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  • 1. EQUITY RESEARCH U.S. Portfolio Strategy | November 12, 2010 U.S. PORTFOLIO STRATEGY WEEKLY Overview: Clouds on the horizon; don’t take cover yet We continue to believe that despite the magnitude of the U.S. equity market rally since Barry Knapp late August as well as the cheapening of index implied volatility skew, the fall in both +1 212 526 5313 implied and realized correlation and the drop in short-dated implied volatility, all of barry.knapp@barcap.com which point to a general decline in risk aversion, it is too early to take cover from BCI, New York the storm clouds building on the horizon. In the coming months, there is plenty of scope for a recovery in the cyclical portion of the labor market which, in our view, was Talley Léger healing in 1Q10 until public policy stopped it in its tracks. In other words, we still +1 212 526 3093 believe there is scope for additional upside macro data surprises as a rebound in talley.leger@barcap.com BCI, New York business confidence boosts capital spending and hiring and defies QE2 skeptics. If the equity market continues to rally through the end of 2010 and the data continue to Eric Slover, CFA improve as we expect, the risks will be far more balanced and some of the storm +1 212 526 6426 clouds, exogenous risks (such as European sovereign debt, Chinese and emerging eric.slover@barcap.com markets inflation) as well as endogenous risks (including the unsustainable growth in BCI, New York U.S. public sector spending and debt) may cause a more significant equity market correction. We are hardly dismissive of these risks; we just don’t think they are large enough yet to offset the positive forces of a large-scale asset purchase program and an improving economic outlook. Focus: The impact of QE2, USD & CRB on S&P 500 profit margins We’ve received many questions from clients about the effect of QE2 on the U.S. dollar and commodity prices and their impact on S&P 500 profit margins. High and rising commodity input costs have been a headwind to margins, but revenue growth has been catching up and is starting to provide an important offset. The same forces which push commodity costs higher eventually push S&P 500 revenues higher (e.g., EM strength/demand, U.S. dollar weakness, high foreign exposure). At this stage, it appears the acceleration in company revenues has come more from unit volumes than price increases. While we remain constructive on the outlook for revenues, it seems the mix of volumes and prices may shift insofar as companies can pass along rising commodity costs to consumers, and industrial production settles into a more sustainable pace of growth. Materials are prime beneficiaries of economy-wide cost-push inflation as rising commodity prices represent better pricing power for these companies. Given the significant rise of food stuffs like wheat, understandably, investors have expressed much concern about the impact of rising input costs on Consumer Staples’ margins. However, there doesn’t seem to be much risk for these companies relative to consensus expectations, at least. However, there are two important sectors at risk of disappointing lofty expectations, Technology and Financials. Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE ANALYST(S) CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 13.
  • 2. Barclays Capital | U.S. Portfolio Strategy Weekly VIEWS ON A PAGE The combination of large-scale Fed asset purchases, a change in control of Congress that should stop the relative growth of the public sector and an improving tone to the macroeconomic data have created a positive environment for equities that should last until early-2011. However, the continued drag from consumer and public sector deleveraging, a divided government with an unsustainable fiscal situation and growing global risks from European peripheral countries as well as increased pressure on emerging market central banks from rising commodity prices and currencies could stall the rally in 1Q11. Our S&P 500 price target is 1,250 and our operating EPS forecasts are $82 (44% y/y) in ’10 and $88 (7% y/y) in ’11 Full-Year 2009a Full-Year 2010e Full-Year 2011e S&P 500 Level y/y Level y/y Level y/y Operating EPS* $57 15% $82 44% $88 7% P/E 20x 7% 15x -22% – – Index 1,115 23% 1,250 12% – – *Trailing four-quarter. Source: Barclays Capital We are significantly more optimistic about U.S. corporate profits. Nonetheless, we believe the current pace of 84% y/y S&P 500 operating EPS growth is unsustainable and expect it to slow dramatically to 44% y/y ($82) this year and 7% y/y ($88) next. While we expect revenues to accelerate due to EM strength and a high % of foreign sales, margins face gathering headwinds such as peaking productivity and troughing compensation costs. Our higher year-end price target of 1,250 reflects our improved outlook for operating EPS ($82) and a 15x multiple. We favor beneficiaries of EM