Is Obama like Clinton or Bush?

- Macro viewpoint: Is Obama like Clinton or Bush? "Continued gridlock in Washington would be very bad for the economy. We expect a reluctant compromise on taxes at the last second."
- Fed watch: QE2: Pondering when and how "The Fed has adopted a clear easing bias, but there is no rush: the economy is weak but not drifting toward recession and Bernanke will want to get broad support from his committee before acting. The Fed has a number of options to further stimulate the economy. Now that they have acknowledged that inflation is “somewhat below” acceptable levels, one way to ease further would be to the “extended period” language to the inflation outlook. The Fed could also tie its asset purchase program to bond yields – buy whatever amount is needed to bring the 10-year yield down to a specific range."
- Housing watch: Builders still downbeat "New home sales remained close to record lows, the NAHB housing survey remained depressed and single-family permits fell, setting the stage for further declines in housing construction. The housing market will be a clear drag to GDP growth this quarter and next."
- The week ahead: New month; New ISM "We are not expecting any major revelations in next week's data flow and expect continued evidence of a weak economic landscape. The main event will be the release of the ISM manufacturing index on Friday. We are expecting the index to decline to 54.0, its lowest level since November 2009. We'll also receive the personal income and spending report."

Defusing the tax bomb

- Macro viewpoint: Defusing the tax bomb "The dysfunction in Washington could cause a “growth pause” in the fourth quarter. However, we expect the Obama Administration to focus on economic growth in the run-up to the Presidential election."
- Fed watch: Taking their time "With the economy decelerating but not crashing into a double dip or outright deflation, we believe Fed officials are unlikely to rush into renewed QE over the next few FOMC meetings. By January, we expect weak economic conditions will allow Chairman Bernanke to forge a consensus supporting the potential for additional asset purchases."
- Housing watch: Spilling over "The construction industry has shrunk as a share of the economy, but the effects of the housing bust are still being felt. Nearly a third of total job cuts were in housing-related industries and a bulk of the drop in consumer spending was in housing-related goods. Bank repossessions have started to pick up steam and should continue to depress the housing market, and by extension, the economy."
- The week ahead: FOMC meeting and housing data deluge "The main event this week will be the FOMC meeting on Tuesday. We’ll be paying particularly close attention to the FOMC statement for any signs of QE2. Our forecast assumes they resume easing in the first quarter of 2011. Besides Tuesday’s FOMC meeting, the week’s data releases will center on the housing sector. Overall, the data should reflect the depressed state of the housing sector."

China banks: Margin and maturity for 2010

- NIM: “the only hope” for positive surprises? "H-share banks reported a strong set of 1H10 numbers, with 20-60% YoY bottom line growth, and continued improvement in asset quality and net interest margin. Looking ahead, we believe sector loan growth should stabilize at ~19% for 2H10 and decelerate in 2011, while NPLs and credit costs are both at low levels with high upward risks. Thus, any positive earnings surprises should be mainly driven by NIM. We analyzed various drivers of banks’ NIM, and concluded that the room for sequential margin recovery is very limited."
- Quantifying the key NIM drivers "H-share banks’ NIM recovered by ~31bp on average from 2Q09 to 2Q10. Based on our analysis, the shift from discounted bills to non-bill loans was the biggest contributor for small banks’ NIM recovery (15-25bp), while the higher LDR helped NIM by ~10bp at BOC, CMB, and BoComm. Longer loan maturity, shorter deposit maturity, better loan pricing, and recovery in treasury yield also boosted margins, though to a lesser extent."
- Expect margin to peak and stabilize "The margin drivers appeared to be running out of steam for 2H10. Discounted bills as % of sector loans was flattish in the past 2mths (-0.2ppt), and may start to rebound as credit demand weakens. LDR in 2H10 should be lower than in 1H10. The maturity mismatch of sector loan-deposit rose to record high levels, and is facing the risk to reverse. Large banks’ margin should be largely stable in 2H10, while CNCB and MSB could suffer margin decline due to the time deposits they gathered in end 2Q10. CMB’s NIM is the most volatile, which may continue to rise in 3Q10, but is vulnerable to any decline in discounted bill yield."
- 1H10 results recap "The big two state banks continued to lead on profitability, provision buffer, and capital. Joint-stock banks enjoyed higher NIM than large banks, but lagged on profitability, due to their relatively low fee income and high operating costs. Loan growth was in line with regulatory guidance, with the property sectors being a key growth driver. NPL ratio reached record low level and credit costs declined further. CMB and MSB appeared tight on core capital, despite their recent capital raising."
- Uninspiring stock performance YTD, watch October "H-share banks' stock prices performed in line with the markets YTD. Most banks traded flattish (except for ABC and CNCB), and the performance converged. We reckon investors are attracted by China's macro story, the banks’ strong balance sheets, and undemanding valuation. Nonetheless, confidence in earnings is low due to the policy risks and asset quality concerns. We believe late October could mark the next milestone, when we may get better clarity on provisions on LGFV l oans, any new property tightening measures, and margin trends in 3Q10."

