Financial Pacific: The Power of a Policy put option (third party) september 29.2010

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Financial Pacific: The Power of a Policy put option (third party) september 29.2010

  1. 1. INDUSTRY  COMMENT SEPTEMBER 29, 2010 RBC Dominion Securities Inc. U.S. Equity Strategy Weekly Myles Zyblock, CFA (Analyst) The Power of a Policy Put Option Chief Institutional Strategist & Director of Capital Markets Research Equities initially rallied over the past month on the back of better than expected (416) 842-7805 myles.zyblock@rbccm.com macro data at a time of excessive investment pessimism. Just as pessimism turned to optimism, business activity, housing, and consumer data have taken a turn for Kien Lim (Associate) the worse, yet share prices remain buoyant. (416) 842-8745 kien.lim@rbccm.com We believe that investors are not only buying into the idea that the Fed will RBC Capital Markets Corp. introduce QE2 in November, but also that it will work – with some noted caveats: Peter Chung (Associate) (212) 428-6622 peter.chung@rbccm.com The link between nominal bond yields and stock prices has broken down, but implied inflation expectations and stock prices are rallying together alongside a weaker dollar. Similar to the aftermath of QE1, equities leveraged to a weaker dollar are leading. These include Materials, Industrials and individual S&P 500 companies with a relatively high share of foreign-sourced revenues. Unlike QE1, some key interest rate sensitive groups are severely lagging. Notables in this category include the Banks and Homebuilders. At this stage, equity investors seem to be buying into the efficacy of a weak dollar over lower interest rates as the primary means to stimulate economic activity. Given what we know right now, we have three scenarios in mind for the equity market: (1) if the leading indicators stabilize or turn higher as the Fed begins QE2, it’s easy to imagine an early-2009 analog characterized by a (smaller-scale) share-price melt-up; (2) were QE2 to occur, absent an imminent upturn in the LEIs, this would probably encourage some incremental risk-taking for a time; and (3) a sharp reversal in the market seems probable if the Fed fails to implement QE2 in November, as is widely expected, while leading indicators continue to drift lower. We should know a lot more about the underlying macro fundamentals by early next week. Initial unemployment insurance claims will be released this Thursday morning, the ISM Manufacturing Index is slated for Friday and the ISM Non-Manufacturing Index is scheduled for release on October 5. Keep in mind that the ultimate “when and how?” with regard to QE2 is still a large question. Priced as of prior trading day’s market close, ET (unless otherwise noted). For Required Conflicts Disclosures, please see Page 7.
  2. 2. September 29, 2010 RBC U.S. Equity Strategy QE2 Musings and Key Indicators on Deck Equities started to rally over the past month as business cycle indicators were more buoyant than expected at a time of excessive economic pessimism. The upward trajectory was reinforced when investors interpreted the Fed’s latest official communiqué as admission that the window to additional asset purchases has re-opened. The first round of quantitative easing helped to compress abnormally large spreads resulting from market illiquidity. The one-sided nature of the market back in late-2008 and early-2009 was brought into better balance once investors realized they could unload securities in size to the Federal Reserve. Assets prices inflated as spreads compressed and the economy – with fiscal help – soon thereafter started to gain traction. Equities reacted powerfully to the Fed’s quantity fix. Sectors most leveraged to the interest rate cycle and financial markets came off the bottom with greatest force. In particular, the areas of the market at the top of the performance scoreboard six months after the start of the Fed’s purchase program were Auto Components, Consumer Finance, Building Products and Automobiles. Market illiquidity is not today’s main problem. As policymakers see it, the economic challenge is linked to weak demand and lingering housing strains in the context of high unemployment. A second