Investors may be underestimating the chance that rising unemployment could push the economy back into recession and that the dollar rallies against the Euro and gold prices slide, says Janney. Barclays is optimistic about U.S. consumer spending and emerging markets, where central bankers have been raising reserve requirements rather than hiking rates to control inflation. KBW expects a quarter of the banks it follows to post a loss in the fourth quarter. But the worst in mortgage defaults may be behind us.
JANNEY FIXED INCOME STRATEGY by Guy Lebas
Forecasting is an imprecise art. That much was evident in the numerous mis-estimates of just how ugly the recently-finished Great Recession and coinciding credit pullback proved to be. In recognition of that imprecision, we’re providing a list of the most significant potential unexpected developments for 2010, as well as a qualitative assessment of their probability and impact. Each of these events has a greater chance of occurring than the markets are currently allowing:
Labor Markets (moderate probability, high impact): Rising unemployment does feed back into first quarter consumer spending, pushing the domestic economy back into a double dip recession and forestalling Fed rate hikes.
Inflation (high probability, moderate impact): Short term evidence of core inflation again refuses to materialize amid limited end user demand for goods and services, limiting the Fed’s need to raise rates.
Inflation (low probability, moderate impact): Policy actions successfully tame fears of long term inflation, leading to a rally on the long end and a sharp flattening of the yield curve, particularly in the 5-30 year range.
Commodities (high probability, moderate impact): Oil prices rally past $110 per barrel by May on demand for industrial chemicals and limited refining capacity. Housing (moderate probability, high impact): Higher mortgage rates have a greater than anticipated impact on housing demand and lead to another leg downward in residential real estate prices.
Currencies (high probability, moderate impact): U.S. dollar rallies back aggressively versus major currencies—especially the Euro—and gold prices slide sharply as a result.
Sovereigns (low probability, high impact): European Union members bail out a member country to stave to default risk, thereby further stretching the economic fabric of both the EU and the Euro currency.
Sovereigns (low to moderate probability, moderate impact): A Middle East sovereign default triggers a range of concerns in the region and in the emerging market sector in general.
Credit (moderate probability, moderate impact): Commercial real estate defaults fail to materialize at the predicted pace as liquidity conditions improve and lenders offer greater concessions to avoid ruthless defaults.
Credit (low probability, high impact): Fed/Treasury elect not to provide support for a financial institution that met the $100 billion “systemically important” threshold and instead unwind the offending institution.
Barclays, Market Strategies Americas, Troy Davig and Peter Newland+
In the past ten FOMC meetings, the Fed has cited four factors constraining consumption growth. In this piece, we evaluate these factors and argue they will be less of a constraint on consumer spending in 2011. Consumer spending remains key to a sustained economic recovery in the US. Against a backdrop of a gradually improving labor market, recent developments are encouraging. The pace of consumer spending growth picked up in each of the first three quarters of 2010. Moving into 2011, the likely extension of the Bush tax cuts and the one-year payroll tax cut should provide a further boost to spending. That said, the rebound in consumption in this economic cycle has been more gradual than in previous recoveries. Indeed, the FOMC has cited four factors – high unemployment, modest income growth, lower housing wealth, and tight credit – in each of the past ten FOMC statements as constraining the pace of consumption growth. Here, we examine what they might mean for the short-term consumption outlook.
Housing wealth poses a modest constraint. To evaluate these factors, we use an econometric model that is built around the concepts that consumption adjusts in the long run to changes in household income and wealth and in the short run to changes in cyclical factors, such as labor market conditions and monetary policy. The model also incorporates an error correction mechanism, which governs how quickly any difference between the long-run equilibrium level of consumption and its current level is resolved (see the appendix for details). Figure 1 plots the long-run equilibrium relationship between consumption and its key drivers (income and wealth), expressed as the ratio of consumption to income. Periods when the actual series rises above the equilibrium reflect episodes when factors such as easy credit conditions, accommodative monetary policy or a strong labor market induce consumers to increase consumption by lowering their savings.Currently, the model suggests that the level of consumption is broadly in line with its long-run equilibrium, given current levels of income and wealth. The fall in house prices lowered long run equilibrium consumption, but as house prices stabilize, the drag from housing on consumption growth will lessen. Granted, millions of homeowners have suffered a huge shock to their housing wealth and, in millions of cases, owe more on their house than its current market value. However, consumers have been in the process of absorbing this shock over the past few years and been adjusting aggregate consumption accordingly. We still expect a drag from the housing wealth effect, but this should gradually subside.
