Plants vs Zombies

Thursday, April 14, 2011

A Portuguese, a German, a Greek and an Irishman walk into a bar. The German pays.

TMM have been struggling for inspiration in generally uninteresting markets over the past week or so - something that is, perhaps, understandable given that punters have been keeping things pretty close to home ahead of earnings season, at least in equities. The FX Carry love fest that has sucked many in over the past couple of weeks appears to be flagging (see chart below of HFR Macro Hedge Funds - orange vs. KRW/JPY - white) and this, perhaps, is forcing many to trade their P&L given that month-to-date numbers for many in Macro-land are now likely negative...

...Especially given that speculative shorts (see chart below) had begun to build in Treasuries which have subsequently squeezed higher.

What with the recent Squid-driven reversal in commodities, it's starting to look a little Pink Flamingo-esque. Except it doesn't quite all add up: this morning has seen the return of Eurobear Missionaries making readings from the Book of Eurorevelations at Speakers' Corner. According to the Good Book, it is written that the Irish Government will seek audience with the Fellowship of Bondholders in order to voluntarily restructure its debt. Financially speaking, Greece, Portugal and Ireland have already died and are effectively financial Zombies. The walking dead. So should we really care if another leg falls off them? The problem is that every time the Zombies scream, the market worries that Spain has been bitten and might just turn into one of them too. Or that Ireland will bite and infect the British banking system. Market judgment, if you were to look at prices this morning , is that Spain may well be infected as it's trading along with the peripheries rather than, as it has until recently, as a core.

TMM are yet to be convinced, and are of the opinion that the past few days' moves have been nothing more than position squeezes ahead of the stream of earnings releases that begin in earnest next week. Indeed, TMM's bond valuation models suggest that Irish restructuring is largely priced in and their credit trading mates report very little volume going through on the widening move...

With a market severely affected by ADHD, together with the Zero-G parabola we mentioned yesterday, we end up with everyone desperately looking for something new to hang on to. "The next big risk". Many of the comments that TMM have received on IBs and emails over the past few days have been along the lines of "equities have failed to push on... sell rallies", which fits in nicely wiith their current resurrection of the EuroZombies. But TMM get the sense that punters have been trying to get short of equities on the idea that margins are being badly affected by the run up in commodity prices. That is certainly a view that TMM take seriously given their generally constructive view on Equities this year, so it seems like a perfect time to have a closer look...

In terms of earnings expectations in general, this is looking to be the quarter that EPS surpasses the 2007 peak (see chart below), a fact that many operating in other asset classes find surprising. TMM must admit they've been very surprised in general with just how well earnings have recovered after the recession.

But coming back to profit margins in particular, punters have rightly observed that the rapid run up in commodity prices presents a serious headwind for profit margins, given that so far, the consumption data has been weak, meaning that it is hard for rising input costs to be passed on. Of course, at face value that seems obvious, but there is also a flip side to this story, in that wages are unable to rise when the unemployment gap is rather large, a situation that the US currently faces (see below chart of US Average Hourly Earnings). The reason that TMM bring this up is that while raw materials make up a significant part of corporate costs, so do wages... and this is particularly important for a service economy like the US.

In addition to raw materials and wages, the other big drivers of margins are financing costs, which are close to multi-year lows and over the past year or so, TMM have noted many of the "smart" corporates extending their debt maturities and fixing their interest payments. That provides structural support going forward. So, tying all of this together, TMM built a very simple and naive model of SPX margins (see chart below, red line, actual margins YoY detrended [in order to strip out structural productivity effects from IT and globalisation] - blue), which while not perfect, due to base effects in CPI (we were too lazy to strip these out) seems to generally do a reasonable job in explaining the broad trends. And the message from the model is that margins are likely to improve further, so TMM reckon that this earnings season could be a lot better than many punters (which seem to be somewhat bearish, in contrast to analysts) expect. In that light, TMM reckon that dips in Spooz prior to the earnings season truly getting under way are a buy.

So, if we see the Earnings as the green shoots of recovery, then today is going to be Plants vs. Zombies.

