Western authorities should also explore the vulnerability of Russian assets abroad. At the least, they can make life difficult for the holders of those assets. Post-Soviet Russia allowed the emergence of businessmen and entrepreneurs who indeed wish to function as normal participants in world commerce. Their number, however, assuredly includes the lucky billionaires under Mr. Putin's protection. All of them want to benefit from the West's rules. That privilege should be restricted so long as Mr. Putin breaks the rules. In the world of global commerce, reputation matters. China has calculated that its own ambivalent reputation can only gain from staging the Olympic extravaganza. The glow of the Games is money in the bank. By contrast, the Putin government has embarked on a strategy that seems to believe its power grows in sync with its reputation as an international pariah, an outsider state. Mr. Bush said Friday that "Russia has damaged its credibility and its relations with the nations of the free world." True, and if the West remains firm, it can make clear to Mr. Putin that the political price of behavior beyond the pale of normal relations is high. Overrunning Georgia was easy. Life after that should not be.

We think NetEase’s results demonstrate that it has the ability and experience to expand the life cycle of its online games despite the fierce competition in the Chinese online gaming market. However, we are concerned that NetEase’s current games have gotten long in the tooth, and new games may not be as successful as its current popular games. We need more time to confirm whether its growth momentum in the fourth quarter is sustainable in the future. Therefore, we are maintaining our Hold rating on NetEase.

The factors in the company’s favor are online gaming and advertising revenues. The potential opportunity for online usage in China is huge, with 253 million internet users. This means only 19% of its 1.3 billion citizens use the Internet as of June 2008.

Based on our estimate for fiscal year 2008 earnings per ADS, the stock is trading at 19.1x, which is well below the industry average and similar to its Chinese peers. Based on our estimate for fiscal year 2009 earnings per ADS, the company is trading at 17.4x, which is far below the industry average. Using a P/E multiple of 18.3x our fiscal year 2009 earnings per ADS estimate yields a target price of $25.25 which we believe reflects the company’s prospects.

Read the full analyst report on NTES

And naturally, the rally in the greenback is kicking gold lower ...

 Gold could make a stand here. But the bullishness in the dollar tends to tell me that gold will go down to test that weekly uptrend I've marked as (2).

Now, let's look at the CRB Index, a broad commodity index (though it is weighted heavily toward energy) ...

 It is testing support as well. So, maybe this will bring a rally early next week. I think I've pointed out why that rally could fade quickly.

And sure, energy could lead the rally. But pay attention to agriculture -- that's where I'm seeing some real bullishness right now.

IN OTHER NEWS ...

URANIUM

Cameco Cuts Production Target by 1 Million Pounds
Cameco said its share of uranium production for 2008 is now projected to total about 19.6 million pounds of U3O8, down from the previous forecast of 20.6 million pounds of the fuel used to power nuclear generating plants.

XX Sean’s note – good thing Cameco got that sweetheart, hush-hush deal to resell 550 tonnes of Iraqi uranium, or it might have to cut its production target even more, eh? Now, how’s your money bet on Cameco cutting its production target again? Do you feel lucky?

Uranium One Reduces Production Targets Of Dominion Mine
The company said that it expected to produce 320,000 lb of uranium from Dominion this year, compared with a previous forecast of 590,000 lb.

XX Sean’s note – A slew of companies have cut production targets. Keep an eye on the spot market over the next couple weeks and let’s see if utilities are getting nervous.

Raids Suggest Russia Targeted Energy Pipelines
A neat row of large craters in a field in southern Georgia strongly suggests that Russia dropped bombs near oil and gas pipelines bringing fuel to the West.

XX Sean’s note – this story is in the Wall Street Journal, which hands its political reporting over to crackpots and wingnuts, so take it with a grain of salt. Also, while Russia won the war on the ground, Georgia has won the information war hands-down. On the other hand, would you put it past the Russians to bomb Georgian pipelines? I sure wouldn’t – I think Russia is trying to build a new Empire of Energy. The only question in my mind is, if this is true, why didn’t Russia follow through?

US Economy

U.S. Industrial Production Unexpectedly Gains 0.2%, Led by Cars, Metals Industrial production in the U.S. unexpectedly rose in July, helped by gains in automobiles, metals and machinery.

CHINA

China's Factory, Property Spending Growth Quickens on Disaster Rebuilding China's factory and property spending growth accelerated, fueled by rebuilding after the Sichuan earthquake in May and snowstorms in January and February.

COMMODITIES

Silver, Oil, Wheat, Copper Plunge as Dollar's Rebound Saps Commodity Boom Gold plunged below $800 an ounce, platinum posted the biggest drop in almost seven years and oil, corn and copper slumped as the dollar's rebound reduced the appeal of commodities after a six-year boom.

OPEC Leaves 2009 Oil Demand Growth Estimate at Lowest Rate in Seven Years The Organization of Petroleum Exporting Countries, the supplier of more than 40 percent of the world's oil, left its forecast for 2009 oil demand growth unchanged at the lowest rate in seven years and warned that consumption may fall further.

OPEC's 2008 Oil Revenue to Exceed U.S. Income Tax Receipts: Chart of Day OPEC is pulling in more money from oil sales than the U.S. government is raising from individual taxpayers.

As Aegon is focusing mostly on life insurance, its position in the market is more favorable compared to non-life insurance companies as mentioned above. The company has also further strengthened its distribution channel in Spain and is entering new growth areas such as Mexico and India and China.

The stock has declined significantly along with the recent market sell-off. At current multiple of 6.0x our current 2008 EPS and 1.1x Book, the stock is trading at a multiple substantially below the average of that of its peers. As such, fundamentally we think that there will be potential gain for stock in the near term. Our six-month target price is $17.00. Full-year dividend has been increased by 13 percent.

Read the full analyst report on AEG

Its profit margin continued to improve due to strong revenue growth and increased commission per ticket sold. CtripÂ’s results were driven by growth in all of its business units. We think CtripÂ’s past results demonstrate that the companyÂ’s long-term growth story remains intact under almost all circumstances.

Ctrip primarily targets the fast-growing frequent independent traveler (FIT) segment as opposed to the traditional tour-group focused travel agencies. The company expects its growth to be driven by the expanding FIT segment. Moreover, the company has a solid competitive advantage with 95% of its hotel bookings revenue coming from star-rated hotels, which offer higher commissions.

Furthermore, CtripÂ’s scalable and profitable business platform provides the company with a high degree of operating leverage. We expect Ctrip to further increase its operating leverage as it shifts customer bookings from call centers to the Internet, which is more cost-effective for the company.

Based on our estimate for fiscal year 2008, earnings per share, the company is trading at 46.7x, which is higher than the industry average. Based on our EPS estimate for fiscal year 2009, CTRP shares are trading at 32.4x, which is similar to industry average. Using a P/E multiple of 37.3x our fiscal year 2009 earnings per share estimate yields a target price of $50.00, which we believe reflects the companyÂ’s solid growth prospects.

Read the full analyst report on CTRP

In response to its solid quarter, shares had jumped 18% by midday Thursday.

"Although the travel industry in China encountered many difficulties during the second quarter of 2008 after the Sichuan earthquake, Ctrip delivered solid revenue and earnings growth," said CEO Min Fan.

Looking forward, CTRP expects third-quarter net revenue growth between 15% and 20% year over year.

CTRP is a Zacks #3 Rank company.

Improved pricing and product mix, along with the positive benefits of the restructuring activity and acquisitions, are helping to realize sales gains. Presently, the companyÂ’s fastest growing markets are China, Latin America and Eastern Europe.

The management is currently using Lean Six Sigma to drive productivity in the corporation. However, a slumping housing market slowed demand for architectural and wood coating products. Moreover, higher raw material costs are eroding margins for the company. These prompt us to rate the stock a Hold with a six-month target price of $22.50.

The industrial paints business is also posting strong numbers on the back of an industrywide recovery and global sourcing. ValsparÂ’s relationship with large retailers such as LoweÂ’s Companies Inc. (LOW) a U.S.-based retail chain of home improvement and appliance stores remains a steady source of demand.

The companyÂ’s discretionary spending on items other than employment costs is down 10% year-over-year. The capital spending was down by 45% for the third quarter of fiscal 2008 and will be down 40% year-over-year in fiscal 2008. The company anticipates capital spending of approximately $45 million in fiscal 2008.

Read the full analyst report on VAL

Read the full analyst report on LOW

However, pricing pressures from original equipment manufacturers (OEM) and excess capacity have negatively affected the company. Although, this has been partly offset by the company’s focus on manufacturing efficiency and cost control. Thus, we rate the stock a Hold, with a six-month target price of $20.

The management is committed to continuing the diversification of its OEM customer base, improving operational efficiency, cutting costs by automating certain production lines and seeking lower-cost facilities abroad. International sales are likely to grow from 12% of sales to 15% of sales in a few years.

Aluminum wheels have outpaced steel wheels by being lighter, so 65% of all vehicles now have aluminum wheels, a ratio that has been increasing by 1% per year. For trucks, the ratio is 70%, while for cars, the ratio percentage is in the high 50s. Aluminum truck wheels now generate about 60-65% of the company's business. The company is likely to grow due to customers such as Toyota (TM), Honda (HMC) and Mitsubishi.

