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.