round of quantitative easing will need to impact the economy through the portfolio balance channel. This is where the Fed’s purchases bid up the asset of choice, lowering its yield while hopefully creating powerful knock-on effects to related assets. The absence of market illiquidity this time around suggests that the Fed will probably get a smaller asset price bang for a given asset purchase buck. The primary transmission mechanism for QE2 to the real economy will mainly be the household balance sheet. By bidding up asset prices, the authorities hope to shore up net worth and lower the demand for precautionary savings. Almost one-third of household assets are linked to residential real estate, but the more than two-year supply overhang (once “shadow inventory” is included) is likely to make house prices rather unresponsive – at least in a direct sense – to these efforts. So, as the story goes, the Fed will need to aggressively inflate bonds, credit and stocks, which represent about 23% of total household assets. As we stated at the outset, the recent equity rally is expectations-driven. This does not mean it is less real. However, the stabilization in leading macro data will also be required to sustain the market’s upward trajectory. Thinking back to the post-October 2007 cycle, we recall that there were no fewer than seven counter-trend moves, which all failed. With the benefit of hindsight, we know that the March 2009 low was established as the Fed announced its $1.7 trillion asset purchase program and leading macro data turned up. We have three potential scenarios in mind for the equity market: (1) if the leading indicators stabilize or turn higher as the Fed begins QE2, we could very easily imagine a similar – but smaller-scale – share-price melt-up; (2) The start of QE2, absent an imminent upturn in the LEIs, would encourage some incremental risk- taking, at least for a time; and (3) a sharp reversal in share prices if the Fed fails to implement QE2 in November, as is widely expected, while leading indicators continue to drift lower. We should know a lot more about the underlying macro fundamentals by early next week. Initial unemployment insurance claims will be released this Thursday morning, the ISM Manufacturing Index is slated for Friday and the ISM Non-Manufacturing Index is scheduled for release on October 5. Keep in mind that the ultimate “when and how?” with regard to QE2 is still a large question (see, for example, Jon Hilsenrath’s September 27th WSJ article titled “Fed Weighs New Tactics to Bolster Recovery”). 2
  3. 3. September 29, 2010 RBC U.S. Equity Strategy Markets Are Smelling QE2 16.0 4.20 Equities have continued to find support on the 15.0 Bond yields and 3.90 back of some generally better-than-expected stock prices diverge economic data via Initial Jobless Claims and last on QE2 hype… 3.60 14.0 month’s ISM. Now with growing admission by 3.30 the Fed of the possibility of a second round of 13.0 3.00 quantitative easing, we are starting to see the relationship between stock prices and bond 12.0 2.70 yields diverge while the dollar weakens. Source: Bloomberg 11.0 2.40 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 S&P 500 P/FE (LS) 10-Year Yield (RS) 16.0 2.60 This dynamic is symptomatic of the market’s anticipation that the Fed will engage the …but stock prices and P/Es stay linked to (rising) 2.40 deflation demon head-on. Looking at a similar 15.0 inflation expectations. 2.20 chart to the left, we note that stock market valuations have moved higher in lock-step with 14.0 2.00 implied inflation expectations. The implied 1.80 inflation upturn started with the announcement 13.0 of “QE-lite” and has accelerated with the 1.60 potential introduction of QE2. Source: Bloomberg 12.0 1.40 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 S&P 500 P/FE (LS) 10-Year Implied Inflation Rate (RS) 25 -600 Source: RBC Capital Markets, FRB, Haver Analytics -500 Money growth usually accelerates as the Fed 20 Money metrics stuck in lowers interest rates. However, the Fed has -400 the mud with Fed funds at 15 0%. -300 already hit the fund rate’s lower nominal bound -200 and therefore is being forced to intervene via 10 -100 direct asset purchases. So far, most metrics 0 5 100 suggest that money growth, the money 200 multiplier and money velocity remain stuck in 0 300 the mud. -5 400 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09 Jan-12 US MZM (yoy% chg) (LS) Fed Funds Rate (Ann chg, Bps, Inverted) (RS) 35 30 Source: RBC Capital Markets, Standard & Poor's, FRB The pace of broad money 37 Were the broad monetary aggregates to show 25 growth is linked to P/E cycles. 