C.M.O. 8.1.2011

Two things deepened last week.  The first was man’s ability to explore the depths of the ocean as Jiaolong, a manned deep-sea submersible named after a mythical Chinese sea dragon, reached a depth of 5,057 meters or 16,591 feet for those of us in this side of the pond.

This would seem to mark China’s continuing technological advancement but Anil K. Gupta and Haiyan Wang wrote in the Op-Ed section of the WSJ last Thursday that while Chinese inventors filed 203,481 patent applications in 2008 according to the World Intellectual Property Organization more than 95% of those applications were filed domestically with the State Intellectual Property Office and that “the vast majority cover ‘innovations’ that make only tiny changes in existing designs.

From this it would appear that the trouble with the reverse mergers we are hearing about with ADRs from the Middle Kingdom is bringing back memories of when “Made in China” was not such a good thing.  All of this while the Xinhua news agency castigated U.S. leaders calling on them to show “some sense of global responsibility”.  What is it they say about people who live in glass houses?

The only other thing that went deeper than the Jialong last week was the morass in Washington over an agreement on the debt ceiling.  What is interesting is that the debt ceiling has actually been raised 78 times in the last 50 years and to keep the record straight 49 of those raises came under Republican presidents while only 29 came under Democratic administrations.

All of the hoopla had the pundits and prognosticators piqued with such luminaries as Philippines Secretary of Finance, Cesar Purisima warning, “once people lose confidence in the U.S. dollar-and they are starting to-it will affect Americans more than what they are fighting about now”.

Even the Big Apple’s Mayor Bloomberg chimed in saying “That the United States of America has come this close to defaulting on its debts – a failure that would have potentially disastrous economic consequences for us all, including New Yorkers – ought to be all the evidence anyone needs that there’s something profoundly wrong in Washington”. To wit there is only one response.  Marvelous grasp of the obvious Mr. Mayor!

None of this though seemed new to David Simon, CEO of Simon Property Group as he said during his company’s earnings call last Tuesday that Uncle Sam is “always 30 days delinquent” on the rent for space it leases from the mall owner.

Which brings us around to the question of how the credit of the U.S. of A. is actually viewed at the moment?  5-year default protection for U.S. Treasuries peaked at 64bps last week which was the highest level seen since the 63bps spike on 2/8/2010 and the period between December of 2008 and March of 2009 when the CDSs on USTs stayed above the 60bps for almost four straight months.

Also of note here is that 1-year protection is trading more expensively than 5-year protection which shows that while the situation is acute, the market believes that if we can make it through the next 12 months we should be around in 60.  One-year CDS protection on the equivalent of 10MM Euros ($14.3MM) of U.S. Treasuries cost E83,000 annually last Wednesday up from E53,000 a week ago Friday according to Markit, the financial data provider.  If you’re questioning why protection on Treasuries is purchased in Euros the answer is that if the U.S. defaults it would be pretty tough to get paid off in the currency of the country that just defaulted.  Not that the Euro is in any better shape at the moment.

A review of the cost of 5 year protection on Bloomberg shows a total of 129 companies that have cheaper default insurance than Uncle Sam at the moment including some with ratings as low as BBB.  (Thank you Time Warner Inc.; TWX)

With all of the focus on whether Uncle Sam is headed to debtor’s prison, recent events in the world of sovereign debt lead Michael Cirami, a portfolio manager at Eaton Vance to ask “What’s the point of these contracts if you have a loss but it doesn’t actually trigger them?  You have to call into question their value.”  Credit-Sights analysts said as much in a July 24th research report stating that the structure of the current Greek bailout “undermines the efficacy of sovereign CDS as a legitimate hedging tool.”

To add to all of this confusion the credit rating agencies, whom a U.S. panel investigating the financial crisis concluded that the crisis “could not have happened without” are being coy as to what happens if the budget isn’t fixed and the debt ceiling isn’t raised as Standard & Poor’s Ratings Services’ Deven Sharma, the credit-ratings firm’s president told a House sub-committee that the company was “waiting to see what the final proposal is” before they would downgrade America’s debt.

Michael Feroli, a top economist at JP Morgan Chase says, “Whether I look domestic or foreign, I don’t see huge implications.  The market would appear to agree with Mike as the yield on the benchmark 10-year note fell to 2.771% last week which was the low of the year and the lowest since November 30, 2010.  In comparison Australia with a AAA rating pays about 4.9% to borrow money for ten years and Japan, rated AA pays just 1.1%

Since these are truly uncharted waters the question to ask might be the one Mohamed El-Erian, CEO and co-CIO of Pimco recently did relating to a possible downgrade; “Will the system simply re-normalize, and therefore the implications will be limited? Or will the loss of the absolute ‘risk-free’ asset (i.e. no credit risk, just interest rate risk) cause a series of structural breaks?”

Economist Carmen Reinhart of the Peterson Institute for International Economics has a completely different take on the situation believing that “a downgrade will accelerate efforts by governments on both sides of the Atlantic to de-emphasize rating-firm opinions”.

So, one might ask, what effect are all the debt deliberations having on the corporate world?  With 300 or 66% of the S&P 500 companies having reported 2nd quarter earnings 72% or 239 have beaten estimates according to Capital IQ, a financial data provider and analyzer.  What’s more 85% of tech sector companies and 74% of consumer discretionary companies have topped expectations.

Earnings grew 18% YoY in the 2nd quarter with all 10 sectors of the S&P 500 posting profit growth marking the seventh straight quarter of double digit growth.  The strongest sectors are Materials (up 50+%), Energy (up 37%) and technology (up 24%).

Nancy Lazar, co-founder of and economist at International Strategy & Investment Group, said of the earnings numbers, “the backbone of our country is companies, and you are seeing their incredible strength”.

Binky Chada, strategist at Deutsche Bank believes that the economic trend most salient to corporate performance is real gross domestic product excluding government and housing activity.  This has grown, he says, at a 4.6% rate for the last two years and was up 1.8% last quarter versus the 1.3% headline GDP figure.

All of the wrangling over our nation’s debt hasn’t phased the market for corporate debt and most specifically the non-investment rated kind.  “What’s benefitting the high-yield corporate market today is a lack of investment alternatives”, says Jim Casey, co-head of leveraged finance at JP Morgan Chase.  That lack of alternatives really benefitted HCA Holdings Inc. (HCA), as the nation’s largest for-profit hospital operator raised about $5BN last week in the biggest junk bond sale since 2008 at a weighted average spread of about 413bps over Treasuries.  And lest we not forget that the sale went off one day after HCA reported weaker than expected earnings.

HCA’s 5 year credit protection closed the week at 422bps up from its low for the year of 327bps on 2/21/2011 and the stock closed on Friday at a multi-year low of $26.68.

Also on the brighter side of things Francois-Henri Pinault, CEO of PPR SA, a conglomerate that owns Gucci, reported strong results and was upbeat about the trend in the coming months.  “Unless there is a major event which leads to a global crisis, the super-rich don’t necessarily feel affected”, said Antoine Belge, a luxury analyst at HSBC continuing, that it is important “to see if this psychological trend continues”.

From the ground up it would appear that individual companies are returning to economic function.  From Washington, however, it’s dysfunction as usual.

Enjoy the week, trade smart.

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