Posted by cpmppi at 12:31 PM  

20 comments:

Bearish Views Growing...Risk Off Event ----- A few weeks ago JPM was first to downgrade Q1 GDP and the majority of noted houses followed suite, the negative strategy and reduction of long tactical trading calls followed these economic calls. Yesterday, JPM was the first to lower Q2 and Q3 estimates and the question now becomes is a repeat exercise forthcoming that results in a new consensus targeting a slower 2H 2011 that is not currently built into investor models. Taken within the context that the inner core of the Fed remains dovish on growth expectations and QE2 ending this quarter, it is easier to understand why anxiety levels are growing. From an Equity standpoint, Financials are now down five days in a row and we already received earnings from the best of breed and disappointment followed. Add in four days of meaningful Small Cap (breadth) underperformance and Energy sector weakness due to net length and Oil price pullback and the concerns become more obvious. The hope at least from an SPX index contribution level was that Financials and Energy could offset each other but that pairs unwind post JPM earnings has lost momentum as both sectors are leadership on the downside currently. Real and levered shorts in the belly of the UST’s curve remain nervous and under duress and new positions in Yen carry trades are being forced to backtrack as well. Finally, the leaked economic data in China overnight just argues more rate hikes in Q2 then consensus believes. On aggregate, this set up makes it difficult to argue that SPX 1295-1300 is final support. I am watching EUR for a bleed into USD short covering, Crude Oil break below yesterday’s low (CLK1 105.31) and SPX below 1295-1300 for a greater risk-off move. Flamingo’s at the greatest risk remain short UST 5yrs, long EUR and AUD, long US Energy Equities, limit long Russia Micex and Rubble, and long Silver. On the other side, remain very bearish Japan and this unwind in JPY carry trades is providing a good opportunity to layer on positions if you missed the last move.

Right Field said...
1:37 PM  

Zapatero throws a bone to the event-starved.

Just when everyone's getting a little bored with 160-something spreads and a tanking bund, our prez announces that Chinese people will be sinking 9 bn euros into the caja mire. Then CIC, the main supposed participant says 'Hello? Ain't us, pal', at which point Zap retracts, claiming that a 'communication error' was responsible. Indeed. Latest is that CIC says that they really are looking at it. Honest, we didn't mean it that way.

Adding to the problem of having a good news bear leading the country is a bit of recent yes-no-maybe coquettery from some place on the Persian Gulf concerning the same proposition and a public drubbing of the BdE's governor at the hands of various bankers.

It isn't that easy, Mr. Zapatero.

Charles Butler said...
1:57 PM  

"A Portuguese, a German, a Greek and an Irishman walk into a bar. The German pays."
I like it,now I expect TMM to do more work on this so we can put together a party suitable for a loud singalong at the annual Ocktoberfest !
I feel a Youtube moment in the making.

Anonymous said...
2:35 PM  

Great post.

Calculated Risk, who was the first to downgrade Q1 growth, had a post up that Goldman now says Q1 ending strong:
http://www.calculatedriskblog.com/2011/04/misc-goldman-says-q1-finished-strong.html

CR seems to see the current slowdown as temporary. I've been reading him daily for six years. He's pretty conservative with his calls, but he hasn't been wrong yet. Almost uncanny.

I've been looking back at 1994. Similar to now, it was the point in a slow recovery after a banking crisis where C&I lending started to pick up. I believe C&I lending by banks grew at 10% SAAR in March.

1994 is when bonds crashed on inflation fears. But at that time the Fed was at least as fearful of inflation as the market and the bond rates went up pretty much in line with the FF rates. What's ironic is that when the Jan 1994 CPI numbers came out in February, in the model of the scare, the CPI had risen 0% MoM. In fact, inflation was falling. I think it was more about not being comfortable with rates below a "normal" range.

Of course, 1994 was the start of the Golden Age for profits, jobs and equities. But I think the tailwind they had of consistently falling commodity prices is the opposite of what were likely to see for the next few years.

Sorry, bit of a tangent there.

Bob_in_MA said...
2:35 PM  

Rught Field
that is not currently built into investor models

I hope this has nothing to do with Wayne Rooney because all his models get f...d

Anonymous said...
2:37 PM  

Nice job, brave call... however wouldn't most corporates have already seen benefits of lower rates and does it really have that much of an impact on margins through all industries? I would imagine not only commodity inflation but operating costs will rise as service firms renegotiate contracts and sales activity ramps. Bigger picture over the short term, IMHO, seems to be the fact that QE impacts stock prices more than bond yields...

Jim said...
2:48 PM  

I see it that way also Jim.
I'd much rather see where bernanke wants to go post the April meeting before I climbed any further onboard equity.
The issue he must have is with QE end in sight where are the UST buyers coming from ? A runaway equity market is only going to make that problem harder to solve surely.

Anonymous said...
2:57 PM  

I suppose it could be false ,but a number of heavyweight sectors are breaking down in the US including banking.If that really is a break that confirms then it's hard to see where the leadership is going to come from.
On a topdown viewpoint as the US goes so does the rest of the west

Anonymous said...
3:07 PM  

should also add that relative strength in the defensives is not typical of equity moving higher.

Anonymous said...
3:09 PM  

Wow. Impressive. It's almost as though everyone had been storing up their most incisive analysis and unleashing it all on an unsuspecting readership today. Very very impressed with the post today, and also with comments by RF and Bob in MA. So, let's have a go from the half-way line.....

