"Measure" Twice, Hike Once
"Measure" twice, hike once: Everyone is waiting for the Fed to raise rates as part of its "measured" approach to inflation, before we all flee for the July 4 weekend. This note's quote: "More than any point in the past 20 or 30 years, there's potential for a reversal." Bill Gross, June 17, 2004 Financial Times interview.
This note's summary:
Stock watch: Securities Brokers ride high on institutional business, and the winners have done well in Q2, but that's the past (thanks to leftovers from the tail end of the reflationary Yankee Carry trade), and declines are likely as the bond bear is ushered in officially, likely on June 30, but inevitably as we hurtle towards 2005.
Fiat watch: Could the Yen ride a domestic recovery story tsunami, while the US dollar bounces before it gets trounced again?
Macro watch: We're just waiting for a rate hike (like everyone else), but US money supply outpaced by real growth signals trouble ahead, regardless of when the Fed hikes.
Country watch: China is still a "fixer-upper" opportunity for investors given its structural inefficiencies, and looks due for a hard landing, not soft-landing (but we suspect someone will start babbling about a V-shaped recovery), after an anticipated drop in its M2.
We anticipate that beneficiaries of the Oct. 02/Mar. 03 rally, securities brokers, notwithstanding the recent euphoria, will eventually meet with softer business, as vestiges of the reflationary Yankee carry trade shrink away and great business in areas including fixed income, forex and futures begin to decline. Meanwhile, we perceive that the Yen will ride higher, both on continued interest in the Nikkei and in the export-triggered domestic recovery story, which may or may not be valid. The recovery story, if valid may or may not be more than a minor pop-up. As Japan moves up, we see a correction for China, pausing the secular bull and clearing overheated markets as authorities try to hit the credit brakes. At home, we think the money supply slowdown, since late summer 03, lower than the (nominal) GDP hints trouble ahead.
STOCK WATCH: Big Brokers beat Q2 estimates, but what of H2 2004 and beyond? This note will be released before or as the Fed meets, and the first breath of relief will have been made by traders, and a "will they and by how much" moment will have passed regarding interest rates. This will be an under-read note, considering most of our readers will have one eye fixed on the Fed meeting, the last Q2 earnings reports, a slew of government reports coming out this week (e.g. payroll, consumer confidence, and ISM manufacturing index) and the other eye on plans for the elongated July 4 weekend. Many traders eager for the long weekend, include the folks at various institutional firms that have reported profitable Q2 results. We mention results from just a few of them.
We reiterate our position from our last market note, that no matter what, the combined pressures of speculative unwinding and of higher interest rates will prove corrosive for those with long positions in such things as homebuilder shares and securities brokers. Again the prices seem to say otherwise, but profit taking and position re-sizing should be prepped for corrections. Having broached the subject of homebuilders in the last few notes, we'd like to quickly revisit the news of the securities brokers who could be next in line for trouble. The charts and the news in the retail end (e.g. Schwab) portend bad business ahead. Schwab's move to lower its commission schedule follows a rise in assets under custody and a shift towards larger-sized accounts. Is revenue yield, revenue divided by assets, lags full service Merrill Lynch, while it continues to also lag behind the no-frills online discount houses. So, Schwab is stuck between the online DIY retail and full service offline. Retail is tough.
Past the retail sector, and their charts, with a decidedly darker outlook, we offer a quick recap of institutional business. Recent news has been good. Morgan Stanley and Goldman reported upbeat releases. We can't help but notice that the Q2 2004 results were lower than Q1 2004, perhaps due to the bloom that came off the reflation rose.
Morgan Stanley's Q2 earnings were 1.22 B vs. 599M a year ago (or $1.10/share vs. 55c/sh, topping Street estimates of $1.05/share). Goldman Q2 reported $1.19B vs. 695M a year ago (or $2.31/sh vs. $1.36/sh, topping Street estimates of $1.95/share). Goldman CFO David Viniar was quoted as saying, " Over the next three to six months, there could be some choppiness in markets. The good part is that short-term uncertainty is caused by growth, which is good in the longer term." For our point of view we're not sure if we understand if that means uncertain growth, or growing uncertainty.
Morgan Stanley noted that its investment banking business had its best quarter since Q4 2000, with M&A revenue up about 130% to $324M and its mergers market share doubling, but its backlog of equity and M&A deals fell from Q1 2004. Fixed income deals rose, accompanied by stronger forex and interest-rate related business. Quarterly fixed income revenue rose 43% year over year to $1.8B, and went up 11% from Q1 2004. Underwriting (of stocks and bonds) rose 77%, while equity sales and trading lagged in comparison and rose 29% year over year. At the end of the pack was retail brokerage, with pre-tax income down 20% to $13M, and Discover card results, down 18% from Q1.
