Larry Shover

Macro Market

“Altering the Currency” – 11/4/14
Larry Shover
Macro-Market Update

Nov mid-term elections preview

• The odds are considered high (~75-80%) that the GOP captures 6 net seats to get them to 51 and Control of the Senate. A pick-up of 7-8 net seats would be an upside surprise.

• The House most likely won’t change a whole lot and GOP control isn’t considered in doubt (the split now is 233-199 and the GOP is seen either holding steady or picking up ~5-8 net seats).

• How much would Washington change under a Republican-controlled Congress? Probably not that much. If the majority is slim (only 1-2 seats) the gridlock won’t go away (the Senate may pass more bills but that may just mean Obama is forced to wield his veto powers more frequently). Keep in mind that once these elections are over the focus will immediately shift to 2016.

Bottom Line: the concept of a GOP Senate is generally considered a “positive” but in reality Congress in 2015 may not function much different from how it does now. There are two actions that have a reasonable change of happening that would be most positive for stocks:

1. Passing corporate tax reform (the odds of this aren’t much higher than 50/50 though).
2. Adopting “dynamic scoring” on budget matters.

Is a year-end melt-up rally now underway? The current environment feels more like Jan/Feb ’14 and less like Oct-Dec ’13. History provides two recent examples to help navigate the present environment.

• The US gov’t shutdown/debt ceiling drama knocked the SPX ~4-5% between mid-Sept and early-Oct ’13 before the index staged an impressive and very linear 200 point rally throughout late-Oct, Nov, and Dec, finishing the year at the highs (1850). If the debt ceiling pattern is followed this time around that would suggest the SPX getting north of 2150 at least by year-end.

• However, the Oct “V”-shaped sell-off/rally feels less like late ’13 and more like what happened in early ’14. This tape has been remarkable in tracking the Jan/Feb ’14 pattern – a minor piece of negative news used as pretext to justify a fierce sell-off (that really was spurred more by mis-positioning among faster-money investors) following by a sharp and complete rebound. If that playbook holds true rather than a further melt-up the SPX instead is in for a period of consolidation and that phase may be starting just about now.

ECB meeting – the 11/6 ECB meeting/press conf. should be relatively innocuous as Draghi seems to be in “wait-and-see” mode (the ECB wants to see whether their existing policies, inc. the TLTROs, asset purchases, weaker euro, and stress tests, can help move the needle).

• The most important takeaway from the Thurs press conf will be Draghi’s language about expanding the asset purchase program – is the ECB studying corporate debt and sovereign bonds? Any hints at doing so would be taken positively by investors.

US Oct jobs – the Oct BLS report will get published Friday 11/7 (the ADP report gets published Wed 11/5). These reports have become less controversial lately thus aren’t the binary events they once were. The St is modeling total adds ~225K w/a 5.9% UR and wages +0.2% M/M. The “ranges of acceptability” are the same as they’ve been for a few months: ~185-270K for adds, ~5.9-6.3% on the UR, and ~2-2.2% for wages.

• The UR and wages will be watched closest – any further decline in the former (below 5.9%) and acceleration in the latter will raise worries about the Fed being forced to tighten before June 17.

German eco data – recall it was the German Aug eco numbers out a few weeks ago that contributed tremendously to the Oct SPX sell-off and so investors will be watching the Sept updates closely. The German Sept factory orders hit Thurs 11/6 (at 2amET) and IP/trade are out Fri morning 11/7.

Geographic sentiment – a quick recap of where things stand:

• US – still the OW choice but enthusiasm levels aren’t extraordinarily elevated. Valuations are elevated vs. other markets but growth trends also are some of the best in the world, liquidity remains healthy, companies are performing well, and policy is still accommodative (although the Fed is moving very gradually down the tightening road).

• Japan – prior to the BOJ this week investors were apathetic towards Japan, appreciative of the valuation discount but worried that “Abenomics” could be losing momentum. The monetary decision Thurs (along w/the GPIF changes) refuted the Abenomics worries although it’s important to remember that the BOJ vote was a very close one (5-4, the first decision of the Kuroda era that wasn’t unanimous) while important structural actions still need to occur (will Abe move forward w/the second phase of the consumption tax hike?).

• China – the SHCOMP is quietly one of the world’s top performing markets on a YTD basis (up 14%) helped by policy actions (while Beijing has avoided “shock-and-awe” fiscal and monetary moves it has made several changes at the margin), decent growth (trends are decelerating but by no more than feared), and anticipation of the HK link (the SHCOMP-HK link missed the anticipated start date but will likely commence before year-end).

• Europe – of the world’s major geographic regions, Europe is (by far) the most hated. The consensus thinking considers the ECB ineffectual and the political process incapable of implementing the types of structural reforms required. Meanwhile, the economies in aggregate are barely growing while the erstwhile bright spot (Germany) is losing steam and disinflation pressures are intensifying (as several countries suffer outright deflation).

Fed purchases will still continue (but the balance sheet has likely peaked in size). While the Fed did taper for the last time and net asset purchases will fall to zero in Nov, this doesn’t really mean the “end of QE”. The balance sheet is going to remain very large for the foreseeable future (and according to Bernanke’s “stock vs. flow” argument it is the ownership of assets, not the purchase of them, that provides stimulus) and the Fed will continue to reinvest maturing securities (so gross purchases will continue).

Oil – crude prices weakened further last week (by about $1 for both WTI and Brent w/the former flirting w/the $80 level) as a lot of the same pressures continue (OPEC disorder, ongoing market oversupply, and dollar strength). OPEC addressed the price decline Wed and the language briefly helped stabilized prices but by Thurs crude was back for sale and the consensus view doesn’t see this trend ending soon. Despite talk of US producer pain it looks like WTI will need to hit the low $70s at least (and stay there for a few months) before shale capacity starts to come offline. Importantly, the oil weakness has stopped being a “negative” for the stock market (as it was back in early/mid-Oct).

Earnings – the CQ3 season is essentially over. With only a few exceptions, all the big “systemic” companies have reported results and in aggregate the reporting period was a solid one. According to Bloomberg, 80% of companies beat EPS estimates by an average of 5.5% (normally the “beat” percent is around 70%) while for revenue 60% of reports topped forecasts. More importantly though was the tone and mgmt. commentary from firms such as INTC, GE, HON, UTX, WFC, and others, all of whom spoke to an economy much more stable and steady. On the current 2015 SPX consensus EPS estimate, the market is now trading at ~15-15.5x

“The Story-line Remains in Motion” – 10/14/14
October 14, 2014
by Larry Shover
Macro update:

· The SPX is now 7.2% from the 2020 high and not far from going into the red on the year (1848.00on 12/31/13). The 10% pull-back so sought after back in the summer is now nearly at hand (that would put the SPX at 1818) but the lower this market goes the less people want to step in and buy (and keep in mind that a lot of key critical groups, such as the SOX, TRAN, RTY, S5ENRS, and others, have all declined at least 10% from their respective peaks and in some cases the decline is north of 20%).

· The last 72 trading hours certainly felt different and it is now safe to say that the last few weeks constitute the most significant sell-off for this market since the summer of 2012. What had been neutral and annoyed sentiment is turning into fear and anger. “Giving up on the year” in particular seems accurate as most people are beginning to surrender hope of the SPX seeing fresh highs any time in 2014. The selling Thurs/Fri/Mon was pretty orderly but certainly more rushed and anxious than it has been in a while.

· Like the summer of 2012 this market is increasingly difficult to explain and compartmentalize – the desire to catalogue every single SPX tick and equate it back to a headline or a specific piece of news is strong but this tape (as it was in 2012) is beyond the realm of pure “fundamentals” and is being dictated much more by sentiment, positioning, and psychology (which is why any summary attempt, such as this one, can sound rambling and nonsensical). In such a nebulous atmosphere the default reaction is to move to the sidelines.

· The real problem isn’t so much what is happening but instead what isn’t – a narrative of negativity is at present dominating this tape and while its supporting evidence is far from overwhelming nothing has occurred (yet) to effectively counter it.

· At the heart of this narrative lies growth – for the last two weeks any market summary in the popular press has started with a lament about growth (that was the case w/the WSJ Mon night – “gathering signs of a slowdown across many parts of the world are roiling financial markets and confounding policy makers”) but when pressed most continue to cite the three Aug German data points from last week. European growth obviously leaves a lot to be desired and German softness can’t be ignored but the narrative isn’t taking into account other more encouraging data (such as the US labor trends, the China trade numbers, etc). Rather than celebrate China’s trade figures investors instead dismissed it as temporary (the iPhone effect) or fraudulent

The last few weeks feel very similar to late-Jan/early-Feb ’14 sell-off. Recall the dip back then also came suddenly and started because of a nebulous “growth scare” that snowballed over the course of ~2.5 weeks into an SPX decline that hit nearly 6% at its trough.

{C}· The following was written by me for FBN on Feb 3, 2014 and it remains appropriate today: “Stocks are scared of stocks. People are getting spooked more by price action more than the actual news and ex post facto fitting headlines to justify every gyration. The tenor of news lately hasn’t been great but the complete aversion to volatility that has characterized trading in the back-half of Jan has helped to exacerbate market moves”.

Extreme volatility belies a calmer underlying fundamental landscape. Investors should look through the former noise and focus on the latter.

{C}· European growth is clearly weakening but expectations didn’t get marked down a whole lot this week there or anywhere (the IMF simply brought its forecasts inline w/the existing consensus).

{C}· The commodity collapse is prob. a reflection more of supply than demand and will benefit pockets of the economy (consumers) as much as it will hurt others (energy firms and miners).

{C}· Monetary policy is shifting but in aggregate will actually become more accommodative, not less (see below). It is too early in the CQ3 season to draw a firm conclusion on Corporate America and while certain red flags exist (most notably MCHP) the Sept-end reports will likely be fine (AA, PEP, and INFY all beat and none of the corporate execs who spoke at a variety of conferences back in Sept suggested a sharp change in trend).

{C}· Finally, on the ’15 EPS estimate (low-$130s) the SPX multiple is back below 15x.

Monetary policy – a few things to keep in mind as the Fed’s asset purchases wind down:

{C}1. The Fed has been dialing back its purchase demand for a while and at this pace is only buying $15B per month of Treasuries and MBS.

{C}2. “Stock vs. flow” – that aphorism was a favorite of Bernanke’s and he used it to make the point that it was the ownership of assets, not their actual purchase, that provided accommodation (the Fed isn’t selling anything – they just aren’t expanding the balance sheet further).

{C}3. the Fed isn’t going to have an ECB problem whereby the balance sheet will automatically start to shrink as it will reinvest maturing securities (after Oct the balance sheet won’t expand further but it won’t shrink either).

{C}4. Despite the end of Fed balance sheet expansion monetary policy in aggregate is actually going to become more accommodative, not less. G4 CB balance sheets have been expanding at a ~EU1T annual pace since ’10 and that number will actually rise going forward. The BoJ is already expanding its balance by close to $650bn per year, so adding a similar pace of increase for the ECB’s balance sheet (€500bn or $650bn per year) should result in an annual pace of G4 central bank balance sheet expansion of $1.3tr, even as the Fed ceases bonds purchases.

Crude weakness continues.

Crude – the IEA published its Oct industry report. The IEA cut its forecast of global oil demand for 2014 by 0.2 million barrels per day (mb/d) from the previous month, to 92.4 mb/d, on reduced expectations of economic growth and the weak recent trend. OPEC crude oil output surged to a 13‐month high in September, the monthly report informed subscribers, led by Libya’s continued recovery and higher Iraqi flows. The higher output from OPEC as well as from non-OPEC producers lifted global supply by almost 910 kb/d in September to 93.8 mb/d. Compared with a year earlier, total supply stood 2.8 mb/d higher.

{C}· The crude selling has been fierce and Brent prices are now 22% off their $115 June highs (they finished the week below $90).

{C}· Supply is clearly contributing to the pressure while OPEC (still the most important swing producer) hasn’t shown much appetite to intervene and provide relief.

{C}· Saudi Arabia recently cut prices (and late last week we learned that Iran followed suit) and hasn’t eased output at all (an OPEC report this week said SA’s Sept output rose 100K BPD).

{C}· The big OPEC producers clearly are keen on preserving their market share and (according to T Boone Pickens and others) are really attempting to cause enough pain for the “US frackers” that American supply gets curtailed (reports this week suggest that pain is near – according to the WSJ, a lot of the American shale output becomes uneconomical w/crude below $90).

{C}· Saudi Arabia won’t repeat mistakes of the past; the Kingdom knows that in order for crude to sustainably bottom they will have to get higher-cost output off the market and that will mean more near-term pain.
“Plenty of Headlines – No Real News” – 10/07/2014
October 11, 2014
by Larry Shover
Macro Update

Equity Strategy : October Chart book: Many red flags, but I still believe that dips should be bought: I acknowledge a number of worrying signals: the selloff in high yield bonds, falling commodity prices, flattening yield curve, and a narrowing participation in the market, among others.

{C}· All of these could keep volatility elevated in the short term, but I think the underlying equity backdrop remains constructive and advise using the dips to add.

{C}· I do not believe US activity is about to take a step lower, as the recovery is far from being “credit-less”, “jobless” and “housing-less”.

{C}· USD strength should not be seen as a bearish signal as it’s largely a result of robust US growth, and the credit selloff is technical in nature.

{C}· Additionally, Q3 results are likely to be a positive event in the US, despite stronger USD, given the very undemanding hurdle rate, and equities offer the best relative valuations compared to other asset classes.

Credit update – a break-down of ownership trends. Central banks and commercial banks have been soaking up sovereign bonds (G4 central and commercial banks own ~52% of the tradable global bond universe). As a result of this diminished sovereign supply, non-bank investors are very overweight corporate bonds. On my calculations, non-bank investors are overweight credit by 17% currently, compared to zero (neutral) weighting in 2009.

Rates update. An update on Fed normalization, the regulatory environment, and the evolution of short-term interest rates. Even as the Fed plots its exit, the legacy of extraordinary accommodation combined with regulatory and economic considerations fuels questions about if it can and how it will raise rates. Some rates will be harder to raise than others.

US Fixed Income Update. Although the September employment report was solid, with the unemployment rate falling below 6%, the strengthening dollar and declining inflation expectations are sources of concern and make the Fed calculus trickier. With no major events on the calendar over the near term, I turn neutral on duration but continue to look for yields to rise over the longer term.

FX update. Although the USD is overshooting most short-term valuation models, I lower year-end targets for several currencies.

· This acknowledges the dollar’s upward bias as long as US 2-yr rates tick higher and non-US growth remains weak.

· New targets for Q4 2014 (previous forecast in parentheses) include EUR/USD 1.25 (1.30), AUD/USD 0.87 (0.90), USD/MXN 13.20 (12.90). Unchanged year-end targets include: USD/JPY 109.