Fiscal fables

- Macro viewpoint: Fiscal fables "The Obama administration has announced a series of proposals this week aimed at boosting growth. These policies, if enacted, will have a negligible impact on our forecast of a growth recession through the end of next year."
- Fed watch: Incomplete transition "Former Vice Chairman Donald Kohn’s retirement from the Board of Governors signals the end of an era. As he was close to Bernanke and other centrists on the FOMC, his dovish comments in a subsequent interview are noteworthy. The fact that his replacement has not yet been approved will be a challenge for the Fed."
- Housing watch: Despite low rates "Record low rates have done little to stimulate housing demand, leaving a growing imbalance between housing supply and demand. We expect the government to introduce more policies to address this glut of supply. One proposal gaining some traction is to facilitate the conversion of foreclosures into rental properties."
- The week ahead: Spending and production: not so bad "We expect a modest gain in retail sales, showing a decent back-to-school shopping season. Consumers are still spending, but are doing so conservatively. New information on the manufacturing front will also be released. We expect the industrial production to pick up with a solid gain in manufacturing output, but for the Empire State survey to point to an impending slowdown."

Growth recession

- Macro viewpoint: Growth recession "The slowdown in the job market and the coming fiscal tightening suggest weak growth is here to stay. However, we still see only a 25% probability of an outright recession in the next year, which is slightly above the historical average."
- Fed watch: Hawks squawk, Big Ben tolls "The difference between Bernanke and the more hawkish regional Fed Presidents has to do with flexibility. The Chairman does not have a dogmatic leaning for or against asset purchases and his threshold to launch QE II, while high, is likely to be much lower than his more hawkish colleagues."
- Housing watch: On the brink "The June S&P Case Shiller home price report showed a gain in home prices in June, but it may be the last in awhile. Similar to Loan Performance and FHFA, we expect Case Shiller to turn lower amid a growing imbalance between housing demand and supply."
- The week ahead: Data takes a week off "It will be a relatively light week on the economic calendar. Markets are closed on Monday for the Labor Day holiday. The main event comes Wednesday, when the Fed releases their Beige Book. The report will provide us with anecdotal evidence on the state of the economy from the 12 regional Fed districts and should highlight the sluggishness of the economy. On the data front, we receive the July trade balance on Thursday and wholesale inventories on Friday."

Merrill Lynch US Economic Weekly 20100903

Growth recession launches QE2

- "After salami-slicing our forecast in recent months, we are ready to make a deeper cut. We now expect a growth recession: we think the economy will manage to post positive headline GDP numbers, but this growth will not be fast enough to keep the unemployment rate from drifting higher. We expect below-trend GDP growth in each of the next four quarters, and with a gradual rise in the unemployment rate above 10%. With the weaker growth, we believe the Fed will launch QE2—a new asset buying program—in Q1 of next year. Our interest rate team expects this to push 10-year yields below 2% in the early part of the year."
- "Recent data show a steady deceleration in growth. After surging in the first few months of the year, the two most important monthly indicators—private payrolls and core retail sales—have stalled (Chart 1). At the same time the post-tax-credit housing hangover has been worse than expected, and even the business equipment recovery shows signs of faltering. Our sense is that the growth recession is already here and it is likely to linger through the first half of next year."
- "For 2010, our full-year GDP forecast has been sliced 0.1ppts to just 2.6%. For 2011, we have shaved growth 0.5ppts to just 1.8%."
- "The downward revision comes from weaker anticipated spending from both consumers and businesses. With business confidence weakening and the economy slowing, we took our 2011 capex forecast down to 7.0% from 12.0%."
- "And, given the protracted inventory overhang in residential real estate and weaker labor market, we assume a long, even more painful, U-shaped housing recovery."

Merrill Lynch Economic Commentary 20100901

What if the US double dips?