At Goldman, M&A revenue also skyrocketed, nearly up 100%, to $513M (and recent league tables show it to be top dog for M&A) but $3.63 B of its $5.5B in revenue came from its own trading and investments - a 35% year-over-year rise. Its revenue from fixed income, forex and futures business, like Morgan Stanley, also rose up 15% for the year to $1.89B, but off 10% from the previous quarter due to rising rates and credit spread volatility. Its stock and bond underwriting business was up a modest 10% to $440M, and as with Morgan Stanley, the one of the losers was the equities trading business at $351M, down 21% from a year ago, down 63% from the previous quarter. It took losses on arbitrage trades that were proprietary but made money from servicing other money managers, to $601 in asset management and $330M for securities services related to hedge funds and stock loans.
We see that other firms reported similar results, that business was great (but not quite like 1999/2000). Lehman reported a 9% drop in net income in Q2 2004 versus Q1, but H1 2004 overall was still a record. Lehman, having reported before biggies like Goldman and Morgan, anticipated that a future drop in fixed income will be made up for by better M&A, as well as stock underwriting. Fixed income underwriting is expected to drop 10-15% as well as trading. Bear Stearns did better, reporting only a 4% drop for Q2 2004 from Q1 ($348M in net income on unchanged revenue of 1.7B). Like the other houses, Bear reported better fixed income business in Q2 (revenue up 3% to $844M), but noted a revenue drop in other business due to lower volatility and client-service related revenue.
The boost in recent business from bonds appears short-lived, and the pullback in retail and equities-related trading adds to our pessimism for brokerage shares. According to press accounts, we note a $17.5 B withdrawal from bond funds in May 2004, which cite fund tracking firm Lipper noting how this rivals the $13.3 B estimated withdrawal in August 2003, prompted by investors' anticipation of a rate hike. If there is a withdrawal in fixed income, where will the good news come from in future quarters as 2004 plays out and various equity-related revenues remain tepid? Will M&A save the day (or will those revenues come under competitive pressure too)? The big picture worries us.
FIAT WATCH: Dollar can bounce on possible repatriation, and the Yen also rises. Another secular theme we voiced caution about was the US dollar long term. A recent update of the current account deficit, released after our last note came out, only served to reaffirm our outlook about the longer-term prospects for the greenback. (see chart from previous note June/July market note part 1). The US current account deficit widened to 144.9B from 127B year over year for the first quarter, up 0.5% from Q4 2003, boosting this broad measure of the trade and investment flows to about 5% the size of the GDP. (The trade deficit portion of this gap accounted for 136.9B, up from 125.5B in Q4 2003) Who is financing us?
Overseas acquisition of US assets still went up, with official foreign purchases of U.S. assets up $125.2 B in Q1 2004, up from $83.7B from Q4 2003. This breaks down into heavy buying of treasuries (66.4B vs. 4.7B in Q4 2003), attributed to Asian buying - one source, Japanese intervention, won't be repeated due to the end in March of their Yen intervention program. This was at a slower pace for US equities and non-treasury bonds, (64.3 B bought in Q1 2004, down from 83.8B bought in Q4 2003). At this time, foreign purchases of US treasuries have brought holdings to just above 50% of all Treasuries or over $1.65 trillion dollars. The overhang for bonds, as inflation comes back, is huge.
Near term, however, we still believe that the slow unwinding of trades connected to or inspired by the Yankee Carry Trade from 2003 may persist, and that will mean some upward movement in dollars. We see a revived trade in some reflation-related trades, but without the fuel of cheap credit thanks to rising interest rates, it seems unlikely to persist for long. That being said, another interesting factor that may prop up dollars may be event driven, assuming passage of the Homeland Investment Act, recently passed by the House. This substitute for a US tax benefit deemed illegal by the WTO ($4B annual) could enable US firms to take home foreign earnings at a vastly discounted rate of 5.25% tax rate (well below 35%). This Act, while still not yet a reality could prove to push the US dollar up dramatically, boosting the exchange rate (while softening the trade deficit). This may be because the subject of much debate in the forex market. This is an event risk opportunity depending on how you look at it. Those short dollars could be hit with losses in the near term as well as margin calls. We read of estimates, that out of 100-200 B in overseas profits, some 70 to 80 B is held in Euros, meaning yet another issue for a currency already facing pressure at home.
All this is assuming the bill will be passed, but if it is, watch out dollar shorts. Reflationfade and repatriation could help give a serious bounce to the dollar.
As for the Yen, we may indeed have been mistaken, given our recent confusion over JGBs. While we continue to see Yen strength, we also see looming trouble for the BOJ, especially if a reflated, growing economy sparks higher and higher bond yields. The BOJ could find itself buying up JGBs should expansion become a reality. (Attention readers: we are not making a call as to structural changes in Japan or to the length of domestic economic improvement but we do see possible trading opportunities.)
