Mark Luschini, Janney, Montgomery Scott
The news last week did nothing to dissuade those of us who have moved more optimistic about the economy. Several readings on the Manufacturing sector, the Chicago Purchasing Managers Index and the Institute for Supply Management (ISM) survey, came in at levels of business activity that were the best since 1988 for the PMI data and 2004 for the ISM report. In addition, car sales increased, banks are reporting increased loan demand, and a survey of the Services sector (which represents the majority of the U.S. economy) indicated continued growth. It was plenty to push equity prices higher and bond prices lower. The Dow Jones Industrial Average rose for the ninth week out of the last 10, gaining 268 points, or 2.3% along the way. Surging corporate profits and announcements of dividend hikes and M&A activity continue to bode well for the stock market’s fundamentals. Bonds, however, moved lower as much of the week’s news suggests the economy is getting better. That, in turn, could mean the Federal Reserve’s asset purchase program may be discontinued after its June term, inflation might begin to build, and along with it, higher interest rates could be in the offing. The Barclay’s Aggregate Bond index lost more than 1% for the week, equivalent to an approximate decline of 120 points on the DJIA.
Hiring in January led to an increase of 36,000 jobs and the figures for the previous two months were revised higher by a collective 40,000. Nevertheless, the report was startlingly low when compared to consensus expectations of 136,000. Yet, we are of the opinion that next month’s release will either be accompanied by an upward revision to this data or February will show a sizeable gain in employment. The reason is that the data used for the tabulation is collected over the course of a week that coincidentally occurred during a stretch of extremely poor weather, including snow storms that ravaged the East Coast. Because so many jobs were impacted, it makes us believe it was an aberration rather than a new pattern of slow employment growth. Employment growth was averaging about 130,000 a month during the final quarter of last year and we expect to see improvement on the number as the year unfolds. Ultimately, it is a necessary ingredient to ensure the durability of the economic expansion. At the moment, the stock market seems to be signaling that the underpinnings for that to occur are solidifying. We urge investors to take advantage of that by owning companies in the Technology, Energy and Health Care sectors.
Dean Maki, Barclays Capital
Many observers are concerned that state and local government spending cuts will prove to be a severe drag on the economy this year.
While we believe this sector will continue to weigh on growth, we think the private sector will be the primary determinant of the strength of the recovery.
The state and local government sector provided a drag of 0.1pp on real GDP growth in 2010, and we expect a similar outcome this year.
One of the risks many clients are very concerned about is that state and local government spending cuts could cause the economy to weaken sharply this year. This concern is understandable, given that most state and local governments took a severe hit to revenues in recent years, and their budgets have generally not fully responded. Also, there is a longrun issue regarding unfunded pension liabilities that will need to be addressed over time, either through higher taxes or benefit cuts. However, this longer-term issue should not be confused with the near-term dynamics of GDP growth, and here we focus on the latter.
Some perspective, please
In thinking about the effects of state and local government spending on the economy, it is worth looking at how much the sector typically contributes to growth. Figure 1 compares the contribution to GDP growth of various sectors. The chart shows that, not surprisingly, the private sector drives economic expansions and downturns. For example, over the past year, consumer spending has contributed 1.9pp to GDP growth, while business investment spending has contributed 0.9pp, the federal government 0.4pp, and state and local governments have provided a drag of 0.1pp. In fact, over the past 60 years, the largest annual drag from the state and local sector has been 0.3pp in 1980-81. Looking at the employment side gives a similar picture (Figure 2). Over the past 12 months, the state and local government sector has shed an average of 20k jobs per month, while the federal government has added an average of 1k and the private sector has added an average of 103k. The message from these data is clear: the state and local government sector has been a drag, but it is the private sector that mainly determines the strength of the recovery. More broadly, we think some of the fears about the potential effect of the state and local budget cuts are out of line with the sector’s contribution to the economy.
