Tag Archives: Banks

article 3 months old

Bank Recovery Remains Some Time Off

By Greg Peel

If you want to generate the greatest amount of visceral anger and disdain from Australian public, just tell it a bank has made a record profit. The populist media likes nothing more, because it makes for sensationalist headlines to spark fury amongst the great unwashed – or in this case, anyone with a mortgage or anyone who's been knocked back on a business loan.

While anyone knocked back on a business loan has a legitimate axe to grind, they can still lay more blame on the populist media and today's purely populist and shallow politicians. For it is they who entrench the notion in the average Australian that all that matters in life is the standard variable mortgage rate, and that banks are the Evil Empire which control the SVR at the average Australian's expense. Aside from Australia's bizarre tradition of basing a 20-year loan rate off an overnight cash rate, the irony is that it is the SVR obsession which is currently impacting heavily on the earnings outlook for banks.

The Big Four banks appeared to sail through the GFC, but for that they only have a populist government and a panicked electorate to thank. Despite hatred of the Big Banks being Australia's favourite indoor sport, it only took a GFC to send those same Australians rushing to the safety and the sanctity of those same banks in 2008-09. And given it is apparently a right and not a privilege in Australia to own one's own home, the government hurled money at prospective home buyers in that period. And where did Australians run to for their mortgages? To the Big Banks they otherwise despise. And so the Big Banks loaded up with new mortgages, as well as old mortgages from bankrupted lenders or gobbled-up smaller banks.

That loan book growth ensured the Big Banks were sitting pretty in FY10 at a time when analysts had expected a year of little earnings growth given likely bad debt write-offs and low credit demand (beside first home mortgages). This was great news, because analysts also expected FY11 would be the golden year when credit demand would return and the recapitalised Big Banks would see exceptional earnings growth off a cycle-trough base.

But there have been a wealth of problems with all of the above.

Firstly, banks simply do not borrow money at the overnight rate to on-lend to mortgage applicants or anyone else. So while the RBA was slashing its cash rate, banks could only remain competitive and slash their SVRs as well (albeit not by as much). The victims in this debacle were the business borrowers who saw little relief at all and a “talk to the hand” attitude from their lenders. SVRs are sacrosanct, and the banks had to act accordingly, at least as best they could.

I say as best they could because the banks knew they were facing a serious funding challenge which was a lot more than credit spreads spiking in the GFC. Outside of deposits, banks tend to borrow to fund their businesses by issuing bonds (of various shapes and sizes) in the two-five year range, not overnight. That is where the concentration of the average bank's loan exposure lies. So when the GFC hit, banks still had at least a couple of years of pre-crisis funding at low rates to carry them through.

When it came time to add more funding, it was simply no longer viable to roll over existing loans out to the same sort of 2-5 year maturities. The blow-out in credit spreads had made rates at that distance ridiculously expensive. So the banks had to take another tack, and that involved three separate strategies: (1) they went to the equity market and raised more capital; (2) they raised their deposit rates at the expense of their interest margins; and (3) they rolled longer term loans into short term loans. Short term loans were relatively much cheaper given the impact of massive global stimulus from central banks (eg, Fed rate at near zero).

The banks knew that they had to somehow get through the period where their previous cheap funding would become a lot more expensive, while at the same time being forced to drop their SVRs. It would be a tense time given the banks also had to put away provisions for an expected flood of customer debt defaults. But the hope was that FY09 would be the disaster, FY10 would be a year of trying to bungle through, and by FY11 the recovery would be underway and things would start going back to normal.

Enter Greece. As we moved into the second half of FY10, funding rates which had been quietly subsiding began to shoot back up again. Fortunately the RBA had also begun to raise again, so at least some relief was offered on margins as SVRs could also be quickly raised. But now that we have entered FY11, the world is facing a possible “double dip”.

To top things off, financial market reform has been on the agenda since the GFC and it is an election year in Australia. Knowing the obsession Australians have with SVRs, and just how popular a politician would become if he/she introduced legislation to curb bank profits, the banks were loathe to raise their SVRs any further than the cash rate implied. At the same time, their funding costs were becoming greater, and greater, and greater. Those short-date loans the banks had taken in the hope things would have settled down by this time now have to be rolled as well. And competition for deposits is fierce.

This means bank margins have been squeezed, and squeezed, and squeezed. And what's more, the blessed relief expected in FY11 is no longer expected. Credit demand outside mortgages has never recovered – indeed it has only weakened – and with the cash rate now back at 4.5% demand for mortgages has collapsed. The global economy is noticeably slowing, and the absolute reality is Australia only ever escaped a “recession” because of iron ore and coal. Australia ex-mining has realistically been in recession ever since the GFC and will likely remain so for some time yet.

Yet the Commonwealth Bank ((CBA)) was yesterday able to announce a record profit, prompting apoplexy from the media, politicians and the great unwashed. And just wait until CBA lifts its SVR on August 23 which is odds-on. There will be lynch mobs in the streets.

It's a strange obsession we Australians have. As noted, banks do not fund mortgages from overnight cash yet they are trapped in this cycle of moving SVRs in lockstep with the RBA. Only about a third of Australians actually have a mortgage, and an ever-growing population of Australians (ie the aging) actually benefit when rates go up, given return on deposits and other investments rise.

And then, of course, virtually every Australian with a superannuation fund, meaning virtually every working Australian, will have an investment in CBA and the other banks. Solid bank share prices and dividends are actually good for a very large proportion of the Australian population which otherwise spits fire when a record profit is announced.

But while record profits should be good for shareholders, yesterday following the announcement CBA shares tanked. Why?

They tanked because it doesn't matter what profit result a company produces – record or otherwise – it matters only whether that profit met the market's expectations. And even if it met the market's expectations, it matters just how that profit was made. In the current environment, perhaps the most important factor is whether or not the company thinks it can do it again next year.

As it was, CBA's profit result was a tad above consensus. So tick that box and then move onto boxes Two and Three. How was the profit made and what guidance/outlook did management provide for the next year?

This is where CBA fell down, on both counts.

Within the record result was an accounting movement of previously retained earnings into realised earnings. This represented a “bringing back” to the bottom line of provisions made in 2008 for expected bad debts. Indeed, CBA cut its provisions back by a whacking 50% despite still having trouble with the bad debts inherited by buying BankWest. This was not “new” profit. This was just old profit that was held back in FY09 and has now been released.

There is a certain amount of encouragement in the fact CBA feels safe enough to halve its bad debt provisions now, provided its reasons for doing so are sound. It is true that all the Big Banks put aside hefty provisions in 2008 – not just against their specific loan books but against general ongoing crisis fears. And it is true that while the world is still struggling no one much is talking Great Depression II anymore. But it would not be comforting to think CBA has rushed provisions back to the bottom line simply in order to meet, or beat, consensus forecasts, and avoid a share price shellacking.

As it was, the shares did take a tumble despite the record profit which beat consensus. The reason is that CBA brought back a lot more in provisions than anyone expected – so much more than clearly there had to be an offset somewhere else. And there was. So desperate has the bank's funding cost issues become, at a time when CBA has no choice but to keep its SVRs on hold, that its profit margins were a lot lower than analysts had expected.

Thus if you assume provisions to simply be a timing issue – a net zero result across accounting periods – CBA has put in a disappointing result. Management also suggested it simply ain't going to get any better in a hurry. And the bad news for any bank investor is the bulk of the problem is sector-wide. Indeed, CBA is arguably the most robust of the Big Four.

Having said that, analysts were somewhat surprised to learn on Tuesday, ahead of the CBA FY10 result, that National Bank ((NAB)) had managed to maintain flat margins in its third quarter. All of NAB, Westpac ((ANZ)) and ANZ Bank ((ANZ)) run on October-September financial years, so the June quarter was NAB's third and its FY10 result is not due until November.

Readers thus have to be aware that CBA is into FY11 now but for the other three FY11 does not actually begin until October.

Bank analysts had anticipated margin erosion, being fully aware that funding costs have been rising, SVRs have been stuck for three months and the competition for deposits has meant some generous deposit rates. So both NAB and CBA surprised – NAB because margins were flat and CBA because margins were even lower than analysts had expected. Yet while CBA beat profit consensus, NAB missed.

The reasons NAB missed were largely twofold. Firstly, unlike CBA NAB did not bring back a big whack of provisions onto the bottom line. It did write-off less bad debts than analysts assumed it would have to, but management chose to keep the bulk of its “provisions against ongoing crisis” intact until it knows more about what regulation changes the government might soon dump upon it.