While Superior has gained from its significant exposure to Ford Motors (F) and General Motors (GM) in the past, this dependence is now becoming increasingly worrisome. Pricing has been weak, which is a function of producers in China, who are trying to undercut Superior Industries by $5-$10 per wheel.

Read the full analyst report on SUP

Read the full analyst report on TM

Read the full analyst report on HMC

Read the full analyst report on F

Read the full analyst report on GM

Despite this, we are raising our diluted EPS estimates to $3.75 from $3 for 2008 and to $4 from $3.15 for 2009, due to higher revenue growth from current strengthening in spot tanker freight rates reflecting increasing tanker demand, limited tanker fleet supply and higher volumes of crude imports into China.

Our estimates do not incorporate potential revisions related to changes in the accounting treatment for derivatives. TK announced that these changes will necessitate restatements of financial results back to 2003. We believe the dividend is safe.

Demand for oil tanker capacity has been rising due to continued global economic growth. According to the International Energy Agency, world oil demand in 2008 is expected to average 86.9 million barrels per day (b/d), an increase of 1%, or 900,000 b/d, above 2007. Demand growth is forecast to increase by 1.1% during both the third and fourth quarters of 2008 relative to the comparable 2007 periods.

Extraordinary growth in drybulk sector has led to a large drop in new tanker orders, as well as the conversion of an increasing number of tankers for conversion to drybulk ships, thereby dampening tanker supply growth.

As a result, spot freight rates have generally been fairly strong. This provides significant operating leverage to the spot market and offers the company opportunities to pursue the best risk-adjusted returns in either the spot or fixed-rate markets. Teekay has also significantly improved its financial metrics using its strong cash flow over the last few years to enhance shareholder value.

Read the full analyst report on TK

Bloomberg consequently serves up a nice batch of conflicting analyses from the currency desks of the world's investment banks and other money movers.  A lot of interesting points can be derived from the piece, but the main message for now seems to be that if you did not manage to catch a ticket to the ride last week, the current level does not seem to offer more juice.

Stefan Karlsson suggests that the past week's move is nothing but a sucker rally which I am sure that anyone having the forsight or luck to buy some USD - leverage style - last monday would happily accept as they buy back their positions today. More specifically he also suggests that now would be a good time to shed any remaining dollar denominated assets due to the obvious relative valuation advantage. Clearly, the thrust of the rally cannot be expected to endure but I feel confident that the relative weakness of other regions and economies could mean that the USD will a find a new higher level. This would apply, in particular, against the Euro, the Kiwi, the Aussie, and the JPY. In this light, I am latching on to Stephen Jen's and Luca Bindelli's general point as expressed here that the rest of the world is finally re-coupling to the US slowdown. It is important here to understand the nature of re-coupling and de-coupling. The main point here would be that the economies of the world who are dependent on exports and foreing income to grow cannot, on the basis of simple logic, decouple from a slowdown which cuts laterally through the economies of the world with substantial external deficits. In this spectrum, the US has already taken its share of the beating and now fellow deficit nations will need to make a similar choice. If interest rates are kept high there is plenty of excess savings to go around which in turn will make sure that the purchasing power of the currency stays high. But it is wise to follow the Fed's lead down? 

In this context, I  think that the following point made by Morgan Stanley's Sophia Drossos (quoted by Bloomberg) represents a good example of the issue at hand.

That means investors will continue to suffer inflation-adjusted returns that are negative based on the current annual consumer price index of 5 percent and Treasury securities yielding between 1.695 percent for three-month bills and 4.53 percent for 30-year bonds.

This has to be one of the most significant deterrents in the context of buying USD denominated assets. However, it also suggests that those who are more than willing to finance the external US deficit with a nominal yield below inflation, are not buying those bonds because of the current return (segmentation theory anyone?). Actually, one could argue that the US, by submitting its creditors to this treatment, is trying to release itself from the yoke of global consumer of last resort. For a time it seemed as if the Euro could take up the baton but this was obviously always going to be a tosh. The Eurozone is likely to have entered a recession in Q2 and going into Q3, but the simple point is that the Eurozone is extremely fragile. At this point the ECB's hawkish tone on inflation carries a distinctly hollow tune with Spain and Italy in the ropes and an export dependent Germany whose main customers in the form of its fellow Eurozone bretheren, and the CEE economies, are heading for serious corrections. 

Another mitigating effect on the USD would be the recent drop in Oil prices which, coupled with a stronger USD, seem certain to improve the overall trade balance. Furthermore, if the oil related deficit is set to fall it will also lay bare the improvements made in the context of the non-oil deficit since 2006. Before you get your hopes up though, I would reiterate Felix Salmon in pointing out how FT's Krishna Guha is a must read this week. Especially the following point also highlighted by Felix;

At today's prices the value of oil in the ground exceeds the combined value of all the world's equity and debt markets. Oil-importing nations are paying oil-exporting nations roughly $1,500bn per annum for oil - about 2.5 per cent of global gross domestic product - by some measures the biggest income transfer in history.

And then Felix' reasoning on the basis of Guha's argument;

Yes, the savings rates of oil exporters might start falling as their capacity for domestic investment rises. But there's no doubt that their savings in absolute terms will rise impressively for the foreseeable future. If you think the SWFs are big now, just wait another decade: they'll have major geopolitical importance then.

The last two waves of petrodollar investment both turned very sour in the end, and I can't say that the medium-term outlook is any better. The magic of capital markets is that they're meant to somehow take capital from investors and funnel it to where it can be put to best use in the real world. But with banks deleveraging and investors staying risk averse, it's not easy to see that happening with any elegance in the future.

This is an extraordinarily important point in my opinion, since what Felix essentially latches on to is the fact that excess liquidity is a structural global phenomenon, not necessarily because of evil doings by Greenspan and Bernanke, but because of too much capital chasing too little yield. Ok, I might be putting Felix' good name on to more than he would like, but it is important to understand these dynamics. The current crisis will only serve to exacerbate the structural trend of more money chasing yield, since the main fault line of the crisis cuts across economies who are net absorbers of global capacity (i.e. the external deficit nations!)

I agree in this regard that lowering interest rates to serve up negative real interest rates for one's creditors is a dangerous strategy indeed; especially with the funding need the US has. However, it is also, I think, a deliberate attempt to free the US economy from the role as global consumer of last resort. 

But what does all this have to do with USD then?

Well, there are two important points here.

1. I think that there is good reason to expect the USD to move for a higher level against a number of key currencies. I would note the Kiwi and the Aussie in particular here as the two most recent external deficit nations who have succumbed to a slowdown. By consequence, the respective central banks are now beginning to prepare markets for potential rate cuts (the RBNZ has already moved in to trim rates). I would also mention the Euro here since the violent movement of the EUR/USD in the past year has been pinned on a hope and belief that the Euro would somehow take over the USD's role and obligations in the global economy. This is obviously not going to be case and as such, I believe it to be quite in line with fundamentals that the EUR/USD is drifiting lower. However, there is also a floor for the USD's potential descend here since the interest rate differential is likely to stay in favor of the Euro for the forseeable future. Whether the Euro will stay strong, in historical terms, against the USD will also depend on the nature of the incoming slowdown. I see considerable downside with respect to the events unfolding in the Eurozone, which also ultimately translates into further downside for the Euro. An important point to watch in this regard will be the extent to which the Euro manages to claw back the past weeks' sharp drop. In short; are we seeing the EUR/USD establish a new level here or will it scoot back to its hitherto maintained 1.54-1.56 band?

2. Then there is the much wider question of global imbalances and what role the US economy should (and indeed is willing to) assume in the global economy. Hardly anyone with but a faint whiff of economic wit would disagree in the fundamental impetus for the USD to fall. Whopping twin deficits, a sharp drop in nominal yield advantage, and a incoming recession are all factors to suggest that the USD should be in for a beating (and beaten it most certainly has). Yet, the US deficit cannot suddenly dissapear without a subsequent reduction in its creditors' surplus or an increase in other nations' deficit. I do think that most will agree here. And this is where the mechanics of the global economy, and I have to say some analysts reasoning, begin to falter. Because, who will be willing and indeed capable to suck up the excess global liquidity? Sure, India, Turkey, Brazil et al will do their part but it is not going to be enough, that is for sure. Meanwhile, and as I have pointed out before, not only mercantilist emerging markets are to blame here. So is the great demographic transition which is sweeping our planet at this very point in time, and on whose end point we can only guess

In a US context, the policy choice is furthermore complicated by the large composition of oil in the external deficit. The point here would be that a strenghtening of the USD would actually reduce the oil deficit in the sense that it makes commodity imports (denomimated in USD) cheaper [1]. This of course, would bring another part of the equation into the spotlight in the sense of the ties to China and her ever growing exports. In a more general light, one could also easily argue that the last thing the US needs at the present time, is for an increase in purchasing power to potentially prolong a show featuring a consumption binge, which has been on the showcase for way too long.

Thus, it seems as if re-balancing is slowly moving forward as per reference to today's news that the US trade deficit improved in june as exports rose 4.1% [2]. Clearly, the recent week's theatricals in the FX markets have little to do with this and even if the USD finds a new level e.g. against at the Euro at around 1.40 it would still be weak in historical terms. This also applies for the current levels of the AUD and NZD as well as to JPY where we would need to see 120-130 before reaching pre-credit turmoil levels.

