Author Archive for BondSquawk

Technicals on Tens – Recent Breakpoints to Rally

By Rom Badilla, CFA, Bondsquawk

Despite accommodative monetary policy via QE3, yields on U.S. Treasuries remained range bound where buyers and sellers were indecisive on the direction of the market. However, with the latest weakness in risk assets as market watchers point to uncertainty surrounding the Fiscal Cliff, yields have broken below this sideways trend in a flight-to-quality bid and may challenge the recent lows.

As you can see in the chart below, with the yield falling 10 basis points to 1.65% on the day following the election, the 10-Year U.S. Treasury broke below the recent sideways trend. That break led to a rally where the yield reached to an intraday low of 1.55% on November 16 which is near the low set in late August. Since that probe lower, the benchmark note has retraced and sold off to the 50% retracement of the October-November rally and the former resistance of 1.69-1.70% which now acts as support in the sideways trend-line.

Technicals on 10-Year U.S. Treasury

Given the action on Friday, support at 1.70% has held and it appears that buyers for the safe-haven asset have re-emerged to start the week with the 10-Year lower by 5bps. A sustained trade below that support line may lead to another test for the late August low. Hence, Treasury Bulls would target an 11bps drop to 1.54% with a Stop-Loss above 1.70%.

The current 10-Year pays a 1.625% Coupon Maturing on November 15, 2022 (CUSIP #912828TY8) and is trading at a dollar price of $99.77 which translates to a yield of 1.65% according to Trade Monster’s Bond Trading Center. In this bullish scenario, the price of the bond would appreciate to $100.77 or a gain of 1.1%. (As mentionedpreviously, an investor can own up to 10 times the amount of Treasuries for each amount of initial capital so performance can be amplified up to an equal amount. In addition, an investor can increase their exposure by using a bond with a greater duration such as the 30-Year Treasury or a U.S. Treasury Strip, aka Zero Coupon Treasuries.)

Furthermore, momentum below the August low would open the door for a retest of the all-time low of 1.38% set in late July.

Another key indicator that is noteworthy is the divergence between inflation expectations and copper prices. Inflation expectations which are a key component of Treasury bond yields have diverged from copper prices recently. Inflation expectations aka “break-evens” which are defined as the yield differential between the 10-Year U.S. Treasury and the 10-Year TIPS (Treasury Inflation Protected Securities) have for the most part, remained lofty. Generally speaking, higher inflation means rising bond yields and vice-versa.

On the other hand, copper is often viewed as a leading indicator of economic growth. Falling copper prices suggest that demand for the base metal, which is used in many sectors of the economy, is declining. While far from being infallible, this in turn may mean slowing economic growth. De-accelerating economic growth typically suggests falling inflation expectations and thus lower bond yields.

As you can see in the chart below, the two indicators generally follow one another. That is, up until mid-October where the two key indicators diverged. According to Bloomberg, copper prices have collapsed close to 6% from the mid-October highs. During that time, inflation expectations have dropped just 10 basis points. If this relationship were to hold and the correlations were to re-align, these two indicators should converge.

Copper Prices & Inflation Expectations

Given the recent string of weak economic data around the globe such as many of the Purchasing Managers Indices falling below or staying near the threshold between contraction and growth, one would think that the fall in copper is justified. Hence, re-alignment between copper and inflation expectations may come with the latter dropping. Again, lower inflation expectations should lead to lower interest rates and add another tailwind to the backs of Treasury Bulls.

The other side of the coin is that a sustained trade above the aforementioned support level of 1.70% coupled with strength in risk assets, could push the yield higher. This in turn may lead to an opportunity for Treasury Bears and a reversal to a short position. The yield on the 10-Year Treasury would find support at the falling 200-day moving average of 1.77-1.78%. Buyers may emerge here but a break above that may lead to a test to 1.82%.

Cautious Money Managers Create Further Downside Risk as Fiscal Cliff Nears

By Rom Badilla, CFA, Bondsquawk

As a follow up to yesterday’s article Stocks Further to Fall if Bond Yields Have Their Say, here is another tidbit of information that may keep the equity and other risk asset bulls up at night.

According to Deutsche Bank, equity fund managers have lowered their exposure to risk assets on concern of the Fiscal Cliff. In their Asset Allocation: Investor Positioning and Flows report released on November 12, 2012, the strategist team led by Binky Chadha wrote the following:

On the heels of the US election, fund managers have gone very underweight risk assets as concerns about the fiscal cliff intensify. Our measure of overall equity positioning (composite beta) is near three year lows after hitting a high just a month ago.

Beta is a measure of portfolio exposure in relation to the market which for many fund managers is the S&P 500. So a measure of 0.0 means that their portfolio will have little correlation with market performance while a positive Beta means it should follow it closely. Conversely, a negative Beta means it should do the exact opposite of the market.

As you can see with the graph, the Composite Equity Beta is well into negative territory suggesting that fund managers are negative on stocks. If the situation with the Fiscal Cliff escalates further, you can expect less support from fund managers until they switch their stance on their portfolio positioning. The consequences could mean a sharp selloff if an impasse becomes visible.

In regards to the bond markets, further weakening in stocks should be positive for U.S. Treasury prices where bond yields fall even lower. Last year’s debt ceiling debacle provides a blueprint for what to expect with U.S. Treasury yields.

On June 22 2011, the 10-Year was trading at 3.01%. On the following day, the debt ceiling discussions made a turn for the worse when an impasse in talks between both Democrats and Republicans failed to agree on proposed tax and spending cuts.

When a deal was reached on the debt ceiling to avoid a technical default at the end of July 2011, the 10-Year was trading lower at 2.77%. When Standard & Poor’s Credit Ratings downgraded the U.S. from ‘AAA’ to ‘AA’ on August 5 2011, the 10-Year yield fell further to 2.40%. So from the end of June to the beginning of August of last year, yields dropped more than 60 basis points on a flight to quality bid toward safe-haven assets.

