Frank Engels, Barclays Capital, Global Economics Weekly
We argued last week that the recent weakening of activity should prove more transitory than the concurrent rise in inflation. This week, however, uncertainty related to the debt crisis in the euro area, coupled with weaker PMI and order data out of China, Europe and the US, seemingly pushed growth concerns more to the forefront of investors’ minds. We think these concerns are exaggerated.
A soft landing now should help prevent a hard landing later in some regions. Economic data have been disappointing relative to what consensus expected, as softer data countered more constructive consensus expectations.
From a business cycle point of view, however, one should not be surprised – two years into a recovery with relatively strong global growth – to see growth momentum decelerate at a time when rising inflationary pressures have been eating into purchasing power, leading to a (muted) rise in policy interest rates by many central banks and, taken together, adversely affecting economic sentiment.
In fact, OECD leading indicators have pointed in the same direction and also global PMI indicators are indicating some moderation. Along those lines, we would argue that a growth deceleration now (rather than later) might be a cure rather than curse for many emerging market countries, but vice versa for most of the developed world.
…All important economies in Latin America are estimated to be operating close to or above potential output levels, which is why a moderating growth momentum could help to avoid (further) overheating. A similar argument can be made for most of Emerging Asia at this stage. While, for instance, car sales in China and India have declined materially in light of scarcer credit, elevated petrol prices and higher financing costs, and signs of weaker car demand are emerging also elsewhere in Asia, the overriding domestic policy concern has been, and will remain in our view, to contain inflation and avoid overheating.
Consequently, the emerging soft patch in activity should allow most EM policy makers to tighten monetary policy gradually (rather than progressively), and let automatic stabilisers work without falling behind the curve. Moreover, the soft patch should help to limit headline inflationary pressures from escalating much further for now, as evidenced by the recent correction in commodity prices. In fact, given the base effects from commodity prices, we would expect headline inflation to reverse in the course of Q3 and Q4 this year. This, coupled with the observed rise in employment in all EM regions, should trigger a recovery in purchasing power, support sentiment and ultimately boost consumer goods demand. …but might increase the vulnerability in others.
Our assessment is somewhat different for parts of the developed world and Emerging Europe. This week’s release of detailed national accounts data offered a stark reminder that growth in some important developed markets, such as the UK or Spain, has been driven to a large extent by net external trade. In fact, in the UK the net trade contribution to growth was the highest since the 1950s and, similarly, Spain would have registered negative sequential growth had it not benefitted from its strength in exports.
Moreover, euro area trade with Asia has recently outpaced its trade volumes with non-euro area EU countries, thus highlighting the rising importance of EM demand for real GDP growth in Europe. Therefore, even a soft patch in global demand could compound growth concerns in selected European countries in light of their sustained weakness of domestic demand. This might increase the policy dilemma for selected central banks, such as the BoE and ECB, as to how to balance growth and inflation concerns going forward. It would also put at risk the incipient recovery in Emerging Europe (relative to other EM regions), which is notably dependent on growth in core Europe, particularly since the move towards more self-sustained domestic demand has yet to occur.
Encouragingly, however, we see leading indicators in other European economies, such as Germany, France, Sweden, Norway and Switzerland holding up reasonably well, reflecting in part more balanced (ie, less export-dependent) growth. Moreover, in the US we expect the weakness observed since April in production-side indicators, regional PMIs and Q1 national accounts to be of largely temporary nature. First, car production should bounce from the earthquake-related supply-chain distortions registered in April.
Second, the weakness in investment spending seems to have been weather-related and the weakness in public defence spending appears exaggerated. Third, the combination of rising labour income reflecting the ongoing labour market improvement and record-high corporate profitability should support domestic demand growth, while the drag from housing on growth has faded. Fourth, monetary policy is expected to remain very accommodative.
