Today's Tidbits

Corporate Profits Revised Substantially Lower in GDP Revisions
From UBS: “The GDP revisions included large shifts in income away from corporations and toward households. On a Q4/Q4 basis, personal income growth was revised up to: 6.0% (was 5.8%) in 2006 and 5.4% (was 4.6%) in 2005. Consequently, the personal savings rate was revised up to 0.4% in 2006 (was -0.9%) and 0.8% in 2005 (was -0.3%). Meanwhile, corporate profits were revised down: now reported up 8.4% (was 18.3%) in 2006 (Q4/Q4) and 9.1% in 2005 (was 12.8%). For Q1, they are now reported up just 2.1%y/y (was 6.5%)—well below the nearly 10% pace reported for S&P500 EPS (see chart). (Unlike the S&P 500, the national income accounts include all companies.) The weak pace in profits growth helps explain the slowing in business investment recently.”

Mortgage Market Relative to Other Markets and Hedging Implications
From Merrill Lynch: “…because of the headlines about the problems in the housing market, most investors are probably unaware that high quality mortgage backed securities issued by Fannie Mae and Freddie Mac have actually appreciated recently. From June 15 to Thursday of last week, high quality mortgage backed securities had a total return of +1.2%. That certainly compares well with High Yield debt's return of -4%, and Emerging Market Debt's return of -1.8%. 10-Year Treasuries, of course the highest quality long-term debt, returned 3.7%. Thus, high quality mortgage backed securities have not outperformed Treasuries, but they have certainly outperformed lower quality high yield or emerging markets debt.”
From Barclays: “Last week saw a massive bull steepening, driven by a bona fide flight to quality. 2s and 5s rallied 28 bp on the week, and 10s and 30s were 19 and 13 bp lower respectively… Mortgages got crushed last week, with the 30-year 4.5s to 6s losing between 6 to 16 ticks against swap duration hedges, led by the discounts. The spike in volatility was by far the reason, hurting returns by 10-14 ticks. The curve, on the other hand, actually added 4-5 ticks in returns as it steepened. Over the month, MBS have now lost 8 to 18 ticks duration hedged. 15s did far better last week, losing just 2-3 ticks duration hedged… Swap spreads widened 4-8 bp across the curve last week, amidst a decline in liquidity… Both short- and long-dated options spiked last week, especially once rates rallied through technical levels. They are now near two-year highs for most contracts.”
From RBSGC: “It was the 1998-1999 credit meltdown which forced the street to look at OAS versus less volatile swaps rather than Treasuries. As has been the case recently, during credit driven rallies, swap spreads tend to widen and MBS trade on a much shorten duration making them difficult to hedge. In fact, we have been recommending hedging MBS with less volatile swaps rather than treasuries for particularly this reason. Based on our hedge ratios we estimate that MBS have underperformed 10-year swaps by only 18 ticks this past months compared to almost 42 ticks versus Treasuries. Another notable exception to the 1998 episode has been that MBS have not benefited to the same extent from a flight to quality from corporates in 2007 compared to 1998.”
From RBSGC: “…so far this year, bank deposits have shrunk back to YE 2006 levels, MBS holdings are lower, yet C&I loan growth continues apace. This is somewhat negative for MBS, and we believe the "mortgage shedding" will continue until the banks perceive a Fed ease is imminent…Mortgages had a tough year last week, as markets other than U.S. Treasuries decoupled and literally stopped trading during Thursday's stock market drop. FNMA 5.5s underperformed the 10Y UST by 24+ ticks from 7/20 to 7/26.”

Housing Problems Spilling Into Weaker Consumer Spending Data
From Goldman Sachs: “ …recent news has significantly strengthened the notion of spillovers from housing to consumption: a) Real consumption grew only 1.3% annualized in Q2. Some of this was clearly due to gas prices…But even with that adjustment the numbers are pretty weak. Moreover, the news for early Q3 remains mostly soft, despite the fact that gas prices have fallen 25 cents since late May. Auto sales in July were probably only around 16.0 million SAAR, and the anecdotal news coming out of retail has remained on the weak side…Market is worried about consumption as well (this downtrend precedes the equity market drop). b) In today's GDP report, consumption for Q1 and prior quarters was revised down. Partly as a result of this revision, the personal saving rate now shows a modestly rising trend over the past 1-2 years. This strengthens the notion that the decline in mortgage equity withdrawal is weighing on consumer spending growth, as we have been expecting. (MEW isn't included in disposable income, so a MEW-driven consumption decline leaves income unchanged, driving up the saving rate.) This would come as a surprise to Fed officials, who have generally downplayed the housing/consumption link. c) If you look at sales tax revenue at the state level, you see a significant slowdown that is mostly due to outright revenue declines in housing boom/bust states such as Florida and California. Moreover, Florida provides some data that break out taxable retail sales into different categories (durables, nondurables, recreation, construction supplies, etc.). These data show a broad-based drop, which supports the idea that the unfolding Florida recession isn't just due to construction but has an important consumer element as well -- just as the MEW story would predict. All this is so important because it's clear that housing will remain weak for the foreseeable future. Our estimate of a 5% decline in house prices this year looks to be on track, and next year is likely to show another decline. In that environment, the squeeze on consumers is likely to get worse, not better, and that reinforces the idea that growth next year will again be below trend.”

