Wednesday, November 3, 2010

Morning Note...

Futures are flat this morning as Republicans take control of the House, gain five seats but fail to take the Senate, and markets await the 2:15pm FOMC statement.  Expectations are all over the place for the size of quantitative easing to be announced, but experts are universal in their expectation that some form of renewed asset purchases from the Fed Reserve will be announced.  Regarding the Republican gains, yesterday’s elections represent the most political territory gained since 1948.  In other words, the pendulum has swung fairly hard.  Markets are certainly behaving – for the moment – as if the GOP gains were priced in…although more Senate gains may have been expected.  Not much to say today as the FOMC decision moves to the fore of the global economy and certainly mutes any corporate news of note.  On that topic, however, BP was upgraded at GSCO.  Anheuser-Busch In Bev (BUD; -3%) is lower on earnings.  Hartford Financial (HIG; +5%) beat earnings estimates and raised guidance.  Note that the BofE and ECB rate decisions are due in the early morning hours tomorrow.  Official nonfarm payrolls and unemployment data due on Friday morning.  Asia mixed overnight.  Europe flat.  USD +17bps.  Oil +55bps.  Gold -30bps.

In terms of commentary, I will leave it in the capable hands of Mike O’Rourke of BTIG (last night’s note) and former Brightpoint analyst Daryl Jones of Hedgeye (this morning’s note):

QE2 Setting Sail.

Tomorrow is D-Day for the next wave of monetary policy.  Many in the global investment community might refer to it as "Debasement Day" and that still appears to be the prevalent attitude in the marketplace.  We are not in the debasement camp.  We believe that, at a minimum, the theme has been overplayed in the short term.  The interest rate hikes by the Reserve Bank of Australia and the Reserve Bank of India only fueled the drubbing of the Dollar.  The Dollar index is down approximately 5% since the August 10th FOMC meeting when the Fed began to reverse the Quantitative Easing exit strategy.  To put that move in perspective, from November 25, 2008 until March 31st of this year, which was the duration of QE1, the Dollar index lost 4.6%.  Many will recall that during the start of QE1, the Dollar was the recipient of a notable flight to quality bid.  One could argue that some Dollar weakness during QE1 was the result of the flight to quality bid dissipating from the currency.

The purpose of Quantitative Easing is to expand the monetary base and thus create a supportive environment for money supply creation.  Had the Fed allowed a contraction of money supply, it would have been a replay of one of the key mistakes of the Great Depression.  Many will remember that the initial expansion of the Fed's Balance sheet was not the result of QE1, but the many emergency facilities the Fed created to provide various forms of liquidity to different markets that froze up.  Market participants will also recall that the Dollar rallied during this balance sheet expansion as the result of a flight to quality bid.  The Fed's emergency facilities were constructed to self-sunset as markets normalized.  Fearing that the automatic liquidation would create a drain on the Monetary Base, the Fed unveiled QE1 to handle the transition from the short term liquidity of emergency programs to longer term liquidity that could be drained as recovery unfolded.  During the weakness of Q1 2009, the Fed upped the ante by $1.1 Trillion in March to bring the eventual size of the program to just over $1.7 Trillion.  Although fears about debasement existed, they seemed remote in the near term as most hoped to avoid a depression.  Today, with the economy on sounder footing, debasement and inflation have become the fear.

We certainly agree that the expansion of the Monetary Base creates a significantly greater risk of inflation in the future, but to us, the market's adjustment process has gotten ahead of itself.  During QE1, the overwhelming majority of the liquidity injected has found itself parked back at the Fed in the form of $1 Trillion in excess reserves that banks are still uncomfortable lending.  To achieve the sustained inflation/debasement/devaluation the market appears so intent upon receiving, the economy needs to recover so that the banks lend the money and that $1 Trillion in excess reserves begins to make the conversion into money supply.  To use QE1 as an example, M2 Money Supply had its strongest year over year growth as result of the Fed's emergency programs.  As QE1 took the handoff from the emergency programs, year over year M2 growth declined.  Currently, M2 growth has improved to 3.3%, which is the low end of the decade long pre-crisis range of 3.3% to 10%.  The irony of this entire situation is that for the feared inflation to materialize in the period the market seems to have priced in, the worst acting sector of the S&P 500 during the past year (Financials) needs to start lending voraciously.

The safe bet for tomorrow is announcement of a $100 Billion per month, with a 3-month commitment, then revisiting, and of course promising more if necessary.  That still seems a touch aggressive from our perspective considering economic data has been improving, but once again the Fed has put itself in a position of not wanting to disappoint.


"We must all strive to find common ground to support the middle class, create jobs, reduce the deficit and move our nation forward."

-Nancy Pelosi, November 2nd, 2010

While it will take many days for the final tallies to come in, it looks like our prediction will hold and that massive Republican turnout has driven a net gain in House seats of 65+ for Republicans.  According to Nate Silver over at the FiveThirtyEight blog (one of the more accurate electoral statisticians we follow):

"Our current projection is that Republicans will finish with a total of 243 house seats: this would reflect a net gain of 65 from Democrats. The range of plausible outcomes is fairly small: our model thinks there is roughly a 90 percent chance that the G.O.P.'s total will eventually be somewhere between 64 seats and 66."

