A L A D D I N C A P I TA L H O L D I N G S L L C 6 Landmark Square, Stamford, CT 06901 â€“ Phone: (203) 487-6700 | Fax: (203) 487-6720
Where Do We Go From Here? A Mid-2011 Outlook On Markets
Scott B. MacDonald, Ph.D. Senior Managing Director Head of Credit and Economic Research June 2011
The Perceptional Lens Aladdin is in the fixed income business, largely focused on U.S. assets. Comments narrowed to U.S. markets with focus on fixed income, mainly IG corporates. The U.S. is a relative safe harbor for investors in 2011.
2012 carries greater risk on a number of fronts, including the possibility of a slowing economy. To understate, the investment environment remains challenging due to a backdrop of structural changes in the global economy, ongoing deleveraging in advanced economies, a heightened period of political instability, and investor caution.
What Do We Expect By Year-End? The Most Likely Scenario: Equity markets are likely to end the year up (with a fair amount of range trading). There will be a rotation of sector leaders. Fixed income bonds will end the year marginally tighter, both IG and HY. The most challenging sectors will remain sovereigns and financials, while industrials, consumer, and tech will outperform. The current softness in the U.S. economy is likely to moderate if it is indeed caused by exogenous factors: Global supply chain and weather volatility. Elevated oil prices will remain a drag on growth. If the global economy recovers at a stronger pace than expected, investors will be drawn into equities over fixed income.
How Do We Get To This Scenario? U.S. economic recovery continues, though there are questions as to the pace and sustainability going into 2012. If U.S. economic indicators remain “soft”, QEIII (or something similar) looms (2012, after all, is an election year). Corporate profitability and balance sheet strength have been robust though new investment has been slow. If “soft patch” continues, profit margins will decline, but remain in positive territory. Growing economy, fundamentals and technical factors will allow defaults to remain low in 2011- early 2012.
Black swans (i.e. a Greek default) are contained in the short term and not allowed to go systematic (or so it is hoped). U.S. investors are not currently pricing in a Greek credit event.
U.S. Forecast: The U.S. Recovery Continues Growth is coming from consumer durables and business fixed investment in equipment and software. Real GDP and Related Measures (% change from Preceding Period)
Gross Private Domestic Investment
Structures Equipment and Software Residential Government Consumption
* Source: Bureau of Economic Analysis (Q1 2011 is a Seasonally Adjusted Annual Rate)
Market Implication: Equipment and Software are leading growth
Excess Capacity means structures may continue to decline
Technology Leapfrogging spurring corporate spending on S&E Housing will remain tepid
U.S. Forecast: The U.S. Recovery Continues 100% depreciation for 2011 CapEx, a new tech cycle and pent up demand will keep this sector strong in 2011, but it is a only 10.5% of GDP Mfrs' Shipments: Nondefense Capital Goods ex Aircraft SA, Mil.$
Manufacturer Shipments: Non-defense Capital Goods ex Aircraft (Mil. $, LHS) Mfrs' Shipments: Nondefense Capital Goods ex Aircraft Manufacturer Shipments: Non-defense Capital Aircraft % Change - YearGoods to Year exSA, Mil.$ (change YoY, RHS) 67500
62500 0.0 60000 -7.5 57500 -15.0
Sources: Census 06 Bureau/Haver Analytics 07
Sources: Census Bureau /Haver Analytics
Market Implication: Capital goods sector will benefit, especially cash rich companies with low leverage. 6
Corporate Cash Balance Sheets Q1 2011
U.S. Companies Cash Balances (Q1 2011) Sector
Market Cap (US $ bn)
Cash on Hand (US $ bn)
% of Market Cap
Paper & Paper Products
Archer Daniels Midland
Discount, Variety Stores
Sources: Bloomberg, Company reports
U.S. Financials Have Stabilized U.S. Financials â€“ 2011 A quiet return to profits, but restructuring continues and lending is not coming back anytime soon. Questions exist over impact of a deeper housing decline. Total Bank Failures 180 157
100 80 60 39
Source: FDIC *As of May 27, 2011.
Moody’s April 2011 Default Report In April 2011 the trailing 12-month global default rate stood at 2.3%. The April 2011 U.S. speculative-grade high yield default rate was at 2.6%. This rate is projected to decline to 1.6% by December 2011. U.S. Speculative-Grade 12-Month Trailing Default Rates - Actual (Red) and Forecasts: Baseline (Yellow), Optimistic (Black), Pessimistic (Grey) 20% 18% 16% 14% 12% 10% 8% 6% 4%
Apr ‘11 12-mo Trailing Default Rate: 2.6%
Source: April Default Report, Moody’s Investor Services, May 5th, 2011
But What About The Current Slowdown? Q1 GDP was lower than hoped at 1.8%. Why? Lower government contribution to growth. A normalization in consumer consumption from Q4 2010. Poor weather. Japan’s earthquake/tsunami interrupted global supply chains. Q2 GDP expectations shaped by more of the same. Q3 and Q4 likely to benefit from falling energy prices, low interest rates and a return to growth in Japan. There are enough positive factors to keep the economy moving, but not enough to launch a broader and deeper recovery. Structural problems are being treated like a can and kicked down the road. The road is now uphill.