· My main short-term reservation is that FX moves have been running well ahead of shifts in interest rates, as the USD appears to be front-loading the approaching Fed tightening cycle.

Fed – the inflation vs. jobs debate will heat up in the coming week.

Inflation trends suggest the maintenance of ZIRP. The broad Fed policy assumptions remain unchanged at the moment (balance sheet expansion over by the end of Oct w/the first hike prob. at the June 19 meeting) but inflation developments (or more specifically disinflation trends) may disrupt the present thinking.

· The Fed already downgraded their inflation language in the last statement and market-based indicators are falling to multi-year lows. 10yr TIPS spreads are sitting below 2% and 5yr spreads are close to 1.7%.

· How much of this is due to plunging commodity prices/dollar strength and PIMCO-related disruptions remains to be seen but the Fed may be hesitant to evolve its rhetoric in a more hawkish direction until there is more clarity on the inflation front (people had been assuming the removal of “considerable time” from the 10/29 statement but that phrase could wind up staying at this point).

· Fri’s wage numbers were tepid and it won’t be until later in Oct when the next inflation releases cross the tape (the Sept CPI is on 10/22).

Fed – jobs suggest a move away from ZIRP. While disinflation pressures appear to be building, the jobs data is signaling a Fed that should begin shifting away from ZIRP. The unemployment rate now has a “5” handle (it hit 5.9% Fri) and other components of the jobs market are improving.


The “risk” checklist – so far, so good. The list of things that need to happen for stocks to begin behaving better:

{C}1. Draghi will have to define his addressable market as including both retained securities and those held by investors – he did that last Thurs.

{C}2. the Fri jobs needs to be within the “range of acceptability” (net adds ~170-235K, UR 6.1-6.3%, and wages 2-2.2%) – that mostly happened Fri (the sluggish wage # offset the “5” UR handle).

{C}3. HK needs to open this Fri and trade decently – that happened Friday although it will have to continue in the coming days.

{C}4. The Fed minutes (Wed 10/8) can’t read any more hawkish than the “dots” already suggested.

{C}5. Some of the fixed income flow information (i.e. out of PIMCO and into others) needs to start stabilizing.

{C}6. The first few earnings reports need to be OK, inc. YUM 10/7, AA 10/8, PEP 10/9, INFY 10/10, C/JNJ/JPM/WFC/INTC 10/14, BAC/AXP 10/15, IBM 10/16, andBK/GE/HON 10/17.


Global Data Watch: The global economy is being buffeted by two sizable market movements: USD strength and commodity price declines. In part, these moves reflect relative shifts in demand and policy.

· Demand is shifting toward the US and away from commodity-intensive consumers at the same time that there is a relative shift in G4 monetary policy.

· I view the Fed implications of the September employment report as mildly hawkish, with the committee likely to place more weight on the falling unemployment rate than on the stagnant wage figures.

· I view the latest signals from the ECB and BoJ as increasing the likelihood that further easing measures will be forthcoming. A rising dollar and falling commodity prices, of course, signal growing downside risk to global growth, a point underscored by the recent decline in risky asset prices.

· Independent of the drivers, there are likely to be important macroeconomic repercussions. The most obvious is a move toward lower global inflation.

· I’m already building in a significant fall in inflation in the coming months, and the recent drop-off in oil prices is not fully incorporated in the forecasts. Viewed on a high-frequency basis, the 3-month annualized inflation rate should fall to its lowest level since the Great Recession


Expectations have dropped for Yum! Brands’third quarter results in the month leading up to the company’s earnings announcement slated for Tuesday, October 7, 2014. The consensus analyst estimate has dropped from $1.00 a share to the current estimate of earnings of 87 cents a share.

The consensus estimate has dipped over the past three months from $1.08. For the fiscal year, analysts are expecting earnings of $3.38 per share. Analysts are projecting revenue this quarter to stay static at $3.46 billion. A year after being $3.47 billion, analysts expect revenue to fall less than a percent year-over-year to $3.46 billion for the quarter. For the year, revenue is projected to come in at $13.67 billion.

Over the last four quarters, revenue has fallen an average of 1% year-over-year. The biggest drop came in the most recent quarter, when revenue fell 8% from the year-earlier quarter.

The company has been profitable for the last eight quarters, and for the last four, profit has risen year-over-year by an average of 16%. The quarter with the biggest boost was the most recent quarter, which saw a more than twofold surge.

Yum Brands develops, operates, franchises and licenses a system of restaurants. Domino’s Pizza, Inc., also in the restaurants industry, will report earnings on Tuesday, October 14, 2014. Analysts are expecting earnings of $0.61 per share for Domino’s Pizza, up 20% from last year’s earnings of $0.51 per share. Other companies in the restaurants industry with upcoming earnings release dates include: Chipotle, McDonald’s and Carrols Restaurant Group.
“Secular Market or Cyclical Market?” – 09/30/14
October 1, 2014
by Larry Shover

Taking a step back and looking at the SPX broadly, it still feels similar to last week. The seeds of this sell-off were planted before the recent FOMC decision more than 1.5 weeks ago and all the volatility since then has been part of a broader consolidation phase (there aren’t specific headlines causing the sharp day-to-day swings). Before all is said and done it will prob. be needed for the SPX (cash) to (approximately) test its 100day MA (1955) but it doesn’t seem like this is the start of a broader “correction” (that being said a period of digestion within the Jul 1950-1985 band may be the path of least resistance near-term).

The market’s head is spinning, splitting its focus between the load of fresh economic data that was released overnight and this morning, and Day 3 of Occupy Central, which continues in Hong Kong.

· Asian equities started the session on a down note, with the Hang Seng shedding another 296 pts (or 1.3%) to a 3-month low while China’s CSI 300 inched up 0.1%.

· European bourses also began their session on a cautious note but have since rallied on expectations of more ECB support. (Bewildering reason to rally…….) Markets are up about 1% so far this morning.

· U.S. equity futures are pointing to a slightly positive open. The mighty U.S. dollar held on to its 4-year highs this morning … the USD index is stronger against most currencies, particularly against the EUR and for good reason.

Events to watch for the week of Mon Sept 29

ECB meeting (Thurs 10/2). The biggest deliverable due from this meeting are details on the new ABS/covered bond purchase program (although the one number investors want to know most, the overall size of the purchase program, may not be revealed by the ECB according to press reports. The St is assuming ~EU500B over two years).

As far as policy and rhetoric, Draghi has spoken a lot lately and prob. won’t change his near-term ton.

The ECB is going to allow its existing policy measures (the TLTROs, ABS/covered bond purchases, forward guidance, euro weakness, etc) to run their course before considering fresh steps.

US Sept jobs report (Fri Oct 3). These releases have been very anti-climactic over the last several months and the Sept reading prob. will be too. Until the figures make a large and sustained break in one direction (i.e. if net adds print at a sub 150K pace or touch ~300K for a few consecutive months, if UR breaks under 6%, or if wages grow at a mid-2% pace or higher) investors will focus less on each individual report.

For Sept specifically, the St is modeling a big rebound from Aug (215K vs. 142K) w/an UR unchanged at 6.1%. Wages are seen staying in the ~2.1-2.2% range. The “ranges of acceptability” for Sept are: net adds ~160-220K, UR 6.1-6.3%, and wages 2-2.2% (anything within these ranges will likely elicit an indifferent response from the market).

Macro Update

Bottom line market update: the 100day MA should (roughly) hold for the SPX (that is now ~1955 on the cash index) but US equities will prob. be “boring” for a period of time; US banks and Europe should outperform going forward. Despite Fri’s rebound (which was driven in large part by short covering and felt similar to Wed’s ephemeral advance) the SPX still finished the week down ~1.5% and while Thurs saw the largest decline (1.68%) since the end of Jul this was a sell-off that had been in the works for quite a bit of time, pre-dating the recent FOMC meeting.

We can blame the “Hilsenrath Squeeze” from last Tues (9/16) for disrupting the trend lower (and causing the head fake rally up to ~2020) but the bias for at least two weeks has been to the downside and Thurs was just the latest phase (albeit a dramatic one) of that pattern.

The very thin liquidity conditions, coupled w/the fact that month and quarter-end are so close, exacerbated the swings this week (people really were focused most on performance preservation and thus “chasing” became the default strategy – this is why the SPX snowballed every day this week, closing on the lows Mon, Tues, and Thurs and the highs Wed and Fri).

Going forward this recent sell-off doesn’t seem particularly unusual and thus the 100day MA (~1950-1955 area) should provide (rough) support. However, the SPX is more likely to mark time (in the ~1950-1985 range) for a little bit (rather than jump quickly back to fresh highs at >2020) while US banks (esp. the largest ones) and Europe should outperform.

European growth update. Despite the 2Q disappointment, my forecast remains for a gradual increase in Euro area growth momentum. Repair of growth perceptions requires three things: a bounce in IP, a steady PMI, and stabilizing sentiment Data through to September suggest reasonably good news on the first two, but not on the third.

ECB update. The ECB is expected to deliver more in the coming months. Draghi’s commitment to balance sheet expansion is real but the policy options now on the table won’t be enough. I think the ECB will first enhance the existing measures (such as making the TLTROs more attractive) while keeping sovereign QE as a policy of last resort.

· Overall, I think that the enhancements to the TLTROs and purchases of retained ABS as well as distributed ABS and covered bonds will take the ECB’s balance sheet to €2.7 trillion. If this move is accompanied by improvement in the data on growth/inflation and by favorable financial market conditions, then the ECB may be satisfied with this. If the December TLTRO disappoints significantly and if ABS/covered bond purchases prove harder than expected, and the data disappoint, then other measures will need to be taken.

Global fixed income weekly. The ECB is set to release further details on its ABS & covered bond purchase programs. I believe the ECB is strongly committed to a substantial increase in its balance sheet over the next few years. I revise higher my balance sheet projections as:

· Draghi hinted at the possibility of the ECB buying retained ABS.

· I believe the ECB will try to increase the attractiveness of TLTROs. These changes could see the ECB’s balance sheet increasing by €700bn-€750bn by end-2016.

A series of data will add to the weight on the ECB’s shoulders when it comes to introducing more nonconventional measures to improve lending and steer the economy away from deflation.

· For starters, the advance estimate of inflation was a letdown. Consumer prices in the Euro Area rose just 0.3% from a year ago in September, slower than the August pace of 0.4% and the smallest increase since October 2009. Still, that was expected. What was not expected was the slowdown in core inflation, to +0.7% y/y from the prior month’s 0.9% y/y rate. If you take it to two decimal points, that’s a record low.

· Meantime, finding the unemployed a job is also high priority. The jobless rate, although it is down from the high of 12% (reached just a year ago), remains elevated at 11.5% in August. Even in Germany, the jobs situation is stronger, but it is clearly not in perfect health. The # of unemployed unexpectedly rose in September, up 12,000, although the jobless rate held its ground at 6.7%. [Remember that German business executives are nervous, with their confidence at the lowest level since April 2013, according to the Ifo survey, and that likely cooled their desire to hire.]

“Bad News Comes in Threes?” – 09/17/14
September 17, 2014
by Larry Shover
Bad news comes in threes?

· Federal Reserve on Wednesday.

· First targeted long-term loan (ECB) on Thursday.

· Scottish referendum results on Friday.

US trading update – the SPX started to stall back on 8/25 and has traded poorly ever since. The index is back in the 1950-1985 range (which confined the SPX for most of Jul) and prob. will spend a little bit of time here. To the extent investors are very nervous about “considerable time” those concerns at this point are prob. overblown but the Fed has a lot of other ways to spook investors Wed and thus the SPX may not have a big relief rally on that day (although if the “momentum” stocks continue to get hit hard into the Fed they could bounce once the news hits). The set-up still seems like it favors European stocks over US ones for the time being.

Fed preview. While it’s a close call, I think the Fed drops the “considerable time” language from the post-meeting statement. 9/17 also brings ’17 “dots” for the first time – I continue to think the ’17 dots will be close to neutral with a center point perhaps around 3.50-3.75%. I would be quite surprised if the median dot were much below 3.50%. Expectations have been building for months that the September meeting will feature the roll-out of the new and improved exit strategy. As it stands, I think we will only get a broad outline of that strategy, consistent with what we saw in the June and July FOMC minutes.

· Regarding my own Fed outlook, I now look for a first hike at the June meeting next year, which is both earlier, and more precise, than my prior call of Q3.

· I see the first hike in June as a 25 basis point increase in the target funds rate corridor, to 25-50 basis points.

· I see subsequent moves in September and December bringing the corridor to 75-100 basis points by year-end.

· I think the Fed can afford to stick with its plan the normalize rates gradually, at least initially. I now see a somewhat more aggressive pace in 2016, with the funds rate reaching 2.5% by year-end.

ECB – the TLTRO results will hit Thurs Sept 18. This facility has been overshadowed by all the asset purchase talk but successful TLTROs (this will only be the first tender) could wind up being the ECB’s most powerful tool (if for no other reason than it has institutional support throughout Europe whereas asset purchases have powerful detractors and thus will never be as powerful as they were in the US). For 9/18 specifically the take-up may be on the light side given the novelty of this facility (the consensus is around ~EU120-150B – anything north of EU150B would be positive).

· While the lack of broad support may emasculate any ECB asset purchase program it will still have an effect and when combined w/the other policy measures (inc. low rates, forward guidance, the TLTROs, and very weak euro) the impact should be powerful.

Surveying the macro landscape – a lot of headlines but not much news. In a lot of ways the backdrop for stocks has stayed static for weeks:

{C}· Central bank policy globally remains very accommodative. The Fed is inching towards tightening but the process will be extremely gradual and regardless the ECB is just now adopting a serious of non-conventional steps. Central bank balance sheets have been expanding by ~$1T annually since ’10 and that pace will likely persist (and may even increase) despite the Fed’s actions.

{C}· Economic growth is strengthening in the US, holding steady in China, and weakening mildly in Europe (this has been the theme since Jul). The US Q2 GDP is looking even stronger than before while China is holding steady. Europe has been the world’s weak spot (although some of the data this week was mildly encouraging). Finally Japan appears to be rebounding from the deep Q2 hole.

{C}· The message from most companies is “status quo”. A slew of companies from multiple industries spoke at a variety of sell-side conferences in the last two weeks and the message from most was “no change” (from when they last addressed investors back in Jul on the CQ2 earnings calls). Aside from small changes at the margin it doesn’t appear that broad trends in Corporate America shifted materially.

{C}· The geopolitical landscape remains tense but no worse than before. The festering ISIS problem finally caught the attention of Washington and a broad strategy is being formulated in response. The Ukraine/Russia ceasefire is holding although remains very tentative.

{C}· Valuations – not much has occurred on this front. The St is still penciling in ~$119-120 for ’14 SPX EPS and ~$130-131 for ’15 (the ’15 forecast has inched up a bit over the last couple of months).

