S&P, gold, crude, the Euro, and emerging markets trending up, according to QAS. Barclays notes the first time in history that Europe has raised rates before the Fed. Janney, Montgomery, Scott recommends bank bonds. Mckinsey says mid-size cities under ten million will generate more than half of global growth.
Quantitative Analysis Service, Global Market Overview
The high level of momentum suggests that the S&P still has an upward bias over the next several months. The near term correction is expected to be containable.
For the next few months, yield on the 10-Year U.S. Treasury will remain in the trading range of 3.2% to 3.8%.
Gold retains an upward bias.
The trend is still for higher prices on crude oil for the next few months.
The Euro is expected to move higher over the next few months.
Emerging Markets are now likely to outperform Developed Markets over the next few months.
Luca Ricci, Barclays Capital
The ECB raised the policy rate from 1.00% to 1.25% this week, while the Fed is still easing, and the UK and Australian held the monetary stance unchanged. This is the first time in the ECB’s history that it has led the Fed in a policy reversal cycle. At the same time, the divergence between peripheral Europe and the core widens. China raised rates again, on inflation concerns, while weak March PMIs confirm an ongoing slowdown, as we expected.
The policy divorce is clearly driven by different inflation and unemployment concerns across the Atlantic. For the ECB, headline inflation above target for three months in a row and rising prompts a key concern that the pass-through from high commodity prices may induce more persistent inflationary effects. Indeed, we now expect euro area inflation to reach 2.8% in May, and continue to expect the ECB to hike again in July. The Fed insists that the inflationary effect from commodity prices is temporary and core inflation is low, although several inflation expectations measures are well above 2%, core inflation is increasing rapidly (1.8% on a three-month basis), and it will take time to drain the massive liquidity injected since the crisis. The Fed is also motivated by the still-elevated unemployment, despite the print of 8.8% in March, a full%age point decline since November. Quite off the radar screen of the ECB, the euro area unemployment rate declined gently to 9.9% in February from a revised 10% in January (mainly due to improvements in Germany and Italy), dropping below 10% for the first time in almost a year.
Interestingly, the divorce may turn out to be shorter than previously thought. The latest Fed policy meeting last month and the minutes released this week indicate a more hawkish Fed than in previous months, on the wave of a stronger confidence in the labor market improvements and the economic recovery. Indeed, a policy rate increase this year cannot be excluded, as now “a few participants indicated that economic conditions might warrant a move toward less-accommodative monetary policy this year”. However, “a few others noted that exceptional policy accommodation could be appropriate beyond 2011”, suggesting that the divergence of opinions within the committee has somewhat widened.
Mark Luschini, Janney, Montgomery, Scott
We are now in the year’s second quarter, and the end of the Federal Reserve’s asset purchase program—dubbed quantitative easing two (QE2)—suddenly seems to be rushing toward us. The debate among market participants that remains unsettled is whether June 30 will in fact be the retirement of this form of monetary policy, or will it instead spawn an offspring for another period of time—QE3?
The Fed instituted its first round of quantitative easing—known affectionately as QE1—in late 2008. At that time, the Fed used its considerable balance sheet to purchase mortgage-backed securities in order to trim interest rates and lower mortgage rates to help the beleaguered housing market, reducing the cost of borrowing for businesses and consumers alike. That program did work to bring rates lower—but did little to cure the ills of the housing market or negate the economic decline from lasting several more quarters. We know with the benefit of looking back two years that the wounds imparted on consumers and businesses from the financial crisis and market meltdown took more than lower interest rates to convalesce. The Fed’s impatience with the fragile state of economic affairs and concerns over falling prices catapulted them into action by announcing another dose of security monetization. Some questioned the necessity of a QE2; arguing that more time was necessary to allow the lagged effects of the already exceedingly dovish Fed policy to propagate the system. Regardless, QE2 was instituted in early November of last year and will most likely run though its intended timeline.
We do not, however, see a renewal of the Fed’s quantitative easing program as likely unless the economy suffers significant renewed weakness. The mission of QE2 was to reflate the economy and risk assets to stimulate inflation and consumption through an increased wealth effect. In that respect, QE2 has been successful. Equity markets, since the unofficial declaration of the Fed’s intent in Jackson Hole, Wyoming by Mr. Bernanke in late August, have rallied sharply. In addition, consumer prices have stopped declining and begun to move serially higher. And employment gains are being reported regularly, an important factor in insuring the durability of the economic expansion as the Fed ultimately begins to withdraw its unconventional policy. Interest rates, on the other hand, have moved higher since the good ship QE2 was launched, bringing some to question the effectiveness of the Fed’s exercise. In all, though, the underpinnings to support the need for further artificial stimulation are mostly absent.