Ultimately though, long term fundamentals in the global economy are much more than standard textbook theories of inflation and external balance driven currencies. It is also about demographics, a subsequent hunt for yield and investment capacity as well as a mixture of floating and fixed exchange rate regimes. In this context, the USD still needs to weaken (or stay weak), but the relative level and duration of this weakness may not be as unambiguous as many would have you believe. 

Notes

[1] Although of course, it is never as simple as it looks. See Econbrowser for good discussion on this and the relationship between the USD and oil.

[2] Of course, there is a negative demand effect here to as the US consumer is simply not spending as vigorously anymore

The median year-over-year EPS growth rate of 9.45% is wonderful news for the market. And it looks like it will probably hold up. Given the expectations for those that have yet to report that seems possible. The median expected EPS growth rate for the firms that are yet to report is 16.9%. Given the propensity for positive surprises to outnumber disappointments, on a median EPS basis, double-digit growth is possible.

Energy is finished reporting and currently holds the gold medal spot with growth of 25.4%. Tech is in silver, with median EPS growth of 22.2%. This is based on the results of 60 companies, or 84.5% of the total Tech firms in the index. Absent some significant positive surprises it seems unlikely to overtake Energy in the median EPS growth event. Telecom is in the bronze medal spot with 17.8%, and it should hold on to its place on the podium.

On the surprise front, two sectors have been particularly impressive. Health Care’s median EPS growth rate is 14.3%. Health Care is showing more than 6 positive surprises for each disappointment, with a median surprise of 4.69%. This is not based on just a handful or results either, as over 98% of Health Care reports are already in. The Industrials have been just as impressive, with growth of 13.6%, a 7.0 surprise ratio and a 5% median surprise.

The Financials have been the weakest sector by far, with the median EPS dropping by 17.4% from a year ago. The sector is responsible for one third of all the earnings disappointments to this point. The Consumer Discretionary sector is the only other one to show negative year-over-year growth on a median EPS basis (-4.3%).

The expected results for the remaining Financials are even worse the ones which have already reported, at -156.2%, but relatively few remain. The remaining Consumer Discretionary firms are expected to show a 1.1% increase, meaning that there should not be a big change from what has already been reported.

Some of the factors which should help median EPS growth are share repurchases, which though have slowed in recent months, will still reflect what happened last year. Oddly, increased share counts will also help boost EPS among the Financials. Since the ones that have increased their share counts the most (by going hat in had to the sovereign wealth funds looking for new capital) are also the ones that are likely to reports losses, so the loss per share will be less.

In addition, to the extent that firms have large operations overseas, they should benefit from the currency translation effects of the weak dollar. The weak dollar has also boosted those companies that export a substantial portion of their sales.

Keep in mind that median growth rates are inherently equally weighted, so the growth rate for Cabot Oil and Gas (COG) is just as significant to the results for the Energy sector as the growth rate for Exxon (XOM).

Second-Quarter Scorecard (Reported)
Sector	Q2 08 Median Growth Rep.	Q3 08 Median Proj. Growth.	2007 Median Rep. Growth	2008 Median Proj. Growth	% Reported	Median % Surprise	# Pos Surprise	# Neg Surprise	# Match
Energy	25.35%	37.68%	12.83%	28.56%	100.00%	2.65%	26	11	2
Tech	22.22%	11.11%	13.76%	14.15%	84.51%	4.17%	37	15	8
Telecom	17.76%	2.11%	9.16%	7.43%	88.89%	4.66%	5	1	2
Healthcare	14.29%	7.55%	17.92%	13.07%	98.08%	4.69%	37	6	8
Industrial	13.64%	11.11%	14.57%	13.73%	92.73%	5.00%	42	6	3
Cons. Stap.	10.28%	6.58%	11.49%	10.30%	82.93%	2.59%	22	6	6
Utilities	8.12%	4.96%	8.70%	4.85%	90.32%	5.47%	16	10	2
Materials	6.58%	3.67%	12.20%	6.55%	100.00%	4.17%	19	7	3
Cons. Disc.	-4.30%	2.93%	8.43%	0.99%	71.43%	3.27%	37	16	7
Financial	-17.41%	-7.58%	5.25%	-4.71%	94.38%	0.00%	40	39	5
S&P 500	10.61%	6.96%	12.25%	10.30%	72.80%	3.33%	233	94	37

Second-Quarter Yet-to-Report
Sector	Q2 08 Proj. Growth	Q3 08 Proj. Growth	2007 Rep. Growth	2008 Proj. Growth
Utilities	69.57%	16.18%	13.33%	12.16%
Industrial	31.47%	19.45%	31.13%	21.21%
Telecom	28.57%	4.00%	-2.94%	8.08%
Tech	24.29%	8.72%	22.66%	18.89%
Healthcare	17.05%	20.18%	9.90%	15.26%
Cons. Stap.	11.76%	11.43%	13.25%	10.63%
Cons. Disc.	1.06%	0.12%	6.57%	7.23%
Financial	-156.20%	-17.82%	-39.13%	-30.17%
S&P 500	16.91%	7.14%	12.43%	11.13%

Total Net Income Growth

While on a median EPS growth basis, things might look okay, the same is not true on a total net income basis. This is shaping up to be yet another very ugly quarter.

The blame for net income decline once again goes to the Financials (with best supporting actor nomination for the Consumer Discretionary). On a percentage basis, total earnings have collapsed even more for the Discretionary firms (-83.5%) than for the Financials (-81.9%). However, the Financials are normally a much bigger sector in terms of total profits. Last year, the Financials accounted for 27.4% of all net income reported at this point, this year they account for just 6.3%. By contrast, last year the Discretionary firms chipped in just 5.9% of all earnings. Overall, the second quarter is even weaker than the first quarter.

Total net income for the S&P 500 is expected to be 21.0% below the second quarter of 2007, which is not much of a change from the 20.8% decline posted so far. This is a weaker overall showing than in the first quarter (down 15.6%) and roughly inline with the fourth-quarter decline of 21.2%).

Looking ahead, the consensus is currently for very weak but positive growth in net income (up 2.2%), thanks to very high expectations for the Energy sector, and the Financials only being kicked in the stomach, not a little lower on the anatomy.

Total net income for all the S&P 500 firms that have reported so far is $161.8 billion versus $204.2.4 billion a year ago. That is however a slight improvement on a sequential basis from the $158.7 billion these same 444 firms posted in the first quarter. While the overall pie is smaller, the size of the slices has moved dramatically. With the Financials share shrinking dramatically, the shares for most other sectors have expanded. Energy is getting the biggest slice, almost 26%, up from 17.5% a year ago. Tech’s slice of the pie is up to 14.2% from 9.4% a year ago.

Surprisingly, Tech is leading in total net income growth reported so far, up 19.1%. Energy is in the Silver medal spot, but Tech is expected to fade at the end allowing it to take the gold. Health Care should make the platform, but with a distant third of 8.3% growth, but taking the second largest slice of the pie at 15.2%.

Total Net Income Growth (Reported)
Sector	Q4 07 Rep. Growth	Q1 08 Rep. Growth	Q2 08 Rep. Growth	Q3 08 Proj. Growth	2007 Rep. Growth	2008 Proj. Growth	2009 Proj. Growth
Technology	30.36%	11.22%	19.07%	6.33%	21.95%	15.92%	17.60%
Energy	23.12%	25.75%	17.33%	52.90%	5.92%	40.14%	13.06%
Health Care	17.95%	3.32%	8.43%	1.71%	18.81%	8.70%	10.33%
Utilities	12.24%	6.91%	5.81%	1.04%	10.52%	6.65%	10.54%
Industrial	4.99%	4.54%	5.56%	2.15%	9.59%	8.35%	10.99%
Materials	-2.24%	14.68%	3.07%	6.02%	8.04%	12.18%	14.94%
Cons.Stap.	5.79%	13.48%	-0.14%	4.61%	9.24%	-0.25%	10.56%
Telecom	31.92%	1.08%	-1.16%	-6.60%	18.28%	0.59%	9.07%
Financials	-116.62%	-76.20%	-81.90%	-32.78%	-19.87%	-48.55%	90.65%
Cons. Disc.	10.73%	-24.35%	-83.46%	-8.63%	-11.86%	-18.53%	62.81%
S&P	-20.64%	-15.45%	-20.78%	2.95%	1.78%	-0.50%	23.64%

Total Reported ($)
Sector	Q2 08 Rep. Growth	Q2 07 Rep. Growth	Q1 08 Rep. Growth	Q1 07 Rep. Growth	Q2 08% Rep. Growth	Q2 07% Rep. Growth
Energy	$42,018	25.97%	$35,812	17.53%	21.63%	15.69%
Health Care	$24,587	15.20%	$22,676	11.10%	15.79%	12.10%
Industrial	$23,110	14.28%	$21,892	10.72%	15.03%	11.91%
Technology	$22,893	14.15%	$19,226	9.41%	13.85%	9.45%
Cons. Stap.	$15,906	9.83%	$15,929	7.80%	8.46%	7.34%
Financials	$10,118	6.25%	$55,887	27.36%	7.54%	28.39%
Materials	$8,277	5.12%	$8,031	3.93%	5.60%	4.44%
Telecom	$7,201	4.45%	$7,286	3.57%	4.89%	5.33%
Utilities	$5,676	3.51%	$5,365	2.63%	4.69%	3.62%
Cons. Disc.	$2,007	1.24%	$12,132	5.94%	2.53%	1.73%
S&P	$161,795	100.00%	$204,236	100.00%	100.00%	100.00%

