Stocks Fly as Fitch preserves French AAA Rating for Now

Fitch does not see EFSF plans changing France's AAA Rating
European stocks were slightly up in the early session before Fitch announced that it does not see changes to the European Financial Stability Facility as a threat to France's AAA rating, and that a strong EU solution would likely preserve Spain's and Italy's ratings as well. Following Fitch's announcement the DAX Index jumped 1.7 percent.

GE meets expectations on finance unit; McDonald's delivers as always
GE reports 3Q operating EPS 0.31 in line with estimates of 0.31 as improvements in GE Capital offset weakness and margin contraction in its energy division. Investors are slightly disappointed sending the shares down 1.4 percent in pre-market trading.

McDonald's delivers what the market always wants, namely better-than-expected earnings, as the company reports 3Q EPS 1.45 beating estimates of 1.43 driven by market-share gains across the globe. The shares are up 2.9 percent in pre-market trading.

Other earnings releases out in pre-market are:

• Schlumberger reports 3Q operating EPS from continued operations of 0.98 missing estimates of 1.01.
• Verizon reports 3Q operating EPS 0.56 beating estimates 0.55

Is Apple like Microsoft or more Like Samsung/Nokia?

This question is important in an analysis of Apple as margins are very different in software and hardware. Many perceive Apple to have a fairly large revenue share from OS, iTunes and App Store. In fact combined these constitute a mere 9 percent of revenue. Normally the more hardware you sell the lower the margin though at the moment, and particularly concerning Apple, analysts think the exact opposite. This is a huge risk!

Thinking into the future
Expectations are high concerning both Apple’s Revenue and EBIT for the next few years Revenue is expected to reach USD 158,230m in 2013. But it is more of a concern that margins are expected to remain above 30 percent - this we have our doubts about!

In table 1 we have listed the competition in Apple’s universe. This ranges from pure software/digital products to mobile handset hardware. Apple operates  in the mixed space (i.e somewhere in between) and has at the moment a margin which reflects this mix to an extent as the margin is lower than Google’s and Microsoft’s but immensely higher than Nokia’s and Dell’s on the pure IT hardware side.

Calculating a weighted EBIT margin on the Hardware companies totals 8.2 percent and for Software/Digital an EBIT margin totals 41.9 percent. On top of this we have made two extra calculations.

First we know the EBIT margin in Apple is 30.7 percent and we calculate what share of revenue should come from Hardware and Software respectively if this 30.7 percent margin should mimic competitors. The current EBIT margin implies a hardware share of 33 percent with the rest of revenue (67 percent) coming from software (see table 2, left side). 

Everything could potentially be fine but the issue is that Apple is a hardware company! 91 percent of revenue comes from hardware (9m of 2011) and only 9 percent is from OS, iTunes and App Store! Basically the company is in danger of a massive margin pressure going forward as the “What-if” EBIT margin drops to 11.2 percent!, (see table 2, right side)

If this margin becomes a reality over the coming years rest assured that Apple’s current share price would not be USD 385.

Can Apple defy gravity?
Our best guess is – it can’t. Take for example Nokia - at its prime time it was certain that it would be able to sustain a margin in the thirties range, as it was the market leader and had the right products. Nothing is as harsh as reality and after a few “missed boats” Nokia is nothing of what it used to be. Nokia might have thought it had a unique product which would last for decades but now it has an EBIT margin of 2 percent and layoffs are its game at the moment.

Hardware producers have over time showed us that hardware becomes a commodity - high volumes with very low margins. We expect Apple to encounter the same tendency in the coming years unless software becomes the dominating element.

Risks are present
Margin risks are present in Apple and possibly more so now that Steve Jobs is no longer at the helm of the company. These two factors in connection should make investors demand a higher risk premium. Looking ahead, we are inclined to expect Apple to struggle more than we have otherwise been used to.

Market Preview - 11 October 2011

Forex Overnight: EUR trading weaker against USD
The EUR has weakened against the USD, this morning, ahead of Slovakia’s final vote on the enlarged European Financial Stability Facility later in the day. Reports suggest that Slovakia’s ruling coalition was unable to end a dispute over participation in the euro-area bailout fund. The GBP has lost ground against the USD, this morning, ahead of a report, scheduled for release later today, which is expected to show that the U.K. industrial production declined in August. At 6 am, the EUR and the GBP have declined 0.1 percent and 0.3 percent against the USD, to trade at $1.3632 and $1.5618, respectively.
The JPY is trading 0.1 percent higher against the EUR, while it has edged marginally higher against the USD, ahead of the release of the minutes of the Federal Reserve’s (Fed) September meeting, later today.

UK Stocks: Likely to open in negative territory
The FTSE 100 is likely to open 6 to 8 points in the red.
Key economic indicators scheduled for release today include Industrial & Manufacturing Production, NIESR Gross Domestic Product Estimate and DCLG U.K. House Prices.
N Brown Group, Edinburgh Dragon Trust, Epistem Holdings and Fusion IP are scheduled to report their results later today.
Royal Dutch Shell has announced force majeure on its exports of Nigerian Forcados crude, following a leak on the Trans Forcados pipeline.
In an interview with the Financial Times, Steve Bertamini, the Head of retail and SME banking at Standard Chartered, has criticised western regulators for using the wrong mechanisms to handle the financial crisis.
Ian Cheshire, the CEO of Kingfisher, has forecast a “broadly flat” retail market in the U.K. for 2012, and added that it would be “more robust” in France.