While Treasury yields may rally in such a scenario, lower rated Corporate Bond yields may not. Again, history can be used as a guide.

The Barclays U.S. High Yield Bond Index took a major beating during this time period. Near the onset of the debt ceiling crisis on June 22, the credit spread or yield differential between the High Yield Index and U.S. Treasuries was at 5.49% or 549 basis points. On August 3rd, that credit spread widened to 573 basis points. When Standard & Poor’s downgraded the credit rating of the U.S., High Yield credit spreads gapped to 609 basis points on August 5th. The bleeding didn’t stop for High Yield as sellers emerged well afterwards as the credit spread reached 670 basis points on August 8th to a peak of 725 basis points only three days later. So from beginning to end, the credit spread on High Yield widened by 146 basis points.

Suffice to say, the price for the High Yield index fell as yields failed to keep pace with falling Treasury yields. Over the course of both July and August, the Barclays U.S. High Yield Index lost 6.48% relative to their U.S. Treasury counterparts.

Whether its Equities or High Yield bonds, risk assets will fall if leaders fail to reach an agreement on the issues surrounding the Fiscal Cliff. The equity fund managers have positioned their portfolios to reflect this view. If pressures begin to mount due to further escalation of an impasse, you can bet that risk assets will have little support. At that point, I wouldn’t be surprised to see equities tumble and yields on lower rated corporate bonds to rise since falling off the Fiscal Cliff will most likely lead to an end of the current recovery and into a new recession.

Household De-leveraging: Light at the End of the Tunnel

By Rom Badilla, CFA –

Despite massive amounts of federal and monetary stimulus and much to the chagrin of policy makers, the recovery following the financial crisis has been lackluster with modest gains in economic growth and in job creation. Consumer spending, which comprises close to seventy percent of GDP, has failed to capture its former glory of the boom as households continue to repair balance sheet and pay down debt. This deleveraging up to this point has been holding back consumption and in turn has been a headwind for economic growth. Going forward, this should no longer be the case.

Deutsche Bank economists, Brett Ryan and Joseph LaVorgna, stated that the U.S. deleveraging cycle is past the midway point which suggests that the recent gains in household debt profiles should be a positive development for the U.S. economy going forward. In their latest U.S. Economics Weekly, they wrote the following:

To be sure, this deleveraging has likely had a depressing effect on the pace of economic activity. Over the past few years, the economy has grown at about half of its historical pace of 4% annualized real GDP growth. Household debt as a percentage of nominal GDP peaked at 97.5% in Q2 2009 and in absolute dollar terms, household debt peaked in Q1 2008 at $13.8 trillion. Since then, debt outstanding in this sector has declined -6.3% (-$880 billion) and at 83% it now stands at its lowest share of GDP since Q4 2003 (82.9%). This marked the early stage of massive debt expansion. In fact, debt has increased in two out of the last three quarters. Clearly, households have made significant progress in making necessary balance sheet repairs. Provided that income growth improves, households may actually begin to modestly increase their absolute amount of debt.

In addition, they wrote that debt in proportion to other measures should continue to decline and may in fact reach more “normal” levels within the next few years assuming modest assumptions.

If we assume the current average pace of household deleveraging (approximately -0.1% per quarter over the past four quarters), and assume approximately 4.0% nominal GDP growth over the next two years, household debt to GDP would intersect its long-term trend line by Q2 2014. As an aside, the story is broadly similar when comparing household debt to gross disposable income. This ratio has declined from a peak of 125% in Q2 2007 to 106% as of Q2 2012—the lowest level since Q2 2003 (105%). Again, this is a dramatic improvement, returning the level of household debt to income back near pre-credit bubble readings.

The latest Retail Sales figures support that the consumer is gaining traction and is spending again. This contrasts with signs that Business Investment which is another integral component in economic growth, is declining as the uncertainty surrounding the Fiscal Cliff approaches. It remains to be seen if the consumer follows suit in anticipation of the potential for the higher tax burden. Having said this, it is apparent that beyond the short-term, consumers will be less encumbered by balance sheet repair given the strides made in debt reduction over the past several years. Coupled with improving conditions in credit and the rebound in housing, consumer spending could provide the tailwind toward better economic growth in the months and years ahead.

RBC: Why the USA Will Remain Dominant Vs China

By Rom Badilla, CFA, Bondsquawk

Critics point out the tremendous amounts of debt and political dysfunction as major headwinds toward long term economic prosperity for the U.S. With massive amounts of debt incurred from two wars and the bailouts stemming from the financial crisis coupled with the lack of political will to address it, the U.S. faces an uphill battle in maintaining its position in the economic balance of power.

Despite this, the U.S. can still regain its stature as an economic power according to RBC Capital Markets Global Macro Strategy Team. In the report released on their website, “Connecting the Dots”, the U.S. has the ability to survive and prosper through its improving Demographics, its Dominance through innovation and its move toward Drilling and energy independence. These main factors should help drive a wave of growth for the U.S. in the coming years.

The Global Macro Team believes that demographics will be a positive development for the U.S. while at that same time should be a headwind for China. Specifically, the working-age-population between the two economies will start to diverge:

Using China as a proxy for the discussion, in 2017 the working age population in China begins to trend down while the working age population in the U.S. continues to rise (see Figure 3). It is quite possible that many countries like China respond to their weakening demographics by utilizing more automation within many of their manufacturing operations. This is already occurring at Foxconn, the main manufacturer for many of Apple’s products, which is beginning to implement the utilization of production robots within its factories. This move toward more manufacturing automation provides two main benefits: 1) efficiency and 2) lower cost to produce. This trend will only exacerbate the increasing levels of unemployment due to the workers displaced by the mechanization of off-shore manufacturing facilities. Automation does not occur overnight and currently wage growth in many of the off-shore manufacturing countries is increasing.