32 significant improvement on the back of 20 27 renewed Fed action, we would anticipate a 15 22 multi-month period of valuation expansion. 10 5 This would most likely require greater 17 0 confidence about the economic future on the 12 -5 part of businesses, banks and households. And 7 -10 for this, we think the Fed will need to generate a -15 Jan-66 Jan-71 Jan-76 Jan-81 Jan-86 Jan-91 Jan-96 Jan-01 Jan-06 Jan-11 2 substantial amount of private sector balance Real Money Supply (yoy% chg) (LS) S&P 500 P/E (RS) sheet growth (a.k.a. asset price inflation). 3
  4. 4. September 29, 2010 RBC U.S. Equity Strategy Quantitative Easing: Then and Now Price Returns Following Announcement of Fed Treasury Purchases Equities reacted powerfully to the Fed’s first 3M After 6M After 9M After quantitative fix, with sectors most leveraged S&P 500 16% 34% 39% Financials 27% 62% 52% to the interest rate cycle, financial markets Materials 22% 50% 51% and a weak dollar launching off the bottom Industrials 22% 50% 54% with greatest force. Down to the industry level, Discretionary 19% 45% 55% Technology 22% 44% 55% Auto Components (+166%), Consumer Finance Staples 10% 21% 25% (+143%), Building Products (+132%), Energy 11% 21% 22% Automobiles (+112%) and Paper & Forest Health Care 7% 19% 28% Utilities 10% 18% 24% Products (+99%) were at the top of the Telecom -2% 4% 8% scoreboard six months after the start of the Source: RBC Capital Markets, Haver Analytics Fed’s first Treasury bond purchase program. 0.15 0.32 0.14 0.30 Banks and Homebuilders were also strong 0.28 performers following the mid-March 2009 0.13 bottom, but recently have severely lagged. 0.26 Relative price weakness that began in the first 0.12 0.24 half of this year argues that the prospects for 0.22 real estate and its related assets remain quite 0.11 QE2 speculation has so far 0.20 poor. A lack of participation by these groups Source: RBC Capital Markets, Haver Analytics failed to lift these two groups. could signify that the Fed is perhaps 0.10 0.18 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 “pushing on a string”. S&P 500: Banks / Composite (LS) S&P 500: Homebuilding / Composite (RS) 0.20x 70 Dollar weakness on the back of QE1 offered 0.19x 75 strong support for the Materials sector. This sector was second only to Financials coming off 0.18x 80 the Fed’s last major asset purchase program, 0.17x rising by 50% in six months. Renewed 85 weakness in the US dollar is once again 0.16x linked to the Materials sector’s relative 0.15x 90 strength profile. Source: RBC Capital Markets, Bloomberg 0.14x 95 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 S&P 500: Materials / Composite (LS) DXY Index (Inverted, RS) 180 The weaker dollar also boosted companies Index: Jan 2009 = 100 with an international revenue base, and their 160 performance advantage is starting to widen 140 since QE-lite. A portfolio consisting of S&P 500 stocks with foreign revenues of greater than 120 50% returned 82% from March to September 2009, in comparison to a portfolio of companies 100 Companies with high foreign with less than 50% foreign exposure, which exposure are leading their 80 returned 70%. Perhaps investors are buying domestic counterparts. Source: RBC Capital Markets, Bloomberg into the weak dollar link as being more 60 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 effective than lower interest rates in S&P 500 Stocks w/ Foreign Revenues < 50% S&P 500 Stocks w/ Foreign Revenues > 50% stimulating activity. 4