Secondly, of all the Big Four it was NAB that was caught out holding the most “toxic securities” when the subprime crisis became the GFC – far more so than the other three. Those securities are still sitting there, and will probably do so through to maturity. But NAB has had to take out offsetting derivatives against those securities to hedge its exposure, and those derivatives have to be marked to market in value each accounting period. Credit spreads blew out again in the June quarter as global fears heightened, so NAB was forced to show a loss which analysts had not anticipated.

The good news is that the loss will eventually reverse, maybe even in the September quarter. More good news is that by not bringing back the same level of provisions as CBA, NAB still has those provisions to bring back at a later date. The bad news is one reason why NAB did not see the same margin erosion as CBA is because it has not been as aggressive in attracting fresh deposits.

What this means is that while NAB's margins and revenues are looking healthy at present, its capital position is not quite as comfortable as those of the other banks. This is rather important given it is NAB, not any of the other three, trying to take over AXA Asia Pacific ((AXA)). If NAB succeeds in its takeover, but most AXA shareholders take cash instead of scrip, a capital raising is a strong probability.

Nevertheless, bank analysts feel a little better about NAB's prospects than CBA's in the nearer term if for no other reason than NAB is currently undervalued with AXA hanging over its head, while CBA is still carrying its traditional 20% premium. In light of the CBA result, analysts were again forced to ask whether or not CBA still deserved that premium. Consensus suggests no, or at least not all of it, and indeed while the Big Two of CBA and Westpac deserve some sort of recognition for sheer size over NAB and ANZ, it also means they are carrying the biggest number of new loans, along with inherited and lower quality loans from BankWest and St George respectively. Hence the Big Two are feeling the margin squeeze the most and are unlikely to be able to grow their loan books ahead as aggressively as the Little Two.

For analysts still believe that while mortgage demand will slow up now, business credit demand is going to come back eventually. But it's not going to come back as fast as analysts were assuming back in 2009, or even as we entered 2010. CBA's FY11 revival now looks like being more of an FY12 story, with a period of low growth in between, while NAB will probably see low growth in the last quarter of its FY10, before a rebound sometime in its FY11.

NAB has indicated it will not move first in raising its SVR, independently of the RBA, immediately after the election. However, analysts assume that while NAB may not lead it will likely follow. CBA would not rule out an increase, which we can probably assume means an SVR hike on August 23, unless the banks go into one of their staring competitions. By lifting their SVRs the banks will be able to remove some of that margin pressure, but the fact remains funding costs are still an issue and the competition for deposits – although probably not quite as tight as a few months ago – only adds to the pressure.

What the Big Banks also have to deal with is that now that the worst of the GFC is (hopefully) behind us, the smaller banks are once again picking up business and renewing competition.

Bendigo & Adelaide Bank ((BEN)) released its FY10 result on Monday, ahead of both NAB and CBA, and boasted a doubling of profit from FY09. But Bendigo's result looked a lot like CBA's in many respects. Bad debts were lower than analysts had assumed, offsetting lower margins. It was a credible result, but a handful of analysts still worry that Bendigo is undercapitalised and will struggle to grow earnings meaningfully unless it can pick up an acquisition. Here, capital comes into question once more.

So what is the overall outcome of this week's bank results? Well, every bank analysts has downgraded earnings forecasts for FY11 for each of the three. Bendigo remains with half-hearted analyst support, showing a Buy/Hold/Ratio of 4/5/1 in the FNArena database.

NAB has come out with its ratio intact, remaining on 5/5/0. However, of the five Hold ratings, four of those brokers are actually restricted given their involvement in one or other side of the NAB-AXA takeover attempt. FNArena ascribes Hold when a broker is restricted given we cannot guess otherwise. Judging by analyst rhetoric however, NAB's ratio may well be closer to that of ANZ which currently leads the four on 8/2/0.

ANZ's ratio, and the better ratio we can assume for NAB, indicates the preference analysts have for the smaller banks on a valuation basis. Ostensibly, when the recovery comes the smaller banks will be looking at more upside potential.

The same cannot be said for the robust yet lumbering giants, who seem to have dug themselves into a bit of a hole as the world slips back into recession fears. Both CBA and Westpac are showing ratios of 2/8/0. Ahead of its result, CBA was on 5/5/0, but three brokers downgraded to Hold in the wake. CBA's average target price slumped from $56.53 to $54.15.

On the matter of targets, it would seem either the market responded a bit too negatively this week or bank analysts are still kidding themselves. CBA might look reasonable, but Westpac is showing a full 16% upside to target and can still only draw two Buy ratings.

We are yet to have a quarterly update from Westpac, or ANZ. Perhaps we shall then see some changes. But if the banks have been too heavily sold this past week then it does not detract from the fact they had become clearly overvalued. FY11 is simply not going to be the golden year analysts had once expected. If anything, the story moves out to FY12 following a period of sluggish growth, perhaps more sluggish than FY10.

article 3 months old

Get Off The Double Dip Trip, Says CBA

By Greg Peel

Recessions inspired by crises directly within the financial system are different from those which follow that natural ebb and flow of an economic cycle through boom into bust, or so many an economist has pointed out since 2008. Typical recessions occur when markets become over exuberant and consumers overconfident, leading to inevitable blow-offs and a swing back the other way, and thus ultimately “recessions we have to have”.

Most Australian bank analysts made the glaring error in 2008 of assuming any recession resulting from the US subprime crisis would be a typical one in which banks became a defensive, safe haven investment. What it took them too long to realise was that it was actually banks that were the problem.

And the problems in the financial sector highlighted the fact just about everybody else – from corporates to households to governments – was simply carrying too much debt. In typical recessions, corporates have to ride out the drop in demand by slashing spending and cutting staff. In financial recessions, corporates have to do the same but they also have to reduce their debt levels – to “deleverage” - and households are forced to do the same. The requirement to deleverage only exacerbates the downturn and that is why, as CBA points out, financial recessions tend to be deeper and longer lasting than typical recessions.

So here we are about to mark the second anniversary of the fall of Lehman Bros and the world is suddenly screaming “Oh my God, we're heading back into recession again”. But are we really heading back into recession across the globe, or did markets just get a little too far ahead of themselves, expecting a “typical” bounce out of recession and then a fresh bull market shortly afterwards?

Clearly the global economic recovery has been weak, and nothing of the V-bounce some bulls were touting as recently as early this year. But CBA argues that the global economy is simply following a predetermined script. Recovery from something as significant as the GFC was always going to be slow and sluggish – the Fed knew it, and even the RBA knew it, albeit the RBA did not see the cavalry coming so swiftly and decisively in the form of China.

“The factors that make recessions associated with financial crises longer and deeper than typical downturns, “says CBA, “also tend to mute recoveries when they finally arrive. So we shouldn't be surprised when the [global] economic data are weak and uneven”. Statistically, such recoveries in the first year after are only half those of typical recoveries and it takes twice as long to return to previous peak growth. Balance sheet repair acts as a “deadweight”.

Those corporates which survive a GFC have little choice but to get on with it – shareholders expect nothing less. But at the household level, consumers are so terrified into submission that it can take a long time before the scars heal, the pain and fear subside and first timid steps are taken again beyond financial sanctuary. CBA notes that while business confidence measures have returned to average levels, consumer confidence remains well below average. Corporates can increase productivity by slashing workers, but enduring high unemployment levels hit right at the heart of the consumer.

The other problem is that most developed economies went into the GFC with high levels of public debt, and have been forced to increase those debt levels in order to stimulate economies and prevent complete Depression. This means corporates and households are deleveraging as governments are increasing leverage, which means come the recovery governments then have to also deleverage and that only serves to slow down recovery.

In order to deal with government debt levels, a structural step-down in economic growth rates must likely follow, says CBA, particularly in those countries most affected. Which brings us to an age-old economic argument.

If a government wants to reduce a deficit, then it would make sense to raise taxes and cut spending, wouldn't it? More income goes in and less expense goes out. But history shows that in fact the opposite tends to be true. If taxes are cut and spending increased, the resultant pick-up in economic growth provides more in the coffers to use for debt repayment. Raising taxes and cutting spending reduces economic growth, and thus net government takings.

This is what Europe has been forced to do, fearing straightforward debt default. Having initially agreed to join the world chorus of stimulate or die, Europe has simply acknowledged it must now live with lower growth rates for quite some time. Meanwhile over in the US, the Fed last night ceased the withdrawal of its monetary stimulus and there is a growing belief the Obama Administration will extend the expiration date of the Bush tax cuts. America can, after all, just print money.