strength and dollar weakness, and cheap to fair defensives Energy ↑ Utilities Telecom Health Care On a breakout, we would favor Energy and Industrials; on a Staples breakdown, we would consider Industrials Utilities, Telecom, Health Care Technology and Staples. Materials ↑ Financials Discretionary Underweight Marketweight- Marketweight Marketweight+ Overweight Note: ↑/↓ = increases/decreases on 10/08/10 to ratings in place since 8/6/10 or earlier. Source: Barclays Capital We would consider sector beneficiaries of emerging market strength (monetary policy tightening on hold) and U.S. dollar weakness such as Energy, Industrials, Tech and Materials. We would look at cheap to fair defensives such as Utilities, Telecom, Health Care and Staples, which are all showing improved analyst earnings estimate revisions and should perform well at this stage of the business cycle. Given the transition from the early to later stage of the cycle and the shift from consumption to investment, we maintain our negative stance on Discretionary. November 12, 2010 2
  • 3. Barclays Capital | U.S. Portfolio Strategy Weekly OVERVIEW Clouds on the horizon; don’t take cover yet Barry Knapp Our core view continues to be that as long as the macroeconomic data are +1 212 526 5313 improving, the primary trend for equities should remain in place (up). barry.knapp@barcap.com As long as CDS curves remain normal, the correlation between European equities BCI, New York and Sovereign spreads is low and the direction of U.S. data is positive, this exogenous risk is unlikely to impact U.S. equities. High and rising commodity input costs have been a headwind to margins, but revenue growth has been catching up and is starting to provide an important offset. As we watched some of the more crowded or popular QE2-related trades (U.S. dollar shorts, 10s30s Treasury curve steepeners, silver, technology stocks and Asian ex-Japan equities, to name a few) come under pressure this week amidst a consistent flow of U.S. policy criticism from foreign policymakers, academics, market participants and domestic politicians, we were struck by how Treasury supply could cause a market reaction bordering on panic in the brief period prior to the beginning of the $600 billion of incremental purchases. It wasn’t just Treasury market supply and demand that caused market concerns; we would also include the G20 meeting, European sovereign spread widening, some backtracking by the President during his weekend address with respect to the looming tax hike, increased equity market supply, Chinese policy tightening and a weak forecast from a technology bellwether. Noticeably absent from our list of concerns is the macroeconomic data, which continued to improve as evidenced by the increase in the NFIB small business confidence index (providing further evidence that an improved public policy outlook is already taking effect), a drop in jobless claims (increasing our conviction that a sustainable downtrend is developing) and a fall in the non-petroleum trade deficit which, taken with the ISM export orders index, implies a much smaller drag from trade in 4Q10 GDP. Figure 1: The NFIB increase provides further evidence that an Figure 2: As long as the macroeconomic data are improving, improved public policy outlook is already taking effect the primary trend for equities should remain in place y/y % chg y/y % chg Index 100 14 12 25 80 10 20 60 8 6 15 40 4 10 20 2 5 0 0 -20 -2 0 2 -4 -40 -5 -6 -60 -8 -10 -10 -15 -80 -12 -100 -14 -20 00 01 02 03 04 05 06 07 08 09 10 11 12 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Russell 2000 (L) NFIB* (3mma, R) BarCap U.S. Data Surprise Index Note: *Small Business Optimism Index, SA. Source: NFIB, Haver, Barclays Capital Source: Barclays Capital While some of these concerns are more legitimate than others, our core view continues to be that as long as the macroeconomic data are improving, the primary trend for equities should remain in place (up). Still, as we experienced on three separate occasions since the November 12, 2010 3
  • 4. Barclays Capital | U.S. Portfolio Strategy Weekly S&P 500 March 2009 low, the unwind of global imbalances and the resultant debt overhang in the developed world, which is likely to continue for years, can quickly morph from a ‘contained’ variable into an important determinant of capital market trends if the recovery appears to stall, despite the vagaries of the economic data such as seasonal adjustment factors, weather or lags in important economic reports (e.g., GDP) relative to leading indicators. Keeping in mind the role the dollar has played in the equity market rally this fall, there were two seemingly unrelated events this week that could be tied to the dollar’s trend and its impact on capital markets. The first was the technology sector’s decline in the aftermath of Cisco’s earnings report (a weaker-than-expected outlook and a sharp increase in inventories). We reduced the sector to