  5. 5. September 29, 2010 RBC U.S. Equity Strategy Sustainable Rally Ultimately Requires Evidence of Economic Stabilization 65 60 Source: RBC Capital Markets, Haver Analytics 60 40 Regional manufacturing data have turned 55 20 more worrisome. The Philly Fed, Empire State and Dallas Fed surveys point to the risk of the 50 0 ISM Manufacturing Composite coming in at 45 -20 close to 50.0 when it is reported later this week. ISM is at risk of 40 dipping toward 50 -40 We believe the leading activity data will soon when it’s reported this need to stabilize, or turn upward, in order for 35 -60 Friday. the equity rally to be sustained. 30 -80 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 ISM (LS) Empire State Survey (RS) Philly Fed Survey (RS) Dallas Fed Survey (RS) Housing market troubles represent fresh 3 15 problems for the economy and financial 4 10 markets. Our fixed-income team believes the 5 current supply overhang increases the risk that 5 6 7 house prices move onto a more worrisome 0 8 trajectory. In fact, they see prices dropping by -5 another 10-15% from current levels. In our Another leg down in 9 -10 house prices is a risk. 10 opinion, the risk posed by home price -15 11 weakness is a key motivation behind the -20 Source: RBC Capital Markets, NAR 12 Fed’s next asset purchase program. Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11 US Existing Single Home Prices (yoy% chg) (LS) Months' Supply of Single Fam Homes on the Market (Months, Adv 6mo, inverted scale) (RS) 375 A fresh drop in home prices could thrust the 12 savings rate higher on the back of another leg 425 down in net worth. With QE, the Fed is 10 probably hoping to reflate financial assets in 475 8 order to more than offset the negative impact of 6 525 house price weakness. If the authorities succeed, Fed’s probably hoping that we’d expect a drop in the saving rate to support 4 QE2 would encourage 575 end-market demand. 2 spending via asset price 625 inflation. Source: RBC Capital Markets, BEA, FRB 0 Jan-60 Jan-65 Jan-70 Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10 The recent improvement in jobless claims is Personal Saving Rate (3mma, %) (LS) the moderate bright spot. An improving jobs Households & Nonprofit Organizations: Net Worth as a % of Disposable Personal Income (%) (RS) market should cure a lot of what currently ails 100 Source: RBC Capital Markets, MBA, Dept. of Labor 50 the economy by generating the income and 80 Jobs would cure a lot 40 confidence required for a self-sustaining of what currently ails recovery. Jobs would undoubtedly remove a lot 60 30 the economy. of the stress we are currently seeing resurface in 40 20 the housing market. 20 10 Bottom line. Stabilization in leading macro data 0 0 will be required to sustain the market’s upward -20 -10 trajectory. With the benefit of hindsight, we know -40 -20 that the March 2009 low was established as the Fed Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10 announced its $1.7 trillion asset purchase program US Initial Unemployment Claims (yoy% chg) (LS) and leading macro data turned up. US Mortgage Delinquency Rates (yoy% chg) (RS) 5
  6. 6. September 29, 2010 RBC U.S. Equity Strategy RBC CM US Equity Market Views Market Outlook (Next 6 – 9 months) Risk Rating High Overweight Market Weight + Neutral Market Weight Market Weight - X▲ Low Underweight ▲/▼ Directional Bias. Source: RBC Capital Markets S&P 500 Earnings Outlook 110 Source: RBC Capital Markets, Thomson 100 96.2 90 83.7 85.0 80 74.0 70 60.8 60.8 60 50 40 2009 2010 2011 RBC Estimate ($) Consensus S&P 500 EPS ($) S&P 500 Sector Recommendations Summary U.S. Current Recent Change Equity Sectors Recommendation (Sep 1, 2010) Consumer Staples Overweight None Energy Overweight None Health Care Overweight None Information Technology Overweight None Telecom Services Market Weight None Utilities Market Weight None Financials Market Weight None Industrials Underweight None Consumer Discretionary Underweight None Materials Underweight None Source: RBC Capital Markets 6