Total Earnings Growth: Yet-to-Report
Sector	Q4 07 Rep. Growth	Q1 08 Rep. Growth	Q2 08 Proj. Growth	Q3 08 Proj. Growth	2007 Rep. Growth	2008 Proj. Growth	2009 Proj. Growth
Industrials	50.93%	40.53%	15.77%	5.00%	28.80%	28.54%	17.99%
Health Care	-1.30%	0.80%	6.86%	12.98%	15.60%	16.85%	13.85%
Cons. Stap.	9.13%	6.04%	5.23%	12.16%	19.38%	12.52%	9.70%
Telecom	15.25%	24.00%	0.25%	-3.09%	-9.80%	16.30%	0.93%
Technology	18.42%	16.02%	-0.09%	9.18%	17.79%	12.24%	15.51%
Utilities	27.52%	32.44%	-10.43%	20.25%	8.70%	10.78%	13.32%
Cons. Disc.	-11.33%	-12.97%	-23.67%	-35.56%	5.53%	-4.78%	10.04%
Financials	-178.27%	-116.50%	-83.26%	5.10%	-35.58%	-67.06%	187.13%
S&P	-26.63%	-16.79%	-22.64%	-5.73%	3.42%	-2.08%	19.48%

Total Earnings Growth: Combined
Sector	Q4 07 Rep. Growth	Q1 08 Rep. Growth	Q2 08 Proj. Growth	Q3 08 Proj. Growth	2007 Rep. Growth	2008 Proj. Growth	2009 Proj. Growth
Energy	23.12%	25.75%	17.33%	52.90%	5.92%	40.14%	13.06%
Technology	28.60%	11.99%	15.65%	6.76%	21.32%	15.38%	17.30%
Health Care	17.26%	3.25%	8.37%	2.06%	18.70%	8.97%	10.45%
Industrial	6.14%	5.58%	6.02%	2.26%	10.19%	9.08%	11.29%
Utilities	13.21%	8.90%	4.24%	2.55%	10.36%	7.00%	10.78%
Materials	-2.24%	14.68%	3.07%	6.02%	8.04%	12.18%	14.94%
Cons.Stap.	6.48%	11.45%	0.94%	6.04%	11.15%	2.33%	10.37%
Telecom	31.57%	1.41%	-1.14%	-6.54%	17.75%	0.82%	8.94%
Cons. Disc.	1.96%	-18.84%	-63.38%	-19.50%	-5.73%	-13.10%	39.97%
Financials	-120.20%	-78.62%	-82.00%	-31.62%	-20.88%	-49.52%	93.95%
S&P	-21.18%	-15.60%	-20.96%	2.20%	1.92%	-0.64%	23.27%

The Zacks Revisions Ratio

To help gauge the direction of the market, we take note of what analysts are thinking. By tallying their EPS changes, we can determine our revisions ratio. This ratio simply divides the total number of positive estimate revisions by the total number of estimate cuts. Thus, a high ratio is a bullish indicator and a low ratio is bearish. For the S&P 500 as a whole, a number below 0.80 or above 1.25 is generally significant. For individual sectors the distance from 1.0 should be greater for the numbers to be significant.

With positive surprises outnumbering disappointments by almost 5:2, it is not a shock that the revisions ratio has started to climb from the depths. After all second quarter earnings are part of full year 2008 earnings, so if a company posts a positive surprise and the analysts don’t raise full year earnings, they are implicitly cutting estimates for the third or fourth quarters.

The ratio is now at 1.05, a reading that is neutral, up from 0.98 last week, and 0.81 two weeks ago. The overall pace of estimate revisions continues its rise, and is approaching its seasonal peak. Over the last four weeks there have been 3,600 changes in estimates: 1,841 up and 1,759 down. (In comparison, last week there were 3,017 changes: 1,521 up and 1,556. This week or next should mark the peak of total revisions activity for the quarter. The ratio of firms with rising mean estimates to falling mean estimates is 0.95, slightly weaker than the revisions ratio, but also in neutral territory.

On the back of their strong surprise ratios, Health Care and Industrials have moved into the top slots for the 2008 revisions ratio, with readings of 3.11 and 2.24. Surprises have not been as strong for Energy (1.7:1 ratio, 1.42% median surprise), but it still has a respectable reading of 1.40. Financials and Discretionary are the weak sisters with readings of 0.49 and 0.63, respectively.

Notable Health Care stocks on the upside include Abbott Labs (ABT), Johnson & Johnson (JNJ) and St. Jude (STJ). The Aerospace and Defense names were particularly strong among the Industrials, including General Dynamics (GD), Lockheed Martin (LMT) and Raytheon (RTN).

In the Consumer Discretionary sector, the analysts checked out of the hotel companies Marriot (MAR) and Starwood (HOT). The Financials included in the Dow 30 seemed under particular pressure, including American International Group (AIG), American Express (AXP), Citigroup (C), and J.P. Morgan (JPM).

Avg. 4wk EPSChange (FY08)	Avg. 4wk EPS Change (FY08)	Revisions Ratio	Firms With FY08 EPS Increase	Firms With FY08 EPS Decrease
Health Care	-1.90%	3.11	37	15
Industrials	1.12%	2.24	34	19
Telecom	0.64%	1.41	4	4
Energy	-1.43%	1.40	25	14
Utilities	-0.31%	1.11	15	12
Consumer Staple	-1.20%	1.08	17	19
Materials	-0.11%	1.02	13	16
Technology	-3.22%	0.87	30	37
Consumer Disc	-5.57%	0.63	28	48
Financial Services	-19.52%	0.49	28	59
S&P 500	-5.10%	1.05	231	243

Unlike 2008, there is no mechanical reason for analysts to raise their numbers for 2009 in response to an earnings surprise. While it did rise, it remains in negative territory. It rose to, 0.79, from 0.76 last week, and 0.66 two weeks ago.

The Energy sector, with a revisions ratio of 2.15, remains the strongest. Health Care also put in a decent showing at 1.91 Energy firms showing noteworthy strength include the Oil Service majors, Baker Hughes (BHI), Halliburton (HAL), National Oilwell Varco (NOV) and Schlumberger (SLB).

The revisions picture for the Financial sector is even worse for 2009 than it is for 2008, coming in at 0.24, or over four cuts for every increase. Revisions like these will eat away at the robust earnings rebound seen for 2009 (unless 2008 gets cut faster). If the Financials were excluded, the revisions index would pop to 1.04. We do not seem to be getting out of the woods on the Financial sector front. While there is weakness throughout the sector, major regional banks seem to be the worst hit. In particular, weakness at BB&T (BBT), Comerica (CMA), SunTrust (STI), Regions Financial (RF) and Zion (ZION) was noteworthy.

The total number of revisions for the whole S&P 500 for 2009 is also near its seasonal peak. There were a total of 3,087 revisions: 1,360 up and 1,727 down. This is up 33.1% from 2,752 (1,189 up and 1,563 down) last week. The ratio of firms with rising mean estimates to falling mean estimates is 0.78, in line with the revisions ratio.

Avg. 4wk EPSChange (FY09)	Avg. 4wk EPS Change (FY09)	Revisions Ratio	Firms With FY09 EPS Increase	Firms With FY09 EPS Decrease
Energy	3.92%	2.15	33	6
Health Care	0.48%	1.91	33	19
Industrials	-0.16%	1.27	24	30
Consumer Staples	-1.06%	1.21	18	16
Utilities	-0.05%	1.21	12	12
Telecom	1.07%	0.95	5	4
Materials	-1.75%	0.90	10	18
Technology	-3.53%	0.65	29	37
Consumer Discr	-6.75%	0.42	21	54
Financial Services	-7.23%	0.24	20	68
S&P 500	-4.98%	0.79	205	264

Market Cap versus Total Earnings

When making investment decisions, growth should always be looked at in conjunction with how much you are paying for a stock. Thus, it makes sense to look at the total earnings expected for a sector, relative to that sector’s total market capitalization. This is basically a variation on looking at the P/E.

The chart below shows the share of total earnings for 2007, 2008 and 2009, as well as the share of total market capitalization for each sector (the final bar shown). Since the S&P 500 is a market cap weighted index, this is the same as its index weight. On the chart below, the difference between the sizes of the first three bars shows if a sector is gaining or losing “earnings share”. The difference between the final bar and the first three bars shows if the sector is selling for an above or below market P/E. If the final bar is smaller than the other bars, the sector is selling for a below market P/E. However, as opposed to just showing the sector P/Es, it also shows the relative importance of the sectors to the overall index.

For years, the Financials were the dominate force in the market, both in terms of market cap, and even more so in terms of total earnings. They have now been decisively dethroned on both counts. On the market cap front, Financials just recaptured 2nd place from Energy. However, the sector has now slipped into 5th place based on 2008 earnings. Still, despite their current problems, the Financials are still a very significant influence on the market.