Asia: Trading in the green
Asian markets are trading in positive territory this morning, amid continued optimism that European leaders would be able to stem the region’s debt crisis.
In Japan, markets are trading higher, with Sumitomo Mitsui Financial and Mitsubishi UFJ Financial Group trading up, amid renewed optimism over the prospectus of a solution to the European debt crisis. Toyota Motor has jumped, after it reported a rise in Chinese sales in September. Nidec Corporation has soared, after it announced an increase in its share buyback plan. At 6 am, the Nikkei 225 is trading 2.1 percent higher, at 8,787.5.
In China, Industrial & Commercial Bank of China, China Construction Bank Corporation, Bank of China and Agricultural Bank of China have added value, after state-run Central Huijin Investment bought shares in these banks. In South Korea, Shinhan Financial Group and KB Financial Group Inc have risen, amid optimism that the Eurozone debt crisis will be resolved. Shinsegae Company and Hyundai Department Store have gained, after South Korean wholesale inflation in September eased. In Hong Kong, markets are trading in positive territory, following China’s support for banking stocks.

US Stocks: Futures trading in the red
At 6 am, S&P 500 futures are trading 3.1 points weaker.
NFIB Small Business Optimism and IBD/TIPP Economic Optimism are the key economic indicators scheduled for release today. Investors also await the release of minutes of the Fed’s 20 September 2011 FOMC Meeting.
Alcoa, WD 40 Co, Synergetics USA, Century BanCorp, and Joe’s Jeans are scheduled to announce their results later today.
Felcor Lodging Trust, the top gainer in after hours trading session yesterday, soared 7.0 percent. Standard Pacific, Amylin Pharmaceuticals and Sotheby’s featured amongst the other major gainers, advancing 5.6 percent, 3.9 percent and 3.9 percent, respectively. Mistras Group advanced 3.3 percent, after its first quarter results surpassed market expectations. Sally Beauty Holdings declined 4.3 percent, after it announced a secondary offering of 15.0 million shares of common stock. Amongst the other key laggards, GNC Holdings, La-Z-Boy and CME Group plunged 9.8 percent, 9.3 percent and 4.6 percent, respectively.
Yesterday, the S&P 500 index surged 3.4 percent, after German and French leaders pledged to present a comprehensive plan to tackle the Eurozone debt crisis and recapitalise European banks. Denbury Resources, the top gainer on the S&P 500 index, rallied 9.6 percent. Record breaking pre-orders for iPhone 4S helped Apple to climb 5.1 percent. Higher metal prices led Alpha Natural Resources, Cliffs Natural Resources and Freeport-McMoRan Copper & Gold to surge 8.9 percent, 8.6 percent and 5.9 percent, respectively. Banking sector stocks, Citigroup, Morgan Stanley, Wells Fargo & Co and Bank of America Corporation soared 7.6 percent, 7.4 percent, 6.5 percent and 6.4 percent, respectively, as risk appetite amongst investors increased. Micron Technology jumped 4.2 percent, after a broker upgraded its rating on the stock to “Buy” from “Hold”. Sprint Nextel Corporation plunged 7.9 percent, after a broker downgraded its rating on the stock to “Neutral” from “Buy”. Netflix declined 4.8 percent, even as it abandoned plans to breakup its DVD-by-mail and online streaming services.

European Stocks: Expected to open marginally higher
The DAX and CAC are expected to open 7 to 8 points and 3 points, firmer, respectively.
No major economic indicators are scheduled for release today.
Givaudan SA, Banco Espanol De Credito SA, Vilmorin & Cie SA and CropEnergies AG are scheduled to report their results later today.
Roche Holding AG has indicated that a small early-stage study has revealed that its experimental drug showed promise in the treatment of Alzheimer’s disease.
Louis Gallois, the CEO of EADS, has stated that the company has not been affected by the difficulties French banks are facing in securing dollar financing.
Reuters has reported that the European Commission would not include over-the-counter derivatives in its review of Deutsche Boerse AG’s planned takeover of NYSE Euronext.

Macro Update
Japan's current account surplus drops
Japan's current account surplus has dropped 64.3 percent Y-o-Y to ¥407.5 billion in August, and sharply lower from the ¥990.2 billion surplus in July.
UK retail sales increase
On a monthly basis, overall retail sales in the U.K., as measured by the British Retail Consortium, have climbed 2.5 percent in September, compared to a 1.5 percent rise in August.
Optimistic on stimulus impact, says Miles
Bank of England policy maker, David Miles, has stated that there are “good reasons” to think that the Central Bank’s expansion of stimulus will aid economic recovery.
ECB backs bond guarantee option
The European Central Bank (ECB) has indicated that it favours government guarantees rather than the Central Bank’s money market operations to strengthen European bailout fund.
Greece pledges to keep creditor promises
The Greek Finance Minister, Evangelos Venizelos, has stated that the Greek government will keep promises to international creditors on pension and wage cuts.
European leaders postpone summit
European leaders have pushed back a debt crisis summit from October 18 to October 23, amid opposition to the German Chancellor, Angela Merkel’s drive for deeper-than-planned write-downs of Greek bonds.

