Monday, April 07, 2008

Armageddon Averted

After a whirlwind month, the global de-leveraging picture looks to have cleared a bit. With the Bear Stearns bankruptcy and the Fed's willingness to break rules, we have some stability. The CDS and bond spreads have tightened. We at least know what the Fed's willing to do along with their partners in the UK and EU.

While this is allowing some risk premium back into the markets, we still have growth slowing in the US, the UK and the Eurozone, the CDS counterparty issues are far from realized, and level three assets are still huge. We are in front of large consumer loan reserves and a US (and UK?) consumer that needs to rebuild their personal balance sheets.

Are the banks ready for your money? I'm not so sure; mark to market is not over and the consumer and corporate overhangs still have at least 2 Q's to play out. All banks will be required to reserve against the off balance sheet products of yesterday in addition to all of the new capital they have raised and that's pretty delutive.

The US banks should see the start of restored earnings power from the credit spread this quarter, something that will grow over the next 4 Q's. That should help JPM, WFC and BAC, the banks with the least balance sheet damage and dilution. The US gov't should start some type of housing bailout process before the summer recess, already backed in principle by Bush. As these factors play out and the banks reserve for consumer and corporate defaults over the next 6 months, I expect the commercial banks to begin to look investable.

But for the investment banks, where will new eps power come from? The big earnings generating businesses of the past are dead: structured finance, huge debt issuances, leveraged prop trades. Only Goldman, with its leverage capability undamaged and its principle focus, looks good coming out of this mess. But we assume that they are still well hedged, despite their huge level 3 asset position. And then there's the unresolved counterparty issues. I'm not interested.

The debate about recession continues, but it's clear that the US, the UK and the Eurozone are slowing. These consumer economies have been so levered up that it seems likely it will be many quarters before they recover. We have more rate cuts ahead, but we're closer to the end than the beginning. UK and EU rates are headed our way and we are likely to be raising in the middle part of 2009. This supports a continued short on US T's and a long on GSE's and Corp's. And maybe a start to the resurgence of the dollar...

Bill Gross has called this the absolute bottom in the US fixed income market and has made a huge bet on mortgage securtities. It does seem likely, in the face of global inflationary pressures, that the US Fed is 100bp from the grand finale. These pressures are not just from higher commodity prices; they also include the reversal of the disinflationary impact of offshore labor rates and continued dollar weakness.

Stagflation looks like the most likely outcome for the US. Rates bottom and come back to "nuetral" in the US next year and the US faces the long term prospects, of a 2.5% growth economy. This new economy will be starved of the jet fuel of leverage, tax cuts and war spending . The good in the story is the US has a flexible labor supply in the millions of undocumented workers, high levels of productivity and therefore limited swings in the US employment rates. Incomes are the lynchpin to a sustainable growth story in the US, supported by a low $.

The US equity markets appear to be holding up well, with strength from the transports, agriculture, energy and resources, and a growing interest in the early cyclical trade (once again). Energy prices are staging an unreal rally in the face of this economic slowdown and of all the issues to focus on this is the most interesting.

US consumer energy behavior is changing, energy use is slowing globally, and substitution is happening. So why are crude prices rallying? The US gov't continues to add to its reserves (in an action considered ominous by Stratfor); the dollar still declines vs the Euro; assets continue to poor into commodities.

It would seem logical that oil prices should slide into the inventory build for the US summer drive season, and then maybe slide more as the US consumer drives less this summer. But this is about speculation, not fundamentals. And it appears that this speculation at its core is supported by the possibility of unrest in the middle east. "The market can stay irrational..."

As we move into second quarter reporting season, Ag stocks (POT, MOS, AGU), shippers (DRYS,DSX), export plays (GE), nat gas (HAL, CHK) and steel companioes (X, MT), look the best positioned for strong eps reports. These reports should be supported by record short levels, huge cash balances and a cheapened US$ equity market.

Many analysts continue to focus on the expected lowering of eps expectations for '08 and '09 and general negative commentary from companies. We are at 14x forward eps, which means we are likely closer to 17x+, after revision. But with the rails staging a powerful rally and the Dow holding against its Jan lows, RR is calling the 28 year secular bull market still alive and says that we make new highs in the coming 24 months. We have finally had a couple of 90% up days, some resolution in financials - so they stop going down - and continued strength in the leadership groups.

So: long HAL, DBA, CHK, ME, IVN, MU, DRYS, EWA, AU, ABX, TFC; should be long: FCX, X, RIO, DVN, DO, RSX, MOS


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