Fixed Income Weekly

The bond world has been a busy one lately. The situation in Greece has been very volatile, which is understandable considering the conflicting opinions in the market and the “contagion” type effect a Greek default could have within the Eurozone and beyond. Chairman Bernanke’s testimony was as expected, but still meaningful as Big Ben confirmed the need for exceptionally low interest rates for a considerable amount of time, in addition to the importance of the Fed’s role as the primary regulator of the banking system.

Treasuries have been fighting two separate battles. One is Fed policy. The short end has been bouncing around within a tight .7%-1.1% range for 6 months now. The hike in the discount rate last week brought about a kneejerk move higher in short-term yields, but after much nay saying by policy makers they have settled down to just about where they were before the Fed made the change. The Fed remains very unconcerned with current levels of inflation, Q4 PCE was 1.6% annualized versus 1.4% in Q3, but longer term effects of current policy have the market demanding much higher yields on the long-end, which explains the record high spread between 2s and 10s of 291 basis points on Monday.

Secondly, the budget/credit/currency issues in Europe are pushing money into dollars, and in turn Treasurys. It’s the typical safety trade really. It sure helped with the $126 billion the Treasury had to sell this week, which all traded through the “when issued” yield, a sign of better than expected demand.

Next week is full of more Fed speak, which should get the market jumpstarted after closing on a very quiet note (relatively) this week.

Have a good weekend.

Cliff J. Reynolds Jr., Investment Analyst

Weekly Roundup: ESRX, MON, RIG

Express Scripts (ESRX) +5.89%
Investors bid up ESRX shares following 2010 guidance that suggested the integration of WellPoint’s NextRx unit is ahead of schedule.

The acquisition of NextRx gave ESRX the scale to compete with its biggest competitors in the pharmacy benefit manager (PBM) industry. PBMs negotiate drug prices with manufacturers and retailers on behalf of clients.

ESRX’s proven track record of successfully integrating acquisitions and the firm’s outlook that suggesting synergies associated with the transaction are likely to come earlier have lifted investor confidence in the firm’s ability to achieve above normal earnings growth over the next few years.

ESRX and other PBMs are positioned to benefit from positive trends such as the aging population, healthcare cost containment efforts, and increasing customer acceptance of mail-order pharmacies. More important, though, is the looming patent cliff in 2011 and 2012 since ESRX earns profit margins when customers use generics over brand-name pharmaceuticals.

ESRX’s fourth quarter income rose 8%, including one-time charges from the NextRx acquisition, helped by an increase in the use of generic drugs to 69.1% from 67.3% helped push margins higher.

Monsanto (MON) -7.10%
MON lowered its second quarter profit outlook as the late 2009 harvest is shifting purchases to the second half of the year.

MON also said the two new products they are counting on to drive earnings this decade may be planted on 20% fewer acres in 2010 than previously forecast. Farmers are trying the new products in the numbers expected, but on fewer acres. MON said the shortfall may reduce earnings by less than 5 cents a share.

The two products of topic are Roundup Ready Yield soybeans, which increase yields 7% to 11% from the original product introduced in 1996, and SmartStax corn seed, which has eight genetic changes (traits) that resist bugs and tolerate herbicides.

MON shares have been crushed this year, but I think sell-off is not justified. The SmartStax corn seed is a true game-changer that can drive margins as well as market share gains for the firm’s corn business in coming years. As for the soybean product, China recently gave import approval to Roundup Ready 2 Yield soybeans, which paves the way for large-scale commercial introduction of the product.

Longer-term, MON’s success comes down to its powerful research and development efforts – the firm plows 10% of sales into R&D – and their elite production and distribution capabilities.

Transocean (RIG) -5.30%
RIG’s earnings trailed consensus amid decreasing demand for rigs. Only 69% of RIG’s fleet was working during the fourth quarter, down from 90% a year earlier.

Utilization declined in six of seven rig categories, more than offsetting the 18% increase in the fleet’s average daily lease rate. Idling rigs, even for a few days, directly hits the bottom line since the day rates (or rental rates) are so substantial.

The market is down on RIG shares after this report, but the company’s superior free-cash-flow generation and above average earnings visibility versus its peers should not be ignored. RIG management has made it clear they plan to return significant cash to shareholders through dividends and buybacks over the next two to three years.