Economists are usually quick to regret suggestions at any point that “this time it's different” but CBA is prepared to point out a couple of reasons why the recovery from this GFC is different to others past.

The US corporate sector was quick to recognise that the best path to recovery was increased productivity, which meant both very tight inventory management and significant cost cutting. The latter meant “savage” job cuts, suggests CBA. Productivity increases means sales increases flow quickly to the bottom line, and so it has been that over the past few quarters – and the current US reporting season has seen more of the same – corporates have reported modest revenue gains but significant gains in earnings. What this means, says CBA, is that the US corporate sector is recovering faster than would normally be expected.

But clearly the US economy is struggling. Why? Because the corporate sector pales by comparison to the US consumer sector, which represents 70% of the US economy. So while American consumers are still hiding in their caves, business capital spending is actually on the rise. The corporate sector isn't big enough by itself to produce a V-bounce, but it's big enough to prevent a double dip, says CBA.

And a quiet turnaround back to capital spending bodes well, on a lag effect, for the consumer. After capital spending comes employment growth.

The Fed was slow to move at first but decisive thereafter as the GFC hit in earnest. It is now expected the Fed will maintain near zero interest rates all the way through 2011, which keeps a lid on the US dollar. The weaker dollar has been an essential element of what US recovery we've seen so far, because it has lowered the cost of US exports into developing countries.

And in 2010, Europe has felt the same benefit. With all the problems surrounding the eurozone and its common euro currency, Germany is actually benefiting from the crisis given a weaker euro reflecting problems elsewhere in the zone. Had there been no euro, the Deutschmark would no doubt have risen strongly as a safe haven currency and thus impacted the export receipts of the world's biggest export economy, notes CBA.

But even Germany entered the GFC with a budget deficit (albeit a large trade surplus), so now Germans, too, are facing austerity measures designed to rein in European government debt. Europe has a long road ahead to swing deficits into surplus, although early progress is encouraging. However, higher taxes and lower spending simply mean structurally lower economic growth for quite some time.

So we have US and European markets facing subdued economic growth, and consumers who are unwilling to buy too many imports. This is typical of past financial recessions, but there is a new factor this time.

This time we have Asia, and Asian economies are outperforming. While much can be put down to government stimulus measures, the reality is longer term structural changes are seeing the Asian consumer emerge as a major driver of domestic growth, notes CBA. Imports into Asia are growing “very quickly”.

So demand from Asian consumers is growing, while demand from developed countries is subdued but still growing modestly. Asia has thus seen its export economies weaken, but its domestic economies appear to be sufficient drivers even if exports to developed countries remain weak, says CBA.

In other words, we're suffering from a sluggish and uneven rebound out of a major financial crisis and that is only to be expected. Under the current circumstances, what doesn't need to be expected is another slide back into global recession, in CBA's view.

article 3 months old

Macquarie’s Conviction And More FY11 Previews

By Greg Peel

Macquarie is pleased with its more recent conviction calls. (Just to recap, a broker's conviction call means rather than just Buy, for example, a rating is really Buy With Ears Pinned Back).

Rio Tinto ((RIO)) went on the list in April at Outperform and has now outperformed the market by 2%. Westpac ((WBC)) went on last month and has provided 3% outperformance.

The broker has now added Stockland ((SGP)) as an Underperform with conviction. The stock is trading 3% above the broker's target price but the company's residential communities business is under pressure from slowing housing finance demand, slowing building approvals, slowing auction clearance rates, and lower house prices. The situation is worst in Victoria where the broker expects an outright house price correction in Melbourne later in the year as housing affordability plummets and immigration drops. Stockland is 25% exposed to Victoria by number of lots in its pipeline.

Macquarie also has Brambles ((BXB)) on the Underperform list, becoming more convinced after the analyst spoke to manufacturers, competitors and customers of CHEP in Europe and the US.

The ASX ((ASX)) is also on the Underperform list while the Outperform conviction list features Boart Longyear ((BLY)), News Corp ((NWS)), and Rio. Westpac and Commonwealth Bank ((CBA)) are also there on Outperform as a switch play out of ANZ ((ANZ)) which the broker has at Neutral.

Looking at the engineering and construction contractor sector, Macquarie expects flat FY10 results but 10% sector growth in FY11 given stronger revenues from increased order books, as well as slight improvement in margins. Some 70-75% of FY11 orders have already been secured, which is to the high end of the historical scale.

The replacement of the RSPT with the MRRT has Rio and BHP Billiton ((BHP)) off and running again, and the contractor sector stands to benefit from planned Pilbara expansions.

Macquarie has United Group ((UGL)) and Leighton Holdings ((LEI)) as preferred on Outperform, while Downer EDI ((DOW)), Transfield ((TSE)) and WorleyParsons ((WOR)) score Neutrals.

RBS Australia also expects flat FY10 results and few surprises in the transport sector, given softer trading conditions and profit downgrades to date.

The broker expects FY11 outlooks to be positive but cautious, given airfreight volumes are growing, business air travel is recovering, container volumes at ports are back to 2008 levels and coal demand remains strong, plus the global economy is growing again.

Qantas ((QAN)) and Asciano ((AIO)) are the broker's top picks in the sector with Toll Holdings ((TOL)) also on Buy. Brambles and Virgin Blue ((VBA)) score Hold ratings.

Morgan Stanley is more circumspect on transport, suggesting cheap valuations are balanced by most industrial companies holding back until there are signs of a sustained recovery.

MS agrees on Qantas however, and has it at Overweight. Thereafter Asciano and Toll only score Equal-weights along with Brambles and Virgin.

Citi has noted the new UK government has produced a white paper which outlines its five-year plan for reform of the National Health Service.

Key to the plan is an element of “patient choice”, based on surveys which suggest most Poms blindly accept a GP's recommended medical service provider without realising the GP can offer options. The government wants to specifically educate that choice is up to the patient.

This could be a positive for Ramsay Health Care's ((RHS)) hospital volumes, Citi suggests, and for Sonic Healthcare's ((SHL)) diagnostic services. But there are a couple of caveats.

One is that pathology reform has been on the agenda since 2002, and Sonic is still waiting, and the other is that the government also wants to change its tariff payment system to reward “excellent care” rather than just using an average price. This might impact on Ramsay – not because it offers poor care but because who on earth is going to be the arbiter?

article 3 months old

The Overnight Report: Stocks, Metals Surge On Thin Air

By Greg Peel

The Dow closed up 208 points or 2% while the S&P gained 2.2% to 1125 and the Nasdaq added 1.8%.

Technical analysts are having a field day at the moment. Last week the S&P 500 regained the 200-day moving average at 1114 having already conquered the 50-day but slipped back again to mount another assault. That assault came last night when the S&P not only re-took the 200-day but at 1125 closed just shy of the 100-day moving average at 1126, having briefly traded above just before the death.

There is one school of traders suggesting that if the S&P can hold above the 200 they will be buyers, and now they're saying if it can move above the 100 they'll be buyers. The way things are progressing, it looks like the buyers are winning at present. But it's times like these when the sellers just wait patiently.

Readers may recall that we spent a lot of early 2009 suggesting that “less bad” was the new “good” before we moved on to become obsessed with “green shoots”. Well those green shoots went on to bloom into reasonably healthy flowers until they were attacked by the Greece mite. Then China began a defoliation program, and finally US garden beds began to wither. The fear was we may end up with barren soil once more.

The US second quarter GDP reading was enough to send the Dow tumbling initially on Friday but a solid read from the Chicago PMI turned that around. The anticipation was that perhaps the Chicago number would mean a not so bad national manufacturing PMI release. There was also a fear the Chinese PMI would dip into contraction, which would psychologically be enough to spook the market once more. And that's where we were ahead of Monday's trade across the globe.

The official Chinese manufacturing PMI, released on Sunday, showed a fall only to 51.2 from 52.1 which meant slower expansion – just as Beijing has intended – but not contraction. Both Australia yesterday and Wall Street last night took this on as a positive, despite the independent HSBC calculation for the Chinese PMI slipping into contraction territory at 49.4.

If the Australian market stumbled, it was only for a moment. The local PMI came out at 54.4, up from 52.9 in June. We all know that mining's in a sweet spot, but grave fears have been held for the rest of the economy.