In addition, the research team believes that dominance in innovation will result in offshore jobs moving back to the U.S. The main impetus for this is the fact that wage growth in China is accelerating dramatically. In fact, RBC’s economics team believes that if this trend continues, they see Chinese wages to equal that of the U.S. by 2024. Here, they explain the implications:

When you see a “Made in China” stamp on a product, lower cost production comes to mind. The Chinese manufacturing complex is not doing anything elegant or innovative other than beating the G20’s manufacturing problems over the head with sheer numbers of workers who provide cheap labor to complete mainly repetitive tasks. The problem is that the Chinese “cheap labor” is not so cheap anymore. Looking at U.S. wages versus Chinese wages, we see that Chinese wages have risen rapidly, see Figure 5. Many U.S. companies are questioning the cost of doing business in China especially with the enormous increase in these costs. Current U.S. manufacturers that have facilities in China, will not have to wait until 2024 as their margins continue to be squeezed. Combining this with the cost of shipping of the product from China, and you have a very fertile environment to conclude that the U.S. will continue to repatriate many of its offshore manufacturing operations.

Finally, the Global Macro Team at RBC believes that developments in drilling should lead to energy independence for the U.S. which in turn should spill over into other industries. Specifically, they pointed out the significance of drilling in the Bakken and Marcellus shale oil and gas regions. Drilling activity in the Marcellus has increased by 7600 percent in a four year span beginning in 2007. The research team provided the following color on this development:

This enormous increase in drilling has had a direct impact on other industries. A recent article in the Wall Street Journal (WSJ), Steel Finds a Sweet Spot in the Shale, verified the thesis that what is “new again” is in fact old. The article stated, “the rising fortunes of a massive U.S. Steel Corporation plant in West Mifflin, Pennsylvania has much to do with what sits below it: massive deposits of cheap natural gas.” The Marcellus Shale deposit affects not only the influx of manufacturing to the U.S., i.e. re-emergence of the steel industry, but also its positive impact on margin enhancement due to increased sales of its end-product as well as the lower cost of one of the steel plant’s main input costs – natural gas.

Lower natural gas prices have had other unforeseen positive knock-on effects by creating a more robust manufacturing environment in the United States. If low natural-gas prices can be maintained, this will significantly enhance the competitive landscape of the U.S.’s manufacturing environment. “Companies that had left the U.S., in sectors like chemicals and fertilizers, are talking about coming back to take advantage of the low cost of gas,” said Don Norman, an economist for the Manufacturers Alliance for Productivity and Innovation.

Assuming it can overcome its inability to make definitive action on the political front and the massive amounts of debt in the next political cycle, prospects appear bright for the U.S. Changing demographics, dominance in innovation via a repatriation of jobs from abroad, and drilling should add to a wave of growth for the U.S. Through these channels, the U.S. should gain momentum toward regaining prominence as an economic power in the global marketplace.

Small Business Hiring Plans Are Declining

By Rom Badilla, CFA, Bondsquawk

Fueled by a drop in hiring plans, sentiment by small businesses in the U.S. failed to increase in September which suggests stalling of improvements in both the labor markets and the economy. The National Federation of Independent Businesses released the results of its Small Business Optimism which fell by one tenth of a point to 92.8 in September.

The lackluster reading failed to meet expectations as the median of economists’ forecasts was at 93.5. In addition, the lack of improvement is evident as the latest print continues to remain near its six month average of 92.9. With 691 firms responding to the survey, there were some noteworthy changes in the components that raise concern toward economic growth.

NFIB Small Business Optimism Index

The net percentage of business owners surveyed that are planning to hire in the next 3 months plunged to 4% from 10% in September. The component of the Small Business survey continues to remain weak at this point in the recovery from a historical perspective. With the September data which marks the 39th month of the current recovery, the six month average of the Plans to Hire component stands at 5.5%. Comparatively, the six month average at the same point in time in the recovery following the recession of 2001 was at 16.0%. Similarly, the Plans to Hire average following the 1990 to 1991 recession was at 11.5%. The net percent is defined by the NFIB as the number of firms reporting increases minus the number of firms reporting decreases.

NFIB Hiring Plans

In addition, small businesses owners are reporting less activity in business investment which coincides with the slowdown in other indicators. The net number of firms reporting Increased Capital Spending fell from 24% in the previous month to 21% in September. The six month average of this component is at 23%.

Other components were mixed. The net number of firms reporting Higher Selling Prices fell from 9% in the previous period to 6% in September. The decline suggests less demand as businesses are less likely to raise prices. The net number of firms showing a Plan to Increase Inventory was unchanged at -1%.

While the components were generally negative in September, the outlook for small businesses picked up according to the survey results. The net number of firms Expecting a Better Economy improved to 2% from -2% in August and -8% in July. While the September figure is barely positive, keep in mind that it is the highest reading since the first quarter of 2011. Also, the Good Time to Expand outlook index increased by three percent on a net basis to 7% in September and is now above the six-month average of 6%. The net number of businesses seeing Positive Earnings Trends picked up from -28% in August to -27%.

All in all, the sideways action in the Small Business Optimism Index may be viewed as a reflection of the muddle through economy. As mentioned earlier, small businesses are the backbone of the U.S. economy as they are a major part in the job growth machine. The drop in the employment components is a concern as job growth for the U.S. economy remains lackluster as evident by last Friday’s Non-Farm Payrolls. Despite this, the outlook for small businesses have improved and may pickup further if economic growth begins to accelerate. Of course, the European Debt Crisis and the Fiscal Cliff are major headwinds that may prevent that from happening in the months ahead. For now, today’s survey results are consistent with a slow growth economy. As a result, bond yields should remain low and capped for the time being.