Last week, RIG announced a $3.2 billion share-buyback program as well as the issuance of a $1 billion special dividend. Instituting a buyback program rather than paying out a larger dividend at this juncture gives the company financial flexibility for opportunistic acquisitions.

The potential for a jackup spin-off could also help support shares in the near-term.

--
Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks pared fairly large early-session losses thanks to an afternoon rally that sent the S&P 500 higher by 1.5% from the day’s low. The broad market failed to make it back to the cut line and all 10 major industry groups decline on the session but I think we can call this one a moral victory – for perspective, the Dow was off by as much as 188 points at the day’s worst. Mid and small cap indices managed fractional gains.

Things got started on a bad note as futures were pointing lower due to concerns over growth prospects in Europe and the likelihood that sovereign debt woes would spread throughout the zone. Also putting the hurt on morning trading was the latest report on jobless claims, which showed the uptrend has extended to seven weeks now. Initial claims have just about returned to the 500K mark – peak levels of the last two economic contractions.

But around 1:00CST stocks staged a comeback, which was also right around the time Bloomberg News reported that the Obama Administration may ban all foreclosures until they have been screened and rejected by the government’s Home Affordability Mortgage Program, or HAMP. We discussed this proposal to halt foreclosures in Wednesday’s letter, so I won’t get into it again here.

Telecommunication and financial shares led the decline. Consumer-related and health-care shares were the relative winners, but still down for the session.
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Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks were able to shake off an ugly housing report and snap a two-day losing streak after Fed Chairman Bernanke stated that it’s necessary to keep the fed funds rate “exceptionally low” in an attempt to spur demand.

Bernanke was on Capitol Hill yesterday providing his semi-annual testimony on the economy and monetary policy, an event officially termed Humphrey-Hawkins testimony although few still call it that these days, and that’s when he reiterated the economy still needs a record-low level of fed funds. That comment reversed a market retreat that had followed the release of new homes sales for January, which we’ll get to below.

Nine of the 10 major industry groups gained ground on the session, led by financial, consumer discretionary and technology shares -- the sole loser on the session being basic material shares.

Basic materials have been down for three sessions now, and the fact that they lost ground again on Wednesday when the overall market was up shows that the mid-session rebound in stocks was all due to the easy-monetary policy trade rather than upbeat sentiment on the potential for economic growth.

Normally, when the Fed reiterates they’ll keep rates at record lows for an extended period commodity-related material stocks are among the leading performers. But people are losing faith in a durable expansion (whether we’re talking global or domestic) and that’s invoking some profit taking within this sector, which has pretty much been in play since mid-January.

I’m not even sure traders want to be buying stocks at this level, but they feel this is the only place to deploy money because of the Fed-induced puny yields within the low-risk sphere – which is precisely a major part of the Fed’s agenda.
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Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks ran into some trouble yesterday following the latest consumer confidence report. The market started the session off about flat but once that confidence reading came out and spurred concerns that the global recovery will be lackluster things kind of fell apart.

Market sentiment appears to be increasingly mercurial. We have these weeks in which the market believes the recovery is going to be normal, both in terms of degree and duration, followed by stints of concern.

The former mentality, in my view, is one that’s distorted by ultra-easy monetary policy and unprecedented levels of global government stimuli. A recent viewing of the 1980s classic (ok, maybe not a classic) “Back to School” reminded me of a Dylan Thomas poem, and indeed the equity market doesn’t want to go gently into that good night, but rages against the dying of the light...I paraphrase. Yet we must acknowledge that debt-driven recessions don’t simply fizzle out as the aftermath drags on – its takes time for the de-leveraging process to play out.

Further, the severity of these types of contractions occurs so quickly that the government response is over-bearing and carries with it additional problems, particularly by delaying the inevitable and the misallocation of resources that result – adverse implications follow and they show up in a lack of business confidence and employment.

These are the realities with which the market is currently entangled, mistakenly euphoric by the distortive actions of government only to be occasional reminded by realities on the ground. We need end consumer demand to take over from the inventory cycle and government stimulus, yet this confidence reading was a stark reminder that we’re really nowhere near this scenario.