Home Foreclosures Expected to Reach 2 Million This Year
From Reuters: “U.S. home foreclosure filings rose 58 percent from the same period a year earlier with the trend likely to increase by the end of the year, RealtyTrac said on Monday…showing a foreclosure rate of one foreclosure filing for every 134 U.S. households…"If the current pace were to continue, foreclosure filings would surpass two
million by the end of the year, which would represent a year-over-year increase
of more than 65 percent," …California's foreclosure filing total was the highest among all states in the first half of 2007, while Nevada posted the country's highest foreclosure
rate, with one foreclosure filing for every 40 households. Foreclosure filings include default notices, auction sales notices and bank repossessions.”
From JP Morgan: “…delinquency rates on agency guaranteed mortgages continued to decline through May and indeed were at new cycle-lows…”


Vacant Homes Rise 50% in 2 Years As New Construction Exceeds Demand
From JP Morgan: “Total vacant units for sale are now up nearly 50% over the last two years, but the year-over-year rate of growth slowed sharply between 1Q and 2Q… Whether vacancies can fall further will in part depend on the path of housing starts and new home sales. This is because while new homes make up only 15% of vacant single-family units, they have contributed 36% of the rise in vacancies over the last year… Data …suggest that the new home sales report is underestimating the inventory level of new homes. This is occurring because if a sales contract on a new home is canceled, the new home sales report does not add that unit back into inventory (nor does it revise sales figures). According to the housing vacancies report, completed new homes for sale rose from 158,000 in 2Q06 to 256,000 in 2Q07, while the new home sales report shows a rise from 131,000 to 179,000 over the same period. The homeowner vacancy rate fell to 2.6% in 2Q from 2.8% in 1Q but is above the 2.2% rate from 2Q06. The rental vacancy rate fell to 9.5% in 2Q from 10.1% in 1Q and 9.6% in 2Q06.”

Banks Raising Hedge Fund Margin Requirements
From The Financial Times: “Investment banks are responding to rising credit concerns by imposing tougher lending terms on hedge funds, in a move that threatens to exacerbate investor unease in the financial markets. Prime brokerage departments at several investment banks have raised their margin requirements for certain hedge fund clients as they seek to insure themselves against the possibility of new hedge fund collapses as a result of the recent market turmoil… Financing terms for hedge funds are being tightened and this is forcing a further deleveraging of risk across global markets," …"Recently we have broadened our stricter standards to funds beyond those with exposure to US mortgage market. I'd say this is now a pretty broad-based retreat from leverage." The move could raise the pressure on parts of the hedge fund sector, since it comes at a time when performance at some groups has slumped as a result of recent market swings. The average hedge fund, across all strategies, returned just 0.8 per cent in June… Fixed income-focused hedge funds were the worst affected, returning just 0.2 per cent in June. If a hedge fund's performance deteriorates sufficiently, its prime broker's bank can demand that it sells assets to repay loans.”

Jobless Claims Good Indicator of Employment Growth as Productivity Slows
From JP Morgan: “Even as growth has been lackluster over the past year, most indicators of the labor market have remained healthy. The simplest explanation is that productivity growth has slowed. Another explanation is that the payroll survey has
overcounted jobs, particularly in the residential construction industry. This week brought the release of the 4Q06 Quarterly Census of Employment and Wages (QCEW), a
comprehensive count of employment that covers 98% of all jobs—the closest thing to a hard number in economic data. Through the end of last year, the payroll survey tracked the change in actual employment, as measured by the QCEW, remarkably well, suggesting that forthcoming benchmark revisions to payrolls will be negligible. Over that period, jobless claims behaved in a manner consistent with the payroll survey, supporting the contention that the claims data are a very useful high-frequency gauge of the health of the labor market. And claims have moved down through July, which is a positive signal on growth. The notion that construction payrolls are being grossly mismeasured also received little support from the QCEW, as the benchmark data were very close to the monthly survey data. Some have argued that the decline in residential investment without a corresponding decline in residential construction employment augurs a fall in jobs in that category and a bounce in productivity. However, nonresidential investment relative to nonresidential construction employment has surged. Taking the earlier argument at face value, this would foretell a surge in hiring and a fall in productivity. A better story is that the demarcation between residential and nonresidential construction jobs is clearerin the data than it is in reality.”