According to Trade Monster’s Bond Trading Center, the yield on the 10-Year U.S. Treasury is at 1.71%, down 4 basis points from the previous close.

Credit Default Swaps Flinch as Bonds Play Chicken With Stocks

By Rom Badilla, CFA, Bondsquawk

Several days ago, we talked about the Federal Reserve’s intent of improving financial conditions by way of balance sheet expansion and QE. Their recent policy action is generally supportive of risky assets such as corporate bonds and equities. Since the announcement, spreads and equities have performed as expected.

Interestingly, not everything is right in the marketplace. With the re-emergence (again) of the European debt crisis with Spanish government bonds reaching 6%, the recent rally in equities has started to unwind. Conversely, the tightening in the spread for Investment Grade Corporates has not and has remained near tight levels.

Since the market closed at 1465.77 which is the most recent highest close set on September 14, 2012, the S&P 500 has fallen more than 24 points as Tuesday. This modest decline of 1.7% has led some to wonder if this is the end of the rally. During that time, the spread or additional yield over U.S. Treasuries of the Barclays’ U.S. Credit Index which is a proxy for high grade corporate bonds has remained the same at 144 basis points.

Big picture market thinkers know the interconnection between the corporate bond market and equities. Wider spreads leads to falling equity prices and vice-versa. Here, that relationship appears to have broken down for the time being with the culprit being the Federal Reserve.

Given the supply trends of the various fixed income products, the Fed’s planned purchases of MBS will undoubtedly overwhelm the amount of new issuance for most taxable bonds. This activity could lead the net supply of the aforementioned sectors to be close to zero or perhaps even negative. This reality could create a scarcity problem for bond investors. Those that realize this (which appears to be everybody) could be reluctant to sell which explains the lack of movement in the spread of the benchmark.

While corporate bonds have maintained their gains, other credit products that are less constrained by dwindling supply, have not. In particular, the spread of credit default swaps (CDS) which are derivatives that mirror the same credit risks of corporate bonds, have widened. The spread on the benchmark index, CDX Investment Grade (IG) 5-Year has widened by almost 20 basis points to a spread of 102. This spread which is usually correlated to corporate bonds is widening due to either selling of credit risk or an increased interest to sell short. In the chart below, the green line represents the spread on the CDX IG 5-Year and is on an inverted scale so that if spreads widen, they will move in the same direction of falling equity prices. The spread on the Barclays U.S. Credit Index and the S&P 500 Index price are represented by the white and orange lines, respectively.

S&P 500, Spread of Barclays’ U.S. Credit Index and CDX IG 5-Year

CDS is a swap designed to transfer credit risk and is originated between two counterparties. As a result, CDS origination is not limited by the amount issued by the corporation but more so limited by finding a counterparty to take on an offsetting view. Unlike the corporate bond market where shorting occurs less often, this dynamic allows an investor to freely take on a view on either the bull or bearish side of the creditworthiness of a company. This freedom is why spreads are widening in the CDS market which contrasts with the lack of movement in corporate bond spreads.

Having said this, warning signals are filling the sky emanating from the market’s take on the creditworthiness of corporations. Historically, this is revealed via jumps in spreads of the transparent corporate bond market. Without knowing the overwhelming effect of QE on the markets, the lack of movement corporate bond spreads would suggest that all is fine. However, the sudden gap in the CDS market suggests that the selloff in equities may have some legs to it.

Chicago Fed Data Points to Slowing Economy

By Rom Badilla, CFA, Bondsquawk

The start of the week featured two major economic data releases. The first release revealed that the U.S. economy is showing signs of weakness while the second release as a separate report showed that manufacturing in the Texas region improved in September.

The Federal Reserve Bank of Chicago released their U.S. National Activity Index, which suggests that the economy is slowing down.  The reading for August came in at -0.87.  Furthermore, the prior month reading was revised from an initial reading of -0.13 to -0.12.  The Index is a gauge of economic activity and inflationary pressures which is drawn from 85 economic indicators that covers output, income, employment, consumption, housing starts, sales, and inventories.

As a result, the 3-month moving average fell deeper into negative territory. The negative August print pushed the 3-month moving average to -0.47 from -0.26 in July. According to the Chicago Fed, a less than -0.70 3-month moving average following a period of economic expansion suggests that there is an increasing likelihood that a recession has begun. Conversely, a greater than 0.70 average more than two years into an expansion equates to an increasing likelihood that a period of sustained accelerating inflation has begun.

In a separate report, the Dallas Federal Reserve released their regional manufacturing activity for September. The General Business Activity index improved from -0.9 in September from -1.6 in the prior month. The September improvement surpassed market expectations as the median of economists’ forecasts was calling for -2.7.

All of the components increased which translated into the better than expected number in the headline number. New Orders which is a gauge of future demand improved from 0.2 in August to 5.3 while Production jumped by 3.6 points to 10.0 in September. Capacity Utilization which represents the number of factories in use in relation to total capacity, jumped from 1.7 in the prior month to 9.3 in September.

The Dallas Fed conducts this monthly survey of manufacturers in Texas regarding their operations in the state. Participants from across the state represent a variety of industries. The threshold of the index and the sub-indices is zero with positive numbers indicating growth and negative numbers reflecting decline.

Overall, the Chicago Fed and Dallas Fed, coupled with last week’s Empire State and Philadelphia Fed surveys, suggest that the September ISM Manufacturing Index which is released in early October should remain soft and come in at or below 50, suggesting below trend growth for the U.S. economy. A print in the low 40’s suggests recession while a print in the high 50’s coincides with robust growth. Baring a major move in the national number, U.S. Treasury rates will remain in its current trading range for the time being.