Macro-Market(s) Update:

Equities – the SPX will stay biased lower (but 1950 should hold if it even gets that low). The SPX really hasn’t done much since 8/25, stalling around the ~2K level since that time (the sell-off that occurred Fri 9/12 actually tried to happen back on Fri 9/5). However, lately underlying price momentum has shown signs of softness and it feels like the index’s path of least resistance is to the downside. The damage though shouldn’t be that severe and the SPX is likely to do no worse than 1950 (if it even gets that low).

Has ZIRP created a house of cards? I anticipate that the start of US rate hikes will do damage to markets in the short term, but that there will be greater differentiation over a more medium term between liquid and less liquid assets. In the short term, investors sell what they can, making liquid assets more vulnerable. But over a matter of months, I think liquid risk assets, such as equities, will fare better than less liquid credit, adjusted for their normal volatility.

Crude update – Atlantic Basin crude markets to remain under pressure until Oct. As evidenced by last week’s $3/bbl sell off in Brent front-month futures, global crude markets remain under pressure. The primary driver of weaker Brent prices continues to be the build-up of crude supplies in Atlantic Basin markets. It seems everyone has a single “reason” for the price dip but a variety of factors appear at play.

· To start supply is pretty healthy. While Saudi Arabia has dialed back on output (per reports last week), others within OPEC haven’t (Kuwait and Libya in particular are pumping more). Meanwhile, it doesn’t look like OPEC is rushing to hold an emergency meeting and coordinate supply cutbacks (Kuwait last week said no such move was needed at the moment and it expressed confidence in Brent prices returning to >$100).

· Also on the supply front, some are worried about Russian supply increasing as Moscow looks to mitigate the effects of Western sanctions. Geopolitical risk has been bleeding out of crude markets for a while but that process accelerated this week as the US began articulating a formal strategy for responding to ISIS.

· Demand has been weakening out of Europe and China, something discussed in the Sept IEA report (published last week). The sluggish crude price environment represents a tailwind for US consumers.

· African exports face a more prolonged period of dislocation than I’ve previously expected, and that a recovery in Brent crude pricing is now more likely to occur in early-to-mid October.

Fixed income update – The three key events coming up this week are: the FOMC meeting, the first TLTRO allotment and the referendum on Scottish independence.

{C}· I see a 50:50 chance of a change in the Fed’s “considerable time”, and expect a new median Fed Funds target forecast for end-2017 of 3.50%-3.75%.

{C}· I expect a take-up of €150bn in next week’s TLTRO allotment and an increase in excess liquidity to around €200bn.

{C}· I expect a “no” vote in the Scottish referendum, but the outcome will likely be very close.
“Souring on Divergence” – 09/09/2014
September 9, 2014
by Larry Shover
Are investors quietly souring on the US (relatively speaking)? There isn’t anything “wrong” with the US – economic fundamentals are fine, corporate earnings continue climb, valuations aren’t unreasonable, and monetary policy is still extremely accommodative. However, investors are looking to the future and finding more to like in other markets.

{C}· US data has been great vs. the rest of the world but that is starting to become a problem – the ISMs prob. can’t sustain their current levels and auto sales will have a tough time repeating the Aug blow-out numbers (esp. since incentives helped drive a lot of the upside).

{C}· Jobs meanwhile are “as good as it gets” – the UR is on the cusp of having a “5” handle while monthly adds any higher than ~275K will prompt a more aggressive Fed response (the Fri headline adds number was light but may be anomalous and regardless it sounds like the Fed views the participation rate dynamics as more structural than cyclical).

{C}· The upcoming FOMC meeting (Sept 17) could bring an important (hawkish) change to the outlook statement (the removal or softening of “considerable time”).

{C}· Finally valuations, while not absurdly expensive, are rich vs. some other big markets (the SPX is 16.8x ’14 and ~15.4x ’15 vs. ~9.15x for China’s SHCOMP and sub 15x for Europe – these numbers are from Bloomberg).

Europe meanwhile is the opposite – growth is bad but should show gradual improvement. The ECB has a pipeline full of monetary stimulus (the first TLTRO is Sept 18 and ABS/covered bond purchases start in Oct) while the bank stress tests (tentatively scheduled for Oct 17) are seen as a positive catalyst.

In China the Shanghai Comp has been one of the world’s best performing markets since the beginning of Jul on back of data stabilization and ahead of the big Hong Kong trading link (the SHCOMP is up ~13% since the beginning of Jul).

Bottom Line: the landscape isn’t “bad” in the US but sentiment has been deteriorating of late. The “pain trade” from here would be for the SPX to falter (moving back into the 1950-1985 range) while Europe maintained/extended its gains.

Are rates biased to the upside over the coming weeks? The path of least resistance for rates (esp. Treasury rates) may be to the upside. The big ECB policy announcements have come – anticipation of an asset purchase program has been a huge driver of the recent rally and while sovereign buys may occur the bar for such a step is high and prob. won’t happen until later in 2015 (if it occurs at all).

{C}· Relative-value traders have piled into Treasuries given the Euro bond price action but if Continental yields don’t move any lower (already Bund yields are starting to inch higher) investors will start to focus more on US-specific fundamentals (very strong growth, improving jobs dynamics even w/the Fri BLS, and a Fed that is gradually tightening) – this should bias Treasuries lower (and yields higher).

{C}· Note that on Friday despite the weaker headline BLS number 10yr yields still finished the day higher. All that being said the relative-value considerations can’t be ignored and US 10yr yields won’t get above ~2.7% unless European bonds (esp. German bunds) materially weaken.

Market update – divergences emerging. Last week brought a number of important macro developments (in particular the ECB actions and US Aug BLS) but it was the divergent stock performance that elicited the most attention.

· European stocks advanced (SXXP up >1.5% and the SX5E up >3%) and big pockets of Asia surged (NKY +1.5%, Hang Seng +2%, Shanghai Comp +4.93%, H-Shares +3.69%, India +1.6%, etc) while the US finished about flat (the SPX added ~4 points on the week thanks to the 10pt move Friday).

· Increasingly investors are coming to view US equities as “stalled” (the index has been vacillating around 2K for two weeks) and as a result money is beginning to rotate (Europe is among the most favored destinations).

· For the time being this shift could have legs – nothing is “wrong” w/the SPX and the index shouldn’t go much below the low-end of the 1950-1985 band but momentum clearly lies elsewhere.

FX update – everyone’s a dollar bull again. Take profits on long USD trades but forecasts continue to show USD appreciation into year-end. Apparently reports of the FX industry’s demise have been greatly exaggerated. Between more ECB easing, a tightening of Scottish referendum polls and a rise in US 2-yr rates, FX turnover has spiked from depressed to almost-normal levels.

· Markets have become more interesting thematically too, but the quite palpable consensus around a higher dollar is reminiscent of early 2014 in terms of tone, rationale and position measures. Thankfully, group-think is rarely a sufficient condition for market reversal.

· The macro and policy drivers need to turn around first, and I am still comfortable with both the current US ones (Fed policy) and non-US ones (low inflation in Europe, political risk in UK, Russia, NZ and Sweden).

· Forecasts continue to show USD appreciation into year-end, more against low-yield G10 currencies (EUR, JPY, CAD) than higher-yield EM ones (MXN) or those with strong balance of payment profiles (CNY, KRW).

Crude markets update – recent research has highlighted a number of the factors weighing on crude markets. While a pick-up in refinery demand is likely several weeks away as maintenance continues to build in Europe and elsewhere, the duration and depth of crude discounts continues to surprise me. This week I consider additional factors that have contributed to the deterioration in crude differentials and the weakness in spot prices. These have driven Dated Brent to its lowest level versus front month Brent futures since 2009, and compressed Dated Brent’s differential versus Middle East benchmark crude Dubai to zero, a four year low.

US Fixed Income: Although recent economic data have largely been positive, Friday’s employment report was disappointing and takes the pressure off the Fed to make big changes to the September FOMC statement.

· Draghi both over-delivered and confused at Thursday’s ECB meeting. While I do think the chances of sovereign QE remain high, I think that ultimately it will not be delivered as the economy improves. In the meantime, however, hopes for sovereign QE will likely benefit European corporate credit markets but have little impact on US securitized product markets.

Calendar of events to watch for the week of Mon Sept 8 (also early Fed look)

China eco data. A bunch of important China Aug eco numbers will hit, including PPI/CPI (out Wed night 9/10), and retail sales/IP/FAI (all out Sat morning 9/13). Chinese stocks (both mainland ones and the HK indices) have been on a tear lately and while some of the recent growth numbers have fallen short of expectations it doesn’t seem like economic trends are taking a material turn for the worse (momentum though isn’t as strong as it was back in Q2).

AAPL iPhone launch event – Tues Sept 9 (1pmET). This is one of the most previewed and expected launches in AAPL’s recent memory and it seems hard to imagine the co will actually “surprise” investors. That being said, even though the iPhone refresh is widely anticipated sentiment on AAPL’s H2 prospects is very bullish (many consider the iPhone 6 one of AAPL’s biggest launches in years). Details on specific expectations for 9/9:

{C}· two new iPhones (a 4.7 and 5.5” model).

{C}· screens – the 4.7” will prob. have a traditional Gorilla Glass (GLW) screen while some of the higher-end 5.5” versions could use sapphire (GTAT).

{C}· availability – the 4.7” phone is seen hitting shelves by the end of Sept or the beginning of Oct while the 5.5” model may not be released until the end of Oct or the start of Nov.

{C}· Price – right now the iPhone 5S costs $199 (16GB), $299 (32GB), and $399 (64GB) w/US wireless contracts. People are expecting the 4.7” iPhone 6 models costing the same at those capacities and the 5.5” model being ~$100 more (so $299 at the 16GB). The 5S will prob. stay on the market but see price cuts (most likely $100 for the 16GB and 32GB w/the 64GB model being discontinued). It sounds like the 5c could be discontinued (w/the 5s becoming AAPL’s “low-end” phone).

{C}· iWatch – AAPL will likely unveil its first “wearable” product which the press is dubbing “iWatch” although it isn’t clear if AAPL will position this as an actual watch or more a fitness-focused device (some reports suggest it will be more the latter). Regardless, the wearable isn’t expected to hit shelves until 2015 (AAPL prob. won’t have pricing details although some reports have said the device could cost ~$400

BOTTOM LINE: this will likely be a very LONG event on Tues with AAPL introducing a number of new products, features, and initiatives. As far as the stock is concerned the most important information to watch will be availability (if the 4.7” and 5.5” models don’t launch by the end of Sept and middle of Nov, respectively, people will be disappointed) and price (most people are looking for the 4.7” iPhone to cost the same as the current 5s while the 5.5” prob. is $100 more – anything more expensive may raise worries).

The next major Fed event will come Sept 17 (the next FOMC decision and Yellen press conf) – will “considerable time” get removed? It looks very likely the Fed will articulate the specific logistics of its exit strategy at this meeting (it sounds like the Fed Funds rate will be scrapped in favor of a corridor defined by the IOER at the top-end and the ON RRP rate on the low-end). On the policy front, some are starting to think the Fed will adjust the “considerable time” language.

“Dwelling in Possibility” (FOX BUSINESS) – 08/29/2014
September 9, 2014
by Larry Shover
The period of “The Great Moderation” (1983-2008) was one resulting in massive assumption and prerogative. Long gone were the silly fears of the “Great Depression” – bankers and brokers were immortal – above reproach and certainly beyond correction. Technology created both speed and choice – this dynamic encouraged a whole new breed of investing mind thought and subsequently pushed equities into a quick-and-easy mainstream investment. Stocks were no longer reserved for the ultra-affluent – the generations who lived at ease on the hard sweat of a relative they heard of yet never knew. The advantage became more balanced – more stock markets, more volume, cheaper commissions and narrower bid-ask spreads. Buying or selling a year’s salary of XYZ; something that used to take minutes could now be done in less than seconds in the comfort of your pajamas.

There was a time in America that young men and women were admitted to college without creating highlight videos of themselves and without pledging their teenaged years to an extracurricular cloister. College arrived, and college led to graduation (four years), a cubicle, modest debt, spouse, offspring, real estate, health insurance, trips to Disneyland. Nurses and math teachers did not need resumes. Single-family homes increased in value every year. That’s etched in stone somewhere. People in their 50s and 60s owned homes that were paid off. If you had been working somewhere for 20 years or more you could safely hide in your office until you turned 65, and at that point, with your golden years ahead, Social Security would be waiting patiently. Forever would Americans buy Kodak film, books at Borders, tools and trousers at Sears Roebuck & Company.

When recession did arrive (the non-Great kind) a company like Circuit City might dally with Chapter 11, but only long enough to get reorganized and draw enough investment capital to return to health. If a developer was stuck with an office tower or apartment project that was still unfinished when economists announced that the downturn had started, the investors pushed to finish the property anyway, and then made an effort to find tenants. Walking away from a property with rebar sticking out of the top was unimaginable. And regardless of the economy, talk of Chapter 11 for icons like General Motors or Bank of America was the province of conspiracy theorists with greasy hair and smudged glasses.

Different Soil Produces Different Plants

By and large, we are grounded by context – what we believe to be true. A young kid growing up in Philadelphia during 2007-2011 would rightly assume the Phillies were always good and always in the playoffs. However, what a baby-boomer Philadelphian pictures inside the frame is a scene vastly different altogether as they freshly recall the “Collapse of ’64” (6 1/2-game lead in the NL East with only twelve games remaining). Indeed, pains memory fades quickly but it does, somehow, score our brains with a deeply personal perspective – for better or worse.

I recall making my first stock purchase (Niagara Mohawk Power ticker: NIA) as a senior in high school. My grandparents warned me of the evil unknowns of the market. “Don’t buy what you can’t see”, “it’s good till it’s not,” “leveraged and illiquid” they would clamor. These familiar phrases seemed exaggeratedly homespun at the time however, would prove remarkably prophetic in future years. As an 18 year old boy, I thought buying equity (especially given the rich dividend) was a judicious thing; something worthy of praise. I subconsciously chalked their cautioning as podunk – nattering from a generation of old irrelevant crepehangers. Little did I realize they were first-hand witnesses to the full-blown destruction of an investor base less than 50 years prior and, more personally, recently and specifically, the wipeout of Penn Central (PC stock fell from $86 – $15) – decimating neighborhood families – their presents and futures.

I learned about market supply/demand and momentum dynamics at a very early age. My uncle owned a scrap yard and my father, who worked their part-time, would take me along. I still remember the earthy scent of stale oil and rusting metal from cars – once full of families – now sitting derelict, awaiting the car crusher. It fascinated me that a New Jersey trash-picker could play a tangible role in supplying the worlds demand. He could drive into the scrap yard with a trunk full of copper, place it on a scale and walk away with a wad of cash. A few weeks later, the trash-picked copper would be refined, melted down, and sold to a bonded warehouse and shipped to perhaps China, ending up deep beneath a railroad bed 7,000 miles away. Better lesson yet was witnessing the daily price action and trend. I distinctly recall and was forever impressed by pig iron and how, during a short period in the early 1970’s, the market abruptly became so abundantly oversupplied that scrap yards went from paying for it (pig iron) to being paid to keep it!

