Thursday, September 30, 2010

Morning Note...

Happy month- and quarter-end… Futures surge ~50bps higher this morning on the better-than-expected, positive Q2 GDP revision (+1.7% vs the 1.6% prior reading) and better-than-expected Initial Jobless Claims for the week ending September 25th:  453,000 versus the 460,000 expectation.  Note the prior week’s reading was revised higher, however, to 469,000 from 465,000.  Markets are also buoyed by stability in Europe, where Ireland disclosed the terms of its bailout of AIB (~EUR35 billion) in order to restore its banking sector.  Moody’s also downgraded Spanish debt and Germany’s unemployment fell less than expected (net positive) as Europe is up ~75bps on aggregate.  Asia mostly lower overnight.  Oil +2%, gold +35bps, and the USD -35bps.  In corporate news, AIG has reached an agreement to sell two divisions to PRU for $5 billion and will use the funds to repay the U.S. government TARP.  CITI downgrades food distributor SYY.  BofAMLCO positive on “BRIC nations and equities” as global reflation takes hold; cautious on JapanChicago PMI due at 10am.  Bernanke testifies before the Senate today, but it will be a non-event because his statements will be back-looking rather than forward. 

Given the news overseas today, it’s worth checking in on some recent thoughts from The Gartman Letter:

Out of Ireland this morning is the news that the Irish government has no choice but to come to the aid of Allied Irish Bank which has had enormous trouble raising the capital it needs to meet demands upon it for increased capital by the international banking authorities. The government in Ireland had previously taken a type of “preferred shares” in the bank, and now in light of the fact that the Bank cannot raise capital itself is forced to ask the government to convert those preferred shares into common shares. Somehow we cannot see this as supportive of the EUR, but then again we’ve known that this sort of thing was going to happen sooner or later and few seemed to care previously, taking the EUR higher nonetheless. Eventually, however, harsh realities have to have harsh effects… don’t they?

He also had this to say on Gold:

Further, each request for an interview begins by asking us, generally, “How much higher can gold go?” The question is also asked enthusiastically, with a sense of gold market fever. As we’d said here yesterday, historically this level of questioning by the media has always in the past marked an interim top in gold. This sort of thing happened back in December of last year; it happened again in the late summer and it is happening again. In December, gold broke $170/ounce and in the summer it broke $100/ounce. We can imagine, given this level of media interest, that gold prices could readily break $60-$80 from their recent highs and do absolutely nothing the efficacy of the long term bull market. Indeed, a break of that magnitude would do nothing other than return the market to a sense of technical health. At the moment, it is technically over-extended and rather markedly unhealthy as a result.

To this end, we have read reports suggesting that we have suddenly turned manifestly bearish of gold and that we are suggesting being short of gold. We are recommending nothing of the sort. We note that this remains a bull market and we suggest strongly that six months hence or a year hence gold shall be demonstrably higher in price than it is now. We note that this remains a bull market and that in bull markets one can have only one of three positions: Very long; modestly long or neutral. At this point we shall suggest something nearer to the latter two positions. This, unless our language is somehow misleading, is far from being bearish. We trust we are clear on this issue.

When asked what has driven gold prices higher we’ve turned to the thesis that at the margin the world’s central banks have gone from being net sellers of gold from their reserves to being net buyers. The operative words here are “at the margin” for that is indeed what has been happening. The Central Banks had been concerted sellers of gold for years; now they are modest net buyers. We note then that in the year ending September the banks that were signatories to the Central Bank Gold Agreement have sold only 6.2 tonnes of gold in total. In previous years they were selling that much each week! Now, after a bit of selling earlier in the fiscal year, their selling has stopped completely. As The FT recently noted

the[se] sales are the lowest since the agreement was signed in 1999 and well below the peak of 497 tonnes in 2004-05. The shift away from gold selling comes as European central banks reassess gold amid the financial crisis and Europe’s sovereign debt crisis. In the 1990s and 2000s, central banks swapped their non-yielding bullion for sovereign debt, which gives a steady annual return. But now, central banks and investors are seeking the security of gold.