Week, Month and Quarter End Flows Affect Markets

Germany successfully ratified the European Financial Stability Facility expansion yesterday with a very clear coalition majority for Merkel which gave the EUR and risk assets a brief bid initially.  Following on from the German parliamentary ratification of the expanded EFSF (as agreed on the 21 July across the Eurozone) the spread between 10yr Greek Bonds and German Bunds has come in from recent highs and the 2-year note yield found a bid in the improved sentiment, driving the yield as much as 500bps lower.

US Data Highlights
In addition to the relief of the German EFSF ratification the highlights of US data were a slightly better than expected Q2 GDP, which was revised slightly higher at the third time of calculating and a substantial improvement in the weekly jobless claims data (though there may be some seasonal anomalies that are likely see the improvement revised away - at least partially) gave risk assets and equities a boost and sentiment was generally improved.

That however appeared to be the top of the risk rally and the squeeze in positioning in short EUR positions that we were looking for at the start of this week that was supported by a sharp sell off in Euribor futures (or a rally in short end Eurozone rates). The revelation that Italy’s deficit rose to 3.2 percent of GDP in Q2 (up from 2.5 percent in Q2’10) just as Italy paid a high of 5.86 percent in its first long dated bond auction since its recent downgrade also helped take the shine off the EUR as the European Central Bank bond buying support seems to have waned or is having a smaller impact on lowering the yield on its debt.

Whilst for the most part of the week the headlines expounding concerns about and the flaws of the European Monetary (but not fiscal) Union have continued, their impact has been minimal.  Overnight S&P action to downgrade New Zealand’s Sovereign rating along with a more fragile start to the day for risk assets will likely bring Eurozone woes back to the fore today and I would expect to see the EUR underperform.

SNB action supports GBP
The announcement yesterday that the Swiss National Bank (SNB) “will likely raise the share of (their reserve) portfolio in GBP” should help GBP to outperform into the USD rally and EURGBP will start to look weak below the important 0.8660 level.  Whilst I have been emphasising the virtues of GBP for a while now I will stop short of suggesting that I was expecting the SNB action but I do strongly believe that GBP will continue to benefit on diversification and safe haven reserve allocation flows going forward. While Greece continues to remain the core focus of concern, the UK exposure to the troubled periphery nation, which is smaller than you might imagine should also be of some relief and despite the fact that everything is far from rosy in the UK economy (though UK consumer confidence rose for the first time in four months) at the moment I continue to be a GBP bull.

Today in the US sees month end index extensions, quarter end, and the twist to ‘operation twist’ as the long-end assets for purchase are announced by the Fed. The US curve is already markedly flatter with 10s 30s at a mere 105bps and I would expect this to remain a broad positive for risk assets and the US.

Data wise again there are no first tier releases today but confidence and activity data out of the US will be closely watched for sentiment into the close of the week month (and quarter).  On the day volatility is likely to pick up around the fixing times as rebalancing flows are potentially greater than usual following some relatively big moves this month, particularly in Emerging Markets and high yielders.

S&P 500 at 1,000?

After an embarrassing and quite disastrous meeting of European Finance Ministers last weekend, all hopes were hanging on the Federal Open Market Committee meeting and the well anticipated launch of “Operation Twist”.

Yet, the outright downbeat assessment issued by Fed Chairman Ben Bernanke poured cold water on a market that was still hoping for a re-acceleration of growth after the summer in a repeat of what happened last year.

We are therefore left with a potentially crumbling European financial system with a backdrop of sharply heightened downside risk on global growth.

On the bright side, it must be noted that after falling off a cliff from February 2011, the Citigroup Economic Surprise Index for the U.S. is slowly recovering:

Citigroup US Economic Surprise Index – source: Bloomberg

This is of course a function of sharp downward revisions to expectations after a disastrous year on the economic front. This remains a factor to watch however.

The crux of the argument remains that the slow death scenario in Europe has to be addressed as an emergency but after the EcoFin meeting we fail to see a sense of unity of purpose in the European Community.

Of course, announcements over the coming weekend might still happen although the probability remains fairly low. Greece of course springs to the top of minds in this respect.

The European Central Bank also stands ready to cut rates in an emergency and there is no doubt that it will do so if we experience another bout of stress next week. But one has to wonder what good this would bring for the fundamental issues that plague Europe right now. Not much more than a very temporary relief on the announcement, in our view.

Clearly, the technical picture on both sides of the Atlantic calls for sharp downward moves in the near future.

At the time of writing, the S&P 500 futures look to be headed for a slight pullback, having avoided an outright bearish close overnight:

S&P 500 Dec. 11 futures contract – daily chart – source: Bloomberg

Still, we would not expect the rebound to exceed 1,150/60 at the very best before the downtrend resumes.

Indeed, the volatility index for the S&P 500 paints a bleak picture as the fear index breaks out of a consolidation pattern. This could open the way for much more upside for the “fear” index:

S&P 500 Volatility Index – source: Bloomberg

Last night’s break to the upside may well be heralding a sharper downward move in equities within a short period of time.

Looking at the weekly chart of the S&P 500 weekly chart, the picture is also bleak: 

S&P 500 cash index – weekly chart – source: Bloomberg

Indeed, the cash index is on course to print a bearish weekly engulfing pattern that would put an end to what had all the attributes of a suckers’ rally. The Friday close will be highly informative in this respect.