The state and local cuts do not compare with those in the private sector
While the sector’s relatively small size limits its effect on aggregate growth, even when looked at in percentage terms, the cuts so far at the state and local levels have been modest in comparison to what has happened in the private sector. Figure 3 shows business investment and federal and state and local government spending, where spending in each sector is indexed to 100 at the start of the recession, so the distance from 100 gives the cumulative percentage change in each form of spending during and after the recession. Business investment spending fell 19.9% from its level at the start of the recession, and still stands 12.1% below that level. In contrast, state and local government spending has fallen by 2.3%, and federal spending is up 18.6%. Private employment fell 7.6%, and is still down 6.6%, while state and local government employment has declined 1.2% and federal government employment has risen 3.3% since the start of the recession. These charts help explain why popular sentiment in many states has turned toward budget cuts rather than tax increases to balance state and local budgets; the cuts in this sector probably do not seem particularly extreme to voters who work in the private sector.
This year, we think the forces acting on state and local government finances will be mixed. We look for sales and income tax revenues to rise, but for this to be more than offset by less grants from the federal government to states and from states to localities. Overall, we expect the state and local government sector to provide a similar drag on growth this year (0.1pp) to what it did in 2010, and we look for 10-15k per month in job cuts in this sector. Because we view the outlook for consumer and business spending as upbeat, we think it is reasonable to expect solid overall real GDP growth despite the headwinds coming from state and local governments
Rajiv Setia, Piyush Goyal and Amrut Nashikkar, Barclays Capital
Derivatives Reform: A Brave New World
The Dodd-Frank Act, signed into law last summer, requires the CFTC and the SEC to establish rules to regulate the OTC derivatives market by July 2011. The CFTC has released advance proposals for many of these rules. In this piece, we focus on proposals related to transparency, such as swap execution facilities, real-time reporting and block trading. Our primary conclusions are: Given the tight deadlines faced by the CFTC and the resulting speed of the rulemakingprocess, it is not clear whether the necessary infrastructure will be in place, which means that implementation of the rules could be delayed.
In Derivatives reform: Evolution, not revolution, June 29, 2010, we raised the concern that standardization for OTC contracts would be difficult to achieve. We now believe the proposed CFTC rules contain workable solutions to this problem.
In the new regime, the distinction between dealers and clients will blur. Over time, large clients may become liquidity providers, especially if trading volumes migrate to swap execution facilities that mandate trade anonymity.
We expect the proposals to lead to greater transparency and competition. This will benefit agile traders, as the proposals reduce information asymmetry and likely will lead to tighter bid-ask spreads for small trades. However, market depth may suffer, and costs for large trades could rise.
We believe that the block-size threshold should be based on the consideration that there should be a reasonable probability, in the minds of other market participants, that a market maker has been able to offload the risk of a block trade by the time its information becomes public. The proposed guidelines for determining block sizes do not adequately account for the fact that trading activity in some markets tends to be more clustered than that in other markets.
Based on empirical analysis, we find that currently proposed thresholds for block sizes are too high. For instance, the block size for 10y vanilla stand-alone swaps using the proposed method would be c. $400mn. Our analysis shows that a much lower blocksize threshold of c. $200mn would be more appropriate.
In our view, the CFTC should introduce lower block size thresholds, while retaining flexibility to raise them over time if necessary. This approach would minimize the risk of near-term market disruption, allow market practices to evolve, and remain consistent with the principle of promoting transparency.
If trading anonymity is implemented on SEFs, it could eliminate reputational risk and reduce the value of relationships. Liquidity may vanish when it is most needed, as anonymity would mean little downside for refusing trades, even for large customers, creating a greater likelihood of large discontinuous price moves ( “flash crash”).
Melissa A. Roberts, Keefe, Bruyette and Woods Large Cap Banks: 4th quarter
Our sample of 165 banking institutions under KBW research coverage posted the weakest quarter of earnings results relative to expectations in 2010, with the highest percentage of earnings misses since fourth-quarter 2009. In total, 58% of the banks either met or beat First Call consensus expectations while 42% missed. This compares to third-quarter 2010 when 35% of banks missed First Call consensus estimates, but represents an improvement from fourth-quarter 2009 when 46% of banks missed First Call consensus estimates.
