Friday, 19 October 2012

Week in review, part I: The earnings stupid!

What’s driving markets? Just as James Carville noted that the economy was what really matter to voters (the economy, stupid), we might well remember that earnings are what has powered markets, particularly the S&P 500, higher – rather than quantitative easing and in spite of worries about the fiscal cliff or eurozone debt crisis. So last week we took heart from the results of JP Morgan; would the rest of the financial sector prove equally encouraging?

In previous posts we have drawn readers’ attention to the contradictions of the “weak is the new strong” theme (whereby weak economic performance prompts stimulus from the Federal Reserve) and this week dichotomous contradictions are no less evident.

First, in the corporate world, the banks saw results which have broadly continued the theme seen last week from JP Morgan. So far, of the twenty or so banks and diversified financials, comfortably 80% of them have been beating expectations. Most notably Morgan Stanley’s results impressed the market despite posting a $1bn loss from continuing operations.

That’s because of a bizarre quirk of accounting called Financial Accounting Standard 159 which means that when a company sees the value of debt it has issued fall, it can accept that as a decline in liabilities (even though it is still liable for the full amount). This time last year, the market value of Morgan Stanley’s debt plummeted (as illustrated by the sharp rise in the costs of insuring against default using credit default swaps, or CDS) boosting the firm’s profits by $3.4bn.

This quarter investors have bid the value of that debt back up and so Morgan Stanley’s apparently sounder financial position and lower future borrowing costs have cost them $2.3bn dollars of accounting revenue. Excluding the effects of the debt value adjustment (DVA) Morgan Stanley made a profit of $0.5bn.

Source: DataStream/Brewin Dolphin

We are very close to the five year anniversary of the advent of fair value accounting for assets and liabilities (15th November 2007). Since then nobody would have dreamt that the introduction of plans to reduce volatility in earnings would have caused such, well, volatility in earnings!

Does this herald the return of sector leadership to the banks? Certainly the outlook for US banks improves meaningfully with further evidence that the US housing market is on the turn. Housing starts reached their highest level since July 2008, their third highest monthly increase since the early 1990s. This is all supportive of our hopes of a wealth-driven recovery in economic activity in the US.

But for all the good news accruing to that bellwether of old, the banks, their stand-in for the last two years, the technology sector, now struggles.

Somewhat ironically with Morgan Stanley impressing the market with a billion dollar loss, investors were displeased by Google’s mere 50% sales growth. Google joined the ranks of household tech-names Microsoft, eBay, IBM, Oracle, Adobe and AMD who all disappointed to some extent. It was enough to take the wind out of the market’s sales but still leaves the week as a positive one for risk assets with most developed markets up between 1% and 3% over the week (at the time of writing) and a rare strong week for Japanese equities, up some 5% still doesn’t suggest they have broken their recent trading range.

Guy Foster
Head of Portfolio Strategy

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