On balance, and unless we get a significant announcement from the Europeans over the coming weekend, we expect to see U.S. and European markets much weaker next week and the area of 1,050-1,000 looks like a realistic target.

In Europe, the technical picture looks even heavier for obvious reasons and the mooted reaction to the upside we are seeing this Friday morning is not encouraging.

The congestion area we highlighted in previous posts was met with heavy selling activity and real money accounts have been bailing out all week.

DAX 30 cash index – daily chart – source: Bloomberg

The “double-bottom” formation is therefore the line in the sand for a sharp move lower.

In conclusion, bar an unlikely surprise announcement from the European side, the downside risk remains wide opened.

Hang on to your hats!

Stocks Rally On Hopes for Greece; US Housing Permits Surprise

S&P 500 Index futures are currently up 0.7 percent indicating a higher open as investors are hanging their hopes on the Federal Reserve's announcement of "Operation Twist" and maybe something more which could lower the interest rate the Fed pays commercial banks on their deposits with the Fed. Operation Twist is a balance sheet maneuver where the Fed buys treasuries further out on the yield curve than 10 years against selling those with shorter maturities.

In pre-market investors got numbers on U.S. housing starts for August which came out at 571K annual rate compared to 590K expected. More importantly the leading indicator building permits rose 3.2 MoM compared to minus 1.8 percent expected. Despite today's numbers it is fair to say that housing will not drive the economy forward in any meaningful way for the next many quarters.

Greece debt talks productive; Italy downgraded by S&P with negative outlook
In Europe, the Euro STOXX 50 Index is up 1.5 percent driven by gains in Banco Santander (+2.9%), BASF (+3.4%) and Siemens (+2.3%) as Greece said its debt talks with the Troika were productive and amid growing optimism ahead of tomorrow's Federal Open Market Committee meeting outcome.

Early this morning Italy's debt was downgraded by S&P from A to A+ with a negative outlook which we must say reflects that rating agencies remain behind the curve. Prices on Italian bonds and credit default swaps have long shown that the market thinks Italy's debt is of a deteriorating nature. In fact we would argue that with the size of Italy's structural deficits and 0.2 annualised growth rate in the last decade the country should have an even lower credit rating.

Adding further to the negative news stream, the Zew Survey (index of investor and analyst expectations) for September came out at -43.3, the lowest reading since December 2008 as Europe's debt crisis continues to worsen. Today's Zew numbers support that the probability for a recession in Europe is higher than in the U.S. The biggest problem for Europe right now is that the lack of market dynamics within the ranks of policymakers are resulting in too slow reactions to the problems. Europe is slowly approaching the critical point where the situation could get out of control if the prophecy of Europe's downfall materialises among corporates and individuals.

More stock specific, Deutsche Lufthansa is out announcing that it is cutting its full-year forecast as economic concerns are hurting bookings. The announcement comes after very confident statements from management that earnings would increase. The shares are down 5.9 percent in Frankfurt trading

Italy Downgraded as Troika Call Proves Fruitless

Not only did the Troika conference call yesterday not result in any concrete initiatives, but not long afterwards S&P, the ratings agency, went ahead and downgraded Italy in line with what it had earlier indicated was likely to occur. The calendar does have a few interesting numbers, but the Eurozone's struggles will be the agenda today before we gear up for the FOMC tomorrow.

Italy downgraded: One of the three big rating companies, S&P, went ahead and lowered Italy's sovereign debt rating by one notch to A from A+ previously and also slapped a negative outlook on the sovereign. The move surprised the markets with the EURUSD giving back all of the hardfought gains yesterday evening, but S&P actually had warned that such a move might take place stating in July that there is a "one-in-three likelihood that the ratings could be lowered within the next" two years. The rating agency expects Italy's economic activity wlil grow 0.7 percent annually over the coming three years which seems very low only until you consider that 1) Italy's GDP has only grown 0.2 percent annually from 2001 to 2010 and 2) that the country faces adverse effects from its coming austerity programme, which will further inhibit growth... Not exactly the perfect starting point of an attempt to lower the debt-to-GDP ratio of 119 percent and public deficit-to-GDP of 4.6 percent (December 2010 numbers).

Greece-Troika conference call proves fruitless: Despite the insistence of Greek Finance Minister Venizelos that the conference was "productive" the end result was weak by any standards with an agreement to schedule another conference call today in which further talks about the data will take place. The announcement afterwards said that a deal is close by, only to be followed up by the statement that some work is still needed to quantify measures. With the markets pricing in a near perfect probability of default let us see how long the charade will continue before the inevitable happens and Greece defaults, in an orderly or inorderly manner.

Building permits to decline in the U.S.: Yesterday's weak NAHB Housing Market Index printing 14 in September down from 15 last month did nothing to change the dismal outlook for the U.S. housing market. Today's Housing Starts and Building Permits report is expected to show declines in both to 590,000. The latter is part of the Conference Board's Leading Indicators Index.

(Note the disruptions in permits in 2010 caused by the First Time Homebuyer Tax Credit programme)

FOMC meeting commences today: The expanded two-day FOMC meeting commences today at 13:00 GMT with the (unchanged) rate decision tomorrow at 18:15. Will the committee announce QE3, Operation Twist or a third monetary policy tool? We will have much more on this in tomorrow's piece.