The UK followed with a dip from 57.6 to 57.3, which was not as bad as expected. And then the eurozone surprised with a rise from 55.6 to 56.7 when Europe's meant to be the one region in the most trouble. It just goes to show what a lower currency can achieve.

So it was all up to the US and sure enough – the number was less bad than thought. July's PMI fell to 55.5 from 56.2 but economists had expected 55.0. And to top things off, economists had expected June US construction spending to fall 0.5% after a 1.0% fall in May but instead it rose 0.1%, albeit boosted by government programs.

It was the third consecutive drop in the US PMI, but the number is still above 50, indicating expansion. It is thus “less bad” than the pessimists have been suggesting. If you ignore HSBC, the Chinese number was also “less bad” than might have been. And Europe? Why are we even worried about Europe?

Indeed, China and Europe had the Dow up 150 points from the bell last night before the US PMI was even released. Aside from the eurozone PMI, major British bank HSBC and France's largest bank BNP Paribas both reported much better than expected quarterly earnings. That was enough to reignite risk-taking, and the US PMI just added another 50 points. “Less bad” is “good” again.

While this may be all very exciting, the fact remains there's not a lot of conviction. Volumes in the US were tepid at best. It was the first day of the month, which is a day when funds make their fresh allocations. Fund managers were then caught in the vacuum that is short-term trading, not long-term investing.

The same was true for base metals in London. While most of the “real” metal market is closed for the summer, commodity funds were making fresh allocations last night and short-term supply squeezes have been sending metal price through technical levels as well. More technical levels were breached last night, sending copper, aluminium, nickel and zinc up 3-4% and lead up 7%.

Of course, such surges in metal prices adds fuel to the stock market via the materials sector. BHP ((BHP)) and Rio ((RIO)) shares jumped 4-5% in London and New York trading.

And oil was not left behind. PMI mania sent oil up 3% or US$2.39 to US$81.34/bbl to its highest level in three months. A breach of the US$80 is also enough to make everyone psychologically excited again. And the oil price spurred on oil stocks.

While it may have been all fun and games in the risk assets of stocks and commodities, there were reality checks elsewhere. Bond yields did rise, but the benchmark ten-year remains below the psychological level of 3% at 2.97%. But what had commentators shaking their heads was a US$1.5bn issue of three-year bonds from Dow component IBM.

The IBM issue was priced, and put away, at a mere 30 basis points over the equivalent Treasury, or 1.14%. This means investors are happy to tie up their money for three years for the miserly return of only 1% when IBM stock is paying a dividend yield of 2%, and management recently suggested the dividend payout would rise. Why take 1% over 2%? because if you buy the bond there is a very good chance you'll get your money back after three years. If you buy the stock, you might get 2% but where will the stock price be?

Clearly investors are not prepared to take the risk the stock price will be higher, even in three year's time. It is that prevailing attitude that has ensured the 2009 stock market rally was no more than a correction from an oversold position. Until true investors, and not just traders, are ready to dive back in, Wall Street is not going anywhere spectacular in a hurry. These things take time. My call for 2010 was sideways. The S&P 500 re-took the 200-day at 1114 last night. The S&P closed at 1115 on December 31, 2009.

The VIX volatility index last night fell to 22.

Over in currency markets, a strong PMI and solid European bank results had the euro on the fly again, sending the US dollar index down 0.9% to 80.89. The Aussie risk indicator naturally flew too, up a cent to US$0.9139. But gold went nowhere despite the US dollar drop, closing up US60c at US$1182.00/oz.

The SPI Overnight jumped 64 points or 1.4%.

The ASX 200 re-took 4500 again yesterday, but the ASX 200 closed last year at 4870, so the local index is undeperforming the US index by about 7.5%.

Today in Australia sees building approvals, retail sales, and the RBA (non) decision. Tonight in the US sees factory orders, pending home sales, vehicle sales, and income and expenditure. Dow Chemical, Mastercard, Pfizer (Dow) and Procter & Gamble (Dow) will release results. 

[Note: All paying members at FNArena are being reminded they can set an email alert specifically for The Overnight Report. Go to Portfolio and Alerts in the Cockpit and tick the box in front of The Overnight Report. You will receive an email alert every time a new Overnight Report has been published on the website.]

article 3 months old

Don’t Write Off Mac Bank Too Soon

By Greg Peel

Stock analysts have always found Macquarie Group ((MQG)) a difficult company for which to forecast earnings. Prior to the GFC, the bulk of Group earnings came from performance fees from its various listed infrastructure funds – a business which came to define the “Macquarie Model” - while the typical investment bank activities of stock-broking, M&A, capital markets and so forth performed well but took a back seat. Commercial banking operations such as funds management were also passengers.

Because the Macquarie Model was unique, at least before others began to copy it, analysts did not have much of a benchmark to work off. This even led JP Morgan's then senior bank analyst to provide two separate valuations for MQG – one as an investment bank and one as a listed fund originator/operator. But there was also another problem.

Macquarie was not known as the “Millionaires' Factory” for no good reason. The Group's success has always been built on hiring the best and brightest and then rewarding them handsomely for being the fundamental drivers of profit. Shareholders learned to accept this model despite around half the profit pool being paid out in executive bonuses each year. It was hard to argue with a soaring share price.

The problem was, however, that the actual percentage of the profit pool paid out to staff has, over the years, fluctuated between 43-53% at management's discretion, as JP Morgan's current bank analysts note. Given the extent of bonus payments to profitable executives, variations in payout translated into large variations in reported profit, yet there was never any reliable guide as to just what that payout ratio might be each year.

Throw in former CEO Alan Moss's propensity to always guide very conservatively – to the point analysts would routinely add about 10% as a rule – and Macquarie has often been somewhat of a guess and giggle from a forecasting point of view, at least in terms of getting the numbers spot on.

More qualitatively, analysts have learned over the years never to write Macquarie off. The Bank, and now Group, has built a reputation for innovation and first-mover status, initially in Australia and then in the world.

The GFC has now put paid to the Macquarie Model, or at least what one might label as the Macquarie Model of about 1992-2008. The truth is Macquarie has no one model but simply adapts to opportunities presented. Prior to the '92 recession, profit was all about the traditional investment bank activities of commissions and proprietary trading profits. With the infrastructure fund business now winding down, the focus is back on such activities.

But just when the FY10 (April-March) rally was providing analysts with an expectation that trading profits would provide the back-up for a stronger recovery in general earnings in FY11, things have slowed to a standstill. The weak markets of the June quarter – Macquarie's first quarter on an accounting basis – has led current CEO Nicholas Moore to suggest FY11 earnings may struggle to beat FY10's. This is a much weaker outlook than analysts were expecting.

Moore has landed in a tough environment having pushed hard for Alan Moss to make good on his retirement plans. Ironically, Moss's background was in typical investment banking activities while Moore was the architect of the now defunct Macquarie Model. Moore now has to work with a less familiar “Treasury” group as the significant source of income, while at the same time the GFC has forced Macquarie to upgrade its commercial banking activities to a more traditional status. One impetus was so that Macquarie depositors and cash management investors could be eligible for the government's emergency guarantees of 2008.

Nowadays the Treasury group is divided into Macquarie Securities (eg stockbroking), Macquarie Capital (eg M&A underwriting) and Fixed Income, Currencies and Commodities (which speaks for itself). It was a weaker than expected first quarter performance in all three now fundamental divisions that led Moore to suggest that FY11 might fall short of FY10, were the conditions of the first quarter to extend for the rest of FY11. Moore's guidance has led analysts to downgrade their FY11 earnings forecasts en masse.

However, Merrill Lynch points out that Moore's warning is “not necessarily a forecast but a statement of fact”. FY11 will only fall short if first quarter conditions remain for all of the next three quarters. In other words, it would require the same weakness in financial markets we saw from April highs to June lows occurring every quarter.

It is a warning worth making, given Macquarie's return on equity for FY11-13 is forecast by UBS to be 10.7%, 12.2% and 13.3% respectively compared to a cost of capital of around 13%. In other words, Macquarie is coming out of the GFC into a period of negative organic growth. But then it all depends on what happens ahead.

Whether rightly or wrongly, Macquarie's share price was trashed in 2008, forcing the Group to raise substantial capital. But once the initial panic had abated somewhat, management went to work deploying that capital by picking off the wounded from the herd in North America and the UK, purchasing stock brokerages and so forth and expanding its international footprint. The Group is still sitting on some $3bn of excess capital.