As it relates to our prediction in the Senate, we were off slightly as a number of major Democratic candidates did marginally better than expected, in particular Harry Reid in Nevada.  Currently, Alaska, Colorado, and Washington are still too close to call, but even if these States all go Republican the Democrats will still retain at least 51 seats in the Senate.  Nonetheless, the Democrats should lose a net 7 seats.

Since it seemed statistically unlikely that the Republicans could take the Senate, the story of the night is really the massive seat losses in the House.  To put it in historical context, this will likely be the largest seat loss in a midterm election for any party since 1938 under President Roosevelt, when the Democrats lost 72 House seats and 7 seats in the Senate.  Clearly, the electoral results today are indicative of a strong statement being made by the American people.

The obvious conclusion from these results is that this is a repudiation of the Obama agenda.  While we would be na├»ve to not agree at least partially with that, more broadly this looks to be a referendum on politicians themselves.   To wit, given a historical incumbency advantage of almost 90%, the last three congressional elections of 2006, 2008 and 2010 have shown accelerated volatility of incumbent losses.  Specifically, in 2006 the Democrats gained 30 seats in the House, in 2008 the Democrats gained 22 seats, and in 2010 the Republicans will likely gain back 65 seats.  In a span of four years, we have seen massive volatility between the parties and the relative support from the electorate.

The chart of the day, which is posted below, underscores the key reason why this occurring.  This chart highlights broad congressional approval.  Currently, 73.8% of voters disapprove of Congress!   If you were a professional politician yesterday and didn't understand the implications of that yesterday, today you do in spades. 

We've used a quote from Nancy Pelosi at the top of the note today to further emphasize our point regarding the popularity of professional politicians.  While Pelosi retained her seat, her approval rating across the country as Speaker of the House was 29% heading into yesterday's election.  Her brief statement last night, assuming it is not just rhetoric, is actually what politicians collectively need to work towards for this nation.  More broadly, the message this morning is clear from Americans, they are tired of rhetoric. 

While the Republicans will take a few victory laps over the next few days, the gauntlet is now thrown to them.  They have been given at least a nominal agenda and the next two years will be a test as to whether they can work with the President to move the country forward.  The questions we would ask are: what is next for monetary policy, what can be done about the burgeoning budget deficit, and how can we address the escalating sovereign debt situation of the federal government?  As Paul Rand stated in his victory speech last night:

"When I arrive in Washington, I will ask them, respectfully, to deliberate upon this. We are in the midst of a debt crisis and the people want to know why we have to balance our budget - and they don't."

To take a deeper dive on some of these questions and to test the mettle of the rhetoric we will be hearing over the coming weeks, Keith and I will be hosting a call next Wednesday November 10th at 1PM with Peter Orszag, former Director of the Office of the Management and Budget.  This call will be a similar format to the one we held with our friend Karl Rove in September.  Peter will present for 20 - 25 minutes and he will then take questions for the duration of the call. 

If there is anyone in the nation who understands what can and cannot be done to reduce the budget deficit, it is Peter Orszag.  If you would like to join this call and are an institutional subscriber, or would like to trial our institutional service for the call, please email Jen Kane at  The budget deficit is one of the most pressing economic issues facing the United States; therefore we think this call will be a valuable use of your time.

To Rand's point in his victory speech last night, the people of America are asking a lot of questions.  The next two years will be a test as to whether the professional politicians are finally ready to answer the people with more than rhetoric. Needless to say, our Hedgeyes will be watching.

Yours in risk management,

Daryl G. Jones

Managing Director

BofAMLCO ups ERJ.  CITI ups KSP, PPS.  FBRC ups OFC.  CITI cuts EOG.  DBAB cuts MRO.  JEFF cuts FDP.  CQB lower on earnings miss.  EOG lower on earnings.  ERTS beats by 20c.  GRMN misses by 5c.  HCP to offer 10M shares.  HYC beats by 8c. OPEN beats by 8c.  PWR reports in-line.  SONS lower on earnings.  STO lower on earnings.  WYNN reports in line.  MA tgt raised at DBAB. 

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

Today’s Trivia:  What percent of globally mined salt is used on American roads each winter?
Yesterday’s Question:  Name the U.S. state with the shortest ocean coastline.

Yesterday's Answer:  New Hampshire has the shortest ocean coastline.   

Best Quotes:  from the MSCO FX desk…”The midterm coverage is about half the papers with dozens of headlines along the lines of Obama dealt a tough hand, a GOP surge and Tea Party comes to power.  The peripheral stress theme remains a front-page story and QE2 is finally here.  Meredith Whitney published a bearish op-ed in the WSJ on state finances calling “the level of complacency around this issue alarming.”   She wrote that states are already desperately dependent on federal assistance (with many of these programs expiring soon) and without BABS which provides a 35% subsidy on interest expense (paid by the federal government) states like California, Illinois and Nevada “might have already reached some type of tipping point…”   A WSJ editorial ‘High rollers at the Fed’ highlighted the increased risk a $2.1T balance sheet creates warning of a losses if rates rise but put the Fed’s gains in context, in fiscal 2010 the Fed was +$76B, a third of the $192 billion that the corporate income tax raised in fiscal 2010!  The FT ran a story ‘Emerging markets braced for flood of new money’ as QE2 will lead to QT2 (quantitative tightening) as EM countries such as Brazil, Indonesia, South Korea and others will continue to look to slow portfolio inflows.”