Market Preview 19 September 2011

Forex Overnight: USD trading stronger
The USD is trading higher against most of the key currencies, amid a rise in risk aversion. An inconclusive meeting of European Union (EU) officials in Poland has led the EUR to trade weaker against the major currencies this morning. Additionally, the EUR is under pressure, ahead of the EU and the International Monetary Fund’s (IMF) assessment, later today, on the approval of the next tranche of aid for Greece. At 6 am, the EUR has weakened 1.0 percent against the USD to trade at $1.3665, and has declined 0.4 percent against the GBP to trade at £0.8706.
The JPY is trading 0.2 percent lower against the USD, following indications from the Japanese government that it might act to curb the appreciation in the Yen.
The AUD and CAD have lost 1.2 percent and 0.6 percent against the USD, respectively, amid rising concerns about global economic growth.

UK Stocks: Expected to open in negative territory
The FTSE 100 is likely to open 47 to 52 points in the red.
No economic release scheduled for today.

Highland Gold Mining , Petra Diamonds, Greenko Group and International Ferro Metals are scheduled to report their results later today.
Bob Dudley, the CEO of BP, has stated that the company remains committed to achieve its oil production targets at Iraq’s Rumaila field and is not renegotiating contract terms.
The South China Morning Post has reported that Standard Chartered has stated that it does not plan to lay off jobs in Hong Kong.
The Sunday Times has reported that Tesco is mulling to bid for all or part of The Garden Centre Group, in a £300.0 million sale managed by Lloyds Banking Group.
The Financial Times has reported that Tim Tookey, the Finance Director of Lloyds Banking Group, is set to resign from the bank to take over as the CFO of Friends Life.
According to the Sunday Telegraph, William Hill is in the initial discussion stage to acquire Probability Plc, the mobile-phone gaming company.

Asia: Trading lower
Persistent concerns about the sovereign debt crisis in Eurozone are weighing on the Asian markets this morning.
In Japan, markets are closed on account of a holiday for Respect for the Aged Day.
In Hong Kong, markets are trading lower, with financial sector stocks trading in negative territory. Bank of China Limited, Bank of Communications and Ping An Insurance Group have retreated, amid reports that Greece might not receive its next aid tranche without further austerity measures. Cnooc Limited and Jiangxi Copper Company have declined, on concerns about the demand outlook for commodities. In China, Poly Real Estate Group and Industrial & Commercial Bank of China have lost value, after data indicating a rise in new-home prices in all cities in August raised speculation of further monetary tightening. Sany Heavy Industry has eased, after it stated that it plans to raise up to $3.3 billion in a Hong Kong initial public offering. Despite South Korean markets trading weaker, Hyundai Engineering & Construction has advanced, after it stated that it has received a KRW 1.6 trillion order to construct a thermal power plant in Vietnam.

US Stocks: Futures trading weaker
At 6 am, S&P 500 Index Futures are trading 20.1 points lower.
NAHB Housing Market Index for September is scheduled for release today.
Lennar Corporation and Accuray are scheduled to announce their results today.
Goodrich Corporation continued its regular session gains in the extended trading session on Friday, soaring 9.8 percent, amid reports that United Technologies Corporation might make a takeover bid for the company. Wipro, Almaden Minerals and NeoProbe featured amongst other key gainers, rising 8.2 percent, 6.3 percent and 5.7 percent, respectively. Healthcare sector stocks, Complete Genomics, Isis Pharmaceuticals and Curis, the major laggards in the after hours session, tumbled 21.7 percent, 6.8 percent and 6.7 percent, respectively.
On Friday, the S&P 500 index added 0.6 percent in the regular trading session, amid optimism that European leaders would act jointly to tackle the Eurozone debt crisis. Aerospace and defence sector stocks, Rockwell Collins, Goodrich Corporation, Textron and Tyco International jumped 7.8 percent, 7.4 percent, 6.8 percent and 3.1 percent, respectively, following a report that United Technologies Corporation is seeking financing for a major acquisition in the U.S. Amazon.com and Procter & Gamble climbed 5.2 percent and 2.5 percent, respectively, after U.S. consumer sentiment index rose in August. eBay surged 5.2 percent, after a broker upgraded its recommendation on the stock to “Out-Perform” from “Neutral” and hiked its target price. General Electric added 1.6 percent, after it signed two new joint ventures in Russia. Netflix plummeted 8.3 percent, after it slashed its U.S. subscriber addition estimates for the third quarter.

European Stocks: Likely to open in the red
The DAX and CAC are expected to trade 53 to 60 points and 48 to 51 points lower, respectively, at open.
Eurozone’s Construction Output is scheduled for release today.
Tipiak SA, HF Company SA, Maximiles SA and Coheris SA are scheduled to report their results today.
Siemens AG has abandoned plans to make nuclear generating equipment with Russia’s Rosatom, following the German government’s decision to phase out nuclear power by 2022.
Markus Ozegovich, the head of Volkswagen AG in Russia, expects the Russian car market to become the  largest in Europe by 2013.
Il Sole 24 Ore has reported that Edison SpA’s Italian investors may give their stake to Electricite de France SA in exchange for a 50.0 percent of the former’s Edipower unit.
Les Echos has reported that BNP Paribas SA is planning to save €200.0 million a year in its Belgium operations.
Peabody Energy Corporation and ArcelorMittal SA have announced that they have extended their joint bid for coking coal miner, Macarthur Coal Ltd., by 17 days.
UBS AG has raised its estimate of losses from unauthorised speculative trades to $2.3 billion.