  7. 7. September 29, 2010 RBC U.S. Equity Strategy Required Disclosures Conflicts Disclosures The analyst(s) responsible for preparing this research report received compensation that is based upon various factors, including total revenues of the member companies of RBC Capital Markets and its affiliates, a portion of which are or have been generated by investment banking activities of the member companies of RBC Capital Markets and its affiliates. Distribution of Ratings Distribution of Ratings RBC Capital Markets, Equity Research Investment Banking Serv./Past 12 Mos. Rating Count Percent Count Percent BUY[TP/O] 643 49.60 192 29.86 HOLD[SP] 591 45.60 123 20.81 SELL[U] 62 4.80 9 14.52 Conflicts Policy RBC Capital Markets Policy for Managing Conflicts of Interest in Relation to Investment Research is available from us on request. To access our current policy, clients should refer to https://www.rbccm.com/global/file-414164.pdf or send a request to RBC CM Research Publishing, P.O. Box 50, 200 Bay Street, Royal Bank Plaza, 29th Floor, South Tower, Toronto, Ontario M5J 2W7. We reserve the right to amend or supplement this policy at any time. Dissemination of Research and Short-Term Trading Calls RBC Capital Markets endeavors to make all reasonable efforts to provide research simultaneously to all eligible clients, having regard to local time zones in overseas jurisdictions. RBC Capital Markets’ equity research is posted to our proprietary websites to ensure eligible clients receive coverage initiations and changes in ratings, targets and opinions in a timely manner. Additional distribution may be done by the sales personnel via email, fax or regular mail. Clients may also receive our research via third-party vendors. Please contact your investment advisor or institutional salesperson for more information regarding RBC Capital Markets’ research. RBC Capital Markets also provides eligible clients with access to SPARC on the Firm’s proprietary INSIGHT website. SPARC contains market color and commentary, and may also contain Short-Term Trade Ideas regarding the publicly-traded common equity of subject companies on which the Firm currently provides equity research coverage. SPARC may be accessed via the following hyperlink: www.rbcinsight.com. A Short-Term Trade Idea reflects the research analyst’s directional view regarding the price of the subject company’s publicly-traded common equity in the coming days or weeks, based on market and trading events. A Short-Term Trade Idea may differ from the price targets and recommendations in our published research reports reflecting the research analyst’s views of the longer-term (one year) prospects of the subject company, as a result of the differing time horizons, methodologies and/or other factors. Thus, it is possible that a subject company’s common equity that is considered a long- term ‘sector perform’ or even an ‘underperform’ might be a short-term buying opportunity as a result of temporary selling pressure in the market; conversely, a subject company’s common equity rated a long-term ‘outperform’ could be considered susceptible to a short-term downward price correction. Short-Term Trade Ideas are not ratings, nor are they part of any ratings system, and the Firm generally does not intend, nor undertakes any obligation, to maintain or update Short-Term Trade Ideas. Securities and Short-Term Trade Ideas discussed in SPARC may not be suitable for all investors and have not been tailored to individual investor circumstances and objectives, and investors should make their own independent decisions regarding any securities or strategies discussed herein. Analyst Certification All of the views expressed in this report accurately reflect the personal views of the responsible analyst(s) about any and all of the subject securities or issuers. No part of the compensation of the responsible analyst(s) named herein is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the responsible analyst(s) in this report. 7
  8. 8. September 29, 2010 RBC U.S. Equity Strategy Disclaimer RBC Capital Markets is the business name used by certain subsidiaries of Royal Bank of Canada, including RBC Dominion Securities Inc., RBC Capital Markets Corporation, Royal Bank of Canada Europe Limited and Royal Bank of Canada - Sydney Branch. The information contained in this report has been compiled by RBC Capital Markets from sources believed to be reliable, but no representation or warranty, express or implied, is made by Royal Bank of Canada, RBC Capital Markets, its affiliates or any other person as to its accuracy, completeness or correctness. All opinions and estimates contained in this report constitute RBC Capital Markets' judgement as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice. 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