Finally, and similarly to what has been said for EM countries, we would expect that positive base effects in commodity prices, coupled with their recently observed price drop, should lead to a recovery in purchasing power, sentiment and ultimately consumer goods demand across developed economies in the second half of this year.
Uncertainty surrounding Greece to fade at least temporarily.
We believe concerns regarding the readiness of the EU and IMF to provide further financial support to Greece without recourse to private sector investors are overstated. In fact, the German finance minister stated that any form of a sovereign debt rescheduling would pose too large a contagion risk, thus endorsing the ECB’s views on this. We thus expect the euro area and IMF to provide the additional financing to keep Greece funded for one more year, on the condition that the Greek government secures parliamentary approval for its new fiscal austerity and privatisation programme and provides special collateral for the new funds. This does not change our view, however, that Greece would need to restructure its debt in 2012.
Jeffrey D. Saut, Raymond James
I thought this morning I would revisit a few of my favorite investment ideas.
To begin, even though I continue to believe commodities are likely on “summer vacation” before they resume their secular bull market, I continue to like a number of special situations in the energy space. For example, Williams Company (WMB/$30.76/Outperform) reported a solid 1Q11 quarter boosted by the strong natural gas liquids (NGL) supply/demand fundamentals. Our bullish thesis on Williams is supported by three main points: (1) we believe the company's E&P assets will garner a higher valuation in the market place as a stand-alone entity when the company splits itself into two parts; (2) we believe the market is undervaluing Williams' ownership of the Williams Partner GP, and (3) we expect strong growth from the Canadian midstream assets.
Next is Clayton Williams (CWEI/$72.12/Outperform), where we sold one-third of our position around $100 last March. Since then the shares have retreated, yet the fundamentals continue to afford an attractive risk/reward ratio for investors despite last week’s reduced guidance. To wit, while the guidance update dials back the near-term outlook of the stock slightly, the company is not alone in facing the rising service costs in the industry. What does set Clayton Williams apart from the rest of the group is its highly oil-weighted production profile (74%), growing position in high-return oil plays (namely the Permian and Delaware Basin), and cheap valuation. Raymond James Analyst John Freeman last week reiterated his Outperform rating on Clayton Williams and stated that he viewed any pressure in the stock as a buying opportunity.
Then there is LINN Energy (LINE/$38.56/Strong Buy), which remains the top pick in the upstream MLP space for our analyst Darren Horowitz. The partnership reported a solid 1Q11, but perhaps more importantly guided to a very strong 2011 with an expected average distribution coverage ratio of 1.4x for the remaining quarters. In 2011, we are forecasting LINN will achieve greater than 35% EBITDA growth and 5% distribution growth. After updating for the acquisition and 1Q11 results, we increased our 2011/ 2012 EBITDA forecast by 3%/1%.
EV Energy Partners (EVEP/$54.04/Strong Buy) is also on our “hit list” given its rating upgrade last week following the stock price plunge. EVEP’s stock price traded down roughly 8% last Tuesday on no fundamental news. After discussions with management, our analyst views the recent weakness in the stock as likely short-term profit taking and not a reflection of the company`s fundamentals or growth expectations. Moreover, EVEP is optimistic that we will learn about Utica drilling results later this summer. Keep in mind that EVEP owns 150,000 net acres and 80,000 royalty net acres in this emerging shale play. Assuming that the partnership is able to monetize its 150,000 net working interest acreage for $5,000 per acre, and acquire new acreage for a 6.5x multiple of EBITDA, we forecast that such a transaction would boost EVEP`s distributable cash flow (DCF) by $2.70/unit, or a 88% increase to our 2011 DCF forecast. Further, the CEO bought stock last week in the open market, which supports our thesis that the stock price pull-back was not driven by any pending operational/fundamental news. Said weakness provides a compelling entry point given our thesis that the decline in the stock price was unwarranted and that EVEP`s stock price is going to be significantly higher in the next 12 months. Yet our favorites list is not just concentrated in the energy space. Indeed, after avoiding banks for over 10 years, we warmed to some of the banks late last year. However, that “warmth” was not centered on the marquee names, but rather names like IBERIABANK (IBKC/$58.81/Strong Buy). To be sure, our bank analyst maintains his Strong Buy rating on IBKC shares following solid 1Q11 results that exceeded consensus expectations. While a fair amount of noise from its five FDIC-assisted acquisitions and two traditional acquisitions expected to close in 2Q11 will continue to impact operating results, we believe the company is beginning to harvest the investments it has made in its franchise over the past few years. Indeed, management’s laser focus on prudent, profitable expansion will drive continued improvement in earnings power, particularly as excess capital and liquidity are fully deployed.
