FRUGALITY THEME INTACT

 

It’s interesting that so many pundits lay claim to how great the shopping season is going – and yet nobody is using credit! Have a look at On Christmas Shopping Lists, No Credit Slips on the front page of today’s NYT. A mere 17% of shoppers have relied on plastic since the Thanksgiving weekend — half of last year’s level and lowest in the 27-year year history of the American Research Group survey. Britt Beemer, who heads up America’s Research Group, had this to say:  

 

“The consumer really feels a lot of pressure from previous debts, and they just aren’t going to dig themselves into that kind of hole.” That sounds pretty disinflationary to us.  

To be sure, the University of Michigan consumer sentiment index did pick up in December, to 74.2 from 71.6 in November — well ahead of consensus estimates of 72.5. Before you uncork the champagne, this is still shy of the 76 nearby peak reached in June, but it is the second increase in a row. How fascinating that it is still below where we were when the last two recessions began. The home buying intentions segment actually slipped to 151 from 154 — not good news for the sector that got the economy into this mess to begin with. And equally fascinating was that even with the recent jump in commodity prices, both the 1-year and 5 to 10 year median inflation expectations components dipped a tenth of a point (to 2.9% and 2.7% respectively).

 

SOME SCATTERED THOUGHTS FOR 2011 AS WE FLESH OUT OUR THEMES FOR THE YEAR AHEAD:  

 

1. Consensus views of 1,350 on the S&P 500 and 4% real GDP growth are far too high. Not one strategist polled by Bloomberg is bearish on equities. So we have a complacency problem on our hands, the exact opposite of what we experienced at the March 2009 and the July 2010 lows. For that reason, the outlook for at least the first half of 2011 is less than positive.
2. Moreover, equities are at the high end of the range and are priced for good news on earnings and economic growth. Valuations are not at extremes (however, according to the Shiller normalized P/E ratio the market is still on the expensive side) but sentiment is. Negative divergences are increasingly apparent and momentum is actually subsiding. We see better buying opportunities ahead but continue to favour companies that are “special situations” — consistent dividend growth, undervalued, strong balance sheets, and non-cyclical in the sense that they have low correlations with the direction of North American growth.
3. In my view, real GDP growth in the U.S.A. is set to slow from around 3% in 2010 to 2% in 2011, or possibly even lower. This is not a double-dip but it is a slower growth profile. We went to 3% in 2010 from -2.6% in 2009 so the second derivative was positive. But for the coming year, the second derivative is likely going to decline. This augurs for a non-cyclical exposure; more defensive and still yield-oriented. As the Bank of Canada strongly suggested, global growth is going to slow and hence a sense of caution over global multinational cyclicals is warranted.
4. The fiscal and sovereign credit problems in Europe are not going away. Neither is the instability in the U.S. state and local government sector. Policy tightening in China is also a source of uncertainty. Volatility is likely to intensify with this outlook.
5. The U.S. dollar is likely to strengthen, particularly versus the yen (the Bank of Japan and Ministry of Finance want the overvalued yen to weaken) and the euro (they need it since Eurozone is tightening fiscal policy more dramatically).
6. Emerging markets will struggle as central banks move more forcefully to curb accelerating inflationary pressure. The Chinese stock market may have already signalled that a major top in the region has been achieved.
7. The U.S. fiscal borrowing need for 2011 is no higher than it was for 2010. As such, fiscal concerns in terms of what it means for lower long-term rates are misguided. The yield curve is too steep and will flatten, led by lower bond yields. The recent increase in long-term rates is very similar to what we saw happen in December 2009 and helped ensure that bonds would enjoy a year of positive returns in 2010.
8. The Canadian dollar is overvalued by at least five cents and is likely to succumb to a softer profile for commodity prices. Basic materials appear over-owned in the short-term and bullish sentiment is at a high. The policy tightening effect out of emerging Asia is an obstacle, especially at current price levels. There is likely an election in Canada and the U.S.A. will not be beset by political uncertainty until 2012. Hence some caution as it pertains to the outlook for the loonie (though I would look to get more positive at 93 cents).
9. Deflation remains the primary intermediate risk for the U.S., notwithstanding the prospect of a near-term follow-through from the recent surge in many commodity prices. Money velocity remains dormant despite the Fed’s reflation efforts. There remains far too much excess capacity in the labour market. This requires an ongoing focus on SIRP (safety and income at a reasonable price) strategies for investors.
10. Corporate bonds are no longer inexpensive but within this space, financials and utilities screen best for value in terms of sectors, the 5-7 year part of the curve in terms of duration, and the BBB-BB area in terms of ratings.
11. One of the most pronounced macro risks is another leg down in U.S. home prices, which actually seems to be underway but is currently receiving very little attention.

Our preferred “buy list” are out-of-favour groups that are not priced for accelerating growth: Utilities, pipelines, oil income, pharmaceuticals (dividend focus as well as being out of favour), food products, and grocery stores.  

U.S. FLOW OF FUNDS FOR Q3 – A MIXED BAG  

The U.S. household balance sheet is in better shape in Q3, courtesy of a $232 billion net debt decline (annual rate) and a $939 billion rebound in equity valuation courtesy of Ben Bernanke.  

