@ the open 2-3-12

Signals for positive US high yield bond returns still in place? The two charts below illustrate the inverse correlation that we’ve seen between the VIXX (option volatility ) index and the S&P 500. These also argue the case for high yield bond returns that you’ve heard basically every analyst and strategist recommending if you’ve been within earshot of a television tuned to a financial news channel within the last two months. While the equity and volatility markets have traded roughly back to where they were in February of 2011, the high yield market (as measured by the Merrill Lynch High Yield Master Cash-Pay Index) has lagged in performance and currently remains roughly 12.1 % below its 52 week high while the S&P 500 is only 3.5% below its 52-week high valuation. This suggests to many that there remains room for the high yield market to improve further as long as volatility remains low (see discussion of this below under “Credit Markets”).

Equity Markets – markets were mixed in overnight trading in Asia with the later closing markets outperforming as more analysts and strategists came out overnight predicting that China will lower the reserve ratio in their banking system to increase liquidity in the system…this was taken as a pro-stimulus indicator and markets moved higher. This has carried over somewhat into European trading this morning with still no resolution on the situation in Greece. Domestic futures indicate a roughly flat opening at the moment but that will change after the jobs report comes out at 0830…hold onto your hats this could be a wild day.

Macro, News & Events

Economic Releases

• January Change in nonfarm payrolls 140k v. 200k
• January Change in private payrolls 160k v. 212k
• January Change in Mfg payrolls 13k v. 23k
• January Unemployment Rate 8.5% v. 8.5%
• January Avg. hourly earnings (MoM) +0.2% v. +0.2%
• January Avg. hourly earnings (YoY) +1.9% v. +2.1%
• January Avg. weekly hours 34.4 v. 34.4
• January U6 last was 15.2%
• January ISM Non-mfg composite 53.2 v. 53 (revised higher)
• December Factory orders +1.5% v. +1.8%

Events

• The US Treasury Department’s Jan Eberly (Assistant Secretary for Economic Policy) will host a briefing on the jobs report @ 1030

Earnings – only 7 S&P companies report this morning: it should be interesting to get the outlook from Simon Property Group (America’s largest shopping mall real estate investment trust) and Weyerhauser one of the largest integrated forest products companies in the US. We’ll also hear from Tyson Foods one of the largest “protein” producers in the US through chicken, pork and beef production which will give additional insight into food cost inflation as well as the US grain market situation.

So far with just over ½ of the S&P reporting, the average EPS growth rate (year over year) is coming in at 3.3% with 169 of the 257 companies reporting so far announcing positive earnings growth, there just isn’t much of it. The best sector so far is IT with 44 of its 71 members announcing and average growth of 20.3%...the worst continues to be Materials reporting an average of -31.7% with 18 of 29 companies reporting.

Asia, Europe & USA

• The China Electricity Council reported that it expects Chinese power consumption to rise 8 ½ to 10 ½% in 2012 . This follows 11.7% growth in power consumption in 2011 and the country is expected to consume 150 mm more tons of thermal coal in 2012 than in 2011.
• The Chinese non-manufacturing purchasing managers index fell in January to 52.9 from 56.0 in December…analysts viewed this result as acceptable given the timing of the Lunar New Year holidays (1/22 – 1/28).
• The National Bureau of Statistics reported that Chinese industrial profits rose 25.4% in 2011 to 5.45 trillion yuan…this compares with a 49.4% rise in profits in 2010
• More voices are coming out publicly that the Greek situation is a “lose / lose” and that there appears to be no way out for the country that can’t (or won’t) reform its economy to the point that it could support the current debt load and that bailouts will only delay and not alter the ultimate result that Greece will fail. The only thing that the bailouts will accomplish is that more money will be thrown down the same hole with the same result in the end.
• The finance ministers of the four remaining AAA rated countries in the EMU (Germany, The Netherlands, Luxembourg and Finland) will meet in Brazil today to discuss options on what to do with Greece going forward.
• Spain’s new government gave banks an extra year to recognize losses on real estate loans IF they agree to merge as it tries to overhaul the financial sector in Spain. I liken this to tying two rocks together to see if they will float. They’re going to take potentially viable institutions and merge them with less viable institutions potentially threatening healthy banks with the losses of those that should fail or be bailed out by the government. This is a terrible 50% solution.
• Deutsche Bank refused to take the three year repo loans offered out by the ECB as Ackermann feared the “reputational risk” that such a move would carry.
• The UK index of non-manufacturing purchasing managers rose to 56 from a 54 reading in December, surprising analysts who collectively expected the index to decline to 53.3…economists are projecting that the latest indications are that the UK economy is growing but that the recovery remains “fragile”…where have we heard that before.
• The Hungarian National Airline, Malev, was ordered to cease operations after the European Commission forbade the Hungarian government from continuing to support the air carrier…
• The bureaucrats in DC will be paying close attention to what’s going on in the Netherlands as politicians are applying pressure to repeal the home loan tax deduction status for the country. These deductions have existed since 1893 and the proposed change is causing buyers to hesitate and essentially freezing sales in the housing market that has been in decline for the last three years. Currently, mortgage debt in the Netherlands stands at 107% of GDP compared to roughly 76% in the US.
• Hedge funds have invested $6.5 billion in US petroleum refiners as production of shale sourced oil begins to swell keeping US oil prices lower than those on world markets…one potential risk to this strategy would be the adoption of CNG as the official transportation fuel for the Class-8 truck market (this market consumes roughly 2 million barrels of oil in the US on daily basis via diesel fuel) which is the continued dream of T. Boone Pickens and natural gas producers everywhere.
• As production from the Bakken Shale increases, crude oil is flowing into Cushing, OK and keeping a lid on near term oil prices which in turn positively impacts the price of oil in the future…the latest figures show that inventories at Cushing are at their highest weekly levels since mid December and that inventory build appears mostly due to oil coming from Canadian sources. Currently, 55% of domestic demand at refineries is filled by supply from the US and Canada and imports from oil outside of North America continue to decline. February demand to ship on the Spearhead pipeline (Enbridge) was up almost 8x from January as production in North Dakota and Alberta surged because of the warmer winter. The flow of oil into Cushing will increase as well once the flow on the Seaway (Enbridge and Enterprise Products Partners) pipeline is reversed away from Cushing allowing more oil to flow from Cushing to the Gulf region and all of this is before ground is broken on the Keystone XL.