A Tourist in Monte Carlo – the fourth moment of a deformed normal distribution, conditional probabilities and Gaussian blurs.

What I learned is markets are often driven by human emotion and unexpected events. Predicting that market movement is mystifying to say the least and the same can be said of defining precise return expectations. Portfolio theory is grounded with the conviction that traditional asset classes will rise in value over the long-term. To date that theory holds however, at the end of the day, our traditional long-only portfolios, our nest eggs, are assuming risk without any of us having any clue about what the risks are! Investors need to be willing to probe beyond traditional stocks and bonds if they want to be truly diversified. Investors need a diversifying component that, over time, has shown to be non-correlated to the traditional market and will help mitigate the crushing blow of volatility.

Unfortunately, many are attracted to alternatives purely for the perceived outsize returns they believe these investments can deliver. They attend parties and are held hostage to loud, grandiose stories from acquaintances who can afford a pre-war apartment in Gramercy Park – not to mention garaging their convertible in Manhattan – all in-part to the huge returns from their alternative investments. No matter how toxic or highly exotic this alternative investment is – it is too tempting to pass up! Yet, we reside in a world of compact probability distributions, where expectations – the mean – and the deviation from that expectation – or the volatility – matters the most and influences all investment outcomes. That said, the investor, when analyzing alternatives with the intention of reducing volatility and truly diversifying, should first look at the divergence benefits of managed futures.

As the name suggests, managed futures invest via global exchange traded futures seeking to profit from a systematic method to investing in agricultural, currencies, energy, equities interest rates and metals. This investment strategy was initially referred to as “Commodity Trading Advisors” (CTAs) and its roots can be traced back to the early 1850’s when the first standardized contract was established in the U.S.

Phony Diversification and Systematic Risk in Returns

The chief philosophy supporting managed futures is that the short-term momentum (direction) of markets is often a direct response to corporate, geo-political and economic data. The inherent flexibility and liquid nature of the futures market (i.e. the futures trader can “go long” or “go short” with equal ease) means that positions can be swiftly reversed as one trend ends and another begins, which is clearly different from the “buy and hold” nature of our traditional long-only investments and most hedge fund strategies. Subsequently, what makes managed futures so particular is that they often demonstrate a low or negative correlation in times of market stress. This suggests that an allocation to managed futures could actually counter, rather than simply cushion, the impact of extended market liquidation.

In short, it simply boils down to convergence (long-only equity, fixed income and most alternative hedge fund strategies) complemented by divergence (managed futures). A convergent investment thesis is one built on the notion that the core value of an asset can be measured using analysis. This analysis will result in a conviction on whether an asset is over or undervalued, based upon the belief that the price will “converge” to its core value over time within a normal market environment. Divergent strategies (managed futures) seek to profit when fundamentals are ignored by the market. Managed futures have performed their very best when they can exploit market price dislocations, often epitomized by successive price movements around asset classes “domino effect” reflecting the realities of changing market sentiment.

Despite the best of intentions, too many of us incorporate a litany of funds, styles and strategies – whether main stream and/or alternative – and yet, simply fail to properly diversify the underlying risk exposures of the portfolio. It is true that alternatives in the form of hedge funds have generally reported higher Sharpe Ratios than standard asset classes and yes, alternative beta (i.e. returns generated from exposure to volatility, credit or liquidity risk) can add value to a portfolio however, “true diversification” critically hinges on the underlying risk and covariance characteristics of your overall portfolio. In a perfect world, you would select a universe of investments that spans a spectrum of risks in search of a balanced portfolio. You would then correctly forecast (econometrically of course) short-term asset volatility and correlation – rebalancing as changes in short-term forecasts suggest. However, in the real world, tails can be really fat and variance can persist and get blown out of proportion. Other words, there are always sharks in the ocean – not just when they are sighted and beaches are subsequently evacuated. We simply don’t know what we don’t know. Risk is a verb – it’s a moving target.
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“The Supportive Narrative Continues Supporting” – 08/26/14
August 27, 2014
by Larry Shover
The narrative is evolving but remains supportive of risk assets:

1. Central banks remain very accommodative. The BOE and FOMC are the most “hawkish” CBs globally but neither can be accused of pursuing a restrictive policy. Meanwhile, others are either doing more (ECB) or thinking strongly about it (BOJ, PBOC, etc).

2. Corporate earnings are strong. The June-end results in Jul were better-than-expected and the mini Jul-end season has been strong too (retail in particular has been a bright spot).

3. M&A/buybacks/dividends are still happening. The anti-inversion drive may have cooled some of the activity but deals are still getting done.

4. The growth landscape is certainly evolving w/the US strengthening while Europe weakens. China has wobbled and the strong Q2 rebound prob. is leveling off (but it remains to be seen whether another downturn is at hand) while Japan is showing signs of life following an extremely soft Q2.

5. Geopolitics are cooling (but this remains a big risk area). The Russia/Ukraine conflict remains very fluid but there is a clear desire on both sides to avoid further escalation (the response Fri 8/22 to the convoy border crossing was healthy as Ukraine accused Russia of invading but refrained from physically interfering)

6. Valuations. The full year SPX forecast for ’14 remains in the ~$119-120 range (SPX is ~16.5x that figure) while the ’15 forecast crept up ~$1-2 over the last several weeks to ~$131-133 range (the SPX is 15x that number). Most people are still thinking about a ~17x number (on $132 that would suggest an SPX at ~2240+).

The Fed was “hawkish” but only w/regards to timing; the two other big components of the tightening process (magnitude/pace and destination) are still very supportive of risk assets.

· Timing – this piece gets the most attention but is actually the least important (by far). The expected timing of the first hike has moved forward by 1-2 months, from Jul/Aug to Apr/May/June of 2015 (the consensus is in the June timeframe).

· Magnitude – the pace at which the Fed tightens is much more important than when the first hike actually takes place (so long as we are only talking about 1-3 months) and all signs point to the target rate moving higher at a very gradual pace.

· Destination – the pre-crisis “terminal” or “neutral” rate was ~4% but signs lately point to the figure being closer to 3.5-3.75%.

Bottom Line: The market feels a lot more comfortable about the Fed than was the case before – it isn’t that the market “doesn’t care” about timing but this is certainly being discounted (appropriately so) compared to the bigger questions of magnitude and destination – it is on these latter two issues that the fate of stocks will hinge and all signs point to Fed pursuing a very risk-friendly tightening process.

Treasuries (long-yield) are being pulled in two opposing directions: domestic fundamentals (improving growth, stable-to-rising inflation trends, tightening labor markets, a central bank moving towards tightening) vs. int’l price trends (plunging yields in Europe and Japan).

· For now, the latter force is exerting more pressure on the long-end of the curve and while all signs in the US would ostensibly point to higher yields, on a relative basis Treasuries are some of the cheapest bonds on the planet (the yield spread between 10yr Treasuries and Bunds continues to widen and now stands at >140bp, the biggest number since the late ‘80s).

· Unless something dramatic occurs in Europe to reverse the direction of their yields (which seems unlikely) then any sell-off in Treasuries will likely be relatively mild (esp. if the Fed proceeds to tighten at very gradual pace).

FX – the EUR has been the “easy” and “consensus” short for weeks given the widening policy gap between the FOMC and ECB along w/the sluggish Euro growth trends and Ukraine tensions. However, some are beginning to wonder whether it makes sense to continue pressing at these levels.

· An easing of Ukraine tensions, stabilization in growth, and hints of more ECB action could help sentiment (which is very depressed) to improve.

· For the GBP people seem neutral at the moment – it was the consensus long up until Jul but lately investors have booked profits.

· The yen has quietly weakened quite a bit but investors are reluctant to continue pressing at these levels.

· The Fed is moving toward a first rate hike, which should continue to support the USD. In spite of marginally weaker July payrolls, Fed officials continue to find the underlying trends positive. Yellen continues to underscore that the labor market is weaker than headline data suggests, and inflation is not yet a threat.

· I am overweight the dollar due to positive economic momentum, the Fed approaching an inflection point where it focuses on reducing its balance sheet and increasing rates, and the potential for further global unease to favor this traditional safe haven.

Banks – “this time is different”. For a while (years at this point) the thesis around banks has been the same:

· They are the only group w/a natural hedge against rising rates.

· Valuations are cheap (one of the few groups w/a lot of large-caps trading meaningfully below the SPX multiple).

· The regulatory clouds are lifting.

· Capital is getting returned at an accelerated pace.

· Loan growth is improving.

Gold: I’m still negative!

· Geopolitical concerns about Russia-Ukraine and Iraq have pushed the gold price above USD 1,300/oz in the first half of August.

· The metal lacks broad support as ETF investors seem to have used the opportunity of higher gold prices to moderate their longs. Moreover, the demand picture in Asia remains muted as well.

· Despite gold’s insurance qualities in recent weeks, I (still) believe the cost of holding gold is too high. With the Fed likely to turn more hawkish over the next 6 months, backed by solid US economic data, I expect the gold price to come under pressure again.

· I reiterate my negative six- and 12-month stance, with a price target at USD 1,200/oz and USD 1,050/oz, respectively. For silver, a weak gold price and a big market surplus that needs to be absorbed by investors leaves the door open for materially lower prices.

Crude Oil: Still optimistic

· I believe the energy market has become very complacent to supply risks in crude oil and natural gas. Production challenges in the Middle East and North Africa region are still a threat, with Libya’s recovery clouded, Nigeria’s production constrained and Iraqi output at risk.

· Global spare capacity remains tight and mostly held by Saudi Arabia. Thus, additional supply disruptions can quickly raise crude oil prices by USD 10–15/ bbl from levels below USD 105/bbl (Brent).

“Tell Bonds to Stop Rallying” – 08/15/14
August 18, 2014
by Larry Shover
Equity strategy – in my opinion, there have been three main headwinds for equities in recent weeks: credit, US wages, and the risk that US GDP growth is now ‘too strong’.

Credit: High yield spreads have widened 17%, compared to an average of 30% prior to previous equity market corrections. However on all previous occasions, investment grade spreads widened proportionately in line with high yield spreads, but this is not the case this time. I see little widening of HY spreads from here given the current and forecast default rates, the carry, and positive earnings revisions. (perhaps a sign of a mature credit market?)
Wage growth is the critical variable to monitor as it is in my opinion the best guide to inflation and profit margin pressure. The year-on-year pick-up in wage growth (measured by the wage component of the ECI and average hourly earnings) is still modest. I believe wage growth will accelerate only when unemployment falls to c.5½% (from 6.2% currently).
Fed and GDP: Economic data has been stronger than expected (particularly ISM and Q2 GDP). I see a risk of the first rate rise being brought forward to Q2 2015 (the house view is Q3), but I believe that the equity market will not correct more than 5 months ahead of the first rate rise. To some extent, ISM new orders have only caught up with PMI new orders (which have tended to be more reliable).
I’m sticking to my year-end target of 2,020 for the S&P 500. Excess liquidity remains supportive; and net corporate buying is double its average. Above all, US and global earnings revisions are at 3 and 2 year highs respectively. Risk appetite is mid-range and ISM new orders suggest a further pick-up.

Has anything really changed? At the margin yes but the broad macro narrative is still the same.

· US Q2 earnings were strong and the full year forecasts are steady (or maybe slightly higher) – ~$119-120 for ’14 and ~$129-130 for ’15. The SPX on those numbers is ~16x and ~14.7x (neither number is very cheap but those aren’t expensive multiples either and putting the current 16x on $130 gets an SPX to ~2050).

· Growth is looking a bit better in the US and China and a bit worse in Europe and Japan (it all nets out to GDP expectations that stay steady or improve slightly globally).

· Central banks remain super accommodative – despite all the consternation around the Fed (and BOE) no one can accuse Yellen or Carney of being “hawkish” and the ECB’s “big bang” hasn’t even started (the first TLTRO comes Sept 18).

· The geopolitical landscape is unsettled and needs to be watched but this has been the case for most of the year.

The Fed – timing assumptions shift slightly but “magnitude” not in doubt. This most recent “taper tantrum” isn’t nearly as severe as the one last May or earlier this year.

· Investors have only shifted their first hike expectation by ~30 days or so (from mid-’15) and aren’t adjusting their assumptions around “magnitude” (i.e. the pace of tightening the terminal/neutral Fed Funds rate).

· Stocks are still hyper-sensitive to any jobs/wage/inflation data point and Fed utterance but in general there is more comfort w/the FOMC than is presently appreciated.

Bonds need to stop rallying – 10yr yields below 0.5% in Japan, ~1% in Germany, and ~2.4% in the US are making stocks nervous.

· While equities have been able to stabilize, the price action in bonds is preventing stocks from feeling really good about themselves.

· 10yr US yields dipped below 2.4% Fri and finished last week about at that level. German 10yr yields are threatening to break under 1% while JGB 10yr yields broke under 0.5% last week.

· Investors continue to have many theories for the strong bond price action – global growth forecasts have stayed stable or inched higher (US a bit stronger and Europe a bit weaker).

· European yields are certainly responding to ECB policy and shrinking nominal GDP forecasts and no matter what happens in the US it will always be difficult for US and German 10yr yields to diverge too much.

The problem w/junk. It isn’t so much stocks that people are nervous about but bonds and specifically junk bonds. Junk bonds had a very bad Jul and the weakness persisted into Aug (although the HYG finished last week higher).

· There is an awful lot of concern about high-yield positioning w/ownership levels crowded and liquidity super thin. Every day there are articles about people shorting junk, about how regulators are worried about market dynamics (too much ETF participation, too little Wall St dealer inventory, etc), and about how this market more than any other is going to be most sensitive to even small shifts in Fed policy.

· People are nervous that junk dislocations can’t occur w/o ensnarling equities and given the latter asset class is more liquid and “easier” to short people are preparing themselves for the eventual HY fallout in stocks.

My gold watch – market has refelcted some of the broader risk aversion present across capital makrets, breaking back up through $1,300.

· I don’t ascribe that to one particular event or headline (certainly not media reports of Russian troop movements near the Ukrainian border), rather to several small streams of unease reaching a confluence during reduced summer liquidity.

· Disappointing EU data, reports of further difficulties for Chinese private property developers, geopolitical events in the Middle East and Ukraine, and no end in sight to the prevailing uncertainty about the Fed’s intentions posttapering.

· But I don’t think this marks the beginning of a turn in trend. expect the recent risk-off tone to moderate through August and similarly expect the current buoyancy in XAU to fade before $1,350 is reached.

· gold could manage a period of relative outperformance versus industrial metals, which are vulnerable to an unwind of large speculative long position should Chinese concerns deepen.
“We Talk About Risk Without Knowing What They Are!” 08/06/14
August 6, 2014
by Larry Shover
I stick with my year-end target of 2020 S&P 500:

There have been two key worries:

· US wages, but YoY wage growth (on ECI and average hourly earnings) is stable.