Even with all the disasters in the sector, for 2007, the Financials accounted for 21.9% of the total net income for the S&P 500. In 2008, that is currently expected to decline to 11.0% before rebounding to 17.4% in 2009. However, in recent years the sector has accounted for well over a quarter of all earnings.

Energy has usurped the crown this year, with its earnings share climbing to 21.8% from 15.6% in 2007. Energy should keep the earnings crown for 2009 as well, gathering 20.0% of all the earnings of the S&P 500.

On the market cap (and index weight) front, Tech overtook the Financials a few months ago and currently stands at 17.6%. The Financials have plunged to 14.7% of the index. As recently as the end of February, Financials had a 17.2% index weighting versus 15.7% for Tech and 13.0% for Energy.

Keep in mind that these numbers are snapshots, when you should be thinking about a movie. At the end of February (the first time we had a complete read on 2009), the Financials were expected to gather 22.1% of all earnings for 2008, and Energy was expected to only get 16.0%. For 2009, the expected earnings shares were 15.0% for Energy and 22.4% for Financials. A year ago, before the credit crunch hit, Financials were expected to gather 26.3% of 2008 earnings and held a 19.4% weighting in the index.

Energy represented just 10.9% of the total market capitalization and was expected to get 12.9% of the total earnings in 2008. In general it seems as if the Energy sector is consistently gaining 0.2% of share for each year every week, with a similar decline for the Financials. If those trends continue, then Energy could be as dominate on the earnings front in 2008 and 2009 as the Financials were in 2007 or 2006.

For many years, Financials were clearly the dominate factor in the overall market, despite generally selling for below market P/Es. Due to an implosion in earnings that has been far worse than the dismal market performance of the sector, the Financials now have the highest P/Es based on 2008 earnings, displacing the perennial high P/E sector Technology. Based on 2008 earnings, the Financials have a P/E of 19.4x. However, given the expectation that the bleeding will stop next year, the P/E based on 2009 earnings is just 10.0x. (The true P/E is probably higher since the actual earnings will be significantly lower.)

Energy has just taken the throne as the cheapest based on 2008 earnings trading at 8.8x, and 7.8x based on 2009 expectations. There is no question in my mind that Energy is the cheapest sector of the market, and every portfolio should be overweight in it. The Tech sector is still a bit on the expensive side, trading for 17.7x 2008 and 15.1x 2009 expectations. Health Care looks interesting trading at 14.4x 2008 and 13.0x 2009 earnings.

Keep your eyes on the revisions, they give you the best clue as to if the earnings will be achieved and if the P/Es are for real. While the recent declines in oil prices may cause the upwards revisions to moderate for the Energy sector, most analysts are using very conservative price assumptions.

The S&P 500 as a whole is trading for 14.6x and 11.7x 2008 and 2009 earnings, respectively. Based on a blend of 50% 2008 earnings and 50% 2009 earnings; that translates to a 7.60% earnings yield, which looks extremely cheap relative to a 3.93% ten year T-note. Even against the A rated corporate bond yield of 6.11% it looks attractive. However, the current level of expectations for corporate earnings still implies that profits will stay well above their historical averages as a share of GDP. That would be an exceedingly rare occurrence during a recession. The comparison between the earnings yield on the S&P and the 10 year T-note is in my opinion more a reflection of the extreme unattractiveness of long term T-notes at this point than stocks looking particularly cheap in general, however there are attractive stocks out there. It appears that the flight to quality has caused a massive bubble in the price of T-notes. This is far and away, in my opinion, the most significant bubble in the market today, not the price of oil. The prices are hard to justify given the risk that the massive injections of liquidity by the Fed to ameliorate the credit crunch will end up fueling the fires of inflation.

Neil Malkin contributed significantly to this report.

Data in this report, unless stated otherwise, is through the close on Thursday, 8/7/2008

"STJM" Free Stock Analysis: Buy? Sell? Hold?
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In fact, a recession seems to be almost a foregone conclusion at this point since if we look at the recent messages emanating from official Japanese authorities, they are indeed bracing themselves for something ugly. Perhaps someone from the statistics department sent a primer of the Q2 GDP figures (due 13.08.2008) to parliament? I sure don't know, but the cabinet office recently released a statement in which the slump in industrial production and exports were used as impetus to argue that the cycle has now definitely turned. The secretary general of the ruling LDP party also chimed in as he notes how especially the economic situation en dehors de Tokyo increasingly resembles a recession. Shigeru Sugihara head of the Cabinet Office's statistics department also noted recently how the economy is very likely to have entered a recession. Finally Bloomberg connects the threads by suggesting that the Japanese economy may have shrunk -0.6% in Q2 after an impressive 1% showing in Q1. These numbers are built on the illusive median forecasts at this point but are indicative of what to expect. 

As per usual, this note will feature a look at developments in prices, domestic demand, industrial production (and exports) as well as the JPY. Obviously, the main thrust will be what exactly to expect in terms of the downturn; how serious it will be and how the BOJ and MOF will act. 

Cost-Push Thrust Continues - To the Consumers' Lament

Adding to the pressure on Japanese consumers, prices rose at its highest pace in June as the main inflation index clocked in at an all time high of 2.0%. Moreover, the US style core price index also managed to eek out a slight increase at 0.1%. This is the second time this year that the core of core index is in the positive but on an aggregate basis Japan remains in deflation.

As ever, the point to take away is how headline inflation from cost-push pressures not necessarily will lead to an underlying  effect on core-of-core prices. This is to say that it is difficult for companies to push forward cost-push inflation through the value chain in a situation where real wages are falling and where domestic demand, in general, is structurally weak. This broken link between headline inflation and core inflation and the congeniantly weak demand can be connected to the demographic profile of Japan. Quite simply, Japan does not posses the domestic demand to generate demand-pull inflation to any significant degree and this is reflected in the core-of-core index. Moreover, this is also why those much discerned second round effects are not very likely to materialise in Japan's context domestic demand dynamics do no support this as external demand slows.

Finally, this also underpins the lack of activity in corporate capex to spill-over into the domestic economy as so many pundits have been expecting during the recovery. It is important to understand the dynamics in this regard. As such, macroeconomics 1-0-1 tell us how to treat excess domestic investments over savings as a leakage which leads to an external surplus (otherwise S=I, and capacity for investments would be a lot smalle than is currently is the case). This rather mechanic perspective is important in so far as it shows us how activity in the corporate sector may be responding to external demand rather than domestic demand. And thus, we have the ensuing disconnect between industrial activity and domestic demand.

In light of the fact that oil seems to have peaked, for now at least, it appears that Japanese consumers not to mention companies may have experienced the worst of things. However, Morgan Stanley's Takehiro Sato seems to be less sanguine than official estimates from Japanese authorities. Alongside colleague Takeshi Yamaguchi he estimates that it will take in the region of 6-12 months for the current back drop in energy and food prices to have a material effect. This suggests that the cost-push thrust is set to linger throughout 2008 and perhaps some time into 2009.

Shifting gears over to consumption the Japanese consumer thus seems to have firmly caved in. With wages now falling, in nominal terms too, it does not take much of an economic literate to see that Japanese consumers are getting sandwiched at the moment. Wages in Japan fell back 2.9% (in real terms) in June and this marks a third consecutive drop this year. The meager evolution in wages has been a consistent feature of the Japanese economy throughout this so-called recovery. Yet, now that cost-push inflation is being added to the equation it is predictably feeding strongly into domest consumption expenditures, which still constitute the largest, if shrinking, share of Japan's GDP (55%).

It is now quite clear that domestic consumption in Japan is contracting and even though expenditures in June contracted less than in previous months the overall trend is one of a slump. Given the trajectory of real wages and inflation this is not particularly surprising but does mean that with external demand now also faltering, Japan is left without any kind of real growth engine.

As per ususal Ken Worsley provides the details of the monthly consumption report through which we learn how especially spending in durables and semi-durables contributed to the decline. If SY is right with respect to the lag in which falling energy prices feed through to the price indices it is difficult to expect a rebound in H02 2008.

Corporate Capex and Exports - The Final Dam Breaks

Perhaps the most significant snippet coming in off the wire since we last convened to look at Japan was the news that Japanese exports actually shrank in June on a y-o-y basis. Coupled with a rising import bill as a result of surging headline inflation, it means that the monthly trade surplus decreased a whopping 89% on a y-o-y basis [3].

If the level of Japanese exports is heading inexorably down, the trend in foreign demand composition is also interesting to consider. It shows that while a savvy Japanese export industry indeed did manage to decouple from the US or more aptly recouple to the big emerging markets, it cannot de-couple from the world. This is the nature of being dependent on exports and foreign asset income to grow. In this light, both exports to the US and Europe dropped at a hefty pace in June, the former being the 10th straight decline and the latter seing a second consecutive drop. Exports to emerging markets and not least China expanded, but at a much slower pace suggesting that the current account margin is narrowing. 

Yet, Japan's external balance is not only about exports.

In fact, the recent years' increase in Japan's positive external position owes more to the accumulation of foreign assets than to exports per se. This is also I point I latch on in my note on how Japanese savings, as a function of its demographic profile, will tend to go for yield.