- Global: What if the US double dips? "While an outright recession seems unlikely, the US appears to be sliding toward a “growth recession.” We think the global economy is more resilient to shocks from the US, but decoupling is unlikely."
- United States: One is the loneliest number "With two-consecutive quarters with a one-handle, the US is dangerously close to a “growth recession.” Structural unemployment has increased but most of the rise in unemployment is cyclical."
- Canada: Bank's rule to rule "The Bank’s own policy rule suggests rates are at emergency levels, ie, too low, and at least one more 25bp hike is in the cards in September."
- Euro area: Germany’s interlinked recovery "Growth remains heavily export oriented – slower growth elsewhere in the global economy could have a notable impact on Germany, and in turn many other Eurozone economies."
- UK: The unwinding (or not) of imbalances "Some of the imbalances in the UK economy have ameliorated in recent quarters. But in part, that has come at the cost of exacerbating others."
- Japan: Strong yen starts to take visible toll "Yen appreciation has started to constrain exports in value terms through falling prices, as evident in the steep drop in export prices to the EU."
- Australia: Take me to your leaders "Take me to your leaders. No, not Abbott and Gillard trying to put together a minority government, but wilting leading economic index."
- Emerging Asia: India’s BoP "India’s balance of payments risks are overdone, in our opinion. To us, a la August 2006 and October 2008, apocalyptic concerns about the current account deficit appear to be a bundle of internal contradictions."
- Emerging EMEA: EEMEA rates about to turn? "Are EEMEA rates about to turn? We don’t think so. We also show that in previous cycles rates only started to rise 50-100D before the first rate hike."
- Latin America: What’s going on with domestic demand? "During past Mexico ecessions, recovery dynamics have been pretty similar: initially led by external demand through the rebound of the manufacturing sector, and then gradually spreading to other large sectors of the economy."

Merrill Lynch Global Economic Weekly 20100827

Staking a claim

- What do we make of the rise in claims? "Last week’s rise in initial jobless claims to the psychologically important level of 500,000 has been met with heightened market scrutiny and suspicion. Initial claims, like most pieces of economic data, are subject to seasonal adjustment.
And, it is widely accepted that initial claims are notoriously difficult to adjust, particularly during the summer given school layoffs, holidays, and factory shutdowns in the auto sector. Now, a series of additional theories have surfaced attempting to explain the recent jump in initial claims:
• The extension of benefits back in July could be prompting Americans whose assistance ran out to file new claims in the regular program rather than file for the extended claim.
• A surge of Census laid-off workers filing for initial claims. Most of the Census layoffs have come during the summer.
• With the war in Iraq starting to wind down, we could be witnessing a rise in initial claim filings from our servicemen and women as they return home."
- If there is a bias in claims, it is upward and chronic "At the outset, let us say if there is a bias in the claims data, to quote the Department of Labor (DOL) official we spoke to, “it is an upward one” that is chronic. This is because an individual does not have to be eligible in order to file an initial claim. Initial claims are administered by states, which are required to take the claims form regardless of eligibility. The question that needs to be addressed is the extent to which the factors listed above are creating an abnormally large upward bias."
- There is a modest additional upward bias in initial claims "Our view is that these additional factors are having a limited upward impact on the initial claims data. The data from the Labor Department on actual payments allows us to create an implied approval rate, which supports our claim. This is important because while anyone can file and show up as an initial claim, what matters is if the government actually pays the claimant."
- Quantifying the upward bias "As of July, approvals ran at 69%. There is seasonality to this data and this is slightly below the 74% July average during the 2005-2007 period when the DOL was not making emergency benefits payments (Chart 1). So, taken literally this implies a 5% upward bias to the latest reading, or about 25,000. That would still mean claims are north of 450,000 and consistent with almost no growth in private employment."

Merrill Lynch Economic Commentary 20100826

One is the loneliest number

- Macro viewpoint: One is the loneliest number "With two consecutive quarters with a one-handle, the US is dangerously close to a “growth recession.” Structural unemployment has increased but most of the rise in unemployment is cyclical."
- Fed watch: Ben buys time "As expected, Fed Chairman Bernanke departed from the usual script at Jackson Hole. He focused on explaining the logic behind policy rather than a specific road map. The speech buys time for the Fed to determine if the economy is weak enough to warrant action."
- Housing watch: Bringing down the house "Home sales collapsed to a new record low while inventory edged higher, widening the imbalance in the housing market. The looming shadow inventory likely will keep this gap wide."
- The week ahead: Anemic August payrolls "The overall mood of the data this week likely will be downbeat. We are only expecting +30k in private payrolls growth in August. Given the accuracy of forecasting payrolls, there is a risk that private payrolls print negative."