· The sell-off in high yield, but investment grade spreads have remained well behaved.

Reasons for sticking to my year-end target of 2020 S&P 500:

Markets correct at the earliest 5 months before first rate hike and a month after end of QE 1 and QE 2. This implies a troubling time roughly towards year-end…not now.
Excess liquidity is still very supportive
Corporate net buying is double its norm
Earnings revisions in the US and globally are close to 3 year highs
Risk appetite is mid-range. ISM new orders implies a rise in risk appetite

Why? Ask 10 people why stocks are so soft and one will get 10 answers – “inflation” is the most popular answer (and many will cite the ECI from Thurs) while BES, Argentina, “weak earnings” (even though this has been a decent season overall), Russia, “rates” (i.e. the dislocations in credit will be painful and reverberate to stocks), and “the Fed” (the expected timing of the first hike may have moved forward ~30 days over the last week) are got plenty of blame too.

· Taking a step back however, this tape (the SPX) has been tired since 7/22-7/23 after failing to convincingly break up through 1985 multiple times and last Thurs was the manifestation of that fatigue (it really could have been anything but it just happened that stocks had plenty to pick from this week to justify their tantrum).

· However, while the selling pressure peaked Thurs the news void staring at investors until at least Aug 20 (the FOMC minutes) and Aug 21 (Jackson Hole) isn’t giving much of an incentive to aggressively step in on the long side (that is a long time to leave a nervous tape to its own devices).

· Breaking 1950 (the low-end of the range) as severely as the SPX did Thurs obviously wasn’t helpful and it prob. won’t be in Aug that the index can make fresh highs. That doesn’t mean though that it can’t climb back into the 1950-1985 range this month.

· Since its recent peak up at 1991 (on 7/24) the SPX has declined ~3.6-4% but in that time the VIX shot up ~30-35% and investor sentiment has deteriorated markedly. It is difficult to accuse this market of being complacent or oblivious given every dip immediately is assumed to be the start of a much broader “correction” and sparks a discussion of existential risks.

Has the broader narrative changed? At the margin maybe but the broader landscape still feels pretty static.

· Growth is proceeding as planned in the US/China/Europe (maybe a touch better in the former two and a smidgen weaker in the latter region) while Japan is a touch softer.

· The Q2 earnings season was a strong one – obviously expectations have risen since the likes of AA and INTC put up big prints (back in early/mid-Jul) and so the last few reports don’t look as “good” but the numbers and outlooks from SP500 companies were better for the June Q (and the full year SPX ests for ’14 at ~$119 and ’15 at ~$130 didn’t shift much these last few weeks).

· The Fed is still on pace to wrap up gross purchases by Oct and rates should start moving up by the middle of ’15. It isn’t ridiculous to argue for hikes commencing 1-2 months earlier than mid-’15 but the tightening trajectory will remain a gradual and shallow one.

· The situation in Russia poses a challenge – while Ukraine forces make military progress against rebels the sanctions unveiled this week were severe and a few large European companies called the conflict out as a headwind.

· Finally in Portugal the BES situation isn’t immaterial but the question investors need to ask is whether it constitutes a “macro” event that will spread to the rest of Europe (Portuguese 10yr yields rose only 6bp this week, from 3.64% to 3.7%).

Bernanke won’t need to schedule more dinners – the market has as a better handle on Fed policy than it is given credit for. The prior Fed-linked “taper tantrums” (inc. May ’13 and the one earlier this year prior to Bernanke’s dinners) were driven by shifting expectations around the magnitude of policy shifts (i.e. how quickly the Fed would hike, where would the Fed Funds be when the hiking was done, will the Fed sell assets?). This time around, the big debate isn’t so much magnitude but rather timing (when will the rate hikes begin?).

· For most of the spring (of this year) the consensus thinking had the Fed beginning its tightening process in the ~Aug ’15 timeframe. That moved to June/Jul of ’15 over the course of the early summer on back of a few strong BLS reports. Now, the date is gradually shifting to ~Apr/May/June of ’15 (although as of Fri 8/1 it still seems reasonable to assume “mid” 2015).

· However, expectations around the more critical components of policy importantly remain static (i.e. the rate hikes will be spread out over a long period of time, the process will be slow and gradual, the Fed Funds won’t return to pre-crisis normalized levels, the balance sheet won’t be actively shrunk, etc).

· So long as this stays just an issue of timing instead of magnitude (and so long as the timing doesn’t move into Mar of ’15 or earlier), then markets will be a lot more comfortable w/the Fed than they were before. While many continue to frame monetary policy as a very binary issue (i.e. stocks can only stay at present levels if the Fed leaves policy unchanged) this increasingly looks to be a fatuous view given that policy has been in “tightening” mode for months (via tapering).

· Stocks would eagerly trade the present policy framework for one slightly less dovish w/growth sustained at the present pace. Unfortunately, we won’t get a ton of Fed clarity until Aug 20 at the earliest (when the minutes from the 7/29-7/30 FOMC meeting hit). Jackson Hole starts Aug 21 and media reports suggest the conf this year will contain a big debate around the amount of slack in the jobs market (i.e. how accurate is the 6.1% UR?). The next Fed decision (which will include a press conf and new “dots”) will be Sept 17.

Events to watch for the week of Mon Aug 4

Nothing major until Aug 21. With the big macro events out of the way (Fed decision, US GDP, US jobs, etc), the rest of Aug will become very quiet up until the 7/29-30 FOMC minutes (Aug 20) and the Fed Jackson Hole conf (which kicks off Aug 21). Even Jackson Hole may not provide the monetary clarity many crave – the event will be focused on the jobs market and therefore FOMC exit policy specifics may have to wait until the post-meeting press conf on Sept 17.


Risks and timing: Asset allocation – Core views are tracking. The risks around them, from lower growth and disruption caused by Fed hikes, balance each other out. Fed disruption risk is to us further out and its impact uncertain. I do not put much emphasis on it, yet. The timing is to me not right to significantly cut overall risk assets now already.

· Economics –– PMIs and monthly run rates keep me comfortable with a rebound to 3%+ global growth pace for Q3.

· Fixed Income –– Trade bearish US view through UW vs TIPS and Bunds.

· Equities –– Strong US and Japanese earnings supports stocks.

· Credit ––Back up in spreads is a sign of a matured credit rally.

· FX – I love the stronger dollar, even as the main move up should come later.

· Commodities – Supply/demand dynamics keep me long energy.

“Dwelling in Possibility” – 07/29/14
July 29, 2014
by Larry Shover
US stocks feel tired. The SPX tried for several days to conclusively break up through the 1985 upper-end of the recent range (1955-1985) but couldn’t quite muster the strength. Selling was never that heavy (even during the Fri/Mon dip) but buyers for the near-term are running out of steam. 2K had been considered “inevitable” and many think that level can be achieved in the coming days as we move into month-end but for the moment the (US) tape feels “tired” and it still seems like we could be settling into a Mar/Apr-like period of “frustratingly flat” (based on the 1955-1985 range).

Calendar of events to watch for the week of Mon Jul 28

US Q2 GDP – the first look at Q2 GDP comes Wed Jul 30 and the St is modeling a big rebound (+2.9%) from the very large Q1 hole (-2.9%). GDP is viewed much differently by the media (a lot of focus) and the markets (not so much) but if the number undershoots St ests by a wide margin (~2.5% or less) growth concerns may revive a bit (although the monthly PMIs and job reports are much more important).
Fed meeting – Wed Jul 30 (there will only be a statement after this meeting and no press conf or “dots” update). Most likely, the Jul statement Wed afternoon will be relatively bland. However, some think the language may need to be updated to better reflect Yellen’s recent testimony (w/regards to growth and policy).
{C}1) The description of labor market slack could be interesting. The most recent statement reads: “The unemployment rate, though lower, remains elevated.” The further 0.2%-point decline in the jobless rate since the June meeting could lead to the addition of a hedge word like “somewhat elevated.” Such an alteration, while apparently minor, would allow a more gradual pivot in communications toward recognizing they are making progress toward their mandate.

{C}2) The alternative would be bottling up the change in message for a more abrupt pivot at a later date. Beyond that, it’s hard to see what else needs major revisions relative to the last statement.

· US jobs for Jul – Fri Aug 1. The last few jobs reports have been healthy and at this point the worry isn’t so much that numbers will undershoot expectations but instead that they will be too strong. The St is modeling ~230K for Jul adds (vs. 288K in June) and investors would rather see a small miss (~200K) than a beat (~275K). The UR is seen staying flat at 6.1% but is right on the cusp and any break under 6% would likely be a neg. for stocks. The key figures to watch will be wages (the St is modeling +2% Y/Y) and the participation rate (most people don’t think it will move much from June’s 62.8%).

Earnings season recap

Q2 earnings overall – the season has been a good one. We are more than half-way through the calendar Q2 season and the numbers were healthy. 78% of the EPS reports have topped St estimates by an average of 6%. EPS beats aren’t “new” – SPX companies have been topping forecasts for several qtrs. but CQ2 is unique in three respects:

· Sell-side didn’t take down estimates in the weeks leading into this season like they’ve done in the past (which makes the CQ2:14 beats more impressive than before).

· Companies aren’t just topping EPS estimates but revenues are pretty strong too (even perennial revenue underperformers like IBM saw relative top line strength).

· Mgmt. teams largely have guided inline w/present St expectations and qualitatively sound more bullish than they did back in Apr.

Tech – numbers for the large-caps (AAPL, INTC, MSFT, IBM, EMC, GOOG, FB, etc) were all pretty good (and a few, like INTC, qualify as outright blow-outs). If there is one big trend or theme so far in tech it is the weakness in semis. The semi season wasn’t “bad” in aggregate but sentiment was very bullish, the group was pretty crowded on the long side.

Banks – the regional bank earnings were just “OK” as strong long growth was offset by ongoing NIM pressure. The larger money centers/IBs were one of the big success stories of this whole earnings season as trading revenue wound up topping very depressed expectations. The large banks have outperformed by a decent degree since WFC kicked off the reporting period but they still seem under-owned (C in particular made important upside technical progress last week closing north of $50).

Macro Update

Reconciling credit and equities – does the HY softness hold negative portents for stocks? If the HY weakness continues, maybe. But for now the SPX likely can survive the junk softness. Investors love to highlight discrepancies between the SPX and other markets (whether it be vs. Europe, vs. small-caps, vs. momentum stocks, etc.) usually w/the assumption being that US large-cap stocks “need” to move lower given weakness elsewhere. For months the SPX vs. RTY gap (+7% YTD vs. -1.5%, respectively) has been a favorite of the “discrepancy” crowd but this week credit supplanted small caps and many see negative omens in the junk bond weakness.

Asset allocation – Core views are tracking. The risks around them, from lower growth and disruption caused by Fed hikes, balance each other out. Fed disruption risk is to me further out and its impact uncertain. I thus do not put much emphasis on it, yet. The timing is to us not right to significantly cut overall risk assets now already.

{C}· Economics –– PMIs and monthly run rates keep me comfortable with a rebound to 3%+ global growth pace for Q3.

{C}· Fixed Income –– Trade bearish US view through UW vs TIPS and Bunds.

{C}· Equities –– Strong US and Japanese earnings supports stocks.

{C}· Credit –– Back up in spreads is a sign of a matured credit rally.

{C}· FX – I like the stronger dollar, even as the main move up should come later.

{C}· Commodities –– Supply/demand dynamics keep me long energy.

Economic growth – seeing the current economic environment as similar to ’03-’04 and ’93-’94. My current outlook shares important parallels to the pivots in global growth that took place in 2003-4 and 1993-4. In these previous episodes, early-cycle sluggishness gave way to a sustained period of above-trend global growth.

{C}· Importantly, in both cases the pivot was led by a sharp turn upward in US growth and tightening in labor market conditions, setting in motion significant Fed policy normalization.

{C}· US and global bond yields rose materially but as a consequence of an improving economy. Indeed, this typical recovery dynamic induced neither inflation nor recession.

TWTR: While I remain cautious on TWTR, I believe expectations have been reset and improving fundamentals will limit downside risk at current valuation. I am NOT yet comfortable with Outperform rating as user growth trends are still an issue. In order to make the jump from niche to mass-market social media platform, TWTR must demonstrate it is able to reaccelerate user growth rates. Until I see meaningful evidence that this has begun to occur, I am reluctant to get more constructive on the name.

{C}· While user growth remains a concern, strong monetization trends have driven upside to consensus forecasts for the past two quarters on the top and bottom lines. We expect this to continue.

{C}· User growth is the main issue preventing me from recommending Twitter shares. While the platform continues to grow, the rate of growth is decelerating and has disappointed relative to expectations over past two qtrs since IPO. It is not clear that TWTR will be able to grow nearly as big as FB.

{C}· Management changes are steps in the right direction. I view the recent executive changes, including, Anthony Noto’s decision to join TWTR as CFO as meaningful positives for the company. In my view, they indicate that TWTR is working to address key problems.

{C}· Meaningful opportunity to grow monetization through new products & formats. App install ad product as well as its mobile ad network, new ad tools & formats, and data analytics can be positive fundamental drivers.
“More Rev Beats Propel SPX to YTD Highs” – 07/22/14
July 22, 2014
by Larry Shover
On the calendar, the focus for this week is on:

Inflation (US CPI out Tues morning – the St is modeling core +0.2% M/M and +2% Y/Y; for many people this is the most important event of the whole week).

· Growth (flash PMIs for Europe, US, and China out Thurs morning 7/24 and US durable goods Fri morning 7/25).

Earnings (earnings so far this season have been encouraging although despite the fact that we are not even half-way through the Q2 season, investors are beginning to move on to other issues).

Geopolitics (European foreign ministers hold a meeting Tues to consider new Russian sanctions. In the Middle East, John Kerry is in Cairo to help broker a cease-fire between Hamas and Israel).

Macro Narrative – Still the same. A lot may have happened but not much changed and US investors are still facing the same landscape. Growth is OK but not great (the US is stuck in a ~2.5-3% GDP world and Europe will be lucky to get to ~1.5%-type rates this year. China actually is the world’s bright spot lately as far as positive GDP revisions are concerned). Earnings actually are tracking better than expected but the broader annual SPX EPS estimates (~$119 for ’14 and ~$129-130 for ’15) don’t appear to be shifting much (which means SPX multiples are still about the same – ~16.5x on this year and a more reasonable ~15x on ’15). Geopolitical tensions exist in several places (but that has been a constant for months). Finally, monetary policy is proceeding along the expected track.

The Q2 earnings season is shaping up to be a strong one. It is still very early as less than half in the SPX have posted numbers but so far 77% are beating on EPS (by an average 7%) and ~70% are topping sales forecasts (by an average 1.6%). EPS is on pace to increase nearly 10% Y/Y in Q2 (based on those who have reported combined w/forecasts for the remaining companies) and sales are tracking up ~4% (all those numbers are from Bloomberg).