Marketweight this summer after our favorite leading indicator of earnings growth, analyst earnings estimates revisions, began falling sharply toward mid-cycle slowdown territory. The moderating trends in earnings growth and margin expansion were consistent with Ben Reitzes’ (our computer hardware analyst) PC sales growth estimates which he cut sharply this summer, twice in a short period. While our call on the core fundamentals may have approximated the truth, the technology sector performed quite well during the market rally from late August and outperformed the S&P 500 in each of the three stages of the rally (please see Overview: Occam’s Razor in our 11/05/10 U.S. Portfolio Strategy Weekly). While it is certainly possible that we misread the technology cycle, perhaps because the forces of deleveraging added complexities we failed to recognize, another distinct possibility is that the dollar’s steady decline offset slowing earnings momentum, given that this sector has the highest percentage of international sales of the 10 S&P 500 sectors. While correlation does not prove causation, we were struck by the strong negative correlation between the dollar and the technology sector from the September to the November FOMC meeting, a period we have described as the ‘pre- QE2’ portion of the fall equity market rally. With technology fundamentals in a mid-cycle slowdown and the dollar being the primary driver of the sector’s performance, we think our Marketweight position is correct for now. However, given our view that slowing earnings momentum is only a mid-cycle phenomenon, we do not believe the Cisco announcement was an important macroeconomic event. Figure 3: Tech analyst earnings estimate revisions began Figure 4: There is a distinct possibility that the dollar’s steady falling sharply toward mid-cycle slowdown territory decline offset slowing earnings momentum 3mma y/y % chg % 40% 80 -20 30% 60 -25 -30 20% 40 -35 10% 20 -40 -45 0% 0 -50 -10% -20 -55 -60 -20% -40 -65 -30% -60 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 00 01 02 03 04 05 06 07 08 09 10 11 12 Correlation: XLK and USD/EUR (60d) Rel. Net Revisions: TEC (L) Rel. Perf: TEC (R) Source: Barclays Capital Source: Barclays Capital The second apparently unrelated issue concerns the release of the Co-Chairs of the President’s Deficit Commission draft proposal. As we read through the proposal, our high level observations pointed towards an acceptable outcome for international investors in November 12, 2010 4
  • 5. Barclays Capital | U.S. Portfolio Strategy Weekly dollar-denominated assets due to the stabilization of the debt-to-GDP ratio by 2014. In our discussions with international investors this fall, particularly Europeans, we found an understandable and relatively deep appreciation for the Tea Party movement’s objectives and the example set by the governor of New Jersey’s unpopular decision to cut entitlements. Our view is that these investors generally believe the U.S. has the political will to make the difficult decisions to stabilize our debt in the foreseeable future (roughly five years). This could, of course, change quickly if the process collapses into a political quagmire early in 2011. Figure 5: The Co-Chairs’ draft proposal points to a Figure 6: The proposal to cap revenues at 21% of GDP is well stabilization of the debt-to-GDP ratio by 2014 above the post-WWII average of 18% % Debt / GDP % 200 22 21 150 20 19 18 100 17 16 50 15 14 0 13 10 12 14 16 18 20 22 24 26 28 30 32 34 12 Co-Chair Proposal CBO Extended Baseline 50 54 58 62 66 70 74 78 82 86 90 94 98 02 06 10 CBO Alt. Fiscal Scenario Federal Receipts / GDP Mean Proposed Cap Source: CBO, National Commission on Fiscal Responsibility and Reform, Source: OMB, Haver, Barclays Capital Barclays Capital As we read the report, we only got to the 7th slide before we found some political tinder, a proposal to cap revenue at 21% of GDP. This is, of course, well above the post-WWII average of 18% and the 2000 peak of 20.6% when capital gains-related revenues were bloating the government coffers. In essence, this commission is calling for a permanent expansion of the public sector to 3% of GDP. At the current level of nominal GDP, that equates to a $440 billion expansion of government revenues, roughly the size of Wal-Mart’s annual revenues. Without going into an expansive analysis of the implications, Wal-Mart has 2.1 million employees, no unions and a 21% return on common equity. Shifting more than $400 billion of GDP to the public sector, which is expected to have negative returns on equity (run deficits) for at least the next 25 years, seems likely to cause a significant drain on the productivity and therefore the wealth creation of the country. The Commission was created by the President and despite some proposals, such as a simplifying the individual tax structure and lowering corporate tax rates (which would appeal to the incoming House), we doubt the revenue