Given weak conditions, new acquisitions are yet to make an impact but RBS Australia feels the recovery that everyone was anticipating in FY11, looking ahead from FY10, has simply stumbled but not fallen. “Whilst the current operating conditions are subdued,” notes RBS, “the investment banking cycle appears to been pushed back rather than cancelled altogether”.

Merrills' assessment is that “Despite the poor earnings revision momentum we think earnings are currently depressed and it is not a foregone conclusion 1Q11 will repeat all year”.

There is general agreement among brokers that the first quarter is not necessarily a template for the future, but disagreement as to just when conditions might improve and when acquisitions might start making a difference. Whenever that may be, Credit Suisse suggests the leverage the Group enjoys to improving activity trends is simply “dead money” at the moment.

JP Morgan also notes that the staff payout ratio of 46% in FY10 – at the low end of the scale – served to offset some of the weakness in earnings results. Obviously this is a trick Moore has up his sleeve if necessary, but it creates another problem.

In the glory days, prospective trainees and executives would be prepared to walk over hot coals to get into the Millionaire's Factory. Today the attraction is not so great, and indeed aside from management quietly putting some of the longer serving executive directors out to pasture there is a groundswell of dissatisfied staff being poached to the opposition.

In 2008 I joked that Macquarie was no longer the Millionaries' Factory but the “Hundred-Thousandaires' Factory” and soon actually learned that many an executive had become technically bankrupt through the leveraged acquisition of company stock. But it seems it was no joke. UBS notes that Macquarie's executive payout per head has fallen to US$487,000 compared to a global peer average of US$1.15m. That's a big difference.

Macquarie has built its reputation and always silenced its critics by being adaptive and innovative over the decades and that has all come down to those best and brightest. Macquarie executives were always the highest paid in Australia and among the highest in the world. But not any more. It is for this reason many an analyst has warned that staff retention is an issue that cannot be underestimated in its importance.

With that caveat, analysts also agree that at 1.1x book value Macquarie is offering compelling longer term value given the optionality of acquisitions, future capital deployment and leverage to eventual recovery. Deutsche Bank can see the Group's return on equity increasing to 16-17% in a recovery and that equates to a price to book of 2.2-2.5x – a big jump from where we are now.

Again, it all comes down to just when that ultimate recovery may be. Yet it would be naïve to write off Macquarie Group and to that end six of nine brokers in the FNArena database (Macquarie does not rate itself) have Buy ratings on the stock, with Aspect Huntley upgrading from Accumulate on the day of the AGM guidance announcement and UBS upgrading from Hold subsequently when the stock price took a tumble.

The three Hold raters are those who believe the recovery will take a little more than the next quarter or two, and cannot see any immediate short term catalysts despite longer term potential. There is a big target price range, from Citi (Hold) at $40.00 to Deutsche (Buy) at $56.50. On a twelve-month basis that implies a range of 6% upside to 50% upside from today's price.

article 3 months old

Just How Risky Are China’s Housing Markets?

Reinhart and Rogoff’s recent influential study of financial crises finds a recurring root – the country’s property markets. This column argues that a similar housing bubble may be developing in China. Urgent research is needed to determine the risk of a full blown crisis.

By Yongheng Deng , Joseph Gyourko and Jing Wu

China is experiencing spectacularly fast growth – so fast that many fear it is driven by a bubble – a property bubble to be precise. Recent memories of what happened when the US housing market bubble burst make the possibility of a Chinese housing bubble a critical concern for the world economy. So, is there a bubble or is it simply hot air?

Financial bubbles are governed by something like the economic equivalent of physics Heisenberg's uncertainty principle. It is impossible to observe a bubble with certainty without actually altering the bubble itself. If people knew it was a bubble, it wouldn't be a bubble – it would have already collapsed. It would not, however, be impossible to envision “diagnostic tests” that would provide a probabilistic identification of a bubble. Unfortunately the state of economics does not provide such a procedure (see Flood and Hodrick 1990 for an early analysis of what would be required to determine convincingly whether or not a speculative bubble exists).

The problem is particularly acute in the case of Chinese housing. Data limitations arise from the fact that there was no real private market in land or housing units in China until the late 1990s, so it is only possible to compare current conditions to little more than a decade of previous data. It is not hard to find highly respected professional investors with opinions on both sides of the question over China’s bubble (see the article by Barboza 2010 in The New York Times for a discussion).

New evidence on a Chinese housing bubble

Our look at the available data strongly suggests that prices are quite risky at current levels, and that it would take little more than a modest decline in expected appreciation to engender sharp drops in prices. The first foundation of this conclusion is that home prices in China are at their all time highs, and have been appreciating at especially high rates recently. This is documented in Figure 1 which plots real and nominal price indexes developed at the Tsinghua University for newly constructed homes in 35 major cities.

Real prices more than doubled over the past decade, with appreciation rates escalating at the beginning of 2007 and then again in early 2009. The most recent data show a record 41% (annualized) growth rate for the first quarter of 2010.

But it was not high price levels alone that convinced Case and Shiller (2003) and Shiller (2005) that US house prices had become unsustainable – it was the all-time high price-to-rent and price-to-income ratios.

Information on price-to-rent ratios is less widely available for Chinese markets. Figure 2 plots them since early 2007 for eight major Chinese cities. Price-to-income ratios are then plotted in Figure 3 for these same markets, using data back to 1999. For those unfamiliar with these markets, they are listed on the map in Figure 4. Each is among the largest markets in China, with none having a population below 8 million.

- Price-to-rent ratios have increased by at least 30% over the past 3 or so years in each of these cities.

- The jump was very large in Beijing, rising by almost three-quarters from 26.4 in 2007 to 45.9 in the first quarter of 2010.

- Hangzhou, Shanghai and Shenzhen also have seen their price-to-rent ratios rise sharply to over 40.

Even though income growth has been strong in urban China, price-to-income ratios also have been increasing in these same markets.

- Income growth did keep pace with house price appreciation in the other large markets, so housing has not become less affordable everywhere, according to this metric.

Chinese government data indicate that these price rises are underpinned by rapidly escalating land values. Because the Chinese government still owns all the land in urban areas and leases its use for long periods of time, we can observe land prices independently from home sales (which include the land plus the structure). We collected data on all the residential land parcel auctions in Beijing dating back to Q1 2003, and created a constant quality price index for Beijing residential land, controlling for a number of location and site quality variables that are described in Wu et al. (2010).

Figure 5 shows that real, constant quality land values increased by over 750% since 2003 in the Chinese capital, with more than half of that rise occurring over the past two years. Additional regression analysis showed that state-owned enterprises controlled by the central government played a meaningful role in this increase, as prices were 27% higher on the parcels they won at auction compared to otherwise equivalent land sites purchased by other investors.

Suspicions if not proof

While it is impossible to conduct a formal test of whether there is any fundamental mispricing in Chinese land and housing markets with these limited data, there certainly is much to make one more than a little suspicious that prices are unsustainable.

The magnitude of the increase in land values over the past 2-3 years in Beijing is, to our knowledge, unprecedented.

These increases post-date the Summer Olympics and the recent price surge in early 2010 suggests a relationship to the Chinese stimulus package which itself is temporary.

The role of state-owned enterprises also is potentially worrisome. It could be that these entities are superior investors and are purchasing sites that are of especially high quality in ways that we cannot control for in our empirical analysis. However, it also could be that moral hazard is at work here, as these entities are thought to have access to low cost capital from state-owned banks and may believe they are too big to fail. If this is the driving force, then prices are being bid up as one arm of the government buys from another.

More broadly, the sharp rises in price-to-rent ratios in Beijing and the other large markets look to be very difficult to explain fundamentally.

Most true fundamentals just do not change so discretely or in such magnitudes as to be able to explain these changes.

The standard economic model of home valuation indicates that owners must be expecting very high rates of price appreciation for these price-to-rent ratios to be sustainable.

That people might believe in such high appreciation is not incredible given the recent history of Chinese house prices. However, this sort of backward looking expectation formation is a classic element of bubble psychology. Moreover that history is quite limited and tells us that prices never go up forever – much less at the extremely high rates experienced over the past few years.

What happens if the bubble bursts?

To provide some insight into just how risky prices and price-to-rent ratios are at these levels, we calculated what would happen if people began to expect that their homes would grow in value by only 4% per year. For Beijing, prices would fall by over 40%, absent offsetting rent increases or other countervailing factors. While a 4% rate of appreciation is lower than what has been experienced in the capital city over the past few quarters, house prices did grow by less than that for five consecutive years from 1999-2003. Indeed, 4% is not an especially low rate of appreciation in the broad scheme of things. If it were to continue for a decade, prices would be 48% higher; over 20 years, prices would more than double (+119%).