· The revenue upside is what distinguishes this earnings season from ones in the recent past – EPS beats have been routine for a while now (thanks to aggressive cost containment and share shrinkage) but sales (so far in Q2) are finally beginning to exceed forecasts too (even perianal revenue underperformers, such as IBM, are coming in better for the June-end period).

· Qualitatively the news is positive too as mgmt. teams across the board sound more optimistic than they did back on the Apr Q1 calls (banks in particular, esp. the large ones, are feeling a lot better about H2). The bulk of the reports thus far have come from financials (specifically banks) and the news out of this group (as far as “macro” indicators are concerned) was encouraging (the loan growth numbers and commentary are suggestive of an economy growing better than the headline GDP figures may suggest).

This market remains obsessed with the Fed (When will rate hikes commence? What will the market reaction be? Can stock prices withstand higher rates?). Implicit in this myopic obsession is a view that stocks are being artificially supported by a reckless monetary policy – it is nearly universally assumed that the last few hundred SPX points (at least) were caused by a Fed policy that is inappropriate (at best) and outright dangerous (at worst).

· Conversely (per this view), 10yr Treasuries yields would be ~50bp+ higher if not for the Fed’s presence. With this as the backdrop the market is acutely focused on anything Fed related and lately inflation has moved center stage (a lot of people think this tape is just “one hot inflation reading away” from suffering a >5% pull-back – growth metrics already would justify a faster policy normalization process and inflation is the only missing ingredient according to this view).

· BOTTOM LINE – the concerns around inflation and Fed policy are legitimate ones and this topic deserves investor attentiveness. That being said with w/the market already considering dislocation inevitable (it is a matter of when, not if, for many people) it is more likely that monetary policy unfolds in accordance w/the present expected schedule (QE done by Oct, rate hikes around mid-’15) w/o causing much disruption. The next two big inflation numbers come on Tues 7/22 (June CPI) and Fri 8/1 (the Jul BLS report).

US CPI for June Tues 7/22. “The most important data point of the week”. CPIs normally aren’t very important but since a lot of people seem to be of the view that “stocks are only one hot inflation reading away from a >5% sell-off”, every price level indicator (CPI, PCE, wages, etc) will be scrutinized closely (the logic behind this narrative being that growth/jobs more than justify the Fed beginning their “normalization” process sooner than people now think with the only missing ingredient being upward inflation pressure). For the June CPI, the St is modeling headline +2.1% and core +2% (Y/Y).

Flash PMIs for Jul Thurs 7/24. These will be the first major eco data points for Jul and thus are watched closely.

· Europe will prob. be under the most scrutiny given economic momentum appears to have waned in the region (the St is modeling the flash manufacturing PMI at 51.8 for Europe, unchanged from June).

· The US PMI remains very robust and is expected to stay elevated in Jul (57.5 vs. 57.3 in June).

· For China, economic trends in the country have stabilized of late and investors will be looking for that theme to continue in Jul.

“Equity Under-performance Here We Come?” – 07/16/14
July 16, 2014
by Larry Shover
A lot of events crammed into the week of 7/14 – the week of 7/14 will be a very busy one w/a slew of earnings (mostly banks w/a handful of tech, health care, and industrials), Yellen’s semi-annual Congressional testimony (7/15 and 7/16), a bunch of US eco data (retail sales Tues, industrial production Wed, and Michigan confidence Fri), some US housing numbers (NAHB survey Wed and starts/permits Thurs), China eco numbers (retail sales/IP/FAI out Tues night), a couple CB decisions (Japan and Brazil), and more.

Fed – Yellen testifies before the Senate on Tues 7/15 and the House on Wed 7/16. It is unlikely Yellen sounds a whole lot different from the last post-meeting press conf. As long as the current consensus assumptions surrounding policy timing (balance sheet expansion done by Oct and rate hikes commencing around mid-’15) don’t change stocks will likely respond well to Yellen’s testimony.

Global eco data – numbers from Europe have been uniformly soft, the US is more mixed-to-good, but China is one of the world’s economic bright spots at the moment (many trim GDP ests for Europe and the US but nudged them higher in China).

· It isn’t so much that growth is exploding higher in China but trends have stabilized and the government’s 7.5% GDP goal is looking a lot more achievable than was the case earlier this year. Also Beijing is tweaking policy at the margin to bolster the growth outlook.

Economic expectations evolve (but not dramatically); the global growth landscape stays largely unchanged.

· Germany dominated the economic landscape last week as a slew of numbers out of the country fell short of expectations and as a result (along w/some softness in Italy) . Despite this shortfall, the region is still recovering economically thanks in large part to fading shocks and momentum should build into H2 and ’15.

· In the US investors are still trying to reconcile conflicting numbers – GDP in Q1 was horrible. On the other hand, the ISMs/PMIs remain healthy and the jobs market is exhibiting impressive improvement (the June BLS release on 7/3 was a strong one and the May JOLTs was positive). The Q1 US GDP hole was most likely an aberration but growth is still going to struggle to achieve “escape velocity”-like speeds (at least for the rest of this year).

· China has been a bright spot over the last several weeks – exports last week may have come in a bit below estimates but data in general has stabilized and this is one of the few regions where many have nudged up GDP forecasts . That being said all that’s really happened in China lately is that doubts from earlier in the year about a GDP undershoot have faded (not many think Beijing will do any better than their 7.5% goal).

· Japan- as the rebound post the Apr plunge proved less robust than assumed (capital goods orders slumped by a record amount according to data out this week). However, forward-looking sentiment indicators suggest Japan’s economy will shrug off the consumption tax hike and as a result we need to raise Q3 GDP goal.

Why isn’t the euro weaker? Although EUR/USD is down almost four cents from its 2014 high, many ask why it isn’t even lower considering the ECB easing package announced June 5. The short answer is that these measures don’t ease monetary conditions that much – at least not this year. My 1.30 year-end forecast remains mostly about higher US front-end rates (specifically, a US 2-yr yield forecast of 0.9%).

The case for US equity market underperformance? It’s all relative…

· The US is the least operationally leveraged region at a time of accelerating global growth (i.e, it is easier for companies to lay off workers in a downturn than elsewhere, while monetary and fiscal policy tend to be more proactive than in Europe or Japan—not least because the Fed has a genuine dual mandate unlike any other major central banks), which means earnings suffer less during a downturn, but also have less upside during an upturn.

· Less earnings rebound potential – the US economy has experienced less economic stress than those in Europe, Japan and the emerging markets over the past four years, US profitability has already rebounded smartly, with US EPS some 25% above pre-crisis peak levels.

· Market expectations about Fed policy risk being too complacent – There are clear signs of a strong acceleration in US growth momentum, with the US PMI new orders relative to inventories in June rising to the highest level in at least five years— and it is now pointing to a sharp acceleration in IP growth. I would also highlight job openings (at a record high), mortgage applications for house purchase (up 13% from their trough). In addition, many measures of core inflation have stopped falling: core CPI, core PCE and inflation expectations are rising, in contrast to falling inflation metrics in the Euro area. Yet one-year rate expectations have remained remarkably sanguine and historically the forward curve has always ended up overpricing rate hikes (as opposed to under-pricing them in as is the case now).

· The US has tended to trade as a ‘safe haven’ asset
“A Case of Misplaced Hysteria” – 07/08/14
July 9, 2014
by Larry Shover
Looking bigger picture, stocks presently continue to elicit more incredulous reactions and observations rather than excitement or euphoria. Even bulls continue to consider the present set-up “as good as it will get”, at least for the next few months.

· Any further strength in economic numbers will likely spur a shift in Fed messaging while the bar for SPX earnings in ’15 is high already (hitting the ~$130 forecast would require ~8.5% in SPX EPS).

· Meanwhile central banks will begin doing less in the UK (BOE) and US (Fed) while the BOJ likely won’t do any more and the ECB will be “watching” for a while its recent policy initiatives.

· Bulls continue to have multiples on their side – the 15.2x PE on ’15 ests isn’t excessive but news flow may not be as supportive as it’s been in the near-term. Keep in mind that after spending most of the YTD “frustratingly flat”, the SPX has embarked on a 100 point/5.3% uninterrupted rally since mid-May.

The Q2 earnings season also unofficially gets underway this week, though the flood of reports is still a few weeks away. Expectations are currently for 6.2% y/y S&P 500 earnings growth, according to Thomson Reuters’ tally—that would be improved from the prior two quarters (4.9% y/y in 2013Q4 and 5.4% y/y in Q1), but quite a bit softer than the 9.7% y/y expected at the start of the year. Full-year earnings expectations have also edged down since the start of the year, to 8.9% y/y from just under 11% y/y. All the while stocks continue to push higher—valuation expansion is the name of the game for equities right now.

Q1 GDP-induced growth doubts are fading. Economic data over the last few weeks has been encouraging (ISMs/PMIs, US jobs/housing, auto sales, etc).

· The PMIs/ISMs have been healthy for a while and stayed that way in June – China prob. made the most progress (investors are increasingly comfortable w/China’s growth outlook for the rest of ’14 notwithstanding ongoing housing pressures) and while Europe lost some momentum, the numbers remain at healthy absolute levels.

· The US ISMs stayed firmly above 50. US housing wobbled late in ’13 and early this year but has stabilized of late (the biggest sentiment shifts these last few months have occurred around China and US housing).

· The domestic jobs market meanwhile continues to heal – net adds had been hovering in the ~200K zone but may be entering a new phase of growth (the June number printed at +288K).

· Economies globally are far from perfect – the US labor market participation rate remains near the cycle low (it was 62.8% in June), GDP still can’t seem to achieve “escape velocity”-like speeds (in both Europe and the US; China faces massive property headwinds, and capital spending everywhere remains tepid (although is showing some signs of life).

Why aren’t US Treasury yields higher? With stocks marching higher many are wondering why bonds still trade relatively well (10yr yields are well below their Dec highs). A few factors are at play.

· To start, the price action in Europe (driven by the ECB’s recent policy steps and lower inflation forecasts) continues to act as a weight on US yields (the spread between Bunds and Treasuries will have a hard getting much wider from here).

· Meanwhile, US inflation measures, while firmer, still aren’t enough to materially shift the Fed’s policy stance (and regardless the Fed has intimated having a higher near-term tolerance for inflation than was the case before).

· Finally, any Fed tightening process will be a slow and gradual one that winds up leaving the long-term Fed Funds rate below pre-crisis levels.

Why and What’s Next. The “why” (i.e. “why are we rallying?”) question is now being followed by “what comes next?” w/the implication being that stocks require “something” to continue along their present path.

· However, notwithstanding all the speed-bumps along the way, the “why” for this market hasn’t changed in >2 years: decent earnings (albeit ones that are helped by “financial engineering” such as falling share counts and margins that are at/close to all-time highs), mildly improving growth (notwithstanding the horrible Q1 GDP), accommodative CBs (this isn’t changing despite Carney’s recent warning and the improved US growth numbers), macro calm (notwithstanding Iraq and Ukraine), and lately M&A (M&A volumes are extremely strong so far in ’14).

· So long as this backdrop remains in place we will stay in a “market of multiples” w/the big question being how high people are willing to push the SPX’s PE? On ’14 ($119) the figure is elevated (16.65x) but if 2015’s forecast can be believed (~$130) multiples aren’t that rich (~15.2x) – keep in mind that Jul/Aug is around the time that people tend to roll their price targets onto the proceeding year’s estimates.

· Bottom Line: rallies aren’t linear and there will be periods of consolidation along the way (positioning/sentiment are important considerations for predicting day-to-day and week-to-week moves and on that front stocks in the very near-term may be extended). But “boring” will likely remain the best way to describe this tape and if that continues the present price action trend (for the time being) prob. won’t change.
“Deflationary Inflationary” – 06/25/14
June 25, 2014
by Larry Shover
Market Update – stocks finished essentially flat following an extraordinarily quiet and uneventful session. It was actually relatively busy on the news front w/a strong China PMI, decent Japan PMI, tepid Europe PMI (although the details were OK, healthy US PMI and existing home sales, further gains by ISIS in Iraq, a resumption of Libyan crude shipments, a possible break-through in Ukraine, and reports of another blockbuster tax-inversion deal.

· Despite all these ostensibly important headlines stocks didn’t really care about any of them and the SPX meandered just below the unchanged mark for most of the day (it finished down less than 1 point, its first red close since Thurs 6/12).

· On the trading front, nothing all that notable occurred Mon. While stocks may feel “tired”, they seem to have decent sponsorship and that prob. won’t change given where we are on the calendar (we are heading into month/quarter-end in an extremely light volume period – the bias will most likely be to “chase” at least until next Mon).

· Stepping back, the broader macro conversation stayed pretty static over the last 72 hours although the “Fed is behind the curve” narrative continues to quietly gestate in the background (this was a big topic of discussion in the weekend press and Mon morning the NAR’s chief economist was on the tape warning that the Fed is underestimating upside inflation pressures coming from higher rents.

With the PMIs out of the way, the PCE number this Thurs morning (6/26) increasingly is looking like it will be the most important figure of the week. Beyond this week though it still feels like the summer is going to be a long one – earnings are the next “major” event (that’s scheduled) but even they may not create much volatility (AA unofficially kicks the season off Jul 8 although the big volume of reports don’t come until the week of 7/14).

Fundamentals are fine, but the sense of inevitability is back (and that isn’t good). The last big obstacle for the summer (the June FOMC meeting) passed last week w/o causing any ripples.

· Contrary to fears of the Fed adopting a mildly more hawkish stance on 6/18 (those fears were stirred in part by Carney’s recent warning and the firmer Apr US CPI), Yellen’s message was one of policy staying “status quo” for the foreseeable future.

· With the Fed (ostensibly) on the sidelines (and central banks globally still pursing extremely accommodative policies), growth continuing to gradually improve (last week was light on growth data points but most of the recent ones suggest a strong uptick from the Q1 hole).

· Corporate earnings on track (ORCL wasn’t great but FDX, ADBE, RHT, JBL, and others, all had nice May-end earnings while a few June-end companies, inc. INTC, have already published upside preannouncements).

· The consensus view is beginning to consider further stock gains “inevitable” (at least for the next few weeks). The fundamental backdrop is tough to argue with but that doesn’t mean the SPX will continue along enjoying what has been a relatively linear and uninterrupted rally.

· Sentiment and positioning aren’t excessive but there is a sense of inevitability sinking into the narrative w/regards to further upside and this could create near-term speed-bumps (this inevitability perception isn’t as palpable as it was in early Jan when it was widely assumed that stocks would continue at their 2013 pace but it is getting close).

· Bottom Line: stocks will stay biased higher for the year but it still seems unlikely that gains will be as “easy” as they were last year and the near-term sentiment set-up feels eerily similar to Jan.