Macro Update
UK house prices rise
On a monthly basis, average house prices in the U.K. edged 0.7 percent higher in September, compared to a 2.1 percent decline posted in the previous month.
QE gave economy significant boost, indicates BoE
The Bank of England (BoE), in its quarterly bulletin, has indicated that the first round of asset purchases gave the economy a significant boost, but any future quantitative easing (QE) may not have the same impact.
Moody's says Italy's ratings under review
Moody's Investors Service has stated that it is continuing its review for possible downgrade of Italy's Aa2 local and foreign currency government bond ratings, and would try to conclude its review within the next month.
Chinese Premier pledges to step up inflation fight
Chinese Premier, Wen Jiabao, has indicated that the government will step up the fight to restrain inflation, which has been led by steep rises in the cost of food.

Economic Calendar

Country	BST	Economic Indicator	Relevance	Consensus/*Actual	Previous	Frequency
UK	0:01	Rightmove House Prices (MoM) (Sep)	PP	0.70%*	-2.10%	Monthly
UK	0:01	Rightmove House Prices (YoY) (Sep)	PP	1.50%*	-0.30%	Monthly
Eurozone	10:00	Construction Output s.a. (MoM) (Jul)	P	-	-1.80%	Monthly
Eurozone	10:00	Construction Output w.d.a. (YoY) (Jul)	P	-	-11.30%	Monthly
US	15:00	NAHB Housing Market Index (Sep)	P	15.00	15.00	Monthly
Japan	-	Respect-for-the-Aged Day Bank Holiday		-	-	-

Note: PPPHigh           PPMedium           PLow


Corporate Calendar

Country	Company Name	Index	Announcement
UK	Alliance Trust Plc	FTSE All Share	Interim
UK	Dairy Crest Group Plc	FTSE All Share	Trading
UK	French Connection Group Plc	FTSE All Share	Interim
UK	International Ferro Metals Limited	FTSE All Share	Prelim
UK	Ocado Group Plc	FTSE All Share	Trading
UK	PZ Cussons Plc	FTSE All Share	Trading
US	Lennar Corporation	S&P 500	Q3 Earnings Release

Another Round of Bad US Economic Data; Greece Backed up?

S&P 500 Index futures are up 0.2 percent indicating a higher open as risk continues its now three-day long relief rally.

The amount of bad economic data continues to pile up with today's worse than expected job and manufacturing data. U.S. initial jobless claims came in higher than expected at 428K compared to 411K estimated signalling that the world's largest economy is still not generating enough jobs on a net basis. Empire manufacturing data for September came out at -8.82, worse than the -4.00 expected, signalling that manufacturing in the New York region is contracting faster than initially expected. The pre-market data hit risk, taking stock futures down a bit.

Later investors will get the important U.S. industrial production for August which is expected (13:15 GMT) to show that industrial production was unchanged last month. Based on the recent downward revisions do not be surprised if industrial production from July is also revised down from the 0.9 percent MoM reading. Finally, investors will get the Philly Fed Business Outlook for September expected (14:00 GMT) to come out at -15.0 compared to -30.7 in August.

Germany and France behind Greece; UBS trader loses USD 2 billion on unauthorised trading
In Europe, the Euro STOXX 50 Index is up 2.5 percent and EURUSD is strengthening as official assurances from Germany and France that Greece will stay in the Euro is somewhat fuelling investor confidence. Also adding some positive flavour to stocks is the Italian Parliament's final approval of the EUR 54 billion austerity package that is put in place to fight contagion risk from Greece's bond market and secure balanced budgets in 2013.

Early this morning a new trading scandal surfaced with the arrest of a UBS trader in London due to around USD 2 billion losses on unauthorised trades, which according to rumours were presumably revealed as the trader was trying to exit naked short positions in an ETF silver instrument. The trading losses may cause UBS to announce a third quarter loss and as a result the bank's shares are down 8.6 percent in Swiss trading.

Stocks are Down With Yesterday's Speeches Changing Nothing

S&P 500 Index futures are currently down 0.5 percent ahead of the open. With all the highest ranking politicians' and central bankers' speeches done this week we can now settle the score as we head towards weekend.

QE3 is not very likely at the September FOMC meeting
Fed Chairman Ben Bernanke did not mention QE3 in his speech yesterday and only said that the Fed was ready to use additional monetary tools to help the economy if necessary. We expect the Fed to keep the powder dry, thus disappointing the market again at the September FOMC meeting, and wait for stronger indications that the economy is sinking pushing the unemployment rate up. The Fed know that additional QE programmes will have increasingly lower marginal impact on the economy so it absolutely imperative that QE3 is only iniated if the economy is falling into a recession again. However, please remind that the 10 year yields are already below 2 percent, the U.S. money supply is already growing at 8.2 percent YoY and the inflation is coming down, so all the important factors are already supporting the Fed's goal of stimulating the economy as much as possible through monetary tools.