 

 

Household net worth jumped $1.2 trillion after a $1.4 trillion slide in Q2. Real estate valuation did deflate by $650 billion, the steepest decline since the first quarter of 2009. Owners’ equity in real estate fell from $7.0 trillion to $6.4 trillion as more and more people lost their homes or chose to leave; as a share of real estate valuation, it fell back near historic lows of 38.8% from 40.8% in Q2. The multi-decade era of homeownership is over.  

Households remain concentrated on deleveraging having seen their outstanding credit liabilities decline now at an unprecedented 10 quarters in a row and by nearly $500 billion. Lord only knows how you can possibly squeeze an inflation forecast out of this secular development. The personal saving rates, as measured by the Flow of Funds, plunged 11.6% Q2 to 4.0% in Q3 — the lowest in the year. Excluding consumer durables, the slide in the savings rate was even bigger — from 10.5% in Q2 to 2.9% in Q3, the second lowest level in the past three years. Just in case you were wondering what’s really underpinning U.S. households, it wasn’t solid employment fundamentals, it was the very large drawdown in the saving rates. 

Corporate balance sheets remain in good shape but there are some yellow flags that need monitoring. Despite an active new-issue calendar, companies in the nonfarm nonfinancial sector retired $368 billion of equity (the most in three years). This helped take the debt/equity ratio down 56.6% in Q3 from 62.9%. Debt continued to be termed out with a record 74.3% of outstanding credit now long-term, up from 73.8% in Q2. The liquid asset to short-term debt ratio also rose to 52.6% from 49.6% and stand at the highest level since 1956 Q1. 

This goes a long way in explaining how it is that the speculative grade default rate in November fell to 3.5% from 14.7% a year ago and why there are fewer and fewer distressed situations. The Moody’s distress index, the share of issuers trading in excess of 1,000 basis points over Treasuries, sank to 11.5% in November from 14.1% in October and 24.2% a year ago.  

Overall, corporate credit quality remains very good but some areas bear watching. Internally-generated funds did decline in Q3 by $20 billion at an annual rate. This hasn’t happened since the economy was bottoming out in 2009 Q2. With capital spending turning up, the corporate ‘financing gap’ turned positive — $128 billion at an annual rate compared with -$104 billion a year ago. This means that companies are spending more on capex now than they are bringing in with respect to cash flows.   

TWO OFFSETS TO THE TAX-CUT PACKAGE  

Remember, all the new “fiscal stimulus” does (assuming it passes) is leave the federal government as a neutral economic force in 2011. But what are possible overhangs: (i) the recent run-up in mortgage rates, to 4.61% from 4.17% a month ago, and (ii) the spike in gasoline prices to $2.97/gallon (over $3/gallon now in 20 states). The gas effect alone will drain $40 billion from household cash flow into the gas tank — a headache to be sure but we would probably have to see the price break to $5/gallon to have the total effects of the tax package reversed.  

TRADE LIFT OFF  

We got some encouraging international trade figures from the U.S. and Canada this morning. In the U.S., the October trade deficit shrank to $38.7 billion from an upwardly revised $44.6 billion level in September. In real terms, exports surged 3.3% MoM, erasing two months of prior weakness. Even more impressive was that the strength was broad-based, with all categories up, including a 4.5% real jump in autos. Yet, it was another disappointing performance from real imports, which slid 1.5% MoM after the 0.9% decline in September. Most of the import components were weak as well, although consumer goods did jump, nearly reversing the drop in September, supporting the positive chain store numbers we saw in November. Trade is very volatile but at this point we feel much more comfortable with the idea that trade will be a net contributor to GDP and have factored in a percentage point contribution. After yesterday’s better-than-expected wholesales inventories, we are now tracking 2.7% QoQ (at an annual rate) for Q4, up from our previous estimates of 2.5%.  

Similarly in Canada, it looks like Q4 GDP will also get a boost from net trade. The October trade deficit narrowed to $1.7 billion from a $2.3 billion gap in September. We saw a huge 4.9% MoM surge in real exports, the largest monthly increase in nearly 18 months, with most components up big. Real imports rose 1.8% and most sectors were positive with notable mention to machinery and equipment (real M&E +1.2% MoM, the ninth straight monthly increase, taking the YoY rate to 27% since July 1997 — all good news for Canadian productivity). All in, we are looking at a 0.2% monthly real GDP increase in October but even with strong growth rates for the rest of the quarter, it’s likely that Q4 GDP will still fall short of the BoC’s 2.6% expectation (they did note that the second half of the year was coming in weaker than anticipated in their latest communiqué). 

 

ASIAN INVENTORY-TO-SHIPMENTS RATIOS  

We dug through some global economic data and noticed some worrying trends in Asia. The inventory-to-shipments (I/S) ratios for Korea and Taiwan have been on a steady rise since early this year. Korea’s I/S ratio is now at the highest level since March 2009 as inventories surged to two-year highs. In Taiwan, the I/S ratio is hovering near one-year highs and inventories are also near-two year highs. Given that both these countries are export-intensive, it makes us worry about global demand and the lofty GDP forecasts penciled in for 2011 by analysts (currently at 4.2% for real GDP in 2011).

 

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