Credit Markets –

Sovereign CDS – spreads are mostly tighter this morning although the moves are once again relatively modest and the SOVX continues to hover in the mid-320’s as the market awaits some resolution on the Greek debt exchange and the next round of international bailout money which has been in the works since last March…that was the first time we heard about the “ultimate solution” to the sovereign debt crisis…back then we used to rally the SOVX index back into the mid-150 basis points level after elected officials issued public proclamations about the immediate resolution to the debt crisis…not anymore.

US Corporate CDS – corporate credit performance yesterday (at least according to the CDS indices) was led by the high yield indices which rallied 8 basis points while the loan index rallied 3 basis points and the investment grade index rallied 1 basis point. The biggest driver of the corporate spread tightening that we’ve seen since mid-December (the high yield index has rallied almost 200 basis points in the last 35 trading days) in my mind has been the decline in volatility. To understand why spreads are linked to volatility you have to understand a little bit about options. As volatility rises, the value of an option rises (all else held equal) this makes sense if you think of the possible payouts as a “bell curve” and the increased volatility as akin to the standard deviation so that as volatility rises the curve widens which increases the probability that a wider number of outcomes could be realized and that, is what options are all about, creating asymmetric opportunities. Now bonds are nothing but a loan with a put option attached to the ultimate borrower (in other words if the company that you loaned money to fails, you may end up owning the company after the bankruptcy court proceeding…i.e. the management team has “put” the company to the lender)…so volatility rises the value of this “put” option rises which means that your bonds that are implicitly “short” this put have fallen in value…and as volatility falls the opposite happens and that is what’s going on right now.

Energy Markets – WTI is up modestly but still down for the week on the heels of the inventory numbers which surprised to the upside earlier in the week…the spread between WTI and Brent has spiked back over $15 as the US becomes less reliant on mid-east crude and domestic demand remains relatively flat while Europe remains tied to the mid-east and the potential embargo against Iranian crude is weighing on prices. I wonder how long it will take the Europeans to decide that we’re pushing them to embargo Iranian crude while we (the USA) hasn’t consumed Iranian crude for decades so what do we care if crude prices in Europe stay high…so far the EMU has been willing to play the part of pawn in this high stakes nuclear weapons / crude oil game of chess.

Futures – well, I was certainly wrong yesterday on the Natural gas “draw” numbers coming out of EIA…the number for the week came in at -132 bcf vs. the survey estimate of -129 bcf so an additional draw of 3 bcf. As for the Futures strip, natural gas over the next year is averaging $3.03 / mcf while oil is $98.60 making our equivalence ratio 5.42x.

Phillip Pennell, CFA
Turnberry Capital Management
(203) 861-2708 (Direct)
(203) 861-2700 (Trading)
(203) 917-2255 (Mobile)

The information included in the above discussion is not intended to be used as a basis for making investment decisions nor should it be construed as a recommendation by the author to buy or sell any specific security. Individuals should consult their investment advisor prior to making any investment decisions.