Asian Growth Accelerating Outside of China
From JP Morgan: “Recent indicators point to a powerful acceleration in growth in EM Asia. Although China’s growth surge has dominated the headlines, Korea’s 2Q real GDP growth of 7.0%q/q, saar and Singapore’s 2Q double-digit growth were both well above their recent trends. Monthly data from Taiwan also show a turn towards much stronger growth, with IP reaching a 22.3% growth pace last quarter; the rise in July export orders
indicated that this momentum is carrying into the current quarter. In these tech-driven economies, inventory drawdowns that were drags on growth around the turn of the year
have faded, and solid global demand for electronics equipment is now lifting output.
These solid growth numbers should give Asian central bankers more comfort to nudge policy conditions tighter, though their motivation is often not around core inflation (which stays generally well contained around the region).”

Unusual Stock Market Divergences Urge Caution
From Forbes: “Since last month, the Dow Jones Industrial Average has hit nine new record closing highs… and breadth has taken a decisive turn for the worse. The DJIA has closed higher in five of the past eight trading days, but declining stocks outnumbered advancing stocks in seven of those eight sessions. That type of negative breadth divergence has occurred only 15 times in 75 years--the majority of which were in bear markets. On Monday of last week, the DJIA hit a record high while declining stocks overwhelmed advancing stocks by a two to one margin. That ominous divergence has never occurred in the past 75 years of market history. Divergences are also appearing in major indexes, as the headline-grabbing DJIA has risen over 1,000 points in the past five months--but the small-cap Russell 2000 Index has slipped lower. If that isn't a flight to quality, we don't know what is! As a consequence, we are moving to a full bear market defensive mode… When the DJIA scores a new record high by closing up over 40 points, yet there are twice as many stocks closing down for the day as closing up, then something is wrong. When the DJIA closes higher in seven out of eight days, but breadth is positive (advancing stocks outnumber declining stocks) on only one of those days, then something is wrong. The "wrong" confirms that fewer stocks are participating and investors become more selective in stock purchases. Historically, this is known as "a flight to quality"--and it is clearly underway.”

Tighter Credit Reduces Stock Buybacks and Mergers – Reduce Market Support
From The International Herald Tribune: “As stocks raced to new highs this year, many investors felt their prices were justified by robust corporate earnings. They were only partly right. Other powerful forces were at work as well: corporate buybacks and mergers, both of which require access to E-Z credit. For instance, the Standard & Poor's Index Services Group estimated that almost $118 billion was spent on stock buybacks during the first quarter of 2007, up 17.5 percent from the $100 billion registered during the first quarter of 2006. In the first quarter, S&P said, 101 companies reduced their actual share count by at least 4 percent, while 72 cut their average diluted shares, used to determine earnings per share, by at least 4 percent. That means that at least 4 percent of the growth at those companies came from share count reductions, not operating earnings. The S&P data also show that information technology companies were the biggest buyers of their own shares, accounting for almost 23 percent of the total buybacks and 15 percent of the market value of that stock during the first quarter. Consumer goods companies were another major player in the repurchase arena last quarter, accounting for almost 15 percent of stock buybacks and 10 percent of the market value.”

Financial Stocks Under Pressure
From Bloomberg: “Moody's shares have declined about 10 percent in the past two weeks, extending their loss for the year to almost 20 percent… After peaking at about 511 points on May 23, the Standard & Poor's index of 92 U.S. financial stocks declined more than 10 percent through July 26, while the S&P 500 index fell just 2.6 percent. In the five years through the end of 2006, the financial index posted a total return of more than 56 percent, outpacing the 34 percent delivered by the benchmark index. Here's a scorecard of some of the world's biggest banks, from wherever the shares reached their high for this year compared with closing prices on July 26. Bear Stearns Cos. is down almost 28 percent. Royal Bank of Scotland Group Plc is down 21 percent. Deutsche Bank AG is down 18 percent. JPMorgan Chase & Co. is down 17 percent. Goldman Sachs Group Inc. is down almost 17 percent. Citigroup Inc. is down almost 14 percent. So much for the golden age of finance. ”