While the U.S. economy has averaged a decent if unspectacular real GDP growth rate of 3% in the past six quarters, a sustained expansion appears to be well underway, and deflation risks have mostly evaporated. That should give the Fed reason to pause if not vocally dispel any need for QE3. There are also other reasons to believe a QE3 is a remote possibility. They include the size of bank reserves which are plentiful to assist in stimulating activity, the unemployment rate which is trending lower, the political disdain for more monetary intervention, and even the Fed’s own internal strife over the need for even completing QE2 let alone a new program of quantitative easing.
A question that looms as the end of QE2 nears is how the bond vigilantes might react. Fears of a jump in bond yields are probably overdone, but we do expect some pressure on bond prices to be in the offing. Not only are there building concerns about inflation, but the void left by the Fed’s absence, the majority buyer of Treasury bonds during this campaign, may be hard to fill without investors demanding a higher return. There is, of course, the possibility that the market may view the removal of the Fed as a buyer positively, treating it as a sign of economic stability and almost de facto tightening if maturing bonds are allowed to run off without replacement.
In either case, our opinion remains that U.S. government bonds are unattractive since the yields offered to investors today are appealing only if the Fed cannot engender economic growth. That seems to us to be a low probability wager. As we have seen so far, the Fed isn’t shy about firing up the printing presses, and we suspect would do so again to preclude that scenario from happening. On the hand, large company stocks, including a diversified selection of domestic and international companies, are appealing given the lack of competition from either bonds or cash at today’s interest rates. Commodities, particularly energy and precious metals, should occupy some room in a portfolio to participate in advancing global growth, but also to provide a hedge against the inflationary pressures that are percolating in the pipeline, and which are already evident in overseas markets, but as yet not problematic in the U.S.
Guy LeBas, Janney, Montgomery, Scott
Twenty months ago, the Federal Reserve released the results of its Supervisory Capital Assessment Program (SCAP) stress tests, which analyzed the 19 largest banking institutions in the U.S. and ultimately required 10 of those banks to raise additional capital. In March 2011, the Federal Reserve released the results of its Comprehensive Capital Analysis and Review (CCAR) stress tests, which analyzed that same group of banking institutions and determined that 12 of the 17 institutions seeking to take capital action would be permitted to do so. Those capital actions included no fewer than 9 dividend hikes, 6 share repurchases, and 2 TARP repayments, all of which had previously been on hold. The transition from SCAP to CCAR has been an impressive one that underscores the progress made in strengthening the U.S. banking system through an improved credit cycle, stronger market conditions, and heightened oversight.
One of the most significant outgrowths of CCAR is a changed approach to capital adequacy requirements. Specifically, the Federal Reserve put the largest financial institutions through a scenario that combines a moderately severe recession with a capital market lock-up similar to that experienced in the 2008 financial crisis. In order to “pass” the CCAR tests, banks were required to maintain a sufficient cushion such that their capital would remain well in excess of regulatory requirements under the test conditions. Banks looking to shrink their capital base through dividends, repurchases, or TARP repayments were required to prove that they could maintain sufficient cushion in this stress scenario even after their planned capital actions.
Prior to 2008, the Federal Reserve relied primarily on the Tier 1 capital ratio, a metric which identifies a bank’s cushion against losses in the prior quarter, to establish a bank’s capital adequacy. Banks were required to perform internal forward-looking assessments of capital adequacy, but the Fed’s major tool was an accounting and not economic-based one. What the SCAP tests attempted—and the CCAR tests do a better job of—is identifying capital needs prospectively rather than retrospectively. We view this forward-looking capital adequacy assessment as a key aspect of not only restoring investors’ confidence in the health of financial institutions, but making those institutions’ balance sheets far more transparent. The complexity of financial institutions’ asset and liability structures—as well as off balance sheet holdings—have left traditional capital metrics such as the Tier 1 ratio susceptible to manipulation.
One need look no further than Lehman’s “Repo 105” transactions, which essentially improved capital ratios by treating a collateralized borrowing as an asset sale, for evidence of how “game-able” capital ratios can be. Much of this “game-ability” stems from the fact that balance-sheet-based capital ratios are point-in-time measures. By contrast, forward-looking capital tests such as the CCAR provide the opportunity to prove capital adequacy not just at a single, manipulable point in time, but rather, over an extended period. Importantly, the CCAR tests also assumed that capital reduction actions (such as dividends and buybacks) would continue even if the U.S. economy weakened and the capital markets once again froze. That assumption reduces some amount of the operator risk, as it effectively institutes capital requirements which are sufficient to protect an institution even if management takes the worst possible actions.