Merrill Lynch US Economic Weekly 20100827

Housing: An abnormally long journey back to normal

- We expect a sluggish U-shaped housing recovery "Housing data have been decidedly weak with home sales tumbling to record lows, housing starts spiraling lower and home prices slipping back. Part of the recent deterioration reflects the volatility induced by the homebuyer tax credit, but even more so, a slower-than-expected jobs recovery. The main factor determining the fate of the housing market will be the macro backdrop. If the economy falls back into recession, which we judge to be a 20% probability, the housing market will follow suit. Otherwise, we expect the volatile bottoming in the housing market to persist for some time, creating a long, painful, U-shaped recovery."
- Another five years until a “normal” housing market "We define a normal housing market to be one in which housing starts are trending at the historical average of 1.5 million homes a year. In our view, we are several years away from this state of normalcy. Housing supply has outpaced housing demand by about 2 million homes over the past few years and is on pace to add another 500,000 excess homes by the end of 2012. For this excess to clear, housing starts must remain at a depressed level, not returning to normal until 2015. This would make it the slowest housing recovery in post-war history."
- What to watch? Labor market and foreclosures "There are two primary interrelated factors that determine when the housing market will normalize: 1) the health of the labor market and 2) the pace of foreclosures. On the demand side, high unemployment and foreclosures will greatly reduce the pace by which new households are formed. Fewer new households will be created as young adults stay with their families longer or live with roommates amid high unemployment and concern about job security. In addition, the loss of homes due to foreclosure leads to doubling up and excess supply."
- Housing will not help, but should only hurt a little "The recession caused serious stress and imbalances in the housing market which will take considerable time to correct. Unlike in prior recoveries, this means that the housing market cannot be looked to for stimulating the recovery, but we do not see much of a drag left from housing construction. The bigger downside risk, in our view, comes from the trajectory of home prices. If foreclosures flood the market faster than we expect, home prices could take another serious leg down, tipping the economy back into recession. The interplay between the economy and the housing market should not be underestimated in our view."

Merrill Lynch Economic Commentary 20100824

It’s not always sunny in Philadelphia

- Macro viewpoint: Its not always sunny in Philadelphia "The economy continues to slow and the risk of a fiscal accident is growing."
- Fed watch: Can Bernanke quell the cacophony? "We would have hoped Chairman Bernanke would speak first after the August FOMC meeting and clarify the view of the majority. Instead, we got noisy clatter from a number of hawks, all of whom we believe are unlikely to reflect the prevailing positions on the outlook or policy by most Fed officials."
- Housing watch: A mini double-dip in housing construction "The housing market is a key barometer of the underlying health of the economy. We are therefore launching a new, “Housing Watch” note within the US Economic Weekly to keep our readers in tune to the evolving state of the housing market."
- The week ahead: Taking a bite out of 2Q GDP "Chairman Bernanke will be delivering a closely-watched speech at the Kansas City Fed's annual Jackson Hole Symposium on Friday. The theme of the conference is “Macroeconomic Challenges: The Decade Ahead.” On the data front, the Bureau of Economic Analysis will likely take a bite out of 2Q GDP. With the trade gap widening even more then initial estimates, we expect 2Q GDP to be revised down almost a full percentage point to just 1.5% annualized from 2.4% previously. Keeping with the theme over the last several weeks, we expect better manufacturing sector data (durable goods orders) to offset the weak numbers emanating from the housing market (new and existing home sales)."

Merrill Lynch US Economic Weekly 20100820

Metals: Balanced view for 2H10, but upside for 2011 intact

- Metals prices have been trading within a range this year "Following sharp price gains as the global economy emerged from recession, metals have been trading within familiar ranges during the past few months. This was peculiar because copper fundamentals strengthened visibly, with LME stocks for instance drawing since March. Physical copper premia, which are a good indicator for the tightness of regional metal markets, have also generally been well supported and rose to an extremely high $150/t in China. Subdued upward pressure on base metal prices has been heavily influenced by increasing macro headwinds as the initial steady recovery started to fade. Headwinds have been reflected in a host of indicators, with last week’s release of US trade data suggesting that 2Q GDP growth is tracking at only 1.3% QoQ annualised according to our economists. There is also evidence of a slowdown in China, the most significant metals consumer, as the government has been tightening policy selectively."
- We see some downside risks to base prices during 3Q10 "Activity in the metals industry normally slows during the summer months, which often reduces price support during that period. With this in mind, we believe that there is a risk for prices to come under pressure and copper could fall to $6,500/t ($2.95/lb) in the coming weeks. Yet, at the same time we see scope for an increase in activity later in September, which should support metals quotations. Our generally balanced short-term view also implies that price movements will likely remain choppy. Nevertheless, without a double dip, we believe that metals should be well supported in 2011."
- Despite uncertain outlook, we keep positive view for 2011 "Our generally positive view on metals for 2011 is based on the BofA Merrill Lynch Economics team forecast that global GDP will rise by 4.2% YoY, following a 4.6% expansion in 2010. It is worth noting that even though Chinese authorities will likely keep a tap on speculative activity in the property sector, measures have been taken that should at least partially offset that. Nevertheless, despite persistent supply constraints for some metals, risks are skewed to the downside and any signs of a sharper than anticipated slowdown (which is not our base case) would likely lead to a reduction of our forecasts. Meanwhile, we also reinforce our gold call and see prices gradually rising to $1,500/oz during the coming 18 months."
- Upgrades to longer-term prices "Using a combination of project incentive prices and marginal production costs, we have adjusted our longer-term prices."

