GREEN SHOOTS AND CHERRY BLOSSOMS

NOT A GREAT DEAL OF DIRECTIONAL CONVICTION FROM HERE; CHASE THE RALLY VIA U.S. CREDIT

I missed the fast and furious global equities rally that started six-week back. While I do not have a great deal of directional conviction, I think risk-reward for jumping into the market at current levels is not great. Continued positive economic surprises would be harder to come by as economists revise forecasts based on the better than expected data flow. Even if good news graces the market, it is no longer oversold to cause the price action evidenced in March. On the other hand, investors could severely punish negative developments.

Yet, I continue to be long spread products: high-yield (HYG), high-yield loans (FFRHX) and investment-grade bonds (LQD). Credit has lagged equities and if this economic improvement is for real, there would be a sharp catch up rally. Battered valuations would limit downside in the event of a setback.

BANKING SYSTEM ISSUES: POTENTIAL FOR UPSIDE SURPRISES LIMITED GOING FORWARD: LONG = GOLDMAN SACHS AND MORGAN STANLEY; SHORT = CITI AND BANK OF AMERICA

The surge in equities began with the assertion of return to profitability by Citi and Bank of America. The earnings out so far have been better than expected, but the massive rally in financials (XLF: 77% up since March 9, 2009) has probably already discounted this outcome. Concerns remain (Goldman’s missing month, AIG payouts, concentration of revenues in trading, impact of the accounting rule change, credit issues in the loan book etc) and sustainability is the key question.

Investors continue to evaluate the likely outcome of the tug of war between a better competitive landscape and legacy assets. Lehman and Bear Stearns’ demise has left future profit streams (and talent to capitalize on this opportunity) on the table. In my view, strong securities focused franchises are in a better position to attract this talent and gain market share. The banks with huge loan books will continue face problems and this should become evident at some stage during the rest of the year (unemployment lags the cycle).

The next big event is the result of the stress tests. Debate rages on how the government should publish the outcome. Questions are already being raised about the reasonableness of the economic assumptions underlying this examination of the financial system. Any declaration of universal health will strip the exercise of credibility. The message so far is that the government will probably release bank level data with a plan for capital injection in some form for the institutions deemed weak. Whatever the outcome, it seems to me that disappointment is more likely than not. Also, the potential for negative surprises is higher for commercial banks with huge loan books.

The last factor is the success of the PPIP. My initial conclusion is that the program will be more potent in tackling the legacy securities issues. Loans are carried at amortized cost and even 6:1 leverage might lead to prices which might result in significant write-downs.