In 2007, the net foreign asset position of Japanese savers (i.e. both companies and households) stood at around 250 billion Yen of which around 75-80% was made up of debt instruments. This makes up a nice cushion off of which to pull income. Add to this the currency gain as the continuation of outflows, due to the low interest rate environment, will tend to keep value of the Yen down (more about that below). I think it is important for investors to lock on to this trend as it tells a lot about global capital flows.

An additional point here would be that since the majority of Japan's foreign asset is in debt, the income flows will be less affected, from the credit crunch, than if it has been tilted towards equity (although one has to assume that asset income will go down with global growth). Obviously and depending on the kind of debt you own, defaults and yield obtained from securities you own and those you buy will depend greatly on where, and in what, you choose to invest.

Ultimately however, the point remains that as Japan external balance is now contracting, in relative terms, it will have a substantial impact on aggregate economic performance.

With exports faltering it should not come as a surprise that industrial output and capex are also slowly but surely trending downwards. On a m-o-m basis production dropped 2.8% and on a seasonally adjusted index (see this graph) it appears that the high levels of the latter part of 2007 are now replaced by one of those famous lower plateaus. In a quarterly perspective, it can also be seen below how the cycle now seems to have turned.

Judged by forward looking indicators and production assements, it appears that the first two quarters of 2008 may well have seen a q-o-q contraction of industrial output. However, it also seems clear that industrial activity may have a long way to fall as it enters the current correction with a lag. Especially the likely reluctance of external demand to reach hitherto heights will make it difficult for Japanese firms to build up production. It would subsequently mean that production plans will need to be further downscaled. 

Sato and Yamaguchi (SY) field some pretty grim numbers for the potential course of industrial activity and manufacturing. They consequently forecast, based on information from previous recessions, that total output may have to come down as much as 6%. SY also indicate that the recent Tankan survey may have been too optimistic in its top line outlook. Should this turn out true, production assessments will have to be further cut.

There is still however some disagreement on the actual outlook here. Bloomberg consequently features a more sanguine analysis in a recent article. The point would then be that forward looking indicators in the form of equipment and machinery orders declined less than forecast. This might be true in so far as goes Bloomberg's own meadian forecast but I think it is quite difficult to see anything remotely positive in the incoming figures. Whether the incoming slowdown will resemble the 2001 recession is another question of course, but at this point I think that it is also an irrelevant one.

The JPY - Macrofundamentals to Take Over?

With the recent turmoil surrounding the near bust of Fannie and Freddie Mae many FX punters would perhaps expect it to be a sure bet to buy some Yen crosses. Consequently, more than notional evidence has suggested how traditional carry trade crosses (CHF and JPY) have been negatively correlated with risky assets. In times of market turmoil and volatility, the only thing a savvy currency trader thus need to do is to pile up on JPY and CHF longs as she was betting on the unwinding of short term highly leveraged carry trade positions. If it was ever so easy.

I am unsure as to whether the correlation is broken entirely, but it is quite obvious that is has weakened significantly in the past two months. As such and while I would still expect the JPY to react on extreme risk aversion two other factors are at work. The first, I think, is related to the recent drop in headline inflation from oil in particular. Not only has this boosted the USD across the board and by derivative the USD/JPY, it has also provided a cushion for stocks and other risky assets. This story has been roaming financial market punditry for the better part of the last month, and suggests the importance investors ascribe to the adverse effects of inflation.

The other factor is more structural in nature and relates to the points made above on Japan's positive income balance and net investment position. In this way, Japan quite literally needs to ship its capital and goods abroad in order to grow. This is a simple reflection of the country's demographic structure and subsequent low domestic interest rate environment. This decline in home bias can thus be considered a lingering structural trend, as it effectively links up with Japan's demographic profile[2]. The conclusion is consequently that the JPY is set to stay weak and steadily weaken against its trade partners. This would apply for the level of the JPY in particular.

If we add the fact that exports of goods and services are now actually falling and the terms of trade shock from a high oil price, the immediate outlook is for further JPY weakness. 

Obviously, I still owe somewhat of an explanation since when does one effect take over from the other?

My immediate response to this question would be that an increased decline in home bias, low domestic interest rates, and the subsequent steady outflow of funds (and goods and services) will dominate and keep the JPY down. In this way, I do not deviate much from Stephen Jen with respect to fundamentals. Yet, this is also a discussion about the nature of capital flows. In this way, the fundamentalist view would hold that the JPY is being held down by plain and simply unlevered outflows or more aptly; diversification out of Japanese risky assets with respect to the market portfolio.

However, there is another perspetive too. If the low JPY is primarily driven by carry trade positions and levered bets against the uncovered interest rate parity it would make sense for the JPY to be sensitive to reversals in the market. This indeed has been the focus of many articles and op-eds over the course of credit turmoil and beyond. For example, we learned recently that the number of margin trading accounts in Japan has now exceeded 1 million and that the funds attacted to these accounts rose 13.5% y-o-y totalling 6.3 billion USD. In this context, the actions of Ms. Watanabe and other savvy Japanese housewives represent an important case in point. Of course, with the recent change of tact in the Aussie and the Kiwi (at least against the USD) one has to wonder whether in fact the fundamentals of the trade is changing, if only for a while.

I will forgive my readers if the conclusion may be a tad bit difficult to discern on this topic. As stated, I hold the view that outflows (levered and non-levered) will continue to keep a lid on the JPY's appreciation. However, the extent to which the JPY will react on sudden spurts of volatility is still something to be aware of, and is likely to depend on the level of levered carry trade positions.

A Recession it is Then - So, What About Policy Response?

I think that SY manage to pin point the situation quite neatly when they note how Japan lost two engines in Q2 2008; personal consumption and exports. Of these two, the latter will by far have the biggest impact since in the case of the former, it never really got past first gear during the present and so-called recovery. 

SY roll out the big forecasting kit in their attempt to give an impression of when Japan's economy may hit the trough; with the assumption being that it peaked in Q4 2007. The conclusion is that Japan is set to hit bottom in Q1 2009 after which it will steadily pick-up. There can be no doubt that this argument is solidly built upon historical performance measures. However, I don't think that the recession as such is the major news point here, in the sense that such things come and go. The key for me is the regularity by which recessions have hit Japan since 2000 and the subsequent nature of the "recoveries". In this way, I am not expecting a recovercy as such, in the sense that unless exports find a new decisive foothold towards external demand, Japan is likely to limping ahead very close to a zero growth rate.

This brings us neatly over to the policy reactions from all this.

Obviously, with growth now slowing the quants in the treasury are being forced into revising their revenue models. Specifically, the objective to balance the budget by 2011 may now be nothing but a good faith declaration on paper with no real bearing towards reality.  One immediate consequence here is obviously that issuing more sovereigns to finance government spending is out. In fact, with a public debt/GDP ratio close to 170%, any faint muttering as such would be sure to prompt the rating agencies into attack mode.

Moreover and as per usual, the prospect of increasing the incoming consumption tax is rearing its head. In May, Economics and Fiscal minister Yosano, from the LDP, consequently suggested that Japan double a planned 5% consumption tax by 2015. No one can deny that the government's top line needs additional input, but it is also important to understand that levying tax on consumers will only further solidfy Japan's growth path whereby domestic demand stays weak and the economy relies on exports to grow. There is nothing wrong with that per se. The problem however is that export dependency will become a structural tendency for many economies during the next decade so Japan will finds its growth strategy more crowded as we move forward. [4] 

Regarding monetary policy, the BOJ held rates steady during their last convention and is widely expected to maintain this stance for the forseeable future. SY are fiddling with the BOJ moving in with a 25 basis point cut in Q2 2009. I am not willing to look that far ahead. Given the already low level of interest rates anything short of a sharp backdrop into deflation or a very severe slowdown would not justify, I think, a move back towards ZIRP.  This may happen and the data should be watched closely in this regard. For now however, I am sticking to my guns that the BOJ is likely to stay on hold.

Notes

[1] See the following notes in particular; Japan - Still Fighting off the Recession; When Will the Strength Ebb Out? and Inflation Returns to Japan - Tightroping Between a Slowdown and Recession

[2] See this note and also Morgan Stanley's Stephen Jen (here and here)

[3] See this chart

[4] See further points on export dependency here

Disclosure (c.f. Seeking Alpha agreement): Trading out of a monopoly money account with the following FX positions: short AUD/USD, short NZD/USD, short EUR/USD, and short EUR/JPY.

[Update: Brad Setser clarifies, in the comment section, his view on Sender's FT piece referenced below]

THE last week (or was that year?) has certainly been something of a ride hasn't? In fact, I thought it would be apt to reproduce this picture by the brilliant KAL who normally spices up the Economist with his imagery that lay serious claim to the adage that a picture tells more than a thousand words. This particular specimen and the ensuing headline were on the front cover in October 1997 when markets also took investors and observers for a roller-coaster ride. I think it is quite fitting in describing the feeling many a trader and market participant must have at the moment.

Even though it could only seem as a few days ago that the credit turmoil went global with BNP Paribas' announcement that it too would be suffering subprime related write downs it is actually almost a year ago. Actually, if you use the same yardstick as I have tended to apply, the first of August will see the one year anniversary of one of the worst global financial crises (arguably) since the 1930s. The ever readable Martin Wolf (from the FT) expresses a similar sentiment in his most recent column. What is more, Wolf makes the point that we may not even have seen the end of the beginning yet. Adding to the gloom, I tend to agree with this.