High Grade Corporate Bonds Ownership Trends

By TJ Kim, Bondsquawk

High Yield Grade bond market has grown significantly for the past years at a rate close to 7%, and now amounts to a size of nearly $4.7 trillion. Looking at the issuance trends, the portion that non-financial issuer take in the overall issuance of the HG USD bonds has expanded since the credit crisis as shown in the graph below, while financial issuers have dramatically subdued their issuance of the HG bonds.

In terms of credit ratings trend, the average rating is lower with BBB-rated bonds now being the majority in the market. Security analysts from JP Morgan explain the lower credit ratings trend,

“Within the High Grade space, downgrades have represented most of the rating action in the last 10 years, especially in 2008 and 2009. As a consequence, the High Grade market average rating has been drifting lower. The recent Banks downgrades have accelerated the trend. For the first time in the past 5 years, BBB-rated bonds now constitute the majority of the bonds with 47% of the total, vs 43% for single-A, 9% for AA and 1% for AAA”.

Moreover, there are some shifts in the demand trend in the HG USD bond market. Prior to the credit crisis, foreign investors, households and financials expanded their holdings of the corporate bonds while insurance companies and pension funds took the opposite position. However, the ownership trends reversed with Insurance companies emerging as the largest holder of corporate bonds. Alongside with Insurance companies, Mutual and Pension Funds also increased their holdings, now account for about 23% of the overall corporate bonds ownership.

Looking at the major players of the corporate bond market, the 20 largest Life insurance companies have the total asset of $1.9trillion. Among their total asset, the largest amount is invested in corporate bonds with $642billion. Insurance companies have been the largest holders in the Non-Financials such as in Utilities, Energy, and Consumer sectors. Mutual Funds (excluding ETFs and Money Market funds) also allocated $2.9 trillion into corporate bonds from their total asset of $9.1 trillion. Finally, ETFs with $1.2trillion of financial assets invests about 9% ($109 billion) in corporate bonds, with the continuous upward trend in their holdings of corporate bonds.

Sliced Earnings Forecasts and Downgrades Spell Trouble for Corporate America

By Rom Badilla, CFA, Bondsquawk

Earlier we talked about how earnings disappointments can leave corporate bonds vulnerable to underperforming. Despite the strong technical backdrop of the corporate bond market, the recent string of positive quarters for companies may be at risk due to results from second quarter earnings. Citigroup’s High Grade Strategy team suggests that the recent earnings season has “left much to be desired from the fundamental perspective.” Given the headwinds of slowing growth, corporate earnings in the coming quarters may be impacted which could in turn negatively affect performance and corporate bond holders.

Specifically, top line growth aka corporate revenues were weak which were masked by strong profit margins. While bottom line growth was decent, the fact remains that stock analysts were wide from the mark in their second quarter earnings estimates. In other words, they were too optimistic. While it is a widely known that Wall Street analysts are an optimistic bunch, the focus should be on the magnitude of their optimism relative to actual earnings numbers.

In fact, according to Citigroup’s credit analysts, you have to go back to the third quarter of 2011 to find such a miss. Back then the big whiff by analysts were due to curveballs thrown in the form of tsunami and debt ceiling negotiations which impacted earnings. Unfortunately, there were no events that led to lower earnings in the second quarter of this year other than weaker corporate growth.

With that said, there are more developments that are piling on that reinforce the deterioration of corporate earnings. Specifically, negative U.S. company pre-announcements going into the third quarter are now running at their fastest pace since the third quarter of 2001 according to Societe Generale’s Strategist, Albert Edwards. In their latest Global Strategy Weekly, Edwards wrote the following:

Analysts are currently slicing around 2% a month off the level of earnings forecasts which have now fallen some 15% yoy

While Edwards concedes that downward revisions by analysts are nothing new given their “jolly optimistic” attitudes toward the companies they follow, Edwards points out that when you look at the downward revisions from a seasonal context, it is quite revealing and unfortunately, quite bearish for companies in the months ahead.

The bad news is that August is typically not a month which sees much in the way of downgrading. It is in the period from September to April that analysts are forced by reality to slash and burn their eps estimates (see chart below). So an almost 2% downgrade in August can be seen as very serious indeed and reflective of deteriorating underlying economic conditions. But on seasonal grounds alone we should expect to see the earnings downgrades accelerating over the next few months.

In addition, Edwards suggests that the change in analyst optimism tends to drive equity performance.

Hence, a decline in optimism could lead to higher volatility and declines in the equity markets. This in turn could lead to wider corporate bond spreads and underperformance relative to safe haven assets like U.S. Treasuries. Deteriorating corporate fundamentals could be the catalyst that pushes investors to leave corporate bonds which have experienced tremendous inflows in this low rate environment. As we mentioned earlier, this turn coupled with the poor liquidity that plagues the secondary market, could be enough to negatively affect corporate bond valuations.

U.S. Heads Toward Fiscal Cliff Without any Brakes

By TJ Kim, Bondsquawk

The Fiscal Cliff scheduled by the end of 2012 has been a central issue, more pertaining to Wall Street than to Main Street. However, as the presidential debate will center on the topic of the Fiscal Cliff, U.S. voters will soon turn their attention to the gravity of the issue that involves a combination of spending cuts and tax increases to reduce the federal budget by as much as $501 billion.

Despite the urgency of the Fiscal Cliff, the politicians have not reached an agreement as to how to go about solving the government’s deficit problem, continuously delaying the progress while the economy is on the verge of tumbling back into a recession. Analysts from Royal Bank of Canada wrote,

“Unfortunately, politicians have not wanted to confront the issue in any sort of bi-partisan way and instead are playing a game of chicken with the U.S. economy by threatening to do nothing. This tactic will result in continued deterioration of consumer and corporate confidence which may translate to less spending and increased personal and corporate savings.”