Although the incentive to buy during deflation may end, the new pressure to buy to keep a lid on yields may arise, perversely enough. Higher rates threaten to crush what could be a nascent recovery - our reading of the situation. And yet the increasingly upbeat outlook tempers our reaction to news accounts that it may be a year before the BOJ drops " quantitative easing", the force-feeding of the markets with liquidity beyond what is called for to maintain zero percent, which would then be followed several months later by the actual raising of interest rates - bringing us well into 2006. Until Japan passes through firmly through what we called in our last note a no-man zone that lay between negative and positive growth, into positive growth and price increase territory, buyers of the bonds will persist buying unless and until their portfolios start bleeding, sometime early in the second half of this decade. The inflation-indexed bonds, mentioned in our last note, that were coming onto the market are in demand, but the plain bonds are still being bought.
Continued Yen strength means we anticipate increasing speculation, and as for the JGBs, maybe our misgivings are not so misgiven. Near-term interest in the Nikkei has helped to lead Yen demand, and that likely been accompanied by recent breaking, around June 21, of the currency above 100 and 200 day averages against the dollar. Recently, there was an S&P upgrade of most of the top banks. This upgrade was characterized as a first in over 20 years, and it was attributed to lower risk exposure and improved capital reserves after the reduction of non-performing loans and overlapping share cross ownerships. S&P noted that the threat of losses in bond portfolios due to rising rates could be countered by returns from improving lending business and stock market. The upcoming 'tankan' sentiment survey released as some begin an unofficial four-day weekend in the US, is anticipated to reaffirm an increasing optimism about Japan. This is great for business, but it points to higher yields and pressure for bonds. According to the BOJ, since April 2004, JGBs purchased by the Bank won't have to be marked at the lower of cost or the market, but valued at the amortized cost, based upon a moving average method. We're not sure what that moving average is. And as the BOJ may be compelled to buy more and more JGBs, what of the Yen entering the forex markets as result of the purchases? We apologize to our readers for our increasing fixation in recent notes, but we sense an increasing opportunity on the short-side in bonds.
MACRO WATCH: Interest rate changes make you think about the ratio between earnings and bond yields, but you should also think about, liquidity and GDP's impact on asset prices.
While the debate is still on as to Japanese inflation, the news is getting old that interest rate hikes in the US are coming, to meet with inflation. Released after our last note, we observe that the reported annual rise in core price index for consumer spending, excluding food and energy, reported as 1.7 percent was then revised upwards, on June 25, to 2.0 percent for Q1 2004. Following this release was the report of a 1% increase in U.S. consumer personal spending in May, on June 28, above estimates of 0.8%. The anticipated start of rate hikes was expressed as home sales and resales shot up, as buyers rushed to lock in rates before the hike.
Aware of the boosted liquidity courtesy of reflation, and the hike in bond yields made long before the Fed will act, we began to wonder about earnings and bond yields - and the ratios that some like to use as market measuring tools. The firm of Smithers & Company, has available a brief paper noting that such ratios between equities and bonds may not pass muster when it comes to a valid broad valuation tool for making investment and divestment determinations, and they favor the Q ratio we mentioned in our last note. We recommend readers go to the Smithers site to spark debate and discussion. We also read however, of another market relationship, which has also provoked us and is serious as the Q ratio. Another respected research firm also in the UK, Lombard Street Research, observes, and we oversimplify here, that when the rate of growth of monetary supply, aka credit and liquidity, outpaces growth in the real economy (as indicated by such measures as the nominal GDP in Lombard Street's work), the liquidity has to go somewhere and inflate financial assets prices. Put another way, when velocity, the turn-over in the money supply within the real economy (aka GDP divided by money supply), turns down, there's dollars available to put into and prop up financial asset prices and vice-versa should the real economy begin to move up, as indicated by all the government data releases touting " recovery". (We apologize if we have muffed up the official version from Lombard.)
Bill Gross opined, in a recent June 17 Financial Times, that small moves in interest rates, in the cost of capital, could have big consequences for the markets. His words: "With all this consumer debt, business debt, government debt, smaller movements in interest rates have a magnified effect … a small movement can tip the boat." Small moves in the price in credit, upwards, are on everyone's mind for this Wednesday. Moves in the cost of credit, and in the supply of liquidity, are on our mind. Our fixation on liquidity started after pondering briefly noting the end of the secular bond bull market in 2003/4 in our recent notes. We began to wonder about the relationship between stock earnings and dividends, or earnings yield, and the riskless yield of US treasuries. We mentioned this at the end of our last note and our musings have led us to fixate on the money supply.