cap at 21% of GDP will fly. Perhaps we will prove capable of stabilizing our debt and the debt ceiling debate, which is likely to occur in 1Q11, will not trigger a Gingrich/Clinton-style showdown where the Republicans capitulate and the world loses confidence in the dollar as a store of wealth. Given that the opening salvo was completely rejected as being too austere by the progressive wing of the government and the proposal targets a 3% permanent expansion of the public sector, we are less than optimistic that bipartisan populism will fade into a viable plan. While our currency strategy team’s outlook for the dollar is an orderly decline, which sounds correct to us at least for the balance of 2010, we will be watching the debt debate closely during the early months of the 112th Congress with a clear eye on the tail risk of a more aggressive decline in the dollar. November 12, 2010 5
  • 6. Barclays Capital | U.S. Portfolio Strategy Weekly Of course, the dollar rally this week wasn’t just about the G20 and some vague notion that there would be an agreement that would lead to a reversal of the weakening dollar trend. The widening of peripheral European sovereign debt spreads also appears to be contributing to the counter-trend dollar rebound. Our initial reaction is that at this time last year European sovereign spreads had already widened for months before any equity investor in the U.S. noticed and even then this exogenous risk was only a factor when the U.S. growth outlook deteriorated. Figure 7: As long as CDS curves remain normal, the correlation between European equities and Sovereign spreads is low and the direction of U.S. data is positive, this exogenous risk is unlikely to impact U.S. equities Bps The widening of peripheral 190 European sovereign debt spreads 180 also appears to be contributing 170 to the counter-trend dollar 160 rebound. At this time last year 150 European sovereign spreads had 140 already widened for months 130 120 before any equity investor 110 in the U.S. noticed and even then 100 this exogenous risk was only a Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 factor when the U.S. growth iTraxx SovX Western Europe Index (5 yr) outlook deteriorated. Source: Markit, Barclays Capital Still, it appears to us that the Germans and French have caused significant uncertainty through the proposal for a quasi-resolution authority (SDRM, Sovereign Debt Restructuring Mechanism), which would allow for haircutting debt holders in the event of a sovereign default, and this uncertainty is likely exacerbated by ECB criticism that it will raise borrowing costs. This argument is reminiscent of the concerns about the credit rating agencies lowering ratings on large U.S. banks in response to the resolution authority established in the Dodd-Frank bill. While our European Rates Strategy team has written about the technical aspects of this proposal (European Rates Strategy Weekly; the German proposal for an orderly SDRM – Questions and answers; November 5th, 2010), our perspective on the uncertainty can be summed up by the words of the economist, Friedrich August Hayek: The important point is that the decision is derived from a general rule and not from particular preferences which the policy of the government follows at the moment. The machinery of government, so far as it uses coercion, still serves general and timeless purposes, not particular ends. It makes no distinction between particular people. The discretion conferred is a limited discretion in the sense that the agent is to carry out the sense of a general rule. That this rule cannot be made wholly explicit or precise is the result of human imperfection. That it is in principle, however, still a matter of applying a general rule is shown by the fact that an independent and impartial judge, who in no way represents the policy of the government of the day, will be able to decide whether the action was or was not in accordance with the law. (F.A. Hayek. Decline of the rule of law, Part 2. The Freeman May 4, 1953, pp. 561-563) November 12, 2010 6
  • 7. Barclays Capital | U.S. Portfolio Strategy Weekly We suspect that credit investors will continue to carry concerns about government involvement in the resolution process as long as the GSE conservatorship, Bradford & Bingley plc, and the auto bailouts are relatively fresh in their minds. Further exacerbating these concerns is a restructuring of an Irish bank’s subordinated debt through an exchange offering that carries a back-end threat for legislative action if bondholders balk. If the SDRM follows the principles delineated by Hayek, the markets should be capable of quantifying the risks, causing systemic risk to fall. Of course, given that the European Bank stress tests were light on exposure to sovereign risks in held-to-maturity accounts, the opaqueness of European bank balance sheets is likely to continue to be viewed as a macro risk. However, it is notable that the