Improving labor market conditions to support consumption growth. Since actual consumption is roughly in line with its long-run equilibrium relationship, this suggests that the growth rate of consumption will be driven over the next year primarily by cyclical factors – in particular, the unemployment rate, growth in disposable personal income (DPI), the real federal funds rate and credit conditions. In the first half of 2011, we expect the unemployment rate to assume a steadily downward trend, which should generally lead consumers to feel more secure in their current employment and overall job prospects. In addition, we find that the change in the unemployment rate, rather than its level, is more informative in predicting the change in consumption. As a result, the improving labor market outlook should translate into higher consumption growth. Based on our estimates, a decline in the unemployment rate from its current 9.8% to our forecast of 8.6% in Q4 11 results in a contribution to average consumption growth next year of 0.5pp each quarter on an annualized basis.
Tax cuts to boost income growth. Consumption growth depends heavily on growth in real DPI. Its two key components are labor income (largely wages and salaries) and net government transfers (ie, transfers from the government to households less personal taxes). Growth in income remains sluggish, although recent employment reports provide encouraging signs. The so-called “payroll proxy” of labor income, which is the product of growth in employment, average hours worked and average hourly earnings, rose a healthy 4.5% 3m/3m (saar) in November. All three components have consistently made positive contributions in recent months, suggesting growth in income is gaining momentum. In addition, the extension of the Bush income tax cuts through 2012, along with a one-year payroll tax cut for all workers, will likely give DPI a further boost. In our framework, the taxcuts translate directly into an increase in DPI. Following the announcement of the tax package, we revised up our forecast for 2011 real consumption by 0.4pp. Overall, with labor income growth gaining momentum, on top of the likely tax cuts, DPI growth should support consumption growth, rather than constrain it.
Tight credit conditions likely to ease. The most recent Senior Loan Officer Survey indicates that the tightening credit conditions over the past several years are showing signs of abating. The net percentage of responding banks that are more willing to make consumer loans has been steadily increasing. Based on our estimates, a 10pp increase in this number translates into an additional 0.4pp in q/q annualized consumption growth. So while easy credit conditions are not essential for generating stronger consumption growth, they are likely to be moderately supportive next year. The drag on consumer spending from wealth has receded An improving labor market will support consumer spending The change in unemployment is as important as the level. Labor income growth has picked up and will get a further boost from the payroll tax cut. Banks have become more willing to lend to consumers.
Keefe, Bruyette, Woods, Fourth-Quarter 2010 Bank Preview
Overall, we expect slowing profit trends as lower credit costs are offset by revenue headwinds. Although we forecast a quarterly increase in aggregate net income to common shareholders, we expect a decrease for the median bank, which we believe to be a more meaningful representation of the quarter’s income trend as all-bank aggregate data are skewed by large-cap banks. Of note, we expect 24% of covered banks to report a net loss to common shareholders in 4Q10.
We believe revenue pressure will outweigh expense control as lower-yielding earning assets and reduced service fees are expected to lower operating revenue by 1.3% linked quarter on aggregate. We expect the full-quarter effect of regulation surrounding overdraft fees to be felt in 4Q10, and take an in-depth look at recent and proposed legislation and its effect on fee income.
Year-over-year income growth expectations are significant at both the large-cap and the SMID-cap banks; however, large-cap growth is primarily driven by the elimination of TARP dividends for many companies, while SMID-cap growth is driven by meaningfully lower provisioning.
We forecast a 0.6% linked-quarter decline in average earning assets at the median large-cap bank and an 8-basis-point increase at the median SMID-cap bank. The slight increase in the SMID-cap space implies a full replacement of declining loans with securities and interest-earning deposit balances as average loans are expected to decline by 0.2%. The median large-cap bank loan portfolio is expected to decline by 0.5%.