Is the Fed really behind the curve? While Yellen may not have followed Carney in admonishing market complacency w/regards to policy expectations and inflation have crept higher in the last few weeks, it’s hard (at this point) to accuse the Fed of being irresponsibly accommodative.

· If eco trends and inflation continue along their present course, the Fed will begin shifting its tone over the coming months (and the articulation of specific exit policy details, which could come at Jackson Hole, will help to convince markets of the Fed’s ability to hike rates when the time comes). For now though, it’s hard to accuse the present policy as being dramatically behind the curve (articulating specific normalization steps, something that will likely come by Jackson Hole at the latest, would go a long way towards disabusing markets of the view that the Fed is lagging on policy).

Asset allocation – Low growth, low vol, and easy money are boosting risk assets but ultimately could lead to financial instability. I continue to prefer liquid over less liquid risk assets.

· Equities – Take profit on periphery. Move DAX to OW in Euro Area.

· Credit – Euro HY yields are now below European equity dividend yields.

· FX – USD, GBP to gain further vs. EUR in H2 on nearing rate hikes.

· Commodities – Stay long Brent and sugar.

· Fixed Income – A widening gap between market expectations and Fed dots and a risk bias towards earlier than Q4 2015 Fed tightening keep us UW US vs. Euro area duration.

Banks find themselves back in familiar territory – with the tape drifting higher each week and valuations extending further, investors scouring the market for relatively “cheap” stocks continue to find financials near the top of any such screen. However, this discount has persisted for months and while sentiment around the group (esp. the banks/brokers) brightened a bit last week, investors are still wary to embrace the space given perceived headwinds.

{C}· Loan growth and banking (advisory/underwriting) are still bright spots and capital returns are ramping while but margins remain tight, trading has been soft.

{C}· Increasingly, the banks are at the mercy of rate sentiment – when markets anticipate higher rates (something that occurred in a small way the last few days thanks to marked up inflation forecasts), the banks/insurers/brokers tend to catch a bid but given how there have been so many bond sell-off head fakes investors are reluctant to draw conclusions w/o firm evidence.
“What to Bring to a Fence Mending Party” – 06/17/14
June 22, 2014
by Larry Shover
Fed decision Wed June 18 (statement/forecasts/dots and Yellen’s press conf). On the surface this shouldn’t be a very controversial meeting – economic trends have tracked mostly inline the language contained in the last FOMC statement (from Apr 30) and the policy path at present is clear (another $10B taper). However, the risks around June 18 are two-fold.

1. The current narrative around the Fed is “lazy” and thus vulnerable to disruption. Markets are anticipating QE to be done by year-end w/rate hikes not commencing until the middle of ’15 at the earliest and while both those assumptions aren’t unreasonable it isn’t a forgone conclusion that tapering will be linear (what if they step up the pace to $15B?) and more important it may be the case that reserve draining takes place as soon as early Q1:15 (will markets conflate draining w/tightening?). The Fed prob. won’t have its exit policy formalized by June 18 but investors need to start thinking more about this subject. As far as growth/inflation is concerned, the headline GDP numbers are uglier than anticipated (for Q1) but jobs are recovering nicely and inflation has stabilized and any change in rhetoric regards these latter two topics could change expectations around policy.

2. The June 18 policy decision won’t be simply a statement but will include new eco forecasts, an updated “dots” chart, and a Yellen press conf, and so the risk of a “surprise” will be higher than normal (recall the last meeting brought Yellen’s “6 months” comment along w/a “dots” scare). Yellen will be more deliberate w/her rhetoric this time (the last press conf was her first as chair) and myriad Fed officials have downplayed the importance of the “dots” but investors will be on edge nonetheless.

Bottom Line: the present Fed policy framework is extremely accommodative and will remain so for a long time. However, small shifts at the margin in expectations have the potential to (briefly and mildly) disrupt sentiment and given the current setup the risk of such a disruption may be relatively high.

June flash PMIs (Mon June 23), Abe’s “3rd arrow” announcement (June 27), Eurozone June inflation (Mon June 30), CQ2 earnings (AA kicks things off Tues Jul 8), etc). However, assuming eco trends continue on their present track and no geopolitical wildcards occur (Iraq obviously is something to watch very closely on this front), than the single most important factor for risk assets will be the Fed. June 18 may be too soon for the Fed to have fully formulated its exit policy strategy but the Jackson Hole conference (late Aug) could provide more detail.

Macro Update

For US equities, things are largely status quo as far as fundamentals are concerned.

· Central banks remain accommodative (w/small changes – see below).

· Eco growth is stabilizing in China (and actually the near-term risks may be to the upside) and continuing to improve in the US/Europe (albeit at a tepid pace).

· Global GDP forecasts didn’t shift a whole lot last week (and the World Bank simply cut its estimate down to where the Bloomberg estimate already stood).

· Corporate earnings seem fine and in the US the risks into the Q2 season could be to the upside (already this Q there have been three upside preannouncements in the semis).

· Geopolitical troubles remain present (Ukraine may have cooled but Iraq violence ratcheted materially higher this week) but for now don’t represent acute global macro risks.

· For multiples not much changed (not expensive but not cheap at ~16.2x ’14 and ~14.8x for ’15 on the SPX). With the fundamental backdrop staying static, positioning and sentiment remain the key determinants of near-term stock price trends and at the moment both are probably neutral-to-negative.

BOTTOM LINE – this tape had a big unexpected (and largely uninterrupted) rally from mid-May up until last Fri (6/6) and some consolidation was inevitable. Sentiment surveys (the latest Investors Intelligence number was pretty high) suggest near-term caution is warranted (although “near-term caution” means more flat than down). The SPX suffered a red week for the first time since mid-May (last week) but the aggregate dip (~20 points) is barely noticeable on a chart and the price action doesn’t seem like anything more than consolidation and digestion (which is healthy and should be expected).

· The “correction” calls aren’t too loud yet (which means the very near-term risk trade may still be very mildly to the downside) but another 10-20 points (sub 1920 or so) will likely bring a howl of “this is it” predictions once again (referring to the elusive 10% pullback) – when that view becomes very popular is usually when stocks stop falling. Beyond this week’s near-term hiccup, the prior trend should reassert itself w/stocks biased higher (although ’14 gains won’t be as dramatic or linear as they were last year).

In terms of the broader narrative, it shifted mildly at the margin but for the most part stayed unchanged. The one area experiencing the most scrutiny is central bank policy where investor expectations are a bit “lazy” and “stale”, esp. when it comes to the Fed. Undoubtedly, the world’s big central banks are all extremely accommodative w/regards to policy and that won’t change broadly speaking but small shifts are occurring at the margin that could be disruptive to near-term equity sentiment.

· The ECB ratcheted up its monetary response recently but outright purchases of sovereign bonds still seem very unlikely (although the TLTRO doesn’t penalize banks from engaging in “Sarkozy Trade”-like transactions and that could help maintain demand for Euro gov’t debt).

· The BOJ increasingly is unlikely to do more – the country’s monetary officials appear relatively comfortable w/the growth/inflation outlook and are content to leave the present framework in place at least until early ’15.

· The BOE is the closest of the world’s big CBs to tightening and Carney’s surprisingly hawkish comments Thurs night will raise expectations for a late-’14 hike (vs. Q1:15 which had been the consensus view).

· For the Fed, the combination of weak Q1 GDP growth, Bernanke’s dinner comments, and a series of dovish Yellen statements/speeches (Mar 31, Apr 16, May 1, and May 7/8) has lulled expectations into a state of complacency but at this point the narrative may have shifted too far towards the “dovish” camp and investors may be too comfortable w/their present policy assumptions.

Global Data Watch: There are clear signs that global growth is picking up into midyear, led by a rebound to above-trend growth in the US and Euro area (and a better outcome in China). However, last quarter’s pothole keeps getting deeper. The US appears to have suffered a sharper contraction.

{C}· At this week’s FOMC meeting the Fed will be in the uncomfortable position of lowering both its growth and unemployment rate forecasts.

{C}· The press conference could provide an update of the exit strategy.

{C}· There is a good chance that the Fed will reorder sequencing such that halting reinvestments is pushed back to well after the first rate hike.

FX update – I have more confidence in my 1.30 EUR/US$ price target after the ECB’s recent easing measures. As comprehensive as the ECB’s June 5 announcement was, I am not revising forecasts materially, either for EUR/USD or for high-yield currencies which sometimes benefit from easier G4 policy. The net increase in the ECB’s balance sheet may be small this year, so I have not changed my near-term targets of 1.34 in Q3 and 1.30 in Q4.

“Can Multiples Expand Forever?” – 6/10/14
June 10, 2014
by Larry Shover
If stocks received a little more respect they may stop rallying. Since the SPX broke out of its months-long range back in mid-May (the index was 1870 on 5/15 and ~1850 on 12/31) it has rallied 80 points/4% in pretty much a straight line (the SPX has finished in the red only four times since 5/15 and on only two of those days was the dip more than three points).

· Part of this rally has been ECB anticipation and despite weeks of speculation Draghi wound up delivering more than anticipated Thurs morning.

· Part has been Fed talk as the combination of Yellen successfully excising her “6 months” comment and Bernanke’s private dinners have caused expectations around the pace and magnitude of the upcoming tightening campaign to change materially.

· Part has been easing geopolitical tensions w/Ukraine and Russia backing away from the brink.

· Better economic numbers (both in the US and China), ongoing M&A activity, and no-worse-than-feared earnings all contributed to the stock rally too.

· But the most important factor has been the sentiment/positioning set-up – the SPX did nothing for the 75 days up until mid-May but during that time investor sentiment deteriorated markedly for a variety of reasons (the “momentum” implosion, rallying bonds, small cap underperformance, Ukraine, soft Q1 GDP in the US, etc). In that 75 day period a steep “wall-of-worry” was constructed, providing a sturdy ladder for stocks to climb (which they did).

A static narrative is just what stocks want (but multiples can’t expand forever). It wasn’t so much that the ECB delivered policy actions that were so far ahead of expectations or that the jobs report was so much stronger than anticipated (although both did contribute to the stock price action). Instead, the present equity-friendly narrative is staying static (gradually improving growth, accommodative CBs, reasonable valuations, and a decent amount of skepticism/caution) and the broader market landscape remains very uncontroversial – the longer this condition stays in the place the higher equity multiples will grind.

· Obviously this process can’t continue forever but the current valuation metrics, while not cheap, also aren’t excessively expensive. Using the ~$119 forecast for ’14 the SPX is 16.3x but that number drops to ~15x using the ~$130 assumption for ’15 (note that as we move through the summer people tend to roll their price targets on to the following year).

At this point the set-up is muddled. How much further this gentle glide higher goes isn’t clear – the very near-term “pain” direction isn’t necessarily to the upside and the (pretty substantial) wall-of-worry from back in Apr and May (built on the back of rallying Treasuries, small-cap/momentum underperformance, Ukraine, poor Q1 GDP, etc) has been climbed. The tape could use a down 15-20 point day (or two) just to help reset anxiety levels and clamp down on complacency but stocks feel pretty sturdy in the current environment.

If stocks love static then they will prob. stay in a good mood for the next several weeks. The events calendar isn’t about to get any busier – the ECB and BLS were the biggest events until maybe the next FOMC meeting (June 18) but even that may not introduce much controversy. Earnings are quickly approaching (AA is Jul 8) but it may not be until Jackson Hole (later in Aug) when the exit policy steps are formalized and communicated (the Fed prob. represents the biggest risk for stocks – reserve draining steps may start as soon as the end of Q1:15 and investors may consider these technical steps a form of tightening. However, this most likely won’t be a problem for a few more months at least).

The news drought may continue for weeks longer. There are plenty of big events to watch, including the next FOMC meeting(Wed June 18 – this meeting will include a press conf and “dots” update), June flash PMIs (Mon June 23), Eurozone June inflation(Mon June 30), CQ2 earnings (AA kicks things off Tues Jul 8), etc).

· However, assuming eco trends continue on their present track and no geopolitical wildcards occur (these are obviously not givens esp. since it looks like the Iranian nuclear talks may very well collapse or at least be pushed out), than the single most important factor for risk assets will be the Fed.

· Right now the market is comfortable in the view that QE will conclude by year-end w/rate hikes commencing by mid-’15 (at the earliest). However, the entire Fed tightening tool kit is undergoing an important revision and the hiking process this time around will be different from prior ones.

· In between QE ending and rate hikes starting, the Fed will conduct reserve-draining operations (these could begin as soon as mid/late-CQ2 2015). June 18 may be too soon for the Fed to have fully formulated its exit policy strategy but the Jackson Hole conference (late Aug) could provide more detail

The market didn’t mix tapering with tightening but what about reserve draining? The market (esp. the stock market) tends to view the Fed and policy in a very binary fashion – either rates hikes are imminent or ZIRP will stay in place forever; Yellen is an uber-dove vs the hawkish Summers; tapering-is-tightening vs. the stock-and-flow argument; etc. However, the reality is always much more nuanced, esp. in the current environment.

· Markets are comfortable w/the timing around tapering and rate hikes – the former will conclude by the end of ’14 and the latter won’t commence until the middle of ’15 (at the earliest).

· However, between those two events the Fed will need to drain some reserves (as of right now the Fed couldn’t raise the Fed Funds rate even if it wanted to) and given the present set-up this process may (briefly and mildly) unsettle sentiment.

· The exact sequencing of exit policy steps isn’t 100% clear at the moment and Yellen may not have formalized the details by June 18 (her next post-meeting press conf) so the Jackson Hole Fed Conf (at the end Aug) could be especially important this year.

I tactically turn bullish EM vs. DM equities, and in particular Asia. One of the biggest reversals this year has been in EM equities. EM equities underperformed their DM counterparts last year and in Q1 of this year, they staged a strong rally between mid March and mid April, led by Brazil and India. The improvement in the flow picture, a strong rally in EM bonds and currencies and a reversal in Chinese PMI momentum induces me to turn bullish EM vs. DM equities.

Gold – Struggling for traction

The price of gold slipped by around 3% during May, ending the month below US$1,250/oz, the first time it had fallen below that level since mid-February. That in itself is not a particularly noteworthy move but it came against the background of a number of factors that might have been expected to be supportive, if not bullish, for the metal. In particular, the slide in US Treasury yields and suggestions that the new Indian government might (in conjunction with the RBI) further ease restrictions on gold imports would, all else being equal, normally be expected to give the metal a lift.

· Gold’s weak performance adds credence to the suggestion that the rally in US bonds has been driven more by sizeable short covering in a market that had become too one sided, rather than by defensive flows.

· In India, the RBI recently allowed approved trade houses to resume the import of gold under the 80:20 rule, alongside the small number of banks licensed to import. That, plus the election of a new majority government, has raised expectations that the rules will be further relaxed and has resulted in local premiums slumping from around $80 to $90 to $30 to $40 per oz over the past 2.5 weeks.

