November 17, 2009


1) S&P 500 -0.1% after the EU close - closing +1.5% at 1109. Following risk-on sentiment from overseas as APEC pledged to maintain stimulus measures, S&P 500 took out the 1100 resistance level early and then managed to stay above to close at a new YTD high. NASDAQ and NYSE volumes were trending -6% and -9% below 30-day averages, respectively. Crude +3.4% to $78.02. Copper +5.1% to $6850/mt. Energy (+2.5%), Materials (+2.3%) and Industrials (+2.0%) outperforming. Consumer Staples (+0.7%), Telecom Services (+0.8%) and Tech (+1.0%) underperforming.
2) Large decline in fed funds rate expectations & interest rates over the past three weeks. December 2010 Fed funds futures have declined to 0.85% from 1.34% (see first attachment). The US 2-year yield has declined to 0.77% from 1.02%. The US 10-year yield has to 3.34 from 3.55%.
3) Core retail sales +0.5% mom in October vs. +0.2% expected - but offset by downward revisions to prior months - 3Q GDP likely to be revised down 0.5 ppt. Retail sales were firmer than expected in October once you strip out the sales that are not direct entries into GDP. The "core" component of sales (excluding vehicles, for which unit sales are used directly in GDP, building materials, which are intermediate product, and gasoline, which is often affected by price) rose +0.5% in October. We had expected an increase more like +0.2%. However, the better-than-expected result for October was diluted by downward revisions to prior data, which took 0.2 percentage points away from the increase posted for August (to 0.5% from 0.7% previously for core sales) and an additional 0.1 point (to 0.4% from 0.5%) for September. As a result, the consumption component of the 3.5% annualized increase reported for GDP is apt to come down a bit, adding to other factors that currently point to a downward revision of about half a point prior to the retail sales report.
4) Empire Manufacturing index suffered a larger-than-expected setback in November - but coming from a high base. The 11-point drop to 23.5 (consensus 30.0) masked even larger corrections in key subindexes -- more than 14 points in orders to 16.7, and 22 points in shipments to 13.0. The inventory index edged up slightly. However, while the tone of this report was considerably weaker than expected, the starting point was exceptionally high. The mid-teens readings for orders and shipments still imply growth in the manufacturing sector.
5) US GDP set to slow again to below-trend pace in 2H2010 as pick up in final demand will be smaller than loss of boost from fiscal policy & inventory cycle - consensus seems to underestimate effect of tighter bank credit, lower personal saving rate, less cyclical labor market, more excess housing supply, and deeper state & local budget gaps. Jan Hatzius: Despite the sharp pickup in real GDP growth since the dark days of early 2009, we estimate that real final demand—net of the boost from fiscal policy—is still contracting at an annual rate of around 1% in the second half of 2009. Although we expect a moderate recovery of around 2% by the second half of 2010, such a 3-percentage-point improvement would be insufficient to offset the loss of 4-5 percentage points of stimulus from fiscal policy and the inventory cycle. Hence, real GDP growth is likely to slow anew to a below-trend pace. The significantly stronger recovery that is now anticipated by a number of forecasters would require a much sharper acceleration in underlying final demand, along the lines of prior recoveries from deep recessions. But this ignores some key differences between the current situation and the aftermath of prior slumps. In particular, bank credit is tighter, the personal saving rate is much lower, the labor market is less cyclical, there is much more excess housing supply, and state and local budget gaps are deeper.
6) Several important parallels between 2004 and what 2010 might bring - slowing industrial momentum, fading fiscal stimulus & fears of exit from stimulative policy. Kamakshya Trivedi: (i) Slowing industrial momentum: between March 2003 and year end, the ISM manufacturing index surged from the mid-40s to 60, well above the 50 no-expansion threshold. Over the same period the new orders to inventory gap moved from close to 4 to a level close to 25 in December 2003. In the subsequent year, while the ISM stayed in expansionary territory, indeed never dipping below the mid-50s, the acceleration in the industrial surveys clearly faded. The ISM ended 2004 at 56.6, tracking the sharp fall in the new orders-inventory gap down to 5.5. Given the sharp drops in the new orders-inventory gaps already in the last two ISM reports in September and October, it is odds on that we go through a phase where the industrial sector while still expanding, suffers a loss of momentum in the next twelve months. (ii) The fading impulse of the fiscal stimulus next year is another concern that has parallels from 2004. During 2003-04 fiscal policy turned gradually restrictive in 2004 due to the frontloaded nature of the Bush tax-cuts package. In the current situation, as our US economics team has highlighted, the boost to growth from the fiscal stimulus has probably already peaked in Q3 of this year, and should gradually subside over the next year. (iii) Fears of an exit from stimulative policy are likely to remain an important concern for much of 2010, and these were relevant in 2004 as well. Over the next twelve months, in addition to the fading boost from the fiscal stimulus and inventory re-stocking, the global economy is also going to have to digest the withdrawal of a number of other temporary support measures, such as the Fed’s asset purchases, and analogous schemes in the UK, and interest rate rises in parts of the world where the economic recoveries are on a firmer footing. Whereas there were less exceptional QE type measures to exit from in 2004, interest rate rises were very much on investors minds, with the first 25bp rate hike from the Fed coming in June 2004. (iv) In both cases markets were coming off quite a sharp rally, staged coincidentally from March in the prior year. From March 2003, the S&P staged a 40% rally by year-end. The percentage increase from March 2009 is already greater (c. 55%), but of course, the initial falls were greater as well.