Linked quarter, we expect total nonperforming assets at SMID-cap banks to decrease by 0.7%, with new nonperforming assets (NPA formations) accounting for 8.4% of total nonperforming assets. Given the continued weak economy, NPA trends are likely to experience volatility over the coming quarters, but remain below the recent peak level, in our view.
Barclays, Emerging Markets Weekly
In The Emerging Markets Quarterly – A Crowded Consensus (December 7, 2010), we stated that the external base scenario was supportive for EM asset prices. This is because US activity data indicate that “double-dip” recession risks are lower (even more so considering the likely extension of the “Bush-era” tax cuts and the unexpected tax break on payrolls), while QE2 has contained expectations-driven deflationary risks. We posited, however, that this view was widely shared among investors and sell-side firms.
Therefore, we saw the risk of a build-up of a complacent view of the economic landscape. Naturally, complacency can rapidly turn into crowded positioning and sizable market responses to unexpected news. Remarkably, in the past few days, one of the risks that we identified in our publication has accelerated: the possibility that markets might significantly re-price US Treasuries in the wake of a revamped view of growth, inflation, and potential monetary policy. However, in line with our expectations, emerging markets have tended to respond well to the build-up of pressure in Treasuries. Since the beginning of December, 10y US Treasuries yield have increased 65bp.
As we go to press, 10y Treasuries yield 3.42%, a level slightly below the one Barclays Capital Interest Rate strategists expect to hold in December 2011. Indeed, forward markets are pricing, excessively we think, the 10y bond to trade, come December 2011, at almost 4%. What could explain such extraordinary response in prices? And, why are EM assets responding relatively well? The UST sell-off may in part reflect positioning clean-up and, from that perspective, it may be somewhat overdone. On more fundamental grounds, however, it may also be reflecting the re-pricing of three fundamental drivers: growth perspectives, which could lead to a faster normalization of Fed policy; the inflation outlook, which again could lead to a more tumultuous Fed withdrawal of liquidity; and concerns over long-term solvency.
Fortunately, markets seem to be responding mostly to a better growth outlook and much less so to inflation concerns (above and beyond the potential side effects of growth-induced higher commodity prices with inflationary consequences). Indeed, most of the increase in nominal yields is accompanied by real yields – the move in breakevens explains only 30% of the nominal sell-off. Equity markets provide additional evidence, having rallied, despite higher discount rates, 5.2% month-to-date. It is difficult to imagine a sell-off in Treasuries and a rally in equities that is not explained by either faster growth expectations or a fall in risk aversion. The behaviour in equity markets, further illustrated by a fall in VIX, is also inconsistent with potentially increasing solvency concerns. Indeed, pointed evidence on this front is provided by the fact that US 5y CDS have actually fallen since early December.
A revised perception of US growth is a positive development for EM assets in general. However, we should be cautious about our market inferences. First, faster US growth could somewhat mitigate the case for EM investments predicated on a differential growth story. This is particularly true as we go into 2011, when growth is slated to slow modestly in EM. Second, faster US growth could eventually lead to a revision of expectations of the future path of Fed policy. Markets could anticipate either that QE2 is unwound earlier or, even, that interest rates are hiked earlier. Indeed, they seem to be pricing the fed funds rate to rise to 0.50-0.75% by the end of 2011, which is clearly inconsistent with our monetary policy outlook. We reiterate the view that we expect the Fed to remain on hold on the interest rate front for all of 2011 and, once QE2 is completed, to hold the size of its balance sheet roughly invariant. Nevertheless, if the expectation of liquidity removal becomes further rooted in the market mindset, global liquidity considerations could rapidly lead to a (perhaps partial) unwind of the EM rally observed since early September.
A final important development is the incipient change in the monetary policy response pattern that seems to be developing in EM. Led by the PBoC’s using prudential instruments (mostly reserve requirements) a number of EM central banks appear to be more inclined to apply a variety of policies – sometimes in an apparently inconsistent fashion – to address domestic challenges. Brazil’s recent move included the hike in reserve requirements and a message to markets that the central bank is prepared to use this regulatory structure to slow credit growth before resorting to rate hikes. Turkey’s central bank openly hinted at an increase in reserve requirements, while cutting the repo rate 50bp, to 6.5%. The use of such methods deviates somewhat from more traditional inflation targeting and suggests that we should be alert to a laxer definition of the monetary policy framework.