Reinhart and Rogoff’s recent study of financial crises often finds the genesis in the country’s property markets (see Reinhart 2008 on this site). Recent data indicate there is reason to suspect a similar predicament in China’s housing sector. Whether it leads to a full blown crisis is another matter, of course, that depends upon the amount of leverage in the system and the safety and soundness of the regulatory environment, among other factors. Those clearly are matters in need of urgent research if we are to fully understand the potential fallout from a meaningful drop in Chinese house prices.

References

- Barboza, David (2010), “Contrarian Investor Sees Economic Crash in China”, The New York Times.
- Case, Karl and Robert Shiller. "Is there a Bubble in the Housing Market?" Brookings Papers on Economic Activity, No. 2 (2003): 299-362.
- Flood, Robert and Robert Hodrick (1990), "On Testing for Speculative Bubbles", Journal of Economic Perspectives, 4(2):85-101.
- Reinhart, Carmen and Kenneth Rogoff (2009), This Time Is Different: Eight Centuries of Financial Folly. Princeton University Press.
- Reinhart, Carmen (2008), “Eight hundred years of financial folly”, VoxEU.org, 19 April.
- Shiller, Robert. Irrational Exuberance (2nd edition), Princeton: Princeton University Press, 2005.
- Wu, Jing, Joseph Gyourko and Yongheng Deng. “Evaluating Conditions in Major Chinese Housing Markets”, NBER Working Paper 16189, July 2010.

Yongheng Deng is Professor of Real Estate and Finance at the National University of Singapore

Joseph Gyourko is Professor of Real Estate, Finance and Business and Public Policy at the University of Pennsylvania

Jing Wu is Assistant Professor at Tsinghua University

Copyright VoxEU.org - the above story was originally published on www.VoxEU.org - readers reading this story through a third party channel may find that any graphs are not included (our apologies for this technical anomaly) - here's a link to the original story on the VoxEU website: click here

article 3 months old

The Overnight Report: No Answer Yet To: Which Way Now?

y Greg Peel

The Dow closed up 12 points or 0.1% while the S&P slipped 0.1% to 1113 and the Nasdaq fell 0.4%.

I asked the question in yesterday's report “which way now?” and it seems Wall Street is not yet ready to come up with an answer. After three consecutive triple-digit gains in the Dow, a fourth was a bridge too far. A fourth would have been significant, given it has never happened before in history.

Instead we managed only a small gain in the Dow, while the S&P 500 slipped slightly to be sitting right a-top its 200-day moving average – a level which the index has failed to breach on three separate occasions since the market fell through the 200-day in May. The S&P did close above the 200-day on Monday night, but 2 points is not confirmation.

I also noted yesterday that were the S&P to tick up over 1117, it all but dismisses a potentially bearish head-and-shoulders pattern on the chart, at least on a short-term basis. But my esteemed Editor was quick to point out that there is another way to view the current head-and-shoulders situation. Have a look at this graph and no – do not adjust your sets:

This is the same one-year graph of the S&P 500 I published yesterday, only it's upside down and back to front. To the right-hand side we note that over the period of nuJ and luJ we've formed a very nice reverse head-and-shoulders. And those are bullish. Again, we just need to knock off 1117 to confirm.

And then apparently if we move through 1128 we've knocked off the 100-day moving average, which is taken by some as a clearer picture of the shorter-term trend without the noise from the European panic earlier in the year. Of course you could go on forever with this stuff.

Back in the real world, last night saw a very positive earnings report from chemical producer DuPont (Dow) which featured both Street-beating numbers and upgraded guidance. This has been the trend for the past few days of the earnings season, but then along came US Steel (Dow).

US Steel doubled its revenue in the second quarter but still managed to make a loss given high iron ore and coal prices (damn that BHP) and an unfavourable currency along with weaker steel prices. Management forecast an uncertain third quarter before an expectation of some improvement in the fourth. Shares in US Steel fell 6.5%, offsetting DuPont's 4% gain.

Offshore companies also had mixed results. BP made a substantial loss, although no one was surprised. But if European commercial banks are struggling at present, and requiring stress tests, clearly European investment banks are in better shape. After solid results, Germany's Deutsche Bank rose 3% while Switzerland's UBS rose a whopping 9%.

On the US economic data front, there was good news from Messrs Case and Shiller. Their 20-city house price index rose 1.3% in May on a month-on-month and seasonally adjusted basis despite May being the month new home sales numbers fell 36%. The twelve month gain in the Case-Shiller is now 4.6%.

But the Richmond Fed announced its manufacturing index fell to 16 in July from 23 in June (zero neutral) while the Conference Board announced consumer confidence fell to 50.4 in July against an expectation of 51, and down from 54.3 in June. This is not a 50-neutral index and the best way to gauge it is to note that the period 2004-07 averaged a reading of 98.

The result for the Richmond manufacturing index corroborated the trend in July which has seen all of the New York, Philadelphia, Chicago and Dallas Fed districts note a slowing in activity – not a contraction, just weaker expansion. On Monday night the US national manufacturing PMI will be released and if it is decidedly weak, it could be the data point that determines the 200-day MA of the S&P is again too hard a wall to penetrate. On the Friday night prior, we will learn the first estimate of second quarter GDP. Expectations sit around 2.5% growth, so any variation could well be a trigger either way (even though the first estimate is usually wildly inaccurate).

In the meantime, Wall Street sat balanced in space last night given the various pros and cons noted above.

There were some interesting moves last night, however, elsewhere in the markets. I have been noting recently that for stocks to rally investors have to move out of the safe havens of US Treasuries and gold and back into risk assets. I have also noted that it's this time of the year gold will usually consolidate at a lower level.

Last night the US Treasury's auction of US$38bn of two-year notes saw muted demand at record low yields. The Treasury is gradually winding down its bond sales from huge levels over the past couple of years to fund fiscal incentives but lower supply did not translate into higher demand. The benchmark ten-year yield rose five basis points to 3.05%.

There was little movement in currencies last night. The US dollar index was steady at 82.16 and the Aussie ditto at US$0.9025. But gold fell US$20.50 to US$1161.60/oz. Silver topped gold's 1.7% fall by falling 3%.

Technical players were once again in the frame, with a fall through US$1175 triggering a fresh wave. We can bring up 200-day MAs again and note gold's is at US$1144, but I would not be surprised if we saw gold take a good look at the old high of US$1030 before the Asian buying seasons begin in September.

That's on the assumption we have no more major scares between now and then. Gold would also be supported were the Obama Administration to decide to renew fiscal stimulus in light of a now stumbling economy, perhaps by reinstating tax credits for new home buyers or even extending the expiry of the Bush income tax cuts.

Base metals did little more than take a breather last night, with the biggest falls being lead and zinc at 2%. Oil dropped US$1.48 to US$77.50/bbl with the consumer confidence release a major driver. Oil has again showed that its wall of resistance is the US$80 mark.

The SPI Overnight was a bit more positive after a couple of lacklustre days in the physical market. It rose 19 points or 0.4%.

Tonight in the US sees durable goods orders for June, while earnings highlights include Boeing (Dow), Comcast, ConocoPhillips, Newmont and Visa. 

[Note: All paying members at FNArena are being reminded they can set an email alert specifically for The Overnight Report. Go to Portfolio and Alerts in the Cockpit and tick the box in front of The Overnight Report. You will receive an email alert every time a new Overnight Report has been published on the website.]

article 3 months old

The Monday Report

By Greg Peel

Friday night saw Wall Street continuing in an upbeat mood following the kick from positive earnings reports on the Thursday night. The Dow rose 102 points or 1.0% while the S&P 500 reconquered the 1100 mark, rising 0.8% to 1102.

More well received earnings results on Friday from the likes of Verizon (Dow), McDonalds (Dow), Ford and Honeywell added to a mix that was mostly focused on the results of the European bank stress tests.

There has been a lot of debate over these stress tests, with cynics suggesting the ECB was starting with a preferred outcome and then setting criteria which would ensure that outcome. In the end, only seven of 91 banks tested were deemed to require extra capital to protect against further weakness, which included a test against a 3% drop in EU GDP compared to the 1% growth currently forecast. None of the “losers” caused any great surprise.