If the current idle trend is to continue, we would have to allow the Fiscal Cliff to kick in without locating the underlying driver of the budget problem, the results do not look good.

“… the expiration of the “Bush tax cuts” will also occur, with the FC being enacted, with all income tax rates going up (the top rate going from 35% to 39.6%) as well as rates on estate and capital gains taxes. This would negatively impact the amount of disposable income that would be available to spend and thus impact growth.”

On the market side,

“UST yields could rise, U.S. funding costs would be negatively impacted and equity markets would underperform.”

As for the impact of the United States’ inability to address the Fiscal Cliff on the global setting,

“The macro impact on Europe would make the economic adjustment harder in the near term. As for the market impact on Europe – the blow to sentiment would be consequential. We would assume an immediate flight to safe and liquid assets, e.g. USTs. In addition, Euro based assets will look less attractive in an environment with very poor growth prospects. U.K. Gilts would certainly be an immediate beneficiary, as would smaller, safer and more insulated currencies (Norway, Sweden and Denmark). Finally, European periphery yields may take a hit and weaker growth will not make it any easier. Overall, this will probably force further monetary policy action and central banks may purchase more governmental debt.”

As mentioned before, Main Street will be more educated on the topic of the Fiscal Cliff as the Fiscal Cliff will the one of pressing issues to be discussed at the presidential debates. As a result, the market may react more dramatically in a negative way. Mainstream’s reaction to the Fiscal Cliff may drive consumption down with equity market, while sprouting a high possibility for the UST yield rising.

The Real Winner of a Housing Recovery: State Governments

By Rom Badilla, CFA, Bondsquawk

Recent data releases suggest that housing may have finally bottomed and a turnaround is near. Historical low interest rates coupled with a dwindling of the current stock of housing in inventory has contributed to the reversal. This is evident in the latest release of the S&P/Case-Shiller Home Price Index for June which increased 1.22% on national level surpassing market expectations.

Furthermore, RBC Capital Market’s Head of US Municipal Strategy, Chris Mauro, wrote in his latest U.S. Municipal Notes, that data provided by the Federal Housing Finance Agency reinforces the belief of a recovery. In particular, quarterly housing price index (HPI) numbers appreciated in many states across the country:

In 2Q2012 the HPIs increased in 46 states on a quarter/quarter basis and in 39 states year/year. We find it encouraging that even some of the hardest hit “housing bust” states are beginning to see home prices move off the bottom. For example, Arizona registered the largest percentage price increase among all the states. While still down nearly 50% from its 2006 peak, Arizona’s HPI is up over 13% year/year.

In addition to easing the pain of many homeowners who are underwater on their mortgages, the reversal and firming of the housing market is a “bright spot” for the local government sector.

These credits have seen their two most significant sources of revenue, property taxes and state aid, come under significant pressure since the beginning of the 2008-2009 recession. According to the Rockefeller Institute of Government, local property taxes have now declined for six consecutive quarters in real terms. While we expect that state aid will continue to be significantly depressed for some time, a bottoming in property values should help to eventually stop the hemorrhaging in property tax revenues. This will indeed be a positive development for local governments, a sector of the market that has seen little in the way of good news in recent years.

Sustained gains in housing should help property tax revenues reverse course for local governments. As we talked about here several weeks ago, a reluctance to spend due to tighter fiscal budgets is having an effect on the municipal market. In particular, with no new projects, there is little need to access the capital markets in the form of new issue bonds. As a result, supply for municipal bonds has been tapering off. Given the early signs of a housing turnaround which could domino into a recapturing some of the lost revenue stemming from the recession, the municipal market could see a reemergence of supply at some point in the future.

Earnings Disappointments Leave Corporate Bonds Vulnerable

By Rom Badilla, CFA, Bondsquawk

Investment Grade Corporate bonds have had a tremendous run as evident by the decline in yields which has led to outperformance relative to Treasuries. Furthermore, inflows into corporate bond funds and ETFs have skyrocketed due to investors seeking high quality assets that provide some pickup in yield relative to Treasuries.

Despite the strong technical backdrop of the corporate bond market, the recent string of positive quarters for companies may be at risk due to results from second quarter earnings. Citigroup’s High Grade Strategy team suggests that the recent earnings season has “left much to be desired from the fundamental perspective.” Given the headwinds of slowing growth, corporate earnings in the coming quarters may be impacted which could in turn negatively affect performance and corporate bond holders.

In their latest U.S. Credit Outlook,the research team wrote the following:

…an underwhelming second quarter suggests that slower growth may be starting to impact earnings. And with the ‘fiscal cliff’ rapidly approaching there’s scope for quite a bit more deterioration ahead, in our view.

It’s not that second quarter earnings were terrible, per se. Top line revenues were weak, but margins remained strong. The issue seemed to be with the setting of expectations. If one were to evaluate second-quarter earnings relative to where bottom-up analyst estimates were a month prior to the beginning of the reporting period (so as to remove the effect of on-going revisions), it’s clear that the quarter was a disappointment to the analyst community. From a historical context one has to go back to the third quarter of 2011 to find a quarter where analyst estimates were off by so much, and that quarter was impacted by the tsunami and the debtceiling negotiations.

What’s more, the possibility that a similar narrative unfolds in the fourth quarter appears to be quite high. Bottom up consensus estimates envision a third quarter that’s relatively flat to the second in terms of revenue and earnings, but the expectations for the fourth quarter of 2012 and 2013 as a whole are far higher. To our minds, these look overly optimistic even before considering the potential impact from the ‘fiscal cliff’.