term structure of Irish CDS is not inverted despite concerns about the banking system and the 2011 budget, due in early December, largely because the government has sufficient liquidity to self-fund through mid-2011. Typically, if there was an impending crisis, one-year CDS protection would be more expensive than five-year and this is not the case at present. As long as CDS curves remain normal, the correlation between European equities and Sovereign spreads is low and the direction of U.S. data is positive, this exogenous risk is unlikely to impact U.S. equities. In the coming weeks, as the Fed expands its balance sheet, we expect the market’s attention to shift from obvious trades, like 10s30s Treasury curve steepeners; in fact, we suspect that the curve might flatten as the portfolio rebalancing effect kicks in to less obvious beneficiaries. It makes some sense that the obvious trades such as a weaker dollar, stronger commodities, rising EM currencies and equities might stall somewhat given the magnitude of the moves and how stretched the charts appear. However, we do not believe that monetary policy in China will have much impact on the real economy or capital markets until real interest rates are no longer negative, at a minimum; if it won’t slow growth in China, it is unlikely to have global capital market implications, either. October CPI increased 80bp to 4.4% y/y and was 40bp above consensus, more than offsetting the 25bp rate hike last month, leaving the real rate at -1.90%. Meanwhile, the Chinese have pushed the yuan up 3% since the de-pegging in June and continued to raise bank reserve requirements, yet bank lending is exceeding targets and capital is flowing in rapidly despite controls. The 6% drop in the CSI 300 Index on Friday is a warning sign; however, as was the case with the U.S. in 1999, we believe the markets and economy are unlikely to respond to policy until it actually becomes restrictive rather than just less accommodating. Figure 8: We continue to believe that despite the cheapening Figure 9: … and the fall in correlation, it is too early to take of index implied volatility skew … cover from the storm clouds building on the horizon Vol pts % 15 75 14 70 13 65 60 12 55 11 50 10 45 9 40 8 35 7 30 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 S&P 500 Implied Vol Skew (90% puts - 110% calls, 3m) SPX Realized Correl (90d) SPX Implied Correl (90d) Source: Barclays Capital Source: Barclays Capital November 12, 2010 7
  • 8. Barclays Capital | U.S. Portfolio Strategy Weekly We continue to believe that despite the magnitude of the U.S. equity market rally since late August as well as the cheapening of index implied volatility skew, the fall in both implied and realized correlation and the drop in short-dated implied volatility, all of which point to a general decline in risk aversion, it is too early to take cover from the storm clouds building on the horizon. In the coming months, there is plenty of scope for a recovery in the cyclical portion of the labor market which, in our view, was healing in 1Q10 until public policy stopped it in its tracks. In other words, we still believe there is scope for additional upside macro data surprises as a rebound in business confidence boosts capital spending and hiring and defies QE2 skeptics. If the equity market continues to rally through the end of 2010 and the data continue to improve as we expect, the risks will be far more balanced and some of the storm clouds, exogenous risks (such as European sovereign debt, Chinese and emerging markets inflation) as well as endogenous risks (including the unsustainable growth in U.S. public sector spending and debt) may cause a more significant equity market correction. We are hardly dismissive of these risks; we just don’t think they are large enough yet to offset the positive forces of a large-scale asset purchase program and an improving economic outlook. As a case in point, in this week’s Focus article we analyze the impact of rising commodity prices on profit margins and find that unless we are on the verge of an economic contraction there is likely sufficient pricing power to allow dollar margins to expand further despite some pressure on percentage margins. This has certainly been the case in the past and, while every cycle is different, we begin with the premise that it’s never different this time and try to prove that adage incorrect. November 12, 2010 8