Concepts such as bear market, stagflation, bailouts of tarnished financial companies, increased market volatility, and housing market busts have thus all become ingrained in investors', regulators' and not to mention central bankers' vocabulary as of late. Personally I think that we may soon add deflation to the list but more on that below.

Where Art' Thou My Fair Market?

If we begin at the first group it has not been an easy game to play; to say the least. Sure, commodities have been a solid play and in general the tendency has been one of wealth destruction in the context of risky assets as most international equity markets have seen near bear market conditions. I hear that real estate projects have been quite sluggish too. But in the current environment and given the amount of volatility, any leveraged position, in any asset class, firmly in the black one day could have easily been subjected to a margin call the next.

One excellent window into the daily workings of the market place is of course our devoted and popular Macro Man who never tires of sharing his insight with the rest of us. Usually, MM massages several topics but one interesting theme passing on his blog recently has been the difficulty with which investors, even the pros, have had exercising their hand. Consider thus the following point made by Macro Man;

As observed a few times over the last week or so, Macro Mas has found trading conditions evolve from pretty relaxing to downright terrifying at times. He's found it pretty easy to second guess every trading decision he makes, often after only a few minutes. That's an urge that he is trying to fight; in all conditions, but particularly when it gets a touch difficult, it's important to look forward rather than back.

In any event, it doesn't take much digging to confirm that conditions have been tricky, and that Macro Man hasn't dropped 50 points of trading IQ since the 4th of July. Consider that over the past 10 trading days, a period in which the SPX has dropped 5.1%, no less than seven of those days have witnessed an intraday rally of at least 1.5%. Unless one is a brilliant intraday trader- and Macro Man is not- this sort of market naturally lends itself to trades that have a, ahem, "suboptimal P/L impact."

In his examples Macro Man uses the SP500 as the main example of the adage that not only the almighty but also, it seems, the market sometimes moves in mysterious ways. These points and not least this graph fielded incited me to have a look at the intra-day volatility of the SP500. The ensuing results confirm the remarks above.

The first graph shows an implied version of volatility during the entire subprime turmoil period. As can been the past weeks have not, on the face of it, been extraordinary. Yet, if we look at intra-day volatility over the past month one can easily see the message conveyed above. The sample period in question can of course be debated ( for the short term frequency graphs I have opted for the same as Macro Man) but it is long enough the prove the point. As such and even though the trend in SP500 has been inexorably down there has been some significant spurts (or as some would call them sucker rallies) along the way. In fact, if we look at the intra-day volatility we see that a good number of spikes above 2% both with respect to the difference between high and low as well as open and close values.

In a general sense and with the distinctly execrable economic environment in the US one should also have expected more action in currencies. This is especially the case with respect to the EUR/USD that has not, despite a faint inclination, managed to break decisively above 1.60. Not unlike neglecting to change gears as you race towards the rev limiter the EUR/USD has been bouncing off against the 1.60 mark and then down again to 1.585ish. Perhaps this has more to do with the stock market than anything else as the USD moves closely together with equities through its correlation with oil; with an inverse relationship of course. In light of the point made above on the 'on-off' nature of equity markets it may just be that the USD is finding it difficult to choose a direction. One thing is certain then; there does not seem to a magic barrier surrounding the 1.60 mark but as long as the market chooses to believe in various rescue packages and the (final) inclination for the Fed to go for inflation it is unlikely that we will see a violent rally.

The latest earning reports have been a bit mixed with a significant addition to the Butcher's Bill by Merrill Lynch over to the less than expected write-off by Citigroup. I will let the gun-slingers of the world markets discern these reports but I definitely think that momentum in equities is down since the slowdown, at this point, is far from over. Although, one has to wonder whether signs that oil prices may be heading down will also provide support for equities in the immediate future. Sean Maher thinks so for one. The main point as can also be derived from the plight expressed by Macro Man would however be that even though you have the overall trend right, you should not leave you trading screen for more than a whee coffee break less you wanna be pulled down by a quick reversal.

Revisiting Old Arguments?

Now, this is obviously not only a story about market volatility which can thus be seen as a derivative of a much wider issue in financial markets and with respect to the global economy. More specifically it is a story about the global economy, its structure through capital flows, and the sustainability of these. In this light, a couple of important new themes have emerged lately while some old ones have been intensified.

On obvious lingering theme is the continuing weakness of the US economy and financial system which is not only sending ripples through the US society but also the global economy. As you can imagine the econsphere and media in general have been absolutely buzzing with the recent shot across the bov in the form of the debacle of Fannie and Freddie Mae. A good place to start would be Tyler Cowen who provides a good overview of the initial flurry. RGE's Finance and Market monitor which has virtually been turned into a Fannie/Freddie Mae watch this week is also a good place to; I would especially highlight the following two from James Hamilton. Also, Thursday's edition of Morgan Stanley's Global Economics Forum features a fine re-cap by Richard Berner and David Greenlaw. Finally, the Economist's print edition just fresh off of the publisher also devotes a fair amount of pages to the issue at hand.

Obviously, even after churning through the pages linked above you would hardly get that illusive "big picture". It is certain that the Fed, in conjunction with the Treasury, have rolled out the big guns in order to ensure that Freddie and Fannie do not fail. So far it has worked, since even though the shares have plummeted the debt outstanding in the form of agencies have not. This is what was initially the intention I think since a crash of the agency market would have been catastrophic.

One particularly interesting aspect here is obviously the fact that a fair part of the financing of the US external deficit and by derivative its mortgage boom was done through purchasing of agencies by foreign central banks and state investment vehicles. The link to the USD peggers are brilliantly exposed by Brad Setser as he estimates that China alone holds anywhere between $500 and $600 billion in agencies or roughly 10% of the outstanding stock.

The functioning of Bretton Woods II and the collective bet on the US consumer of last resort is well known. As such and since the external deficit in some ways has been fuelled by the financing of the housing boom it would only be natural to expect that as the debitor struggles so does the creditors. Well, unfortunately this does not seem to be the case. I say unfortunately here since the devil in me (and although I know this is not really an option) would have no problem seeing US creditors taking part of the hit from this; i.e let those bonds burn if that is what it takes. Consequently, I had to shake my heads several times when I read some of the initial reactions by foreign holders of agencies as conveyed by one of Michiyo Nakamoto's recent pieces in the FT. Consider example the following tidbits:

The Financial Supervisory Commission (FSC), Taiwan’s regulator, said the market reaction had been driven by fear rather than fact, pointing out that the US lenders’ federal backing made their debt quasi-governmental.

(...)

“We believe that the impact on Japanese banks [of their exposure to the government-sponsored enterprises] is minimal since they do not own equity,” Hironari Nozaki, banking analyst at Nikko Citigroup, said in a report yesterday. The default risk of the GSE bonds that Japanese banks owned was extremely small, he said.

Now, let me be clear that I don't really think that Paulson and Bernanke could have acted otherwise here (well, the banning of "naked" shorts is another matter) but what a royal mess we have on our hands. It is hardly a wonder that some, in the current environment, are musing about the credit worthiness of the US government all together. Obviously, this has a whiff of theatricals about it, not least in a context where one major rating agency recently downgraded India at one and the same time as Japan is upgraded (recently) and Italy maintains its rating. Anyone with a definition of "economic fundamentals" ready at hand?

In a more structural perspective the FT (and here through Reuters) also ran story well in line with current sentiment as it suggested how the big players amongst the sovereign wealth funds and central bank authorities were seriously considering to diversify away for the USD. This is hardly news as these stories have been surfacing in regular intervals since the subprime turmoil hit global markets. Given the y-o-y slide in the buck it is difficult not to put more than a little bit emphasis on this story but to me it is also somewhat of a smoke screen. As such, I wholeheartedly agree with those who believe that the Bretton Woods II is due to a revision. However, so far I can only see one strong impetus for this and that is the obvious need for the US economy to get the house in order and reduce the twin deficits. Recently quarterly reports on export contribution to US growth are good news in this regard. The other part of the equation however is still somewhat missing.

The question we need to ask is thus the extent to which the USD peggers can actually turn the ship around at this point ... you know, with respect to becoming consumption driven and all. More to point and if we accept that the US should be replaced by another economy or a group of economies it is not straight forward, at this point, to see where the candidate(s) are.

With respect to the illusive concept of diversification I rely on the principles of the comparative advantage and thus the work by Brad Setser and Rachel Ziemba. The former massages the above mentioned article posted in Reuters and unlike what you might expect he does not latch on to the fact that Gulf states are reducing their exposures to the USD (he already knows the data by heart I imagine). Rather, Setser points out the growing discontent of reserve asset managers with their investments in Europe and the US.

But perhaps the most interesting part of Sender’s article is the part suggesting that the United States’ creditors are increasingly frustrated by US policy — and no doubt also unhappy that their investments in US (and European) financial firms have performed so poorly.

The fact that this frustration is starting to spill over into the press is news. My guess is that a lot of funds are down significantly so far this year, and in some cases the falling value of their existing portfolio may be a big enough drag to nearly offset all the new oil inflows.

