicans will net the 39 seats needed to have a majority in the House and to provide a check on President Obama and the Democrats’ agenda in Congress. However, Republicans face serious structural challenges to winning control, including strong Democratic fundraising, strong core Obama support, and candidate-quality concerns. The attached report examines the factors that will drive the 2010 House elections.
            Key Points

·                     Midterms are about the President. Midterm Congressional elections tend to serve as a referendum on the President. In the post-war era, Presidents with approval ratings below 50% have lost an average of 36 seats in the House. Obama’s approval rating has reached dangerous lows. Despite the President’s declining popularity on Wall Street, we note that his core support kept his job approval in the mid to high 40s through the early summer. According to the Gallup survey, President Obama’s approval rating dropped to a record-low 42% for the first time in the August 12–14 polls. Our review of the past dozen midterm elections shows that an approval rating of 42% or lower could lead to a net loss of 39 House seats for the President’s party. The President appears to have been hit hard by the so-called “Ground Zero Mosque” controversy. We will watch closely whether the latest Gallup results were a late-summer blip or the beginning of a more serious trend.

·                     Top-line numbers may hide more serious declines. Despite modest total job approval numbers, the President suffers much lower approval with groups more likely to be key midterm voters. The President faces much more significant approval gaps among older voters, white voters, and more affluent voters who are more likely to vote in midterm elections.

·                     Intensity is on the side of Republicans. Among voters who say that they have the most interest in the midterm elections, Republican Congressional candidates enjoy a double-digit lead. Nearly half of all Republicans say that they are “very enthusiastic” about the midterms, compared with about one-fourth of Democrats.

·                     Swing voters are leaving the President. The President’s approval rating with crucial independent voters also dropped to a record-low 39%. Republicans also enjoy a double-digit lead on the generic ballot, with 35% of independents saying they would vote for the Democrat and 46% for the Republican.

·                     Dollar signs of optimism for Democrats. Despite challenging trends, Democrats enjoy a number of advantages. Control of Congress has helped the Democrats maintain a significant fundraising advantage. Heading into the third quarter, the Democratic Congressional Campaign Committee (the campaign arm of House Democrats) holds more than $35 million, compared with just $22 million for the National Republican Congressional Committee.

·                     There are few swing seats for the taking. In order for Republicans to win the House, they would need to win a net of 39 seats, taking the six likely takeovers and 33 of the 37 too-close-to-call Democratic seats without losing any Republican seats. Among the bright spots for House Democrats are four seats currently held by Republicans that are likely to be won by Democrats this fall. These include historically Democratic seats in Hawaii and New Orleans, Louisiana, as well as open seats in Delaware and Illinois. Congressional Democrats like to point to these four seats as an additional firewall they have built to maintain their majority in the House.

·                     Multi-way primaries will take their toll on Republicans. Despite the importance of national trends, we note that candidate quality is also crucially important. The opportunity to unseat Democrats has lead to large bruising multi-way Republican primaries. Republican nominees will emerge from this contentious process with damaged images and depleted war chests. Moreover, the swelling Tea Party movement is producing Republican primary winners who are not the preferred groomed candidates of the Republican establishment. These unpolished politicians increase the risk of gaffes that could cost the GOP seats that they should win. Even when the establishment candidate wins, the presence of a Tea Party candidate has forced a number of candidates to move further towards the right than they would have wanted to win their primaries. This will make it harder for these candidates to attract swing voters during the general election.

·                     Most likely outcome: a narrow majority for either party. At this early stage, the most likely outcome is a narrow majority for either House Democrats or Republicans. Either scenario would severely compromise the President’s agenda. Republicans have shown a much greater ability to hold ranks with narrow majorities and attract conservative Democrats in Congress. On the other hand, Congressional Democrats have a broader coalition and have demonstrated difficulties passing controversial measures without losing a number of their Members.

BERN lowers MDT target.  TOL earnings surprise to the upside.  BofAMLCO ups WIN.  BCAP ups TSP.  JMPS ups QSII.  OPCO ups ORCC, GLW.  JMPS cuts NLY.  MSCO cuts D, PEG.  WEFA cuts MDT.  PCX COO resigns.  PSUN lower on earnings.  VECO buyback. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 

Today’s Trivia:  Remember Ted Kaczynski?  Why was he known as “The Unabomber?”

Yesterday’s Question:  A little business trivia this morning…in 2009, the airline industry collected roughly $5.1 billion from what two fees in particular?
Yesterday's Answer:  In 2009, the airline industry collected $2.7 billion on baggage fees and $2.4 billion on ticket change fees. 

Best Quotes: 

Morgan Stanley - Fixed Income Research  
Sovereign Risk Analysis 
Primary Analyst: Arnaud Marès 

August 25, 2010 

Sovereign Subjects: Ask Not Whether Governments Will Default, but How
This is the first issue of Sovereign Subjects, a new Morgan Stanley publication focusing on sovereign risk in advanced economies. In this first installment, we take a broad perspective on government balance sheets and raise several themes to which we will return in more depth in subsequent issues. We encourage clients to provide us with feedback on this new publication. 

Debt/GDP ratios are too backward-looking and considerably underestimate the fiscal challenge faced by advanced economies’ governments. On the basis of current policies, most governments are deep in negative equity.  

This means governments will impose a loss on some of their stakeholders, in our view. The question is not whether they will renege on their promises, but rather upon which of their promises they will renege, and what form this default will take. 

So far during the Great Recession, sovereign (and bank) senior unsecured bond holders have been the only constituency fully protected from partaking in this loss. 

It is overly optimistic to assume that this can continue forever. The conflict that opposes bond holders to other government stakeholders is more intense than ever, and their interests are no longer sufficiently well aligned with those of influential political constituencies. 

There exists an alternative to outright default.  ‘Financial oppression’ (imposing on creditors real rates of return that are either negative or artificially low) has been used repeatedly in history in similar circumstances. 

Investors should be prepared to face financial oppression, a credible threat against which current yields provide little protection.