U.S. Markets Have Held Up Relatively Well Expectation of continued loose monetary policy has helped contain volatility while there is a discounting of European sovereign risk. VIX: Volatility Index 90 85 80
75 70 65 60 55 50 45 40 35 30 25 20 15 10
Contained Volatility in U.S. Credit Markets New issues have been strong and most of it priced to sell. Barclays Capital U.S. Credit Index (OAS) bps 600 550 500 450 400
Federal Reserve Issued Stress Tests Results
350 Global De-Leveraging Begins
300 Enron / Worldcom Scandals (224bps)
250 Tech Bubble Burst
200 US Recession 150
US Bank Crisis / First Gulf War
US Economic Recovery
Fed Raises Rates 6 Times
US Economic Recovery US Invasion of Iraq
US Economic Slowdown
GM Files for Chapter 11
The Great Recession
Mexico Debt Rescue End of USSR
US Housing Bubble
Russian Default (69bps) Asian Crisis
Updated as of April 12, 2011
Source: Barclays Capital Live
Risks to Resilience Remaining risks contain market upside and could make the current market correction a bear market. The risk to the U.S. economy is that it slows further than expected: housing double-dip, lower spending, continued exogenous shocks. Government policy becomes more interventionist. With a growing budget deficit and nascent inflation, Financial Repression could be used to keep rates artificially low. U.S. Federal and municipal debt levels will hinder growth and equity market performance if not addressed.
Events around the world – Japan, the Middle East, and Europe – derail U.S/global recovery.
An Extended Season of Black Swans and Warning Signs 2010 April-May:
Greek tremors / EU/IMF agreement on May 2.
Mozambique food riots mark return of food-inflation related problems.
Ireland goes to EU/IMF.
Tunisiaâ€™s Jasmine Revolution (president Ben Ali ousted Jan. 14th). Riots occur in Yemen, Bahrain, Oman.
Egyptâ€™s Mubarak Resigns (February 11th). Riots begin in Libya and turn into civil war.
Earthquake hits Japan (March 11th). Tsunami/Nuclear problems follow. Saudi intervention into Bahrain. Jasmine Revolution spreads to Syria.
Oil at $110 a barrel. Portugal goes to IMF/EU for help.
S&P changes outlook of U.S. sovereign AAA from stable to negative. Commodities sell-off. Greek 2yr bond hits 25%.
The U.S. Credit Landscape – The Most Likely Scenario
Corporate sector is profitable. Q1 2011 earnings were strong. Q2 likely to show marginal profitability decline.
Although cautious, U.S. corporates have a large cash reserve to sustain them if economic “soft patch” continues. Cash is also being used to raise dividends and finance stock repurchases and strategic M&A. Weaknesses in bank lending indicates U.S. corporate bond market will remain open. Also will force infrastructure funding needs to nonbank sources. Shadow banking system is an increasing source of debt financing as banks remain constrained by bad legacy loans and heavy regulation. Demand for alternative credit products will remain strong.
Investor Concerns Keep a Lot of Cash on the Sidelines Significant investor cash keeps investment grade spreads and high yield spreads relatively tight. Stock: SavingsMarket Deposits, including MMDAs(SA, bn USD, log scale) Savings Deposits,Money including Money Deposit Accounts SA, Bil.$
Source: Federal Reserve Board /Haver Analytics
Source: Federal Reserve Board/Haver Analytics
Conclusion Investor dilemma is risk-trade v. safety. Cash is safe, but very low returns.
Low interest rate environment to continue through 2011. Bank lending remains anemic (both in the U.S. and Europe). Uncertain global factors add to the risk factor and are not going away. U.S. equity and credit markets offer a relative safe harbor from volatility and uncertainty in other regions – for 2011. Indicators point in multitude directions for 2012, leaving the investment environment lacking clarity.
Biography Dr. SCOTT MACDONALD, Senior Managing Director, Head of Credit and Economic Research Dr. MacDonald has an extensive background in credit and economics, having worked at the U.S. Comptroller of the Currency, Credit Suisse, and Donaldson, Lufkin and Jenrette. His experience covers banks, commodity companies, energy, sovereigns, and emerging markets. From 1995 through 1999 he was consistently rated as one of the top fixed income analysts by Institutional Investor. Dr. MacDonald is widely published on international economic and financial issues with sixteen books to his credit. He received his Ph.D. in Political Science from the University of Connecticut, an MA in Asian Studies from the University of Londonâ€™s Oriental and African Studies Department, and a BA in Political Science (with Honors) and History from Trinity College.
Disclaimer This document was prepared by Aladdin Capital Management LLC (Aladdin Capital), and reflects the current opinion of the contributor. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This document is for informational purposes only and does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice. Neither Aladdin Capital nor any officer or employee of Aladdin Capital or any affiliate thereof accepts any liability whatsoever for any direct, indirect or consequential damages or losses arising from any use of this report or its contents.
No part of this document may be reproduced in any manner without the permission of Aladdin Capital.