The Monday Edition- Economic Outlook From Bonds – Fed Focus – Earnings – Bank of Japan

By Yaser Anwar, CSC of Equity Investment Ideas

In this week’s institutional newsletter I’d like to talk about: 1) Deciphering The Economy Through Bonds, 2) Fed & Earnings Focus and 3) Bank of Japan’s Actions

Bonds- Deciphering The Economy

• Tighter corporate spreads have been at odds with fundamental indicators in recent months, such as: worries about higher inflation, slower growth and the inverted yield curve (which is a precursor to economic hardship). Furthermore, an important factor such as: record new issue supply in the high-yield credit market have not softened the market as many had expected.
• Nor have deteriorating upgrade/downgrade credit rating ratios of the investment grade and high-yield corporate sectors covered by Moody’s and S&P. Instead, risk appetites do not appear to have waned, highlighted by historically tight spreads, increasing appetite for junk bonds (read: WSJ article).

A few reasons I can think of are-

• 1) Global liquidity continuing to fuel demand for US$ denominated debt instruments from foreign institutional investors.
• 2) Default rates remain near a record low (at approx. 2%) while credit ratios overall are strong despite the continued M&A (reached $135.98 billion in 06, a new record- According to TF) or LBO transactions (which are usually financed with debt, triggering credit rating agency downgrades, thanks to leverage which is shouldered by the balance sheets).
  

Fed Focus

• Fed officials remain focused on inflation and according to the Fed Futures, the odds of a Fed rate move in either direction in 1H look dim. In my view, factors such as: a maturing business cycle, less accommodative financial conditions overseas, and the potential for moderating consumption trends (due to further declines in the housing market and the impact on the labor pool), will slow margin expansion and allow inflation to drift lower over time (drop in oil should help too).
• However, we need to keep in mind that even with the drag in housing and autos, inflation has only been able to moderate mildly. This is the Fed’s worry and should the contracting sectors of the economy stabilize (latest NAHB figure showed housing somewhat improving), inflation is likely to pick up.

Earnings Focus

• Through January 19th, 77 companies in the S&P 500 index have reported earnings for Q4. "According to Thomson Financial: Of these 77 companies, 57% have reported earnings above analyst expectations, 19% have reported earnings in line with analyst expectations, and 23% have reported earnings below analyst expectations.
• In a typical quarter (since 1994), 60% of companies beat the estimates, 20% match estimates, and 20% miss estimates. Over the past 8 quarters, 67% of companies beat the estimates, 14% matched estimates, and 19% missed estimates."
• Trucking Industry, which is closely watched for clues about the economy, so far has been the main contributor to companies announcing negative results pre-announced.

Global Macro- Bank of Japan

• As you know, BOJ left the interest rates unchanged. Policymakers admitted that the economy and consumer prices have been somewhat below their initial October forecasts, they continue to expect the economy and prices to move generally in line with their forecast in the coming quarters.
• The BoJ believes core CPI, much like their economic assessment, is expected to "develop broadly in line with the outlook". While the BoJ admits, “consumer prices have so far deviated slightly downward from the projection, partly reflecting the drop in crude oil prices,” policy makers still expect consumer prices to develop generally in line with their projection.
• I expect GDP to have expanded around 2.8-3% QoQ in Q4 of 06. If so, the upcoming release of this data will likely shift the majority of the Board toward a rate hike at the next meeting.

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