Obama is trying something he cannot impact anyway
Whereas Ben Bernanke did not give the market anything, Barack Obama's job speech gave more than anticipated with a job plan worth USD 447 billion, which he first of all will not get through Congress, and secondly if a smaller programme gets through it will not materially change the job situation in the short timespan that he has to the next election in 2012. On a net basis this is insignificant for investors and the economy.

Later today the only economic data coming out is U.S. wholesale inventories for July is expected (14:00 GMT) to come out at 0.7 percent up from 0.6 percent in June. This indicates that companies are still forecasting decent demand from consumers as the re-stocking of inventory is still running at a very high pace compared to previous levels since september 2001.

Europe down on concerns over the Economy; Porsche down on postponement of Volkswagen merger
Euro STOXX 50 Index is down 0.7 percent snapping back from previous lows but still reflecting growing concerns over the global economy and the situation in Europe's credit markets; both Spanish and Italian 10 year yields are coming back above 5 percent.

Porsche is down 9.8 percent in today's session as pending lawsuits in the U.S. are dragging out the expected deadline for the merger with Volkswagen which was expected to be within year-end but now investors are looking at 2012.

European Stocks up on SNB intervention

U.S. stock futures are indicating a lower opening Tuesday ahead of ISM Non-manufacturing figures for August expected to show economic activity is still expanding. In Europe stocks rebounded early in the session on the Swiss National Bank's intervention.

S&P 500 Index futures are currently down 2.1 percent ahead of the open. Today’s main economic release is ISM Non-manufacturing Index expected (14:00 GMT) to decline to 51.0 in August from 52.7 in July showing U.S. services grew at the slowest pace since late 2009. Despite the index weakening it is still above the 50.0 threshold indicating that the service sector is still expanding.

We continue to maintain our modestly positive view on stocks as the spread between bond yields and dividend yields (and earnings yields) are the widest since 1997 in the MSCI World Index. Our view is founded on the premise that the U.S. economy will not enter a recession. The biggest risk to our view is the escalating crisis in Europe. If the crisis consolidates and spills into the global banking system it could pose a severe risk to the real economy and thus our view on stocks. For now though we stick to a scenario of a temporary slowdown in the global economy but not a new recession.

SNB fights for minimum 1.20 EURCHF exchange rate; German factory orders disappointed in July
Early this morning the Swiss National Bank announced that the appreciation of the Swiss Franc poses a huge risk of deflation and thus the SNB has chosen to fight for a minimum EURCHF exchange rate of 1.20. The SNB says it is ready to buy foreign currencies in unlimited amounts to hold this exchange rate to the Swiss Franc. Currency pegs have been tried before without much luck so the SNB will find it very costly to defend its new target exchange rate to the Euro if the market decides it wants the EURCHF down under 1.20. However, only the future will tell us how effective the SNB's plan is. Nevertheless, the SNB announcement kick started a rebound in European stocks and the Euro STOXX 50 Index futures are currently up 0.1 percent mid-way through the session.

Earlier German factory orders in July came out at -2.8 percent MoM, worse than estimates of -1.5 percent, indicating a faster slowdown in Germany’s manufacturing sector. This is hardly a big surprise as the export hungry Germany is dependent on economic growth in China and India which has been slowing down in 2011.

Italian, French banks in trouble; even Bernanke can’t change that

Italian and French banks are the potential ’phoenixes’ in the European banking arena. The characteristics of a bounce back could really hide a great investment trap as three decades of credit expansion has come to an end.

Some of the recent falls in banking shares have been based on ‘reality’ whilst others were considered to be simply ‘innocent’ bystanders. Does this present bargains when the market stabilizes and recovers? Not in France and Italy, in our view, especially as the European interbank market remains under great stress with rates at late 2007 pre-crises levels (see chart 1).

 

Multiple risks ahead
Given the complex nature of the banking system we highlight a number of characteristics that investors should place on the “watch-out’ profile. These are:

1. a level downshift in ROE (chart 2), 
2. sluggish interest margins (less provision costs) coming out of the 08-09 crises (chart 3), and
3. unchanged Balance Sheet leverage (chart 4).

These properties combined with substantial non-domestic activities and, in particular, PIIGS-related debt will determine a risky profile for a European bank today. Italian and French banks have many of these traits in common.

 

Geographies in the cross-hair
Italy and France’s larger banks all have significant non-domestic credit exposure, and in some cases, to rather exotic markets. Furthermore, both countries face heavy sovereign debt pressure, and as government funding costs go up so does the domestic banks', with this being very much the focus of the present market. Rating agencies focus on the quality of the “lender of last resort” and their ability to bail out with lower national ratings spilling over to the ratings of the banks, straining earnings.

High volatility expected
Since the financial turmoil started in early August we have seen large trading ranges in the European banking sector. There was the initial free fall of the market resulting in a high correlation between so called solid banks and those previously pointed out as containing toxic assets. Lately, we have experienced an “attack on the French banks”, particularly Société Generale on the back of rumors regarding urgent funding issues and possible insolvency. Regulators responded with a temporary short-selling ban on all financial stocks.

Thus we think investors will be reluctant to rethink their bearish attitude versus the French and Italian banks.

European Countries Impose Short-Selling Bans

The volatile markets experienced in the last few weeks have resulted in short selling bans in a number of European countries. France, Spain, Italy and Belgium have imposed short-selling bans starting today.