Merrill Lynch Metals Strategist 20100817

A Cautious, Careful Consensus

- The August consensus: cautious and careful "Our August FMS reveals a consensus that is cautious on global growth and risk. The bearishness of June & July has abated. But few investors hold extreme views or extreme positions right now, so directional signals from the August FMS are limited."
- Growth expectations stabilize, trough in China "The collapse in growth expectations in June and July was followed by stabilization in August. A mere 5% of investors forecast stronger global growth in the next 12 months, but a large 78% majority do not expect another recession. China growth expectations have troughed: the growth diffusion index rises sharply to -19% from -39% last month, which caused commodity exposure to rise."
- Risk metrics back in their trading range "In a new question our survey said the two largest "tail risks" are premature fiscal tightening and US municipal/EU sovereign debt defaults. That said, risk appetite in August has stabilized. The BofA-ML Risk Appetite & Liquidity Index rose to 39, a fraction below the long-term average level. The average investor cash balance fell to 3.8% from 4.4%. But hedge fund net exposure remains near a 4-year low."
- Still uw bonds, but raising exposure to commodities "No contrarian "sell signal" for bonds: global asset allocators remain stubbornly underweight bonds (exposure dropped to -23% from -15%) and modestly overweight equities (broadly unchanged at a net 12% ow). Commodity exposure has risen to 9% ow from marginally uw last month."
- Out of US/Japan into Europe/UK "Big drop in exposure to US, with a net 14% uw the market, the lowest level since Jan'08. Big drop in exposure to Japan, with a net 27% uw. A net 62% of investors view the Yen as overvalued, the highest reading on record. Big rotation into Europe (+11%) and to UK equities (lowest uw since May '07). GEM remains the most preferred region (+38%) for asset allocators but is not at extreme levels (a net 53% were ow last Nov)."
- Out of utilities/pharma into banks/industrials "August saw rotation into banks, though investors are still uw (-19%), and further rotation into industrials (+12%), financed by lower weightings in pharma (12% ow from 23% last month) and utilities (-27% = least loved sector). Tech remains the most-favoured sector (net 34% ow) despite recent underperformance."
MerryllLynch_Fund_Manager_Survey_Global_20100817

The new “untouchables”

- Introducing our “musings on” series of reports "To move away from reactive writings on short-term issues, we’d like to introduce our new series of reports called “musings on”. In this series, we will write about long-term issues and try to think laterally. Some of our musings will have immediate market implications, but many, we suspect, may not. In our inaugural issue, we will contemplate on sectors that may face significant policy risks over the next few years as China undergoes structural reforms. We name them the new “untouchables” for effect and it doesn’t mean we won’t recommend them from time to time for other reasons."
- Untouchable No. 1 - monopolies "Many protected sectors are earning high ROEs and the government is going about changing that by capping salary growth, introducing private competition, limiting fee increases, and imposing additional taxes. Sectors vulnerable here include banks, energy and other resources, IPPs and telcos, by our assessment."
- Untouchable No. 2 – twin-high industries "I.e.,, high energy consuming and highly polluting industries e.g., steel, cement and metals. They benefited greatly from China’s investment-driven growth and have not paid their fair share of resources and environment costs. The government has rolled out a resources tax, cancelled tax rebates and concessionary tariffs, limited financing and shut down operations. It may also impose an environmental tax and a carbon tax, and raise environmental standards and charges."
- Untouchable No. 3 – property developers "Rightly or wrongly, many people in China are blaming developers for unaffordable houses and the government’s policies have turned increasingly hostile, e.g., cracking down on investment/speculative demand, expanding welfare housing programs, doubling land supply, collecting more taxes and restricting funding. Real estate taxes, property taxes and a capital gains tax may also be on the way."
- Untouchable No. 4 – public goods/services providers "The government has vowed to check their costs carefully to prevent excessive profits. This may undermine pricing power in a broad range of sectors, including fertilizer makers, drug makers, gas suppliers and distributors, IPPs, ports, airlines, airports and financial service providers."
- Untouchable No. 5 – the market "Untouchables No. 1-4 accounted for some 90% of market earnings in 2009."