Regarding the prospect of some kind of USD crash I still think we need to keep our heads decidedly cool. My feeling is thus first of all that we need to tackle the extent to which we are past a point of no return. The extent to which we will see significant diversification (or depegging) therefore rests on two important obstacles in my opinion. First of all there is the question of what SAFE et al. should diversify into and whether the 'recipient(s)' would accept this? Surely, the Euro is heading for more than a bit of problems in the years to come which will make it quite clear that it cannot take up the baton for the US. Secondly, many SWFs and central banks WOULD have to incur loses on their remaining USD holdings if they decided to bury the buck. All this does not mean that we won't see diversification at all; to put this as an argument would also be somewhat of a reality defying argument. My only point would simply be that the process will not be a linear one in which the Euro takes over from the Dollar and therefore that old notions of de-coupling and rebalancing need to be taken with more than a pinch of salt.

As a final point on this, the hunger with which the recent Fannie/Freddie offerings was munched suggest, at least initially, that it is all back to business as usual. Note here that 61% of the issue was picked up by investors outside America apparently content with the higher, government backed, yield over treasuries.

To Inflate or Deflate?

If the credit crunch began with a fear of growth and damage control it has since shifted into a focus on the adverse effects from inflation. Especially, the nexus made up by the pressure from headline inflation fuelled by a weakening Dollar over to the ensuing pressure on risky assets have been much under scrutiny. In fact, it would not be a long shot to say that the graph below pretty well sums up the market's response to the credit turmoil.

The focus on inflation is understandable and important not least in the context of indications that inflation expectations have been edging up. Much debate has been devoted to the extent to which global central banks are really serious when it comes to focusing on inflation at the same time as the economic edifice is crumbling. Of course, in emerging economies such as for example in Eastern Europe, key parts of Asia and Latin America inflation is a very serious concern as many of these economies are quite literally burning up. But how much can higher domestic interest rates help here? In a world where capital goes for yield, inflation targeting by one central bank will not work if the rest of gang chooses to go for growth. Moreover, there is the delicate point with which to balance the need for emerging economies to see nominal appreciation of their currencies while avoiding to become to the new global consumer of last resort as the hot money comes flowing in. China is almost a perverse example here since, while there has been no official mutterings about a revaluation money is coming in fast on the expectation that inflation ultimately will bring the USD peg to its knees (see nice discussions here and here). In India and Brazil policy makers are wrestling with the same problem as the attempt to keep the economy balanced conflicts with the need to do something about inflation. There are no easy solutions here it seems.

In an immediate policy context, there is also a lot of sentiment flying around I think. Lowering interest rates to cushion those who should not be cushioned and, in turn, submitting the global economy to a heavy yoke of inflation is thus not popular. Bernanke and Paulson are certainly making themselves distinctly unpopular in some parts of the investment community as they have chosen to respond to the crisis by supplying ever more liquidity. But could they have done anything else?

As I have argued before it is rather funny to see the US being branded the scarlet letter of the global excess liquidity source. The point here would be that it was only 1 and a half year ago that this role was assigned to Japan and since the BOJ has not exactly managed, with great force, to shed itself of the low interest rate policy it is difficult to see whether anything has materially changed? I shall be the first to admit that excess global liquidity is a problem and that this problem to a large extent is at the heart of the current mess. However, I would also wish that more people tried to connect the dots in a slightly more sophisticated way than to blame it all on Greenspan and Bernanke.

Ultimately then, this is first and foremost a debt crisis coupled with a search for assets to match the structurally persistent availability of excess liquidity. Thus, it is also important to understand that as we are about to enter a significant bout of asset destruction and while at the same time providing more liquidity, the global yield game is likely to intensify. The debt problem and the subsequent need for many economies to significantly tighten the belt and ramp up savings is a key trigger effect here. It means that the effects on the real economy may well turn out to be deflationary in the context of some economies who simply do not have the ability to propel internal demand at the same time as turning the ship around towards more focus on saving. If you doubt me on this I suggest you take a look at Spain and quite possibly also Italy, Germany and Portugal; not to mention key economies in Eastern Europe but that may be further into the future. In the end this is also why I have been persisting in my focus on the distinction between core and headline inflation; In for example Japan (top graph) and the Eurozone:

The figures obviously do not indicate that core prices are not rising since in many economies they are; and fast too. The point I would like to emphasise here is simply the asymmetries by which the current crisis may unravel with inflation continuing on a global scale while some countries risk falling into a Japan like deflation trap, out from which it is very difficult to escape. My hypothesis is furthermore that countries with a weak demographic profile will be in the front line as potential candidates to see persistent and ongoing deflation. In a Eurozone context I have been particularly adamant in pointing towards this risk since it is quite clear I think that the ECB would find it very hard indeed, if not impossible, to administer some variant of ZIRP in the context of one country. And then we have not even talked about the effects any provisional liquidity arrangements would have on the Eurozone's countries' relative sovereign debt standing.

So far the market discourse still seems set on inflation even if the recent near collapse of the two US mortgage giants have moved the focal point a slight bit. Moreover, and as is visible in the graphs above oil has recently taken a dip which is prompting many to ask whether the current rally is, if not coming to an end, easing slightly. In-house RGE analyst Rachel Ziemba asks the same question while Paul Krugman and Stefan Karlsson chimes in. I tend to agree with the sentiment expressed by these contributions and while it is true that oil may sell off it is difficult to see a plunge. I think there is a considerable hysteris effect in operation here (in the long run) with respect to commodities in the sense that they are much more elastic to the upside than to the downside. In the short term of course it may be well be the opposite case. 

My main point would simply be however that there is very little central banks can do about this. In fact, as can be seen from the recent Eurozone trade data flogging the Buck has not helped with that distinct problem. I would also add that we should never forget how rising costs of primary goods could ultimately add to the deflation pressure due to the cross price elasticity with core consumer goods. The key for me is the extent to which a given economy is able to muster the sufficient domestic demand to avoid seeing deflation in its domestic market if the going really gets tough. Italy, Spain, and Germany for example may not be able to do this.

Faint mumblings are consequently also beginning to move the focus from inflation to deflation/growth. In the Eurozone where the ECB managed to sneak a last minute raise past the post Trichet is bracing for a recession in the next two quarters which effectively means that the ECB's hands are tied. I also noted that the D-word was mentioned in a Bloomberg headline recently as Société Générale's Albert Edwards, among others, was quoted saying that deflation may be the next story to watch out for. Michael Mandel makes the same observation predicting that the next story on prices will be deflation. I hardly think that this would be a surprise. Personally, I am on record for flagging the deflation flag for quite some time and while it has nothing to do with complacency against inflation or me being an apologist, it is simply a question of adequately balancing the risks.

One Year In ... Still Some to Go

Almost one year into the credit crisis the hard truth remains that we are not near the end of the road. Things are likely to get worse before they get better.

In this note I have dealt with a couple of themes. Firstly, there is the strict market perspective where fundamentals and trading models are being revised by the day. As I noted, I do think that we need to see some volatility in currency markets soon, but in what direction obviously remains the key question.

More specifically, I have also re-visited old arguments and not least in the context of the much tarnished BWII edifice. In many ways, one could argue that it already has crumbled or at least changed significantly. It is consequently quite clear that the US decisively has signalled the unwillingness to act as the future anchor, effectively pushing the decision over to the USD peggers who are finding it more than a bit difficult to contain inflation while at the same time staying pat with their currency policy. Given the extent to which emerging market and BRIC central banks are willing to intervene it is very difficult to envision some kind of rapid move. All this has so far handed the Euro with the dubious honor of taking over from the USD. This is not very likely to be sustained, but when that is said it is also hard to see how the EUR/USD could suddenly move back into the 1.20s. The need to correct a US deficit and rebalance the US economy will mean that Trichet et al. WILL need to pay off their strategy with interests.

In a similar vein, I have emphasised the need for economies such as Brazil, India, and Turkey to accept their potentially new role in the global economy. If they do not, we will simply have too many exporters relative to importers and even if these three do not go mercantilist there will still be too much savings going for too little yield. This is still the ultimate nut to crack in the global economy and the sooner we realize that demographics have something to do with it the better.

Finally, I also noted how the discourse perhaps slowly is beginning to nudge back onto growth and, if core inflation remains subdued, deflation. So far, this is not the case but it is a narrative important to watch I think since it may change quite quickly.

Post Script

Here at the end of my note I would like to feature (or present as it were) two pieces which I enjoyed immensely reading but never really got to comment on; an omission which I am sure my readers will excuse given the sheer amount of pundity being posted on the internet. The author is one Cassandra who, apart from doing Tokyo on a regular basis, recently returned from the soothing calm of Tyrol in Italy to resume services. 

On a side note I would not be going out on a limb, I think, when I say that Cassandra, together with Macro Man and the olive producing Charles Butler make the econsphere a distinctly better place to be. The reason for the grouping of the three might seem odd at first but if you read carefully and stay with them for a while you will see that they manage to combine succint observations and deep financial knowledge with excllent writing; a combination I value greatly.

Anyway and to move things back on track before this turns into a fan letter I thought that the following pieces by Cassandra were very much to the point with respect to (attempting) a lateral cut through this whole mess in which the economy and financial system finds itself.

Liquidity Tug-o-War??

Notes To Self - End Q2 2008

A belated plug I know, but still much worth a closer look.