7) What 2004 tells us about likely asset market performance in 2010: Modest positive index returns, declines in implied volatility, rates-equity tango. Trivedi cont'd: (i) Lots of choppy trading with modest positive returns. The S&P 500 traded in a +/- 4% range for the first ten months of 2004 until October, only breaking out to the upside in the final two months of the year to end the year up 9%. In other words, a decelerating but still expansionary industrial cycle is consistent with modest positive index returns. (ii) Declines in implied volatility. Even as the index itself chopped around without any direction, implied volatility moved decisively lower. By November 2004, ten months in which the equity market had made next to no progress, the VIX declined from around 16 to around 14, falling further to around 12 by the year end. Realized equity volatility, which was lower to start with, stayed low. 21-day realized vol started and ended the year at around 9. (iii) Watch out for the rates-equity tango. 2004 provided at least two clear examples of how the rates-equities tango can play out. First, starting in the spring of 2004, 2 year swap rates in the US moved sharply higher, from 1.8% to a high of 3.2% in June, as markets began pricing in the post-recession rate hike cycle. As mentioned above, equities struggled to progress over this period. But things were quite different later in the year. After hovering around the 3% level until October 2yr rates moved higher again in the last two months of the year, up to 3.4% as evidence of better growth prospects accumulated. Over this period, equities moved significantly higher as well, hand-in-hand with the moves in the rates markets. These two episodes suggest that as long as it is better growth (rather than higher inflation) that drives rates up, equity markets may be able to hold their own or even move higher. To be clear, we expect no rate hike from the Fed for all of 2010, but that may not stop markets from worrying about inflation and exit policy. We are likely to see an increase in headline inflation in early 2010 on account of the base effects borne of the commodity price gyrations of last year. With core inflation firmly on a declining trajectory, these fears will, we believe, be ultimately unfounded. But as we pass through them, equity markets may face a bout of indigestion as in the spring of 2004.
8) One important difference between 2004 and 2010: Divergence between weak advanced economies & strong BRICs = better global growth & easier financial conditions = good environment for risky & cyclical assets. Trivedi cont'd: Probably the most important difference is the very significant divergence that we expect in our outlook in the US relative to the rest of the world. Our forecasts for US GDP growth are well below trend at 2.1% in 2010, compared to the 3.6% actually recorded in 2004. As a group, we expect advanced economies to grow by only 1.9% in 2010 compared to the 3% outturn in 2004. On the flip side though, this tepid recovery in advanced economies does imply that financial conditions might remain easier for longer. Despite this much weaker US growth profile, we actually expect higher global growth in 2010, 4.2%, relative to the 3.8% recorded in 2004. This is powered by the 9% growth we expect for the BRICs. It is this combination of better global growth and easier financial conditions that still keeps us pro-cyclical and constructive on risk for now. But with a more complicated trading environment like 2004 ahead of us, we are focussing actively on strategies that differentiate between places and sectors with different growth recoveries.
9) A late US harvest has contributed to the lack of OECD energy demand - farming distillate demand likely to materialize in the coming weeks. Jeff Currie: Part of the recent weakness in OECD demand can be explained by the record late US harvest. Harvest activity typically requires significant amounts of diesel to complete, however, poor weather has delayed most US fieldwork in both September and October this year. As a result, the pull from farming distillate demand has failed to materialize and we expect this demand to become visible in the coming weeks. We estimate from its current progress that the harvest will generate a further 170 kb/d increase in distillate demand and consume a further 11 million barrels at the national level.
10) GS spend on air travel turns positive on a year-on-year basis for first time in 18 months. We've just received our latest internal travel data which tracks what we as a bank spend on Air Travel. Our index rose +20% in Oct vs a -18% fall in Sept and -26% fall in Aug. This is the first time our index has moved into positive territory this year (see second attachment). Our absolute spend on Air Travel is now higher than the levels we saw in Oct 05 and a touch below Oct 06. Clearly comps have gotten much easier vs post Lehman months last year but there are also indications that underlying demand is starting to improve.
11) Research focus today...
GS SUSTAIN - Media........................Returns dispersion across the media value chain Semiconductors................................Industry capacity data suggests sound supply-side dynamics. Opera Software.................................Near-term business transition risks still to clear; down to Neutral Arriva...............................................Buy: Valuation compelling: Upgrade to Buy and onto Conviction List
Eurazeo...........................................Our favorite Buy idea, disconnect remains; reiterate Conviction Buy Aveva...............................................Positive tone at GS hosted investor meeting; Reiterate Conv. Buy Oce.................................................Canon makes cash offer for Oce at 70% premium TRG Weekly Market Drivers

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