Merrill Lynch China Musings on 20100813

BIS3: Some reprieve, with US banks OK on capital/liquidity

- BIS3: US Banks OK given softer standards, longer timeline "Proposed changes to BIS capital and liquidity standards have been a key source of uncertainty for Global Banks. Original proposals were vague but harsh, particularly as it related to liquidity requirements and timeline. BIS has now pushed back implementation dates for key items and softened some effects including deductions from Tier-1 Common, netting of derivatives, and liquidity requirements. We believe, US firms appear well armored in terms of capital/liquidity, with JPM strongest on relevant metrics. See tables on pg 3 for impact of key BIS3 capital/liquidity standards on US brokers/money center banks."
- JPM, GS, C well positioned for early capital deployment "Under our base case which assumes 2.5x Market Risk RWA (i.e. trading book) “inflation”, we believe the 4 big US dealers we cover appear sufficiently capitalized to meet BIS3, with JPM, GS, and C well positioned for early capital deployment in 2011, MS in 2012. Under BIS3 liquidity req. (Net Stable Funding ratio >100%), we est. C and JPM are already at or above 100% target while GS and MS are currently below it - though given NSF ratio isn’t mandated until 2018, they have ample time to reach target. Based on our analysis, C appears most liquid (105%), MS least (86%)."
- Scenario: Rising RWAs, Core Tier-1 target of 6,7,or 8% "Impact of RWA “inflation” on BIS3 CT-1 ratio (i.e. adjusted T-1 Common) hard to estimate as capital targets not set and US banks report RWA under BIS1. In our scenario analysis, we assume: Market Risk RWAs rise 2x-5x; counterparty credit risk RWAs rise 37.5%; a CT-1 target ratio of 6, 7, or 8%; no increased capital deployment; and roll forward RWA & earnings to 2012E. Results show JPM, C best positioned to withstand higher multiples of Market Risk RWA. Note though, C may face higher RWA “inflation” than peers (see below)."
- Stressed VaR to drive differences in RWA “inflation” "Comparing VaR across firms is treacherous given different methods of calculating it. However, comparing VaR reported at “peak” stress periods to Market Risk RWA, we can estimate how much of a firm’s RWA drives capital to support “normal risk” and how much reflects extra “cushion” for “tail risk”. Firms that currently fail to address “tail risk” face higher RWA “inflation”, we believe. Given VaR inconsistencies, we run 2 scenarios where we measure “tail risk” as a % of Market Risk (trading risk) and as % of combined Market and Credit Risk (cpty. credit risk). Based on our analysis, C appears weak on both metrics and could face higher RWA “inflation”. That said, given C’s excess CT-1, per our estimates, we believe it can withstand significant RWA “inflation” and still achieve min. CT-1 t argets. We also see potential for capital deployment at C, as early as 2011."