The crisis in Europe has seen policymakers look for scapegoats and once again the markets are readily available. Financials have been under siege in recent weeks and Societe Generale in particular has been subject to speculative selling as rumours spread earlier this week that it has trouble.

Is short-selling really the way to go when confidence is waning, or will it just confirm in the minds of investors the feeling that something is wrong? The history has plenty of examples of the latter being the case, as seen in the subprime crisis turned Great Recession, which did not exactly arrest declines and uncertainty. And to boot, France just reported a miserable flat GDP for the second quarter on expectations of a 0.3 percent increase. No, there is nothing to see here. Move along please!

U.S. Retail Sales set to increase: the weakness displayed by consumers in the second quarters is not expected to continue in July according to consensus, which expects sales at the retail levle to grow 0.5 percent month-on-month after a weak 0.1 percent print in June (Retail Sales are not inflation-adjusted). Yesterday's surprise widening of the trade deficit in the U.S. ($53.1 billion vs. 48bln expected and 50.8bln prior) will see 2Q GDP be revised down, likely even below 1 percent, when the first revision is released in a few weeks. And while such a revision only confirms the wakness in the second quarter, it also means that a pick up in consumer spending will translate into a better 3Q GDP print.

Sell-off in solar stocks creates opportunities

Solar stocks have plunged 20.6 percent in May alone sending the year-to-date performance into negative territory, driven by worse than expected first quarter earnings releases in the industry. We believe the sell-off provides an opportunity to pick up solar stocks.

In our Yearly Outlook we put forth the idea that solar stocks would be a great play in 2011 and with at least 30 percent potential. While that target was almost reached in February the latest development in the Guggenheim Solar ETF (see chart below) has erased this year's gain. The main driver is concerns over demand as the Eurozone struggles (the largest Photo Voltaic market), overcapacity leading to price wars and a weak euro.

 Source: Bloomberg

All the arguments against solar are fair and reasonable. However, we believe the upside potential still outweighs the risks and investors will eventually realise that during 2011.

Many investors have talked about solar energy being non competitive and only booming because of government subsidies. While the latter is correct the idea that solar energy is not able to compete in the marketplace is wrong. Mark Little, GE's global research director, was out saying yesterday that GE believes that solar energy could be cheaper than fossil power in five years as technological advancements keep pushing down the unit cost for a kilowatt-hour; the cost of solar cells has fallen 21 percent in 2011. According to research, the cost of solar power is now about the same as the rate utilities charge for conventional power in the sunniest parts of California, Italy and Turkey. It is this underlying trend in unit costs that eventually will support the investment case in solar stocks.

We think fierce competition and continuing declines in production costs remind us of the old days in the computer industry. The constant push for lower prices will ultimately grow the market into a global mass market, but on that path many companies will fail due to inefficiency etc. Overall, we are optimistic on solar energy and believe it will be the largest disruption to utility markets in the coming decades.

Behind Buffet's Lubrizol deal; A bit of a gamble

Berkshire Hathaway’s USD 9 billion cash bid for U.S. specialty chemical company Lubrizol on March 14 is not classic Warren Buffet value investing, as several commentators said, but rather a big bet on a structural change in Lubrizol’s future operating margins.

By many classic value metrics Lubrizol would not be an attractive investment, so the deal looks to have been structured around two data points and a dinner between Lubrizol CEO, James L. Hambrick and former crown prince of Berkshire Hathaway, David Sokol.

When we first looked at the Lubrizol numbers we could not get our heads around the deal. According to our Benjamin Graham-based valuation model the offer did not make sense. Our valuation came in the range of USD90 to USD100 per share depending on the assumptions about growth and profitability. Needless to say, the range was far lower than the Sage of Omaha’s “elephant gun” bid at USD 135 per share.

Looking at Lubrizol’s EBITDA-margin since 1987, as we have done in the chart below, we would expect a value investor to carry the average of the last five years into the next five - around 15.6 percent. For Buffet’s bid to make sense, however, the last two above average data points must have been extrapolated into the future.

 Also, over the last 20 years or so, inflation-adjusted earnings per share and the share price have not exactly indicated this company is the new Coca Cola. Earnings and the share price have been moribund until the last two years, and the company made a loss in 2008. Value investors would normally steer clear from these warning signs and not get carried away by the euphoria of two years’ earnings.

The key to Berkshire’s bid, therefore, lies not in value investing, but in what David Sokol said about the lead-up to the deal in the now infamous CNBC interview March 31. Sokol explained what Buffet initially said of the move: “I am not sure it makes economic sense”. Indeed, Buffett sent Standard & Poor’s company fact sheet to David Sokol just before the latter’s dinner with Hambrick highlighting the last two years’ operating margins and questioning whether they were sustainable. Well, he obviously got his answer!

Lesson learned… Private equity (which is a considerable activity for Berkshire Hathaway) is a valuable strategy when used the right way. You get information not otherwise easy to obtain or interpret from public information.

But the rich bid is still a bit of a gamble for the ‘Sage’. Yes, ignoring the future operating margin sustainability conversation, Lubrizol is interesting because it has pricing power in an industry with very few players. It manufactures and sells specialty chemicals used in various industries such as transportation, industrial and consumer markets. But is that still enough to produce above 22 percent EBITDA-margin in the future?

Time will tell. But according to Sokol in the CNBC interview, this structural change in operating margins is what you have to get comfortable about. Buffet is.