Troubles in Europe isn’t helping matters as those economies appear to be losing steam. The German economy unexpectedly stalled in the previous quarter and that is weighing on the entire euro-zone, not to mention their sovereign debt issues.

All 10 major industry groups declined on the session, led by financials (yesterday’s best performer), basic material and energy shares.
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Brent Vondera, Senior Analyst

Currency Swaps

Currency swaps have been getting some attention recently in relation to Greece entering such agreements to conceal the extent of its budget deficit.

In its simplest form, a currency swap is an over-the-counter derivative in which two parties agree to exchange streams of interest payments in different currencies. A country or corporation typically enters into a currency swap when they borrow money in foreign currency and are concerned about foreign exchange fluctuations.

For example, if a country like Greece borrows dollars in the U.S., then they have to repay that debt in dollars. If the dollar strengthens against the euro, then Greece’s debt burden would increase. As a result, Greece might prefer to repay the debt in Euros, and currency swaps are an easy way to do that.

In a plain vanilla swap, two parties exchange principal amounts at the beginning of the swap – the principal amounts are set so as to be approximately equal to one another given the exchange rate at the time the swap is initiated. Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts. At the end of the swap agreement, the parties re-exchange the original principal amounts – the principal payments are unaffected by exchange rates.

Greece’s swaps were not the plain vanilla kind that are designed to help manage debt, but instead were customized swaps designed to generate cash. In this instance, one party agrees to exchange money up front in return for higher payouts in the future. This sounds an awful lot like a loan, right? Yet these currency swaps are not accounted for as loans on the books of the national government.

It’s pretty easy to understand investors’ fears considering Greece has been hiding huge long-term liabilities from creditors. It’s even scarier to think about all the other countries that may have potentially entered into similar contracts.

Peter J. Lazaroff, Investment Analyst

Daily Insight

U.S. stocks bounced between gain and loss on several occasions Monday, failing to ultimately hold onto an afternoon session rally as energy and basic materials shares sent the broad market lower in the final hour.

Dovish comments from the ultimate monetary dove Janet Yellen – President of the San Francisco Fed Bank – helped bank stocks as she stated the Fed will need to keep rates very low as the economy will operate below potential for the next two years. Yellen is not a current member of the rate-setting FOMC.

Financial and industrial shares were the only gainers among the 10 major sectors. As mentioned above, energy and basic material shares led the decline, along with utilities.

Oil prices advanced past the $80/barrel handle again, just two weeks back it looked as though crude was going below $70. The index that tracks energy stocks didn’t follow this move in crude though as shares of Schlumberger (which makes up roughly 6% of the index) weighed on the measure. The oil-services giant announced it would purchase Smith International in an all stock deal. Schlumberger shareholders didn’t like the premium the company decided to pay for Smith, so sent the stock lower as a result.

Volume was lackluster yet again as just 905 million shares traded on the NYSE Composite. That’s 21% below even the weak average volume of the past six months and 35% below what was considered the norm a couple of years back.
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Brent Vondera, Senior Analyst

Daily Insight

U.S. stocks shook off pre-market jitters and an early-session decline to extend the latest winning streak to four days. The latest report on mortgage delinquencies and a better-than-expected CPI reading provided the impetus to push stock prices higher.

The headline delinquency figures for the fourth quarter looked good, in a relative sense. The report showed mortgages that are at least 30 days late improved on a quarter-over-quarter basis, although mortgages that are 90-days late deteriorated, more on that below.

The CPI data helped to ease concerns that the Fed will earnestly begin the Great Unwind sooner than was previously expected. Pre-market trading showed a significant degree of unease following the Fed’s surprise discount rate hike after the bell on Thursday (at least in terms of timing, Bernanke has telegraphed this was coming). The tamer-than-expected CPI print, namely the negative reading on core CPI (a worthless indicator right now in my view but the Fed continues to give core inflation readings -- which exclude food and energy prices -- the most merit), offered support the fed funds rate won’t be hiked anytime too soon.

It was a good week for stocks. The market was open just four days due to Presidents Day and the broad market was up in all four, ending the week higher by 3.13% and erased most of the late-January/early-February losses. As we open this morning, the S&P 500 is just 3.56% below the 15-month high hit on January 19.

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Brent Vondera, Senior Analyst