MISC

From Goldman: “Fear is sweeping through the financial markets, with a tightening of credit conditions prompting a broad based repricing of risk (i.e. a widening of spreads). The equity market has been the highest profile victim of the pullback in credit markets. The S&P 500 index fell roughly 5% on the week, with financial intermediaries the hardest hit sector…A key feature of the current turmoil is that credit has become scarcer, rather than simply more expensive. This could affect the real economy in at least three ways. First, it could exacerbate the already large overhang of unoccupied housing. Second, it could curb consumer spending through a combination of negative wealth effects, constraints on those who require access to smooth spending through a combination of negative wealth effects, constraints on those who require access to credit to smooth spending, and potential labor market contraction. Finally, tougher credit conditions could constrain capital spending and hiring by firms that depend on external financing.”
From The Financial Times: “Global banks are well-placed to withstand the weakening in credit markets but could face a squeeze on revenues if the situation worsens, according to a report Monday by Standard & Poor's, the ratings agency… S&P says an upturn in defaults "cannot be far away". Banks could - if the situation worsens - see "sizeable losses" relative to earnings and capital. In terms of revenues, they will no longer receive such substantial underwriting fees from leveraged finance activity.
From Business Week: “…it's not the Fed's job to bail out stock and bond investors. The Fed takes notice of the financial markets only when conditions there threaten to cause a genuine credit crunch—that is, when even credit-worthy companies and families can't borrow money. We're still far from that scenario. In the mortgage market, for example, prime borrowers are getting, if anything, even more offers of credit because lenders need to make up for their lost subprime business.”

From JP Morgan: “The shock waves currently reverberating through financial markets are putting monetary authorities in a tight spot, balancing the risk of a full-blown credit crisis against the risk of a decisive move up in inflation. However, for some countries,
inflation risks are turning into inflation realities, leaving little option but for higher policy rates in the coming months.”

From JP Morgan: “Strong economic fundamentals and high commodity prices had until recently insulated financial assets in emerging markets from the troubles in US credit markets. However, this changed dramatically this week, as the subprime woes finally
hit equity markets and investors took profits in emerging markets to offset losses elsewhere. This led to a massive 42bp widening in the EM bond index (EMBIG) spread this week. Moreover, in EM countries where appreciating currencies have been a disinflationary force allowing central bank to ease, the spread of the US credit market anxiety to EM’s raises the possibility of currency depreciation.”

From Market News: “In an interview with the Sunday Telegraph, Lord George, former governor of the Bank of England, claimed criticisms of China's handling of its currency were often misplaced. "The Chinese I speak to understand that in the longer term a stronger renminbi is good for the welfare of the Chinese people as a whole," George said. "It's the same argument the Americans used to use - a strong dollar is good for the US. "But their immediate priority is not improving the overall welfare, in terms of the overseas purchasing power, of the Chinese people. Their priority is to create jobs for all those coming off the land. That's a good thing for the Chinese economy and for the rest of the world. "They've lifted millions out of poverty in the last few years and they have recognised these concerns through the increasing flexibility of the renminbi. But they recognise that you can't change things overnight."”

From ASPO: “China [total oil]… Imports were 19.7% higher than a year earlier… making Tehran the largest supplier of crude to Beijing… China plans to build four levels of crude oil reserves made up of two parts - the government reserve and “enterprise storage.” The government reserve will be at two levels, a strategic crude oil reserve base by the central government, and an oil reserve base by local governments. The enterprise storage will also be at two levels, commercial oil reserve by the largest oil companies and oil storage by the medium and small ones.”

From Market News: “Treasury says it expects to hit the statutory debt limit of $8.965 trillion in early October and Paulson sends letter to Congress requesting an increase ‘as soon as possible.’”

End-of-Day Market Update
Treasuries retreated as the flight-to-quality buying eased after the equity market rallied. As of 4pm, two year yields fell 9bp to 4.58% while ten year yields fell a more modest 5bp to 4.81%, causing the yield curve to flatten. Swap and other credit spreads stopped widening (worsening), and finished the day tighter.

Stocks bounced. The Dow closed up 93 to settle at 13,359 after trading up over 130 points in the early afternoon. The S&P finished up 15 at 1474, and the Nasdaq improved by 21 points. The S&P is 3.9% higher since the beginning of the year, but is down 5.3% from its recent new high.

The dollar weakened slightly in the afternoon after trading around unchanged overnight. Versus Friday’s close, the dollar index has fallen 15 points to 80.80.

WTI oil futures rallied to set a new contract high of $77.33 earlier in the day, exceeding last summer’s high of just over $77, before settling back to close down 19 cents at $76.72.