Saturday 21 May 2011

"Vanitas vanitatum, omnia vanitas" - This time is different or is it really? US macro outlook

US Corporate BBB Effective Yield close at 2004 lowest point:

High Yield CCC or Below Effective Yield as well extremely tight:

US Corporate 15+ Year Effective Yield back to 2006 levels...

The deleveraging story runs unabated for US Households:

Complacency is still the main story. Spread levels are very tight and the deleveraging is still alive and kicking.

Housing markets in the US continue to be very weak and a big concern for the macro outlook for the US economy.
First quarter delinquencies were on the rise. The seriously delinquent/foreclosures continue to slow due to the ongoing massive delays within the process. Are banks buying some time by slowing down the process?
Most likely.

The foreclosure route from first notice to completion according to CreditSights latest weekly housing monitor, takes now around 400 days and in some states 900 days (New Jersey and New-York).
There is currently 3.5 million homes in reported inventory as of the end of March 2011.
You might want to add the 4 million loans which are more than 90 days delinquent with a likely to enter the foreclosure pipeline in the future. And by the way, there are around 830,000 REO properties (Real Estate Owned, basically homes sitting now on Banks Balance sheet which have been repossessed) which are not typically included in the available inventory data.
So, the inventory is more likely to be closer to at least 4.5 Millions. How long you think it is going to take to clear this inventory? My guess is about 4 to 5 years. This is also Gary Shilling's view in his latest insight on the housing mess (May 2011 edition of A. Gary Shilling's INSIGHT).

Housing Starts still in the abyss...

Gary is expecting another 20% drop in prices given current inventories and pressure on prices. The more foreclosures, the bigger the inventory, the bigger the inventory, the longer time it will take to clear it and the bigger the pressure on house prices and acceleration in fire sales.

Another big drop in house prices will almost guarantee another recession because of its financial impact. You might want to track the levels of credit loss provisions in US Banks future quarterly results. In recent quarters some losses on loans relating to Real Estat have been offset by higher capital markets revenues and gains from lower credit loss provisions that were set aside under worst-case scenarios.

What we know thanks to Zeeshan Siddique in his article "1 Powerful Trend to Capture in the Banking Industry"

Credit Loss provisions have been declining for most US Banks:
-Citigroup: it declined to USD 2.9 billion for Q1 2011, compared to USD 8.4 billion in the first quarter of 2010 and USD 4.6 billion in the preceding quarter.
-Bank of America: quarterly profit in Q1 2011 after posting losses for two consecutive quarters thanks to its provision for loan losses which went down to USD 3.8 billion from USD 9.8 billion in the 2010 similar quarter.

Even nationalised Freddie Mac (FMCC) turned a profit this quarter thanks to lower loan-loss provisions. It has set aside less to cover potential credit losses amid "signs of improving credit quality". Credit-loss provisions were USD 1.99 billion, down from USD 5.4 billion a year earlier and USD 3.07 billion in the fourth quarter of 2010.

Zeeshan recommends buying stocks of well run banks, I have to disagree because lending is stagnant or still contracting at most U.S. institutions.
Also, Banks are losing revenue as a result of new federal rules that limit the types and amounts of fees they can charge consumers (regulatory changes coming from the CARD act of 2009). Lack of loan growth = poor revenue growth. Until the loan books of banks start growing again, I would avoid the sector. Loans still make up half of bank revenues.

Biggest Banks Beating Estimates Can’t Hide 13% Drop in Revenue
"Real estate loan balances at all FDIC-insured institutions, which represent more than half of outstanding bank credit, fell 4.4 percent in the fourth quarter to $4.27 trillion from $4.46 trillion last year, the FDIC said. New loans are earning significantly less yield, also cutting into revenue."

Economy 101: The two major economic factors that drive bank asset quality are unemployment and housing prices. So don't buy to much in the improving credit quality story. Stay cautious, housing and unemployment levels are key.

If house prices continue to drop, watch out for credit-loss provisions levels. We are getting New Home Sales on Tuesday next week, stay tuned.
Keep in mind the impact an additional drop in house prices could have on State and Local Tax Revenues, it could be even more devastating that it already is, as indicated by David Goldman:

The Coming Collapse in State and Local Tax Revenues
"in 2010, state and local governments collected about $88 billion in corporate income tax, $260 billion in personal income tax, $436 billion in property taxes, and $430 billion in sales taxes. Property taxes were the biggest single contribution"

So this is the reason why people are so jittery about Municipal Bonds...

While the latest NFP print at 244,000 in April was a good number, the unemployment rate moved up to 9.0% from 8.8%. Mixed results. USD GDP estimate came out at 1.8% annualized growth in Q1. This a very weak number for the recovery story. On the 26th of May we should get the revised figure for Q1, expectations are 2.1% revised for US GDP.

Remember we are still in a balance sheet recession which is still the worst recession you can get. So as John Mauldin points it, let's hope we muddle through that one, but I would not bet too much on that, particularly when I see the stupid valuations 1999 style we are getting, as illustrated with the IPO: PE of more than 1300, and trading already at 135 times book value. You can also check for some interesting valuations metrics as well.
I know, this time is different...

Apart from the ongoing deleveraging for households and housing continuing issues, corporate America is still sitting on a large pile of cash. Shares buy-backs and M&A activity are on the rise. My concerns relates to cushioning profit margins in Q2 due to rising commodity prices. Gap's share prices dropped 17% on Friday. Gap's 1st quarter profit dropped by 23%.
Rising prices for cotton and other commodities are eating into their profits this year. Its product costs are going to be 20% higher in the second half of the year. Because consumption is still weak, companies like Gap are having difficulties in raising their prices to compensate for the rise in commodity prices. They lack pricing power and their profit margins are therefore sinking.

In an environment plagued by rising commodities prices, pricing power is essential. Companies which have pricing power and can raise their prices accordingly without impacting their sales, should be followed closely. They will be in a better position to maintain their profit margins. Luxury companies for example, have more pricing power.

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