Cpmppi points out that there may be some positive earnings surprises ahead this season, and we concur. While most industrials and bricks and mortar retail are likely to disappoint based on the impact of higher commodity and gasoline prices, the much-discussed margin squeeze will not be felt equally, and technology and services stocks are much less likely to be affected by energy costs. So we are in the SPX 1295-1305 support camp until proven otherwise.

Polemic had posted recently on the likelihood of yen shorts being squeezed and we are indeed looking at that right now. I have been expecting a substantial retrace of the move to 85 that followed the co-ordinated intervention after the USDJPY fell to 75 after the Japanese event. With Japan still early in its recovery, one feels that the BoJ will not want the yen to go beyond 80, so perhaps the present retracement will be halted between 80 and 82. So, we agree with Right Field, a great time to add to yen shorts, and perhaps to Japanese equity longs.

So along those lines, I wonder whether we are looking at a regime change here where the dominant FX carry trade will be JPY and not USD going forward, with DXY maybe just drifting sideways for some time? Who knows we might even see equities and USD rise together, if the commodity sell-off gathers steam.

Bob has commented several times on analogies to 1994, but macro conditions were so different then, and I would counter that there are anchors on both the short end (output gap, slow growth) and the long end of the Treasury curve (mortgage rates have to be <5%) in this situation. Higher long end rates would precipitate a second ugly housing meltdown and another credit and banking crisis. As the slower growth view begins to dawn on people, watch for the stable low interest rate plays to outperform and for the reflation trades to falter.

Not only will QE2 be completed, but the subsequent tightening will likely be achieved very gradually by reverse repos that will need to occur at a rate that is probably slower than the QE2 itself, maybe $5-10B/week over 50-100 weeks. Regulating the rate of reverse repos will allow the Fed to imagine that they can exert a degree of control. Surely, it makes no sense to raise rates until this reverse easing process is complete? The Fed will be unable to raise rates at all in 2011 and probably in 2012 as well. By 2013 we will perhaps have seen the true bottom in US housing come into view.

Leftback said...
3:21 PM  

Micro is the new macro.

Anonymous said...
3:23 PM  

"The government collected $36.1 billion in corporate taxes in the first quarter. That includes the taxes due on March 15 for the prior calendar year. That number is down 31% from collections in the first quarter of 2010. Collections since then through April 11 suggest a continuation of that weakening trend for the first quarter. The final final verdict on the quarter will not be in until April 18, the date that quarterly taxes are due this year. While, it’s theoretically possible that the numbers could recover when the final tally is in for April 18, the indications for the period so far continue to point down."

Anonymous said...
5:54 PM  

Bob_in_MA where are you seeing 10% annual in C&I for March? Last I see is Fed published 2.2% for Feb, a decline from 8+ in Jan

mw said...
6:41 PM  

Well, the budget deficit is expected at record level relative to GDP for this cycle. This money has to show up somewhere. There are not so many options with imports and corporate profits being to top ones. So no surprises here.

6:50 PM  

mw,

I did the math myself, by last Friday all the data was there but a day or two. Tomorrow's report will have the Fed's figure.

LB, I think the biggest benefit of low mortgage rates is that it's brought down loan payments for all the millions of people who've refinanced. That had to have fred up tens of billions of spending power.

For sales, I'm not sure how much it matters whether rates are 5% or 6%--at 7% it might start to matter. But really, it comes down to jobs. If jobs were to start growing at 350,000/month, then housing could come back by the end of the year, even if rates are 6.5%.

If things were to slow down after QE2, Bernanke has the votes for QE3 in his pocket. The regional bank presidents who are most against are in an extreme minority.

Bob_in_MA said...
11:08 PM  

Bob,
What if his pocket has been removed from the Fed ,or are you saying his position there is guaranteed and the opposing philosophy we hear about is not really a threat to him at all?

Anonymous said...
6:49 AM  

what if oil at 125$ prevents the fed from further QE ... like QE3 wouldn't take it straight to 150$ and game over.

Anonymous said...
1:00 PM  

xa xa!! "A Portuguese, a German, a Greek and an Irishman walk into a bar... ,that was the best i have heard!

nikos said...
3:04 PM  

Anonymous,

The FMOC has 12 members, Bernanke, Yellen, five other members of the board of governors, NY Fed pres., plus four other regional bank presidents.

The first eight are almost sure votes for QE3 if there is a slowdown and probably one of the regional presidents.

All the hawkishness comes from the regional presidents, half of whom don't have a vote in any given year.

Bob_in_MA said...
3:06 PM  

start charging for this or keep it to yourself-what's the advantage on giving away analysis?

Anonymous said...
4:37 PM  

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