Merrill Lynch Banks Multinational Universal 20100812

A little help from my FED

- Do you need any money? Extending Quantitative Easing “to help support the economic recovery”. "The Fed addressed market expectations of reinvesting principal paydowns in the Treasury market in today’s statement. Yesterday, we highlighted that the failure to do so could result in shrinkage of the portfolio of around 15%, an implicit tightening the Fed now acknowledges it does not intend to allow. Notably, the NY Fed clarified the location of those purchases in the 2 to 10 year curve - precisely where the strongest rally in the Treasury curve has occurred since the end of June. That suggests much of today’s action was anticipated though clearly not all as the belly of the curve (5 and 10 years) outperformed today declining in yield by around 8 and 7 basis points respectively."
- Yields – the magic 4%. "In the euro credit market, flows have historically been dictated more by spread-based investors. However, in recent years, there has been a growing participation from investors that focus on yield: retail investors, insurance companies, and institutional investors managing absolute return funds. To meet return targets, investors will need to extend in duration, buy lower-rated cyclicals, or dip into BBs. We highlight bonds in the European space which are yielding over 4%."
- BIS3: Some reprieve, with US banks OK on capital/liquidity. "BIS3: US Banks OK given softer standards, longer timeline. Proposed changes to BIS capital and liquidity standards have been a key source of uncertainty for Global Banks. Original proposals were vague but harsh, particularly as it related to liquidity requirements and timeline. BIS has now pushed back implementation dates for key items and softened some effects including deductions from Tier-1 Common, netting of derivatives, and liquidity requirements. We believe, US firms appear well armored in terms of capital/liquidity, with JPM strongest on relevant metrics. See tables on pg 3 for impact of key BIS3 capital/liquidity standards on US brokers/money center banks."
- FOMC: Shift back into neutral. "Fed announces reinvestment plan. In an effort to “help support the economic recovery,” the Federal Open Market Committee (FOMC) announced plans to maintain the current size of its balance sheet by reinvesting the principal payments from its mortgage portfolio into longer-term Treasuries. This action is best thought of a return to a neutral stance for policy, in which mortgage runoffs are not passively tightening policy — rather than the first step toward an inevitable restart of outright asset purchases. The outlook for growth and inflation would need to deteriorate materially for the Fed to move to actively expanding their balance sheet further, in our view."
- Productivity declines for the first time since 2008. "Hours jump as output slows. Nonfarm business sector productivity fell an annualized 0.9% in the second quarter as output advanced 2.6% while employee hours jumped 3.6%. Employee hours have now increased for three consecutive quarters and the second quarter increase in labor input is the largest since 2006. The recent surge in hours worked suggests that the backdrop for employment is improving as employers have exhausted the current staff. The median of analysts’ expectations was for a productivity gain of 0.1%. Productivity growth in the first quarter was revised from a preliminary increase of 2.8% to 3.9%. The upward revision is due to an increase in output as hours worked was unchanged. Over the past four quarters, productivity increased 3.9%. For the four quarters ended 2009Q2, productivity increased 2.5%."
- China: Trade surplus widened on slower imports in July. "Bottom Line: China’s trade growth is softening in 2H. China’s export growth softened to 38.1% YoY in July from 43.9% in June, mainly on a higher comparison base. The reading was stronger than expected, suggesting external demand had held up well. On the other hand, import growth declined sharply, on a rapid fall of YoY growth in import prices and sequential slowdown of the Chinese
economy. As a result, trade surplus widened significantly in July from June."

Merrill Lynch Situation Room 20100810

Tired trade

- Global: Tired trade "The growth in global trade continues to slow, but we expect a soft landing in the year ahead. We are less sanguine about global imbalances: much of the improvement in the US trade balance appears to be cyclical."
-United States: To QE or not to QE, that is the question "The Fed’s decision to stop the run down of its portfolio has prompted a chorus of questions. We argue that the odds of another round of full-blown quantitative easing (QE2) have risen to 35%."
- Canada: Inflation on the horizon "With the output gap nearly closed, we continue to believe inflationary forces are building and a significant breach of the 2% target lies in the not-too-distant future. Euro area: Stunning differences in 2Q growth in Europe Eurozone 2Q GDP rose by 1.0% qoq, exceeding the 0.7% qoq consensus forecast. There were dramatic divergences, with Germany expanding by 2.2% qoq (9.0% annualized) while Greece contracted by 1.5% qoq (5.8% annualized)."
- UK: Slower growth, higher inflation once again "The BoE continues to expect inflation to fall back below target in the medium term, but with upside risks and unusually large uncertainties."
- Japan: Testing time for policy response to strong yen "In case the yen continues to appreciate, some options the BoJ could take include: (1) steps to reduce the term premium, (2) gearing up commitment and (3) formal quantitative easing."
- Australia: AUD – Parity or paucity? "The June quarter export surge and further rise in commodity export prices in July has revived interest in where the Aussie dollar will end up."
- Emerging Asia: Will China’s wheat prices follow suit? "A global wheat price surge should have limited impact on inflation in China."
- Emerging EMEA: "We review the Russia budget and conclude that the government forecasts mask two key underlying risks."
- Latin America: LatAm inflation: not concerned yet "The current grain supply shock is nothing like the global food crisis of 2007-2008 a nd as a result, the effects on inflation, rates and FX in LatAm should be marginal."

