Wednesday, April 28, 2010

Sweet Spot Of Fed Funds To Stay Exceptionally Low For Extended Period

While FOMC press release cheers bulls with the sweet spot and Goldilocks expectations, let's look at the latest message by the super-bull on the Street. Although guys at Bespoke Investment Group ranked Binky Chadha of Deutsche Bank only second after UBS riders yesterday, Binky did not give up and went on to upgrade his year-end S&P500 target to 1375, just ahead of UBS riders.

This is how Binky and team summarized their view yesterday, among other things:

Limited forward upgrades on beats suggest upgrades/surprises to come

Forward estimates moved up on the Q1 beats, but only modestly. The bottom-up consensus is thus treating a major proportion of the beat as temporary. While this may be reasonable on the face of it, this is exactly what happened in the prior four quarters with each subsequent reporting season then delivering a sizable upside surprise. We expect positive earnings momentum to thus continue.

Prudent on margins but we see the risks as being to the upside

S&P 500 operating EPS margins have risen significantly from their lows following the collapse of sales in the aftermath of Lehman. First, corporates aggressively cut costs. Then, beginning in H2 2009, top-line growth kicked in, providing operating leverage. Ex-Financials margins thus have some, but limited, upside to their last cyclical peak (50 bps from 8.25% to 8.75%). Our forecasts maintain the last cyclical peak in margins as a ceiling. But various cyclical drivers suggest significant further upside:

(i) cautious hiring in the face of top-line growth should see solid productivity gains; (ii) high unemployment should restrain wage costs; (iii) low but rising capacity utilization will provide operating leverage; (iv) these factors should be offset only partly by rising raw material costs. The biggest upside risk to margins in our view though comes from looking across cycles: cyclical peaks in margins have been successively higher as corporates make some of their cost savings over the cycle permanent. A linear extrapolation across past cyclical peaks implies significantly more upside for Ex-Financials margins in this cycle (150 bps from 8.25% to 9.75%).

Conservative on top line but we see the risks as also being to the upside

The decline in top line in the Great Recession has been the steepest in at least 30 years, with sales falling 25% from their peak and 15% below historical trend levels. Our forecast for top line uses as a proxy DB's forecast for US nominal GDP growth (5½% through 2011); we see growth of foreign sales in local currencies as continuing to decelerate; and the dollar as rising modestly.

On net this implies average top line growth of about 6% at an annual rate through 2011. This would leave sales significantly below trend and well below their previous peak levels by the end of 2011. Like the prospects for margins, we believe that the risks for a recovery in the top line are also tilted to the upside relative to our forecasts for several reasons:

(i) the traditional top line macro multiplier associated with a turn in the labor market is just beginning (jobs and income growth leads spending which feeds back to more corporate hiring and spending); (ii) the pace of consumer durables spending to date suggests plenty of pent up demand from the crisis; (iii) corporate capex guidance has continued to be positive.

This is a nice exhibit on momentum in Krugman's sales pitch of US banking system. Click on chart, courtesy of Deutsche Bank.
Only thing that bears should be afraid is upside risk? Simple linear extrapolation is sophisticated tool ... Indeed, What Do Earnings Tell Us? James Bianco was voicing yesterday, among other things:

... we believe the percentage of companies that beat expectations is a meaningless statistic. The game is designed for this to happen, even when earnings are collapsing.

This is also a great reading on earnings expectations, not to lose a balance ...

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