What the testers did not divulge is just what level of sovereign debt weakness was factored in. European banks hold between them the bulk of sovereign debt issues from the likes of Greece and Spain, and the fear of a European crisis has been based not so much on the impact of sovereign restructuring on the country in question but the fallout and possible chain reaction through the commercial lenders which are forced to take a “haircut”.

The detailed results will be released next month, but in the meantime many European banks have taken it upon themselves to assuage such fears, independently publishing their balance sheets for all to see and assess. The result on Friday night is that the cost of insuring sovereign debt amongst the PIIGS generally fell.

The result was a slightly stronger euro leading to a weaker US dollar index. After its big run up on the Thursday, the Aussie was relatively steady at US$0.8955. Gold lost US$4.80 to US$1189.70/oz.

Demand for European bonds was countered by selling in US bonds, pushing the US ten-year yield back to the level of 3% which is psychologically important for the stock market.

Oil lost US67c to US$78.64/bbl, while technical trading triggered stop-loss orders in London sending lead and tin up 2-3% when the others were only modestly stronger.

The SPI Overnight added 40 points or 0.9%.

Two weeks of US earnings reports have met with mixed results, particularly in terms of outlook for the September quarter. But close to 80% of stocks reporting have beaten on earnings and around 65% have beaten on revenue, so realistically it's a positive trend. There will be plenty more reports released this week, along with more economic data, all of which will provide more evidence as to whether the US might double dip or not. So far, it seems unlikely.

Data in the US begin tonight with new home sales and the Chicago and Dallas activity indices. Tuesday sees the Case-Shiller house price index, Conference Board consumer confidence and the Richmond index. Wednesday it's durable goods, Thursday the Fed Beige Book, and then Friday brings us second quarter personal consumption and expenditure, a Michigan Uni consumer confidence survey, and also the big one – US second quarter GDP. The market is looking for 2.5% growth, down from 2.7% growth in the first quarter.

And earnings season kicks off in Australia this week. The next two weeks will see a handful of reports ahead of the flood mid-August, and GUD Holdings ((GUD)) leads us off today. Later in the week, highlights include reports from Australand ((ALZ)), Coal & Allied ((CNA)), Alesco ((ALS)), Austar ((AUN)), and ERA ((ERA)). Macquarie Group ((MQG)) will hold its AGM on Friday.

The beginning of earnings season has also run into the back of the resource sector quarterly production reports, and this week sees Centennial ((CEY)), Macarthur ((MCC)), Oil Search ((OSH)), Whitehaven ((WHC)), Lihir ((LGL)) and Minara ((MRE)) among others. And Wesfarmers ((WES)) will release its quarterly sales figures today.

On the economic front, it's inflation week in Australia. The headline rate is tipped to exceed the RBA's 3% comfort level but the trimmed mean – which is the RBA's preferred measure – is not. Unless the trimmed mean shoots up wildly, there will be no rate increase next week. Even then, it's not a given.

We kick off today with the second quarter PPI followed by the Conference Board leading index on Tuesday and the second quarter CPI on Wednesday. Thursday sees new home sales and Friday wraps up with private sector credit for June, another set of data the RBA will be watching closely, and the RP Data-Rismark house price index.

For further global economic release dates and local company events please refer to the FNArena Calendar.

article 3 months old

The Overnight Report: Uncle Ben Disappoints

By Greg Peel

The Dow closed down 109 points or 1.1% while the S&P lost 1.3% to 1069 and the Nasdaq fell 1.6%.

US Federal Reserve chairman Ben Bernanke was scheduled to make his regular testimony on monetary policy to the Senate last night at 2pm. Wall Street was looking for Bernanke to provide stock markets with some impetus in announcing fresh monetary policy stimulus measures. But he didn't.

Prior to the testimony, the stock indices simply stumbled along the flat line. Earnings reports are now coming thick and fast enough that no one report is sufficient to move the market in isolation. Reports released during the session last night included Coca-Cola, Morgan Stanley and Wells Fargo while Apple's strong result from Tuesday's after-market also had to be accounted for.

Aside from being in waiting mode ahead of Bernanke's speech, Wall Street was unable to gain strength from earnings reports despite a trend of outperforming forecasts on both the bottom and top lines. Generally better than expected earnings and revenues were not enough to overcome a general trend of cautious third quarter guidance and CEO talk of uncertainty ahead.

Then at 2pm, Mr Bernanke sat before the Senate committee and told it that economic conditions were “unusually uncertain”. Bam – the Dow went into free-fall.

The chairman explained that while the Fed had all along expected the US economy to post only moderate and sluggish growth out of the GFC, growth is apparently a bit more modest and sluggish than previously expected. Employment is not picking up as soon as hoped. And the European situation is providing a good deal of the uncertainty.

Bernanke did not, however, believe that the US would suffer a feared double-dip, and he did believe that swift action from the authorities in Europe had overcome the need for possible sovereign debt restructuring. But the Fed had slightly reduced its US GDP growth forecasts for 2010-11 and had begun preliminary discussions on monetary policy measures it may need to deploy or redeploy if the situation worsened.

In the course of an hour, as Bernanke was grilled by Senators, the Dow fell around 150 points. The reality is Bernanke needn't have bothered writing any new speech – he could have just read from the minutes of the FOMC meeting which were released last week. Absolutely nothing was different. Once again the market was jumping at shadows.

When asked what further policy measures the Fed might deploy if the situation required, Bernanke offered three strategies: (1) The FOMC could be more specific in its statements about just how long it foresaw the “extended period” of “exceptionally low” interest rates (ie a funds rate of 0-0.25%) lasting; (2) it could drop the interest paid on bank reserves held by the Fed from 0.25% to zero to encourage banks to shift their cash out of the safety of the Fed and back into lending to businesses; (3) it could roll over the mortgage securities which remain on its balance sheet rather than let them expire, or it could also recommence the purchase of mortgage securities, all of which provides support to the waning housing market.

The last option is representative of “quantitative easing” which the Fed had deployed in response to the GFC but had allowed to wind down in April, back when the US and global economies were seemingly a lot healthier. Wall Street has dubbed such a move “QE2”. What Bernanke did not venture into, however, was any talk of the ultimate form of QE – when the Fed buys US Treasury bonds with money provided by the Treasury.

Other than being a bit more specific about potential QE2 measures, again I can say that Bernanke said absolutely nothing new last night. And indeed, the cautious outlooks provided by reporting companies earlier in the session did not more than echo the Fed's view. But Wall Street wanted action on monetary policy, not just talk.

That the Fed has not yet decided action is warranted can be taken one of two ways. A bearish view is: “Oh God, we're not going to seeing any rescue from the Fed to support the market”. A bullish view is: “Thank God the Fed doesn't see the situation bad enough to warrant a return to quantitative easing”. It all depends which half of the glass you're looking at.

The Dow did recover somewhat to the close to be down only 109 points instead of more than 140. After the bell, Starbucks continued the day's trend of posting a Street-beating result but qualifying it with a sombre outlook. However both of eBay and Qualcomm both beat estimates and provided upbeat guidance.

Perhaps the most telling movement last night was not in stocks, but in bonds. Having reclaimed 3%, the ten-year Treasury yield had slipped again on Tuesday night and last night fell to a 15-month low at 2.88%. The “unusual uncertainty” of which Bernanke speaks is enough to have investors eschewing equity and other risk investments and preferring to park in fixed interest safety for the time being. We now appreciate that US companies are all cashed up – the tune of some US$1.8 trillion – that US banks are all cashed up and enjoying Fed interest payments, and that there remains a high level of “cash on the sidelines” amongst the investment community.

All dressed up and nowhere to go.

Until Wall Street can see its way through lingering post-GFC uncertainty – uncertainty which is hardly surprising – then we are going nowhere much for the time being. The bulls argue all that cash is a reason to be bullish because it will ultimately be “put to work” But when? I said at the beginning of the year that 2010 would be the year we go sideways, and so far that's exactly what's happening.

Over in Europe, currency traders began to square up on their euro positions last night after a good run ahead of the European bank stress test results due on Friday night. The US dollar index rose on euro weakness to be up 0.6% at 83.31. The Aussie fell half a cent to US$0.8781.

The stronger dollar had gold slipping US$6.10 to US$1186.10/oz. Gold will not rally while QE2 is only talk and not action.

Oil fell US$1.02 to US$76.56/bbl in the new front month of September delivery on the usual rollercoaster of weekly inventory movements.