The additional information, transparency, and confidence that the CCAR prospective capital test offers represent the final piece of the puzzle for banking sector credit quality. Twenty months ago, we discussed debt issued by the major global banks/investment banks as cheap relative to credit prospects, but still quite risky. Six months ago, we began to view bank sector debt as attractive based on technicals, as spreads in the sector were wider than others at a time when investors were hungry for yield. In the wake of the CCAR tests, we now believe that fundamental credit quality for the banking sector is improving, in large part because of the proactive regulatory structure which seems to have taken over from the pre-2008 passive regime. While new regulations have had the impact of impairing profitability—and likely limiting long-term shareholder returns by decreasing capital distributions—they also in our view have had the impact of securing institutions’ creditworthiness. As a result, we are affirming our overweight position on debt issued by the big global banks / investment banks as well as the smaller regional institutions, with a preference for firms over the $100 billion threshold (those subject to the CCAR test).
McKinsey Global Institute, Mapping the Economic Power of Cities
The urban world is shifting. Today only 600 urban centers generate about 60% of global GDP. While 600 cities will continue to account for the same share of global GDP in 2025, this group of 600 will have a very different membership. Over the next 15 years, the center of gravity of the urban world will move south and, even more decisively, east.
Today, major urban areas in developed regions are, without doubt, economic giants. Half of global GDP in 2007 came from 380 cities in developed regions, with more than 20% of global GDP coming from 190 North American cities alone. The 220 largest cities in developing regions contributed another 10%.
But by 2025, one-third of these developed market cities will no longer make the top 600; and one out of every 20 cities in emerging markets is likely to see their rank drop out of the top 600. By 2025, 136 new cities are expected to enter the top 600, all of them from the developing world and overwhelmingly—100 new cities—from China.
To help companies looking for growth opportunities and policy makers to manage the increasing complexity of larger cities more effectively, MGI has built on its extensive research on the urbanization of China, India, and Latin America to develop Cityscope to develop a database of more than 2,000 metropolitan areas around the world, the largest of its kind.
Companies looking for cities that will generate the most GDP growth will find another different list of potential urban hot spots. The top 100 cities ranked by their contribution to global GDP growth in the next 15 years—we call this group the City 100—will contribute just over 35% of GDP growth to 2025. And the top 600—the City 600—will generate 60% of global GDP growth during this period.
Until now, a company strategy focused on developed economies together with emerging market megacities (with populations of ten million or more) has made sense—this combination generates more than 70% of global GDP today. But these regions and very large cities in developing economies are likely to generate only an estimated one-third of global growth to 2025. A strategy focused on this combination will be insufficient for companies seeking growth.
It is a common misperception that megacities have been driving global growth for the past 15 years. In fact, most have not grown faster than their host economies, and MGI expects this trend to continue. Today's 23 megacities—with populations of ten million or more—will contribute about 10% of global growth to 2025, below their 14% share of global GDP.
In contrast, 577 middleweights—cities with populations of between 150,000 and ten million, are seen contributing more than half of global growth to 2025, gaining share from today's megacities. By 2025, 13 middleweights are likely to be have become megacities, 12 of which are in emerging markets (the exception is Chicago) and seven in China alone.
Emerging market mega- and middleweight cities together—423 of them are included in the City 600—are likely to contribute more than 45% of global growth from 2007 to 2025. Across the world, MGI identifies 407 emerging middleweight cities contributing nearly 40% of global growth, more than the entire developed world and emerging markets megacities combined.
By 2025, developing region cities of the City 600 will be home to an estimated 235 million middle-class households earning more than $20,000 a year at purchasing power parity (PPP). This compares with more than 210 million such households expected in the cities of developed regions. So even at the higher end of the middle-class segment, there will be more households in emerging market cities than in developed ones.
MGI finds that population in the City 600 will grow an estimated 1.6 times faster than the population of the world as a whole. By 2025, the City 600 will be home to an estimated 310 million more people of working age—and account for almost 35% of the expansion of the potential global workforce. Almost all of this increase is likely to be in the cities of emerging markets—and two-thirds in the leading cities of China andIndia that have significant regional differences in their market characteristics.