  • 9. Barclays Capital | U.S. Portfolio Strategy Weekly FOCUS The impact of QE2, USD & CRB on S&P 500 profit margins Talley Léger We’ve received many questions from clients about the effect of QE2 on the U.S. dollar (a +1 212 526 3093 downward force) and commodity prices (an upward force) and their impact on S&P 500 talley.leger@barcap.com profit margins. Indeed, raw industrial commodity prices (a proxy for associated input costs) BCI, New York were already growing 17% y/y in June 2010 and they picked up at a 24% clip in September 2010 (21% y/y so far in November 2010). The good news is market-wide revenues grew Eric Slover 6% y/y through 2Q10 (a difference of -11 percentage points); so far, they look like they +1 212 526 6426 accelerated at an 11% y/y pace through 3Q10 (a preliminary difference of -13 percentage eric.slover@barcap.com points). BCI, New York Figure 3: High and rising commodity input costs have been a headwind to margins, but revenue growth has been catching up and is starting to provide an important offset Difference, % 60 40 In December 2009, the gap between the CRB and revenues 20 widened to 58 percentage points; 0 however, that difference has narrowed considerably to 13 -20 percentage points. -40 -60 74 77 80 83 86 89 92 95 98 01 04 07 10 13 S&P 500 Revenues y/y % chg Minus CRB Spot Raw Industrials y/y % chg Source: Barclays Capital. In the chart above, we show the difference between S&P 500 revenue growth (y/y) and commodity inflation as measured by the CRB Raw Industrials Index (y/y) to acknowledge the concern that high and rising commodity input costs have been a headwind to margins, especially in December 2009 when the gap between the CRB and revenues widened to 58 percentage points. As you can see in the chart, however, that difference has narrowed considerably to 13 percentage points as revenue growth has been catching up with commodity inflation. In other words, cost-push inflation remains a concern but company revenues are starting to provide an important offset. In Figure 2, we plot the CRB Raw Industrials Index (y/y) lagged nine months alongside S&P 500 revenues (y/y); the correlation coefficient is an impressive 0.66. In our minds, this relationship supports the notion that the same forces which push commodity costs higher eventually push S&P 500 revenues higher (e.g., EM strength/demand, U.S. dollar weakness, high foreign exposure). (For a discussion on the growing importance of the developing world, the impact of global ex-U.S. nominal GDP on S&P 500 revenues, and the increase in foreign sales as a % of total sales to 30%, please see S&P 500 EPS: Revenue tailwinds (EM), margin headwinds (DM) on page eight of our 10/08/10 U.S. Portfolio Strategy Weekly.) November 12, 2010 9
  • 10. Barclays Capital | U.S. Portfolio Strategy Weekly Figure 4: The same forces which push commodity costs higher eventually push S&P 500 revenues higher (e.g., EM strength/demand, U.S. dollar weakness, high foreign exposure) y/y % chg, lagged 9 mos y/y % chg 60 30 50 Correlation = 0.66 25 40 20 30 15 While revenues look like they 20 10 accelerated at an 11% y/y pace 10 5 through 3Q10, we’d like to point 0 0 out they grew as much as 24% -10 -5 y/y in the mid-1970s. -20 -10 -30 -15 -40 -20 74 77 80 83 86 89 92 95 98 01 04 07 10 13 CRB Spot Raw Industrials S&P 500 Revenues Source: Barclays Capital. At this stage, it appears the acceleration in company revenues has come more from unit volumes than price increases. In the chart below, we plot total industrial production growth (a proxy for unit sales or volumes) lagged nine months versus S&P 500 revenue growth since 1974. Indeed, the 5% y/y growth of unit volumes in September 2010 almost completely explains the 6% y/y growth of S&P 500 revenues. While we remain constructive on the outlook for revenues, it seems the mix of volumes and prices may shift insofar as companies can pass along rising commodity costs to consumers, and industrial production settles into a more sustainable pace of growth. Figure 5: At this stage, it appears the acceleration in company revenues has come more from unit volumes than price increases y/y % chg, lagged 9 mos y/y % chg 15 30 Correlation = 0.53 25 10 20 While we remain constructive 5 15 on the outlook for revenues, 10 it seems the mix of volumes 0 5 and prices may shift insofar as 0 companies can pass along -5 -5 rising commodity costs to -10 -10 consumers, and industrial -15 production settles into a more -15 -20 sustainable pace of growth. 74 77 80 83 86 89 92 95 98 01 04 07 10 13 Total Industrial Production S&P 500 Revenues Source: Barclays Capital. November 12, 2010 10
  • 11. Barclays Capital | U.S. Portfolio Strategy Weekly Needless to say, rising commodity prices don’t affect all sectors equally. As one might expect, Materials are prime beneficiaries of economy-wide cost-push inflation as rising commodity prices represent better pricing power for these companies. In Figure 4, we show the CRB Raw Industrials Index (y/y) alongside net profit margins for the S&P 500 Materials sector (y/y). As you can see, commodity inflation and changes in Materials’ profit margins have gone hand-in-hand over time. In the current environment, this is a unique example of companies that are benefiting from unit volumes and price increases. Figure 6: As one might expect, Materials are prime beneficiaries of economy-wide cost-push inflation as rising commodity prices represent better pricing power for these companies y/y % chg y/y chg 80 15 60 10 As you can see, commodity 40 inflation and changes in 5 20 Materials’ profit margins have 0 gone hand-in-hand over time. In 0 -5 the current environment, this is a -20 unique example of companies -10 -40 that are benefiting from both unit -60 -15 volumes and price increases. 