We also like the technology sector despite its recent underperformance. One of our more controversial picks has been Equinix (EQIX/$100.76/Strong Buy). Recall, we recommended EQIX after its collapse last October. Recently, Equinix beat earnings estimates and raised guidance. We continue to see favorable drivers for the data center space and strong top-line growth. We view pricing concerns the market has had regarding data centers as being overdone and still view Equinix as our top idea given its superior revenue growth, and its dominant position in the colocation space.
Additionally, some 13Fs were released last week showing the biggest increases and decreases in major institutional holdings. Four of the biggest increases from our research universe were: Chevron (CVX/$102.57/Outperform), HCA Holdings (HCA/$34.63/ Outperform), J.P. Morgan (JPM/$43.13/Strong Buy), and United Healthcare (UNH/$49.74/Outperform). The name showing the biggest decrease in institutional holding was Cisco (CSCO/$16.53/Market Perform).
The call for this week: This week should be “kiss and tell” with the equity markets in a position whereby they either gather themselves up and finally decisively break out above the 1340 level, or break below the SPX’s 50-DMA (@1325.35). This morning, however, it’s again European debt woes that are pressuring stocks to the downside leaving the S&P 500 pre-opening futures off some 13-points. If they open there, it would leave them slightly below that 50-DMA, indeed, kiss and tell time . . .
Jason Pride, Glenmede
The U.S. Debt Ceiling – Past The Limit
• The U.S. debt ceiling has been reached, an important moment for our nation’s debt debate.
• The Treasury is employing evasive actions to avoid breaching that limit before August 2.
• Likely outcome: a compromise to increase the debt ceiling combined with near-term cuts, future deficit targets and triggers for further automatic spending limits and tax increases.
• This would not be the long-term solution, but would buy time and embed incentives to follow through.
• Ongoing 2012 budget negotiations will be injected with political overtones given the election cycle.
• Unease in bond markets is likely to increase if some form of agreement is not reached.
Dates of Interest:
8/2: Estimated Treasury extension of debt ceiling
A Growth Scare or More?
• Leading indicators are hinting at a slow-down in growth from elevated levels at year-end.
• This slow-down has multiple causes, including the Japanese earthquake, tighter global monetary policy, fiscal austerity, storms/floods in U.S. Mid-West
• The slow-down could be temporary, but the risk of a more material slow-down has increased.
• Some economists and strategists are reining in their growth projections, from 3-3.5% to 2.5-3%.
• Watch Thursday’s unemployment claims since employment holds the key to halting the slowdown.
Dates of Interest:
5/24: New Home Sales
5/25: Durable Goods Orders
5/26: Unemployment Claims, Corporate Profits, GDP
5/27: Personal Income, Consumer Spending
Europe – The Walls Are Closing In
• After public discussions of a possible Greek debt restructuring, the ECB has essentially refused to accept this option, backing Greece into a corner in terms of implementing and carrying out austerity plans • An intransigent ECB adds another degree of difficulty as European politicians continue to search for a positive outcome for Greece and the other peripheral states.
• As long as the ECB refuses to change its position, restructuring looks like a much more difficult option. • Austerity alone is proving a difficult solution – Greece is having trouble meeting budget targets. • Contagion risk will increase if no way out of the current dead-end scenario can be found.