As inflation eggs on the bond bear, equities should prosper under rising profits from the nominal profits of rising prices. But what if speculators heel to an assumed parallel relationship between bond yields and earnings yield? This relationship was nurtured during a time, basically the last twenty years, when inflation fell, enabling the purchase of financial assets despite declining face value yields. For this ratio to be maintained, as bond yields rise, earnings yield must do so too, and therefore equities would have to fall. But this relationship's value has varied. There was low correlation between bond yields and equities earnings from the roaring 20s to the last bull market of the 60s, during which earnings yield exceeded bond yields. Afterwards, in the post 1960s bull market environment, earnings yields galloped alongside bond yields - but that could change back to the pre-1960s relationship. We don't know, post-market bubble busts of 2000 (US equities) and 2003 (bonds), what the relationship will be for this yield ratio. We are more concerned at this time, about the relationship between monetary supply growth and economic growth.
As we see a rise in a measure like GDP, in the real economy, is accompanied by lower monetary growth, there is less liquidity available to prop up financial asset prices, namely stocks prices. Accompanying the recovery reported in the real economy, would be lower free liquidity available to pump up propped up financial asset prices. The decline, since last summer 2003, in money supply growth, is below nominal GDP growth and this hints at eventual trouble ahead.
COUNTRY WATCH: A quick look again at China Speaking of trouble ahead, we anticipate a rough correction for China. We still see a secular bull market, but we also see a popping of the recent good times bubble in China. We will continue to see a decline in the more speculative shares sparked in early 2004. This is at a time when the OECD has reported that China beat out the U.S. for foreign direct investment (leaving out tax-haven country Luxembourg), with China's 53B in 2003 (down from $55B in 2002) versus U.S.' 40B in 2003 (down from 72B in 2002).
A counterpoint to this optimism is the recent news of a negative European Commission report about the Chinese economy. The EC report noted that China was still marked by heavy government involvement via inefficient state enterprises, poor accounting standards (as bad in some instances as no record keeping at all for some companies), fragile real, and intellectual, property rights, and a financial sector which inefficiently (and sometimes arbitrarily) misallocated both the supply of credit and the price and cost of risk. A recent report from the Chinese National Audit Office noted credit excesses within consumer lending practices for property and automobiles - with findings of corruption and fraudulent dealing. Within the report, one of the excesses included an approved mortgage application in Shanghai from the Industrial and Commercial Bank of China (a big "four" bank that was at the center of the audit report), for the equivalent of over $US 8.5M, enabling a sole applicant to buy over 100 apartments, rivaling anything we fret about with regard to the US "housing bubble".
As for the notion of heavy involvement by the State in the business world, news accounts, in fact, reported that the Communist party is planning to have companies with 50-plus employees contain at least one party member, with a party committees set up for companies with 100-plus employees. Officials in Shanghai, a city likely to be the centerpiece of the modern Chinese economy, noted this as a goal to be achieved within 3 years, under this particular 5-year plan. The focus will not be on the rank and file proletariat but middle management. The People's party will become the Party of the Middle Manager, at least in the private sector. Other press accounts relay news that giant Citigroup suspended top two China bankers, namely its department head - the daughter of former Chinese premier Zhao Ziyang, and a director serving under her, for "false information" given to the company and regulators. In the long run, this news bit will likely prove a footnote in history, but it is another crack in the near-term façade.
Yes, we see great opportunity ahead, but we also see a correction reflecting the true prices of those unique risks for this opportunity. We are optimistic but we can't help but see a correction, as revealed by price action and the slowdown sparked by credit tightening - signs that the authorities maybe successful in tightening the reins of credit.
This truncated note offers us a chance to talk about things that caught our attention during relatively lower volume markets, as we await the start of what futures markets have anticipated of what could be the start of a 125 basis point move up by the Fed over the rest of the year. In our next note, we are considering talking about recent events in shareholder/manager-dominated companies that are interesting. To our readers in the States, have a great and safe July 4 weekend.
This report's evolving market perspective is based upon a perceived structure to speculative activities - which we characterize as falling within four groups: trend, contrarian, arbitrage and expert-based. Trends are profitable for the momentum and trend player. At some point contrarians have their moment in the sun and those who are "lucky" enough to come in, or have somehow timed their speculations successfully, make their money by fading the aging trend. About the same time sometimes an "arbitrage" is detected, based upon an assertion of an over-, or under-, valuation, or prices under, or above, historical mean prices and multiples, or an evaluation of an anticipated regulatory or corporate event, while "experts" and knowledge specialists, who waited for some confirmation, in quarterly, periodic or fundamental indicators begin to evaluate, publicize their opinions and findings, confirming the emergence of what evolves into a new trend. This new trend then picks up steam. It could emerge into a cyclical high or low, or a manic period, to be followed by a countercycle and/or reaction enjoyed by the next contrarians, and so on and so on. We disclose this evolving bias to our readers as a caveat.