While stocks are near their recent high with the S&P 500 trading near the 1400 level, there is a certain air of complacency as if all is well with the economy. However, the fact is that economic data has been tepid at best and the Fiscal Cliff and its potentially crippling effects on the economy, is fast approaching.

And yet, as Citi economists note, one really can’t form a complete earnings outlook for late 2012 or 2013 without taking a view on the actions of policymakers. For if a compromise can not be reached to avoid the 3%-plus GDP drag from taking effect, it’s almost a certainty that earnings will suffer.

Earnings weakness usually does not affect corporate bond holders to the same degree as stock owners for investment grade corporate issuers since their credit worthiness in the grand scheme of things, remains fairly intact.

However, the recent trend of companies catering to shareholders first may ultimately hurt bondholders. Specifically, dividends which reduces cash on hand to service debt holders have been increasing. Furthermore, share repurchases which increases leverage ratios for a company since it reduces the amount of equity outstanding while debt levels remain the same, can hurt bondholders.

As a result, fundamentals are at risk for turning sour as we approach the end of 2012. If such a scenario plays out, the potential for corporate bonds to underperform is high given the current environment of limited liquidity for corporate bond players.

But for those that believe the technicals are unassailable in credit, it’s worth bearing in mind that a turn in the fundamentals is likely to diminish the relative attractiveness of the asset class. And in today’s poor liquidity environment, the outflows need not be all that great to push valuations wider.

The ECB is Ready to Act, but Will it be Enough?

By Rom Badilla, CFA, Bondsquawk

In late July, European Central Bank President, Mario Draghi unleashed a tape bomb on the markets by pledging that the Euro will be defended at all-costs. In particular, the ECB signaled that they would institute an unlimited bond buying program from debt-heavy peripherals such as Spain and Italy.

Since then, borrowing costs for peripherals have declined tremendously. Spain’s yield on their 10-Year benchmark bond fell well below the 7% threshold which is viewed by many as the Rubicon for unsustainable debt levels. Since then, details have been sparse on program action which has led to speculation on what to expect at their next meeting, slated for September 7.

Amid facing controversy and criticism from within the region, the ECB is expected to announce a bond buying program through the secondary market (as opposed to the primary where bonds are bought directly from the sovereign which is currently not permitted under the ECB mandate). This of course assumes that the sovereign would agree to ‘conditionality’ which means promises of reigning in their fiscal balances in exchange for support by the central bank.

A bond-buying program would ease financial conditions of a dysfunctional Euro market system which in turn would improve monetary policy transmission according to Goldman Sachs’ Huw Pill. The economist from the Wall Street giant wrote in their latest ‘European Economics Daily’ other reasons for the ECB’s buying-spree initiative.

  1. Easing private financing conditions through monetary expansion. The quantitative easing (QE) programmes undertaken by the Federal Reserve and the Bank of England have aimed at easing financial conditions. Most narratives have emphasised the role played by portfolio balance effects. By making money-financed purchases of sovereign debt from the market, these central banks have shortened the average duration of private balance sheets. As private investors attempt to rebalance their portfolios in response, they buy longer-dated assets to increase the duration of their holdings, thereby driving up the price of equities and bonds. This leads to lower financing costs for borrowers. Such mechanisms allow monetary policy to ease financing conditions even once the lower bound on nominal interest rates has been reached.
  2. Financing governments. Central bank purchases of sovereign debt in the primary market constitute direct monetary financing of governments. Given concerns about the inflationary impact of such purchases – amply demonstrated by history, with the Weimar experience weighing heavily on German attitudes – they are prohibited by the Lisbon Treaty (the relevant clause – Art. 123 – is applicable both to the ECB and to other EU central banks, including the Bank of England) and many other central bank laws. Purchases in the secondary market can also support government financing, for example by suppressing sovereign yields. In the limit, secondary market purchases can be functionally equivalent to primary purchases, if an intermediary simply stands between the sovereign issuer and the central bank purchaser to circumvent any prohibition on primary market purchases.
  3. Reactivating private markets. Finally, central bank purchases can be used to reactivate markets that have seized up on account of information or coordination problems. For example, should a sovereign with a fundamentally sound fiscal position face a market sceptical of its solvency or commitment to the Euro, borrowing rates will rise as a credit and/or convertibility risk premium becomes embedded in government yields. But that rise in yields, by its nature, increases sovereign funding costs and could validate concerns about fiscal sustainability and/or Euro exit. The government may be trapped in a high interest rate / high default risk equilibrium, even though another, more desirable low interest rate / low default risk equilibrium exists. Well-designed interventions by the central bank can shift the market to the more desirable situation. Since the main concern is rolling over outstanding debt at sustainable rates, interventions at the short end of the maturity spectrum may suffice. And – since sovereign markets are integral to the functioning of the broader financial system – such actions can yield significant broader external benefits in terms of improving the functioning of financial markets and institutions.

While the aforementioned program may lower borrowing costs for the peripherals, the fact is that problems lie below the umbrella of sovereigns and within the banking system. This disconnect between the two disrupts the flow of credit to the rest of the economy which in turn leads to contractionary economic activity. Lower economic growth leads to further deterioration of their fiscal balances and escalation of their debt problems.

While necessary, these measures alone are unlikely to be sufficient. Funding problems for peripheral sovereigns undermine their domestic bank systems and hinder credit supply. As we have argued previously, to improve monetary transmission and ensure monetary stimulus reaches its target – notably, the peripheral private sector – additional, more targeted credit easing measures (e.g., further widening of collateral eligibility, lowering of haircuts and purchases of private sector assets) may be required.

Because of this, further action such as providing liquidity where it is needed coupled with further fiscal reform is required in order to quell the crisis. Until then, the situation across the Atlantic should remain unstable and continue to jostle markets going forward as had been the case for the past several years.