Dates of Interest:
5/23: Germany, France, Eurozone PMI
5/24: Germany GDP, IFO Survey
5/25: UK GDP
5/27: Germany CPI
• Correlations between asset classes have fallen recently, although they remain somewhat elevated.
• Nonetheless, there are plenty of potential events that could trigger a return to “risk off”.
• Events in the Middle East could reach yet another crisis point.
• Japan has yet to fully resolve its nuclear situation.
• European contagion remains a possibility.
• Traditional Portfolio Protection is Expensive
o Underweight low-yielding investments such as cash and Treasuries
o Utilize alternative risk control: hedge funds, secured options strategy, high quality equity
• Emphasize relative value opportunities within asset classes
o U.S. large cap quality
o European and Japanese Multinationals
• Position to benefit from growth in Emerging Market middle class
o Direct Emerging Market investments
o Multinationals selling into Emerging Markets
• Protect against inflation and developed currency devaluation
o Emerging Market currencies and a broad/active commodity basket
Why we're still bullish on money markets:
The last few years haven't been kind to money market funds, with yields hitting historic lows and many investors considering alternatives for their short-term savings. But Vanguard believes money market funds are every bit as reliable as they've been in the past, and that they remain a great option if you're looking for price stability and convenient access to your money.
According to the Investment Company Institute, more than 50 million Americans keep at least some of their assets in money market funds. As of March 2011, in fact, some $2.7 trillion was held in money markets—about 25% of all mutual fund assets in the United States. Equally compelling is the fact that in the 40-year history of money market funds, only two funds have seen their net asset values dip below $1 per share (often called "breaking the buck"). During that same period, in contrast, some 2,800 U.S. banks have failed, according to the Federal Deposit Insurance Corporation.
A conservative, prudent approach.
Despite the challenging times money markets have faced, Vanguard remains confident in the stability, liquidity, and credit quality of our money market funds, all of which are managed with the objective of maintaining a stable $1 share price.
We've always managed our money market funds conservatively and with prudence, focusing on high-quality short-term instruments. And Vanguard's low operating costs give us the opportunity to invest in securities that we believe can provide competitive returns without incurring undue risks to get higher yields. Every holding within a Vanguard money market fund is scrutinized by the skilled and experienced credit analysts of our in-house Fixed Income Group. Our analysts thoroughly assess the quality of each fund's underlying issuers through diligent credit analysis, and do not rely on agency credit ratings. As a result, we're happy to report that no Vanguard money market fund has ever "broken the buck," and we're confident that there's little risk this will occur in the future.
So, while we can't control the markets—or the effects that investor behavior may have on them—we can "control the controllables" in our money market portfolios, chief among them credit quality, diversification, liquidity, and maturity.
A word about "floating" NAVs:
Several proposals circulating in the nation's capital could fundamentally alter money market funds. The proposed changes include excessive capital requirements and a change in the funds' value from a stable share price of $1 to what's often called a "floating" net asset value (NAV).
Vanguard opposes such proposals because of their considerable impact on individual and institutional investors, as well as their broader negative effects on the workings of the credit markets and the U.S. economy. It's important to note that money market funds are already subject to a comprehensive regulatory structure that has worked extremely well.
Money market funds have a 40-year history of serving investors and fueling the U.S. economy. Vanguard doesn't want to see these funds fall victim to unintended consequences of Washington's well-intentioned efforts to "clean up" Wall Street.
Jim Corridore, S&P Equity Analyst
We think that some investors have become worried about a pullback (defined as a drop of 5%-10%), Correction (10%-20%), or even a new bear market (over 20% correction). Fueling the recent weakness in U.S. equity markets has been weak U.S. economic data, European Sovereign headline risks, and worries about potential tightening of global monetary policies that would lead to slower economic growth.