“Search for a Catalyst Continues” – June 3rd, 2014
June 4, 2014
by Larry Shover
Market Update – Activity and liquidity both remain extremely light and as has been the case for the last ~1.5 weeks, investors have their eyes focused firmly on this Thurs (ECB) and Fri (jobs) and don’t plan on doing much until those catalysts have passed.

· Although given that the ECB has been intensely previewed since the last meeting in early May, this Thurs morning may wind up being pretty anti-climactic.

· For jobs, the trend on adds has been in the ~200K range for a while and thus it will take big movement on the wage front to really nudge markets from their present lull).

The broader macro narrative remains largely unchanged, esp. on the growth front (although sentiment towards China is quietly improving w/the NBS manufacturing PMI just the latest data point signaling “stabilization”). When it comes to inflation the disinflation trend in Europe appears to be growing more pronounced (the German inflation figures yesterday undershot forecasts by a decent margin and while talk of upside pressure in the US is growing more popular thus far signs of American inflation haven’t manifest themselves.

BOTTOM LINE – this remains a market in search of a catalyst but it is unlikely that a single specific event will be able to disrupt the present placid trend. The SPX no longer has the “pain squeeze” that benefited prices last week into month-end (it is still there to an extent but the most acute performance anxiety-related flows have abated) but for now the index feels very sturdy (despite sitting at all-time nominal highs).

Events to watch for the week of Mon June 2

ECB meeting Thurs June 5. Expectations for this event are very high and the ECB is expected to at least cut the refi and deposit rate 10-15bp (that would bring the deposit rate into negative territory). The suspension of SMP sterilizations, an extension of the regular allotment refi tenders from mid-’15 to mid-’16, and fresh (targeted) LTROs are possible too (the LTROs, if introduced, will prob. be “conditional” and modeled after the BOE’s FLS; media reports suggest it could be worth EU40B). The wildcard will be asset purchases – if a small ABS purchase program gets announced this would likely represent an “upside” surprise that could open the door to broader QE down the road (right now the market isn’t penciling in a purchase program).

· The absence of a specific purchase program won’t necessarily be “bad” if Draghi strongly hints at one coming down the road later in H2. The key to determining how aggressive policy steps are at this meeting will be the new ’16 inflation forecast.

· BOTTOM LINE – this June 5 meeting has been discussed, previewed, and anticipated for weeks and the prospect of further easing out of the ECB certainly has had a market effect. Yields across the board in Europe have collapsed over the last few weeks, dragging borrowing costs lower globally (the Euro bond rally has been a big factor behind the US Treasury strength). In addition, the EUR has bled lower and is presently sitting at multi-month lows (although the bond rally has been more dramatic than the EUR sell-off).

· At this point some are worried about the current state of “expectations” and there is a worry that Draghi winds up underwhelming on Thurs. While this is certainly possible and historically it has taken the market as long as 24 hours to fully absorb ECB policy decisions (it seems like the knee-jerk always is “not enough” but upon further review the market usually adopts more favorable impression of ECB actions), at this point the “pain” direction would be for an upside surprise on June 5.

· Keep in mind that this doesn’t mean sovereign bonds should rally further – the objective of these incremental ECB policy steps isn’t to drive sovereign yields lower so much as it is to encourage “riskier” behavior (more bank lending, greater equity allocations, etc) – for Draghi to be “successful” on June 5, he will need to cause bond yields to move (mildly) HIGHER.

US jobs report for May – Fri June 6. The St is modeling a decline in adds (to +218K total vs. +288K in Apr) and a small uptick in the UR (to 6.4% vs. 6.3% in Apr). Wages will be watched closely given the relationship between this number and inflation – the St is modeling +0.2% (vs. +0.00% in Apr). This number has become a bit less important over the last few months and so long as the figure stays north of 175K and sub 300K, people likely “won’t care” too much.

Will Draghi or the BLS report represent “unbalanced forces”? Two potentially big catalysts are coming up w/the June ECB meeting (Thurs June 5) and May US jobs report (Fri June 6) and Wall St is predicting (hoping?) that at least one of these events will mark a return to more normal trading patterns (i.e. volatility).

{C}· While Thurs morning is certain to see some wild swings in the SPX futures as investors digest what is likely to be a few policy decisions out of Europe (and it isn’t clear whether everything will be included in the 7:45amET press release or be unveiled by Draghi at 8:30amET), those hoping for a major inflection point will probably wind up being disappointed.

{C}· The last “big bang” policy action in Europe (the “bumblebee speech” and subsequent OMT introduction) came in the middle of a market panic where the euro itself was under existential attack – with that as the backdrop such a seminal shift from the ECB as the OMT represented was very likely to elicit a massive market reaction.

{C}· This time around markets are far from panicked and the euro no longer is questioned like it was before. The ECB presently is working towards more technical and less ambitious achievements (weakening the EUR, spurring bank lending, manufacturing inflation, etc) and isn’t trying to change wholesale the current market psychology (like it successfully did back in the summer of 2012).

{C}· In 2012 markets sought salvation from Draghi; now they are watching w/more w/a curiosity (that is bordering on apathy).

“Tightness in Physical (Crude) Market Developing?” – 05/29/14
May 29, 2014
by Larry Shover
Crude – tight physical market(s) developing?

While EM demand has slowed, it was felt that OECD consumption is now coming back to the fore, and doubts are being raised about the claim that US demand is in structural decline.

· However, considerable supply risks remain; while it was felt that this can be currently met by Saudi Arabia, spare capacity was perceived to be under pressure.

· It was also noted that although crude inventories appear high in the US, they are not accessible by the international market; on the products front the situation is much tighter at the global level, particularly with respect to distillates.

· Moreover, positioning continues to be short vol in oil, and consequently it was feared that any breakout could result in a considerable pain trade.

Despite persistent market worries over recent quarters about the effect of a Chinese economic slowdown on global oil consumption, aggregate oil demand growth has been quite resilient.

· As the latest OECD and non-OECD oil demand data, from the IEA and JODI respectively, show, Q1 2014 global oil demand growth appears to be on track to increase by 1.4% yoy.

· Further, even though there has been weakness in non- OECD East Asia, including China, most signs do not point to global oil demand collapsing in the near future.

In the OECD, oil demand is far from strong, but has been growing at a rate above the underlying downtrend. In aggregate, quarterly average OECD oil consumption is ~0.1%, although demand momentum was up in March.

Non-OECD countries, on the other hand, continue to soldier on; even with demand growth flagging in China, aggregate non-OECD oil demand appears to be holding the line at ~2.7% yoy , below trend, but stronger than many people have worried.

Seasonally adjusted demand momentum is a little more differentiated, as non-OECD Asia ex-China incremental demand growth has been down in the first quarter, bottoming in February at -0.3% 3mma/3mma percentage change, but up in other regions such as the Middle East (+5.8% in March ) and, importantly for US refiners, Latin America (+3.9% in March).

Additional talking points:

· WTI fell this most this month on forecasts that U.S. supplies rose (consensus 500k bbl) last week and as the euro weakened against the US$.

· WTI July contract slid to lowest level since May 20th – biggest one day decline since April 30th.

· Low volume – low volatility: trading has averaged the lowest level since December.

· Cushing supplies may have increased after decreasing 15/16 past weeks.

“Bond Rally to End on June 5th?” – 05/20/14
May 21, 2014
by Larry Shover
Market update – stocks are mixed and quiet following a slow night of news. Asia generally traded well while Europe is suffering mild losses so far this morning. As far as headlines are concerned, there were a number of country-specific stories but no overarching global macro themes or trends. The bigger picture observations remain the same (for the SPX) – the path of least resistance may be for a further upside squeeze (for the very near-term) but ~1900ish looms as an area of resistance and this market most likely still hasn’t escaped the “frustratingly flat” YTD pattern just yet.

· Investors were heartened to see both “momentum” and small-cap stocks (and to a lesser extent banks) outperform while TSY yields ticked higher (it seems like the only tickers people look at these days, in order, are: GT10 Gov’t, RTY, SPX, and QNET).

· Keep in mind that this market is in somewhat of a news and liquidity vacuum – there are a bunch of events on the calendar (inc. the Fed minutes Wed and the flash PMIs Thurs) but the next really important catalysts won’t hit until the week of June 2 (ECB meeting June 5, US jobs report June 6). On the trading front, the extremely thin liquidity conditions is making for a market filled w/”air pockets” (both on the upside and downside).

· Fed – minutes from the Apr 29-30 meeting will hit on Wed May 21. The 4/30 Fed statement was very innocuous and it doesn’t seem like these minutes will reveal any fireworks. The biggest FOMC debates concern more logistics (i.e. what tools specifically will be used once the decision is made to raise rates) than timing (tapering over by year-end w/rate increases commencing by mid-’15). That being said the discussion around housing could be interesting (in particular is anyone at the Fed thinking about contingency options in case housing stays sluggish?).

· Eco data – probably the most important numbers will be the May flash PMIs for US/Europe/China (all out Thurs morning May 22). This is the first big eco data point for May. The German Ifo for May (Fri May 23) also will be watched closely (following the soft ZEW print).

· Housing – a bunch of US housing data points will hit, including existing home sales (Thurs May 22), new home sales (5/23), and earnings (HD is May 20 and LOW is May 21). The WFC analyst meeting (Tues May 20) also will shed some light on housing. More than any segment of the US economy, the biggest clouds are sitting over housing and as a result every data point from the sector will be watched closely.

· Small-cap correction may be coming to an end; many are worried that the R2K plunge has neg. portents for the SPX but the former index may simply be correcting lower following a huge run in ‘13. The valuation gap between the two indices was the widest since ’78 as of the end of last year according to Reuters. However, the gap is narrowing – from 9+ multiple turns to ~6. Meanwhile, money is starting to flow back into small-caps.

{C}· Will the Great Bond Rally of 2014 come to an end on June 5? It is a widely held view that the ECB will “act” on June 5 but this can mean many things. Cutting the rate corridor 10-20bp (which brings the deposit rate into neg. territory) seems like a “done deal” (per a Reuters article this week). Suspending SMP sterilizations and extending the full-allotment refi operations from mid-’15 to mid’-15 would be easy (although it may not want to do both the allotment extension and sterilization suspension at once). A “targeted” LTRO also wouldn’t be very hard. Asset purchases are what the market wants most but things here are a lot less clear.
“Early May Commodity Update” – 05/09/14
May 9, 2014
by Larry Shover
Crude Oil: An extended soft patch for US crude oil contrasts with Brent strength

While Russia/Ukraine, Libya and Iraq are all making the headlines, worries about their oil exports lend early seasonal strength to Brent, but in the US, WTI values have taken a plunge. Nevertheless, I remain confident that global refiner demand should clean up the Atlantic Basin, USGC, eastern US, and ultimately Cushing, OK.

· East of the Rockies, crude inventories continued to rise this week, reaching yet another five-year high of ~344 million barrels.

· The build-up of crude oil across the eastern US is a key factor contributing to the weakness of WTI, relative to Brent, over the last seven trading days.

· Troubling too are recent downstream inventory builds, despite low refiner output.

Crude Supply

•Big growth in N.A. markets, 800 – 1 MM BPD

•Rising global F&D

•Elevated disruption risk is status quo

•Algeria, Angola, Libya, Iran, and N. Sea consistently a disappointment

Demand Details

•Diesel growth slows

•Industrial demand moderating

•Gasoline – The Return of the King

•Strong US growth through at least 2015

•S. America accelerates in 2014 before slowing again in 2015+

Additional thoughts: US: Light sweet oversupply is coming, WTI spread: $12 to $18 below Brent long-term; Crude imports to fall 35% from 2010-2020

US Natural Gas:

US natural gas may not be the most interesting or “worldly” commodity, but it is likely to take the prize for most volatile in 2014. More importantly, the US natural gas market is highly tradable; unlike natural gas in Asia or continental Europe, it benefits from benchmark pricing and a deep/liquid futures market that is comparatively transparent, thanks to copious amounts of real fundamentals data. Additionally, just to make it more interesting, in essence natural gas is a weather market as well.

· This past winter, extreme weather drove gas prices some 23% higher than year-ago levels, ratcheting up volatility.

· While volatility came back down to the low levels of last year by the end of March, longer-run measures of volatility have picked up.

· Moreover, tight supply/demand fundamentals and weather, should keep things interesting going forward.

An extreme winter event sets up a “very interesting” summer season

In a nutshell, the story of 2014 US natural gas is that its fundamentals are stronger than they have been in at least five years.

· Reaching inventories anything like normal levels ahead of next winter will require the largest ever storage injection over a six-month period , probably taxing the US natural gas supply system as well as the ability of electricity generators to burn more coal. At a price, this should be achievable … if the weather is close to normal.

· Should anything on the supply side go wrong this summer, and/or the weather turn out too warm, then prices should have a great deal of upside.

· More production and/or lower demand due to a meaningfully milder than normal summer arguably leaves markets with somewhat more limited downside price risk, given the extremely wide year-on-year storage deficit.

Demand side: The key is ‘reverse switching’ to more coal burn for power

· The lion’s share of incremental injections will need to come from the demand side – for all practical purposes this means natural gas prices need to be high enough to incentivize more coal burning for power generation.


The price of copper did indeed stabilize in early April and then rallied, trading a little above that $6,750 level earlier this week. The physical market clearly tightened, as reflected in a partial recovery in premiums in China but this, I believe, is a transient feature:

· China’s latest macro indicators are not providing much room for deep optimism. Although a semblance of recovery is under way, demand looks to be heading for a generally disappointing Q2, which is typically one of the strongest seasonal periods.

· Fabricators continue to express concerns about weaker orders activity than they had hoped for, especially in the key power cable and building wire sectors.

· The Chinese property sector has been struggling for traction since the New Year holiday.

· Credit remains relatively tight for construction projects, new infrastructure approvals have been specific rather than blanket, and the anti-corruption drive still appears to be acting as a drag.

· Durable goods production has been mixed so far and the pace of auto production and sales were on the soft side in March. The spring pick-up this year has fallen below the seasonal norm.

· On the supply side of the equation, I believe Chinese smelters have merely slowed the pace at which they ramp up new capacity. This has meant that refined supply growth has not been quite as strong as might have been expected in the past month or so.

Gold: Why I’m still bearish

· A widening appreciation that the flow of gold between Hong Kong and China is a lot more two-way than trade data suggest.

· The turn up in US CPI (and the lack of market reaction to Fed Chair Janet Yellen’s attempts to push a dovish line on Wednesday, 16 April).

· Subdued premiums for kilobars throughout Asia and flat to negative Shanghai-London premium, both indicative of soft demand and excess stock.

· Little prospect of a rapid relaxation of Indian import regulations (recent comments by both the RBI and India’s Finance Ministry have suggested that any further relaxation in regulations will be measured and cautious).

· US yields are consolidating ahead of what is expected to be another move higher.