Remember, this Agreement was signed back in ’99, and for the decade since the Banks have been steady, aggressive sellers… until this year.

AIB -25% on EUR5 billion capital raise.  AIG to sell two divisions to PRU for $4.8 billion and use the funds to repay the U.S. Government.  RBCM ups BBY.  DBAB cuts MO, RAI.  RBCM cuts AAP.  CVD and SNY sign 10-year R&D alliance.  DB CEO makes positive comments.  MTW to refinance senior secured credit.  NEED cuts N.  NOK N8 smartphones ship.  OMN lower on earnings.  Cramer positive LLNW.  OPLK to replace LNY in S&P600.  SNX beats by 12c.  TLAB cut at MOKE.  XRTX beats by 20c.  YRCW board approves labor agreement and reverse stock split. 

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

Today’s Trivia:  According to an NPR story yesterday, who is the largest employer of musicians in America?

Yesterday’s Question:  Name the only country to have a capital named after an American president.

Yesterday's Answer:  Liberia’s capital is named Monrovia, for U.S. President James Monroe.   

Best Quotes:  From BTIG’s Mike O’Rourke… These days, the theme on the minds of traders and investors is the return of the reflation trade that was so dominant throughout 2009 as the Fed executed its large scale quantitative easing program.  Since August 10th when the FOMC put the brakes on the exit strategy but then subsequently indicated it would reverse course and open the door for a second round of quantitative easing (QE2), signs of the reflation trade materialized.  We have been hesitant to look at the market from a reflation perspective because we anticipate that QE2 will look very different from QE1.  The key way we have described QE2 is that the Fed would use asset purchases and sales in the same manner as it has historically used the Fed Funds rate.  For example, if the economic data were to weaken notably, the Fed would pick up the pace of asset purchases.  Likewise, if the economic data were to ramp up (although nobody believes that is about to happen in the near future), the Fed would start making asset sales.  Due to the obvious soft patch in the economy over the past several months, the market is widely focused upon the potential for asset purchases.  Whether or not purchases are made is conditional upon the severity of developments within the economy.  The greater the weakness, the more assets will be purchased.  The more mild the weakness, the less the Fed will do.  It will be notably different than the process during QE1 where purchases were consistent over a set time period with few adjustments.

The market's expectations for QE2 are currently fairly large due to the weak expectations about prospects for the economy.  We are in a data dependent environment.  There are only signs of the reflation trade because only certain asset classes are responding.  Theoretically, assets like Equities, Gold and Crude should rise.  Bonds will have a bid near term, pushing yields lower as players try to get ahead of the Fed.  The Dollar should suffer as the monetary base is expanded in hopes of an expanding money supply.  Since the August 10th course reversal, Gold has rallied 8.5%, the 10 year yield has dropped 25 basis points and the Dollar index has lost 2.5%.  Those are all acting as one might expect in a reflationary environment.  Equities have gained 2.1%, they are up but not even enough to offset the losses of the Dollar.  Finally, the missing link is Crude.  Even after today's rally, Crude is down 3% since August 10th.  Additionally, the solid performance from Crude today was the result of a fundamental catalyst in the form of DOE inventory data, not reflation.  Even if we expect the reflation today, the process should be different than the approach of  consistent asset purchases over the span of just over a year.  We will describe what we suspect is going on.  We know others will have a different view so please take this as simply one opinion.  We are of the view that the comfortable reflation trades are being put on in a speculative manner. In this environment, it is easy to justify buying Gold and Treasuries and selling the Dollar, so that is where the speculative momentum is headed.  Those are positions that managers can sleep with and are likely getting a little crowded, at least until we see what QE2 really looks like.  Stepping into Equities and Crude does not feel as easy or comfortable, therefore, they are not getting the attention.  If reflation is the true catalyst behind the action, than Equities and Crude should participate as well.  The divergence illustrates that either the three that are working need to consolidate their recent moves or the other two should join the party.