More Muddle Through, but the Details Offer Hope

By Rom Badilla, CFA, Bondquawk

The U.S. ‘Muddle Through’ storyline of growth continues as the economy expanded more in the second quarter of 2012 than initial reports. The Department of Commerce released a report that second quarter GDP growth came in at 1.7% on an annualized basis. This is an improvement from the initial report of 1.5% reported in July. Today’s figure is the first of two revisions on the initial report and equaled expectations as evident by the median survey of forecasts by economists.

Beyond the headline numbers, the components were mixed. Personal Consumption, highlighted by gains in demand for Services and Household Consumption, improved to 1.7% from the initial report of 1.5%. In addition, a 6.0% increase versus the advance estimate of 5.3% in Exports added to the headline number. Government expenditures were less negative with today’s release showing a decline of 0.9% from a previous estimated fall of 1.4%. Imports fell from 6.0% to today’s revised report of 2.9% while Private Investment was revised from 8.5% to 3.0%.

While the headline improved and was in-line with market expectations, the real news lies in the Real Final Sales component which was better at +2.0% from 1.2% as reported earlier. Real Final Sales represents gains less changes in Inventory suggesting higher demand and production gains. Deutsche Bank’s Chief Economist provided color on this tidbit of information in their latest Macro Data Flash report:

The fact that GDP was revised higher but inventory accumulation was less significant bodes well for economic activity in the second half of the year. Less inventory building suggests that production momentum should be more durable. Thus, these revisions are favorable for our broader forecast of a growth acceleration in the second half of the year, consistent with what has occurred in each of the past three years.

In addition, Aggregate Corporate Profits surged higher, reversing a decline seen in the first quarter. Deutsche Bank wrote that this also bears watching since it may translate to job growth in the coming months.

Corporate profits rose 0.5% in the quarter, or 6.1% in year‐on‐year terms. The fact that corporate profit growth is holding up in the mid‐to‐high single digits is a positive development for private sector investment and hiring—although in the short term, economic uncertainty (in part due to the fiscal cliff) is taking a toll.

That said and given that the Unemployment Rate ticked higher last month, all eyes will be watching the next jobs report which is set for release on the first Friday of September. Hopefully, profit gains in the private sector will translate to more robust growth in jobs as Deutsche Bank suggests. Naturally this should bode well for equities and other risk assets going forward and may give reason for the Federal Reserve to put QE on hold for the time being.

Don’t get Your Hopes up for Jackson Hole

By TJ Kim, Bondsquawk

The Federal Reserve’s annual symposium at Jackson Hole is only a few days away. Despite some investors’ expectation on new stimulus that might be hinted at the meeting, the situation now seems more likely that Chairman Ben Bernanke may not signal or announce any definitive plan. Especially with some signs of a rebound in the economy and thus reducing the urgency of another round of Quantitative Easing, the Fed may take more time to  reassess the economy before drawing up any stimulus package.

While it is hard to figure out what will be announced at the symposium, it will be helpful to understand what the focus of discussion was at last month’s FOMC meeting.

The underlying theme at the meeting was “mixed signs in the economy.” While the GDP is indeed growing, there are no vibrant industrial and commercial activities at the moment. Consumer Sentiment has improved with some indications from the recent rebound in the housing sector. On the contrary, due to the tight credit rules for loans, the private sector is not well positioned to fund investment and consumption while savings at the banks are piling up. So it is ambiguous where the growth is heading. Economics Research team from Credit Suisse wrote in their recent report,

“…may not show enough improvement to satisfy the “many” FOMC members who on August 1 “judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.”

“After a $1.3bn slip in the latest week, commercial & industrial loans are growing 13.4% yoy, their slowest pace since late May. At $1.5tr, the level of C&I loans is some 9% below its 2008 peak, when firms frozen out of primary markets tapped contingent credit lines. Real estate lending has been considerably more sluggish. Real estate loans held by banks dropped $14.7bn (+0.7% yoy) to their lowest level since late January. The weakness was concentrated in residential loans (-$12.5bn). Consumer loans fell $0.7bn (+2.2% yoy).”

In terms of the Federal Reserve Balance Sheet, the Fed has reduced its balance sheet, having sold off most of the assets that it bought to provide liquidity to corporations during the financial crisis. This hopefully means that companies have become more financial sound since the crisis.

“The Fed has been selling off assets from its three Maiden Lane portfolios, which it acquired during emergency operations in 2008 related to Bear Stearns and AIG. At year-end 2008, Maiden Lane assets totaled $73.9bn; on August 22 the total was $3.5bn. On August 23 the New York Fed announced the sale of the remaining securities in Maiden Lane III. This follows the wind-down of Maiden Lane II in February 2012 and the January 2011 termination of the New York Fed’s extension of credit to AIG. The total net profit to taxpayers from the Fed’s assistance to AIG and AIG-related facilities was $17.7bn.”

The most recent Beige Book which contains the Fed’s conversation with businesses, noted the following,

“…overall economic activity continued to expand at a modest to moderate pace.” This was a slight downgrade from the “moderate pace” language in the June 6 report.

Over the past few weeks, the tone of the domestic economic data has brightened somewhat, perhaps enough to upgrade the characterization of US growth back to “moderate.”

The next Beige Book will be release on August 29th, and it will be an important reference during the FOMC’s meeting next month.

With two objectives, price stability and revival in employment, the Fed will decide whether there is a need for an additional large asset purchase program. As mentioned in the meeting, the key point is to keep the monetary policy rules simple and to find the best measure that would keep the long-term interest rate tame while stimulating commercial and industrial activities to boost employment once again. As of now, however, we need to wait and see if the recent rebounds in housing and automotive will remain steady, possibly providing confidence in other sectors as well.