Standard & Poor's investment policy committee recently shifted its investment stance to what it calls a "more balanced sector stance," by making consumer staples an overweight recommendation, joining overweight recommendations in industrials and energy. Staples is seen as a defensive sector, since, by its nature, staples are goods and services that consumers buy through economic ups and downs, like food, beverages, tobacco, and basic household products, like bleach or detergent, for example.
In addition, S&P's technical strategist Mark Arbeter believes the market may be facing a drop of 15% to 20%, and possibly more due to technical factors, including the recent breakdown in commodities prices, the potential bottom in the U.S. dollar index, and lagging emerging markets. He also cites the potential completion of a 5-wave advance in the S&P 500, and a weekly momentum divergence on some major indices as reasons why the bull market that started in 2009 might be coming to an end.
With the market showing increased risk, it makes sense that stocks in the Consumer Staples sector could hold up better than some stocks from other sectors over the next few months. With that view in mind, we decided to look for mutual funds ranked 5 star by S&P Mutual Fund Reports with a heavy presence in the consumer staples sector. We decided to look for funds that are still open to new investors, with a minimum of 20% of their total assets under management invested in the consumer staples sector.
We highlight the following funds.
Rydex Consumer Products Fund (RYCIX 39)
You can't get much more invested in the consumer staples sector than RYCIX. The fund, which had total net assets under management of $61 million as of March 31, 2011, had 99.5% of its assets invested in the consumer staples sector. This 5 star fund was ranked in the 2nd quartile versus peers for its 1-year performance, and the top quartile for its 3-year performance. Names in its top ten holdings that are also viewed favorably by S&P equity analysts include Coca Cola (KO 68*****), Phillip Morris (PM 70 ****), Altria (MO 28 *****), and General Mills (GIS 40 *****). The fund has an initial minimum investment of $2,500, no front end sales load, and its net expense ratio of 1.37% compares favorably to its peer average of 1.54%.
Franklin Rising Dividends Fund; A (FRDPX 36)
FRDPX, which had $3.4 billion under management as of March 31, 2011, is a good pick for investors that may want a more balanced approach. Its top three sectors are Health Care (23%), Staples (20%), and Industrials (17%) as of March 31, 2011. Top ten holdings recommended by S&P Equity Analysts include Wal-Mart (WMT 55), Abbott Laboratories (ABT 53), Becton Dickinson (BDX 88), Pepsico (PEP 71), and Praxair (PX 103). The fund has a $1,000 initial minimum investment, and a front-end sales load of 5.75%, but a lower than peer average net expense ratio of 1.07% vs. 1.43%.
Dreyfus Appreciation Fund (DGAGX 41)
DGAGX has 28% of its $3.6 billion in assets under management as of March 31, 2011 invested in the Consumer Staples sector, its largest sector weighting. Energy, recommended overweight, was second at 23%. Top ten holdings also recommended by S&P Equity Analysts include Exxon Mobil (XOM 81 ), Phillip Morris (PM 70), Coca Cola (KO 68), Chevron (CVX 102), (AAPL 332) and ConocoPhillips (COP 71). It has an initial minimum investment of $2,500, no front end sales load, and an expense ratio of 1.09%, which is better than its peer average of 1.27%.
BBH Core Select Fund (BBTEX 16)
BBTEX has the highest initial minimum investment of the funds featured, with a minimum of $10,000. It also has 1, 3, and 5 year performances in the top quartile versus peers. Some 24% of its $597 million in assets under management as of March 31, 2011 were in the Consumer Staples sector, its largest sector weighting. Top ten holdings that S&P views favorably include Wal-Mart (WMT 55 *****), Waste Management (WM 38 ), Comcast (CMCSA 25), Visa (V 78), Novartis (NVS 61), and Diageo plc (DEO 82 ). It has no front end sales load and a net expense ratio of 1.0% vs. 1.27% for its peer average.
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