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 CRB Spot Raw Industrials Net Profit Margin: Materials Source: Barclays Capital. Given the significant rise of food stuffs like wheat, understandably, investors and analysts alike have expressed much concern about the impact of rising input costs on Consumer Staples’ margins. However, Figure 5 illustrates that there doesn’t seem to be much risk for these companies relative to consensus expectations, at least. Specifically, sector margins peaked at 6.5% between 2004 and 2007, they’d already re-attained peak levels in 2Q10 and 2010 & 2011 expectations are flat (6.5%) to slightly higher (6.7%), respectively. However, a closer look at Figure 5 shows there are two important sectors at risk of disappointing lofty expectations, Technology and Financials. Technology margins peaked at 11.5% near the end of the last cycle and, based on our estimate, were 15.5% in 3Q10, surpassing peak levels by 400bp. The rapid growth of the enterprise space following the post-recovery upgrade cycle has cooled, so achieving the consensus estimates of 16.6% and 16.9% in 2010 & 2011, respectively, could be a challenge for a sector facing a potential mid-cycle slowdown. Unsurprisingly, Financials have the largest profit margin gap to bridge between 3Q10 (8.6%) and 2011 (12.9%). True, the lingering effects of past margin weakness are set to fall out of the trailing four-quarter sum, and loan-loss reserve reductions should provide a boost. Nonetheless, shrinking balance sheets, contracting net interest margins, regulatory uncertainty, lower market volumes, as well as higher liquidity and capital requirements put this sector at risk of further disappointment. November 12, 2010 11
  • 12. Barclays Capital | U.S. Portfolio Strategy Weekly Figure 7: There are two important sectors at risk of disappointing lofty expectations, Technology and Financials Net Profit Margins (%, Trailing 4Q) Peak Actual Actual Estimated Consensus Consensus Segment ’04 – ’07 2009 2Q10 3Q10 2010 2011 Consumer Discretionary 5.1 4.1 6.1 6.4 6.4 6.9 Consumer Staples 6.5 6.4 6.5 6.5 6.5 6.7 Energy 11.1 4.7 7.2 7.6 7.5 7.7 Financials 15.3 2.6 6.8 8.6 11.0 12.9 Health Care 9.7 9.3 9.0 9.0 9.7 10.1 Industrials 8.9 6.4 6.9 7.4 7.3 8.0 Information Technology 11.5 12.3 14.7 15.5 16.6 16.9 Materials 8.8 4.5 6.5 6.9 7.1 8.5 Telecommunication Services 9.6 6.8 6.9 6.9 6.6 7.4 Utilities 8.9 8.5 8.9 9.0 8.8 8.6 S&P 500 9.3 6.3 7.9 8.3 8.9 9.4 Source: Reuters, Compustat, FactSet, Barclays Capital. November 12, 2010 12
  • 13. Barclays Capital | U.S. Portfolio Strategy Weekly Analyst Certification We, Barry Knapp, Talley Léger and Eric Slover hereby certify (1) that the views expressed in this research Company Report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this Company Report and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this Company Report. Important Disclosures The analysts responsible for preparing this report have received compensation based upon various factors including the firm’s total revenues, a portion of which is generated by investment banking activities. On September 20, 2008, Barclays Capital acquired Lehman Brothers’ North American investment banking, capital markets, and private investment management businesses. All ratings and price targets prior to this date relate to coverage under Lehman Brothers Inc. For current important disclosures, including, where relevant, price target charts, regarding companies that are the subject of this research report, please send a written request to: Barclays Capital Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer to http://publicresearch.barcap.com or call 1-212-526-1072. Barclays Capital produces a variety of research products including, but not limited to, fundamental analysis, equity-linked analysis, quantitative analysis, and trade ideas. Recommendations contained in one type of research product may differ from recommendations contained in other types of research products, whether as a result of differing time horizons, methodologies, or otherwise. Barclays Capital offices involved in the production of Equity Research: London Barclays Capital, the investment banking division of Barclays Bank PLC (Barclays Capital, London) New York Barclays Capital Inc. (BCI, New York) Tokyo Barclays Capital Japan Limited (BCJL, Tokyo) São Paulo Banco Barclays S.A. (BBSA, São Paulo) Hong Kong Barclays Bank PLC, Hong Kong branch (Barclays Bank, Hong Kong) Toronto Barclays Capital Canada Inc. (BCC, Toronto) Johannesburg Absa Capital, a division of Absa Bank Limited (Absa Capital, Johannesburg) November 12, 2010 13
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