Oil inventories might be higher, but copper inventories are falling. The speculators have again taken over the LME now that the industry dealers are sitting on a beach. Copper broke up through its 100-day moving average last night as technical trading defied all else, leading all metals to 1.5-2.5% gains. The LME closed before Bernanke spoke.

The SPI Overnight is down 49 points or 1.1%.

There have been 100 of the S&P 500 stock reports out so far, and the score card is 78% wins on the earnings line and 65% wins on the revenue line. Wall Street would like to see more revenue growth, but realistically it is cautious guidance which is balancing out generally above-expectation results at this point.

It's a big night tonight, with five Dow components – 3M, American Express, AT&T, Caterpillar and Microsoft – all reporting amongst a host of others such as Amazon, Credit Suisse, Etrade and a company much in the spotlight at present – Diamond Offshore Drilling.

Wall Street will also have to deal with leading economic indicators, existing home sales and the government's house price index, and Uncle Ben will have to endure another grilling, this time from the peanut gallery. Or as they like to call themselves, the House.

[Note: All paying members at FNArena are being reminded they can set an email alert specifically for The Overnight Report. Go to Portfolio and Alerts in the Cockpit and tick the box in front of The Overnight Report. You will receive an email alert every time a new Overnight Report has been published on the website.]

article 3 months old

Previewing FY10 Results And FY11 Outlook

By Greg Peel

Cash is king, says RBS Australia. The analysts recognise this line is a cliché, but in such uncertain times they suggest the “quality” of earnings results is just as important as the quantity. Quality is obviously a subjective measurement, but RBS believes quality can be quantified at least in part by a calculation known as a “cash realisation ratio”.

The analysts want to deploy CRR measurements given cashflow generation is a “unifying force” among companies that cuts through the noise of factors within company reports including one-off items, provisions, seasonal earnings bias and so forth. The CRR is measured as normalised profit after tax (NPAT) plus depreciation and amortisation divided by operating cashflow. It represents the “cash backing” of earnings and thus their quality, RBS suggests.

RBS has applied CRRs to its FY10 forecasts for stocks in the ASX 100 and will recalculate once all reports are in.

The top ten stocks on a CRR basis are Australian Worldwide ((AWE)), Oil Search ((OSH)), United Group ((UGL)), OZ Minerals ((OZL)), OneSteel ((OST)), Goodman Fielder ((GFF)), Myer ((MYR)), Alumina Ltd ((AWC)), Woodside ((WPL)) and DUET ((DUE)).

The bottom ten are MAp Group ((MAP)), Paladin ((PDN)), Intoll ((ITO)), BlueScope ((BSL)), Amcor ((AMC)), CSR ((CSR)), Sims Group ((SGM)), Westfield ((WDC)), JB Hi-Fi ((JBH)) and James Hardie ((JHX)).

BA-Merrill Lynch has been looking at the infrastructure and utilities sector. The analysts expect “very solid” six-month results. Assuming no more “debt events” (such as another European implosion for example), Merrills expects this sector to hold up well through any further market volatility, although it is not so clear as to whether this “defensive” sector can actually continue to outperform.

Those companies in the sector Merrills is looking to for “stand-out” results are AGL ((AGK)), Asciano ((AIO)), MAp Group, Transurban ((TCL)), Australian Infrastructure ((AIX)) and ConnectEast ((CEU)). The analysts particularly like MAP and AIO.

The analysts have these stocks trading at steep discounts to their discounted cash flow valuations, but note that price/earnings and other multiples do look high in comparison to other sectors. This may mean some resistance from the market, but Merrills considers them reasonable “in light of earnings security and likely growth”.

The broker warns, however, that AGL has outperformed the market by 6% since the beginning of June which limits its upside.

Morgan Stanley has considered another so-called “defensive” sector, being healthcare, but suggests regulatory risk undermines such defensiveness. MS has Ramsay Health Care ((RHC)) and Ansell ((ANN)) on Overweight ahead of reporting season believing the market may be too conservative in its earnings forecast consensus. ResMed ((RMD)) is the analysts' preferred growth exposure, but upside appears now to be capped, they suggest.

The new government initiative of pathology centre licensing is a negative for companies in that game, Morgan Stanley suggests. The analysts thus have an Underweight on Primary Health Care ((PRY)) and note that while less exposed, Healthscope ((HSP)) and Sonic Healthcare ((SHL)) remain “vulnerable”.

Morgan Stanley believes expectations for earnings growth for Cochlear ((COH)) are too high following a survey of the implant industry.

From defensive to offensive, or cyclical, Morgan Stanley has also run its ruler over the resources sector.

Companies which the analysts believe have upside risk to earnings results are BHP Billiton ((BHP)), Rio Tinto ((RIO)), OZ Minerals, PanAust ((PNA)), Equinox ((EQN)) and Newcrest ((NCM)). Companies with downside risk are Alumina, Iluka ((ILU)), Fortescue ((FMG)), Macarthur Coal ((MCC)) and Centennial Coal ((CEY)).

Morgan Stanley suggests management outlook from resource sector companies will tend to be on the conservative side given ongoing global uncertainty over European debt and Chinese slowing. The MRRT will no doubt crop up and the Chinese steel price will be seen as a lead indicator with iron ore spot prices now falling.

The analysts nevertheless expect improving share prices for mining companies over the course of the September quarter.

UBS has looked at the Real Estate Investment Trust sector. After considering upside and downside risk to results and guidance, the “always coming” office recovery, debt refinancing obligations, asset valuations, dividend payout ratios and the recovery of funds flow into REIT investment, UBS prefers Westfield and Goodman Group ((GMG)).

Moving on to FY11 guidance and analyst forecasts, UBS suggest margin expectations are a little optimistic. The analysts expect timing will be adjusted to suggest a longer than previously anticipated recovery, such that FY11 earnings forecasts across the market will need to come down by some 5%. UBS does not expect any “huge” downside.

On a sector distribution basis, UBS' strategists are Overweight the mining sector and the industrial cyclicals (media, selected consumer discretionary and selected mining services). They are Neutral on the banks but note banks will outperform in any market bounce.

At the stock level, the strategists' strongest growth/defensive ideas are ResMed, AGL and Crown ((CWN)).

While RBS is looking at cash realisation ratios to assess FY10 results, Deutsche Bank is using profit “run rates” to gauge the outlook for FY11 in the emerging companies (small industrials) sector.

A “run rate” is simply an extrapolation of a previous result. If company XYZ posted $100m profit in the first half of FY10, for example, then its run rate implies a full-year profit of $200m. But Deutsche is using forecast second half run rates to gauge expectations of first half FY11 earnings.

Run rates lose their value for certain specific sectors or stocks where seasonality is a major factor (Christmas for retail, for example). And for cyclicals in general, run rates are not taking into consideration troughs and peaks in cycles. But nevertheless, Deutsche notes most stocks in its coverage universe have run rates below current forecasts. Says Deutsche, “It appears that the market's expectation for earnings growth has improved over the calendar year to date, but remains slightly negative to FY11 earnings growth. If results prove to be closer to run rates than current forecasts, the analysts would expect downward pressure on the Small Industrials index.

Stocks with an FY11 run rate below current forecasts include Ardent Leisure ((AAD)), Crane Group ((CRG)), GWA International ((GWT)), Miclyn Express ((MIO)), Mermaid Marine ((MRM)), Realestate.com ((REA)), Salmat ((SLM)), Spotless ((SPT)), Swick Mining Services ((SWK)), Transpacific ((TPI)) and Wotif ((WTF)).

Stocks with run rates above consensus forecasts include Flight Centre ((FLT)), Bradken ((BKN)) and NRW Holdings ((NWH)).

Leaving off where we began, with RBS, the analysts have had a look at FY11 prospects for the construction and engineering sector.

The upshot is that the roll-off of government infrastructure stimulus coupled with delays to new resource projects in light of mining tax uncertainty have meant a risk to short-term performance. The sector does appear to be recovering, but the recovery is neither uniform nor linear, RBS suggests.

The analysts thus warn of downside risk to current FY11 forecasts in the sector but they nevertheless have a positive medium-term view, looking for performance on a three-year basis.

On that measure, the stocks RBS prefers in the sector are Downer EDI ((DOW)), Transfield ((TSE)), WorleyParsons ((WOR)), Monadelphous ((MND)), United Group, Leighton ((LEI)) and Boart Longyear ((BLY)).

FNArena will bring readers more broker previews as they come to hand.