Merrill Lynch Global Economic Weekly 20100813

US deflation would likely imply higher USD

- Deflation is a potential scenario for currency markets "We take a very preliminary stab at considering the possible FX implications of such a scenario for G10 currencies. Risks on the deflation side have clearly been growing and our US economics team would characterize the odds of a return to QE in the next year as 35%, which is a substantial risk of such a bad outcome."
- We consider two different deflation scenarios "We consider two possible scenarios for the US in such a deflation environment: the “recoupling” scenario where deflation becomes widespread outside of the US, and the “decoupling” one where deflation starts and stays in the US. But our base case is that if deflation starts in the US, it will not stay limited to the US."
- Our base case deflation scenario: recoupling "Unlike Japan, which has been in deflation on its own, the US would wind up pulling the developed world into similar deflationary straits. Intuitively, this scenario feels like the most likely deflationary scenario for the US, in our opinion, given the central importance of the American economy to both the global growth picture and global financial markets."
- US-specific deflation could be quite USD-negative "The Fed would be implementing another massive round of quantitative easing as other banks either stand pat or normalize their own rates. Interest rate differentials would wind up tilted against the USD. In this state, the dollar would be viewed as the chief funding currency, replaying the great yen carry trade of 2005-2007."
- One commonality in both of our scenarios: more QE "In either case, there would likely be additional action out of the Federal Reserve for additional quantitative easing. Short term reaction depends crucially on policy: re-emergence of QE could mean a frenetic but short term USD sell-off, similar to what to December 2008. It is hard to overlook such an event given how frantic and powerful such moves can be; the move from 1.24 to 1.44 in that December 2008 episode was both stunning and deeply concerning. However, the persistence of such a move depends on the scenario."
- Limited currency lessons from Japan "While Japan has been in deflation, essentially by themselves, nominal JPY has bounced around a fair amount. But since the rest of the world joined Japan in financial, macro and banking dysfunction, deflation has become more entrenched and the risk properties more enhanced. There has also been a stronger JPY in both nominal and real terms."

Merrill Lynch FX Spotlight 20100813

To QE or not to QE, that is the question

- Macro viewpoint: To QE or not to QE, that is the question "The Fed has moved back into the spotlight. Here we address a number of the “frequently asked questions” about Fed policy."
- Fed watch: And now the hard part "While the Fed has not stated what would prompt renewed quantitative easing (QE), we expect it will act on sustained signs of weakness, and not just a couple of bad numbers. Hence we think the probability of a move at the next two meetings is low, but over the year ahead we see a 35 percent chance of QE."
- The week ahead: Softening manufacturing surveys "Sentiment takes center stage next week in the manufacturing and housing sectors. The Empire State and Philadelphia Fed manufacturing surveys will give an early indication of conditions in August. With the inventory cycle fading and the economy softening more generally, we expect both to paint of picture of slowdown but not outright contraction. Indeed, the industrial production report should show that manufacturing production continued to increase in July. In contrast, the housing data released this week is likely to be weak, with a decline in housing starts in July and depressed NAHB housing index. Homebuilders have kept construction at a feeble pace amid weak home sales and an uncertain economic outlook."

Merrill Lynch US Economic Weekly 20100813

Why Russia is not like China

- China sneezes, Russia catches a cold.. but not for banks "With Russia analysis increasingly focused on second-guessing Chinese industrial policies, we were not surprised to be asked about the potential read-across from the Chinese banks stress-test for 60% real estate price falls. Our Chinese banking colleagues conclude this is a potential negative for the sector from an earnings perspective, but not a threat for book value. For Russia, we conclude that there is very limited read-across we can reasonably see:
• the Russian real estate market is at a different point in the cycle vs the Chinese property market as prices have already corrected and activity levels remain relatively subdued
• Russian banks’ mortgage exposure is much smaller, at 6% of gross loans (vs 11% in China) and only 2.5% of GDP (vs14.8%)
• Mortgage momentum remains subdued, with mortgage y/y growth finally in positive territory in May (but up 49% in China)
We look at CBR stress-tests, which were historically more concerned with market volatility (FX, bond, equity price moves), depressed macro environment & liquidity. With 12.4% of sector loans to real estate, including construction & developers, we show that brutal assumptions of 20-50% NPLs with 40-50% recoveries lead to losses equal to 20-22% of equity. Considering non RE collateral revaluations, this adds a shortfall equal to 13% of system loans."
- 2 sector catalysts: stabilising NIMs & volume growth "We continue to favour Russian banking sector, with Sberbank our key pick in EEMEA. We believe there is a strong catch-up & rerating argument considering the performance lag to GEM peers, and we are encouraged by positive developments in 2 key variables: margins & volumes. First, volumes in both retail and corporate have turned a corner and have shown consistently improving momentum (June up 2.1% m/m, July +1.1% FX adjusted, notwithstanding the seasonality and heat-wave). Secondly and even more importantly, is the easing in corporate loans pricing pressure, a lead indicator for future margin evolution. Interest rates on corporate RUB loans rose 10bp in June to 11.5%, while retail deposit rates dropped 40bp to 6.3%, boding well for NIM stability in 2H."
- Foreign banks 2Q results – restarting the engines "With Russian banks results still to be published mid August/ beginning of September, we note the improving trends in foreign banks’ 2Q results: volumes & revenues are up, with provisions volatile q/q but still on an improving y/y trend. Unicredit reported E54m PBT, while SocGen remains loss-making (E42m PBT loss). Due to report on 31 Aug, we see RAIF post E55m PBT in Russia (vs E11m in 2Q 2009)."

Merrill Lynch Russian Banking 20100811