The operating environment continues to improve for banks; however, there remains some disparity in the quality of earnings results by geography. The quarterly results revealed signs of stabilizing and modestly improving credit conditions for the majority of banks. Also, for the fifth consecutive quarter, banks posted annual operating EPS growth. The rate of annual operating EPS growth increased to 52% in fourth-quarter 2010 after having decelerated to an EPS growth of 46% in third quarter 2010.
Credit improvement materialized, as banking institutions began to see the benefit of the action taken to manage credit issues in third-quarter 2010. NPA and NCO ratios decreased on a sequential basis across both large and SMID capitalizations.
Regional areas of credit weakness persist in the West, Midwest and Southeast. Midwestern banks posted the weakest credit results with the second-highest annual and highest sequential increases in NPA ratios. Midwestern banks performed accordingly in the quarter, accounting for nearly 30% of the 4Q10 misses. Meanwhile, Southwestern banks showed the greatest improvement in credit metrics, with sequential and annual decreases in their NPA, NCO, and Provisions/Loans ratios. Accordingly, the Southwest region saw the largest percentage of earnings beats at 60%.
Banks with outstanding TARP posted weaker results than the overall banking industry as 29 of the 57, or 51%, of the banks with TARP outstanding in our sample missed First Call consensus estimates compared to last quarter’s 36% miss rate. Additionally, the banks that repaid TARP also posted weaker results relative to the overall banking industry, with 24 of the 50, or 48%, missing First Call consensus estimates in our sample.
On an operating EPS vs. First Call consensus estimate basis, SMID-cap banks and large-cap banks performed similarly, with 43% and 41% of the banks missing estimates, respectively.
Geographically, the Midwest was the weakest region as 62% of banks in the region missed First Call consensus estimates. The West followed with 42% of Western banks missing estimates, while the Southeast and the Southwest were not far behind, both with 40% of banks in these regions missing estimates. The Southwest region posted the strongest fourth-quarter results as 60% of Southwest banks beat consensus estimates, and the New England banks also posted a solid quarter with 54% of the banks in these regions beating consensus estimates.
Operating EPS increased both annually and sequentially in the fourth quarter, representing the fifth consecutive quarter of annual growth after 11 quarters of annual EPS contraction. Median year-over-year operating EPS increased 52% in the fourth quarter, compared to third-quarter 2010 growth of 46%, and fourth-quarter 2009 growth of 6%.
By market capitalization, operating EPS for the large-cap banks increased 53% annually, and 5% sequentially. SMID-cap banks also posted operating EPS growth but at slightly lesser magnitude annually and sequentially, rising 50% and 3%, respectively.
The Southwestern and Midwestern regions posted meaningful annual operating EPS growth, increasing 83% and 61%, respectively. Annual operating EPS growth was weakest in New England, increasing 28%. On a sequential basis, the Southwestern region experienced the highest operating EPS growth of 41%, and the Midwest region posted a decline of 11%. In fact, the Southwest and West were the only regions where banks posted double-digit sequential operating EPS growth.
Fourth-quarter credit results revealed overall improvements in credit quality, though results still differ by region. The median NPA ratio was 3.71%, increasing 3 bps annually but declining 6 bps sequentially. The NCO ratio revealed signs of improvement as the median NCO ratio declined 20 bps annually and 5 bps sequentially to 1.17%. On a year-over-year and sequential basis, provisions as a percentage of average loans declined 39 and 2 bps, respectively, to 1.00%.
Overall, on an annual and sequential basis, both large-cap and SMID-cap banks posted improved credit metrics. However, large-cap banks posted greater annual and sequential improvement than the SMID-cap banks in the fourth quarter.
NCOs/Loans decreased 54 bps annually and 14 bps sequentially to 187 bps for large-caps and decreased 14 bps annually and 3 bps sequentially to 109 bps for SMID-cap banks. NPAs/Assets improved for both capitalization groups on a sequential basis. Large-caps saw a greater decline relative to SMID-caps with their median NPA/Asset ratio decreasing 33 bps annually and 16 bps sequentially to 3.18%, While large-cap banks maintained a higher provisions/loans ratio than the SMID-caps, the large-caps posted greater improvement in the fourth quarter. The median Provisions/Loans ratio for large-cap banks fell 88 bps annually and 6 bps sequentially.