Evening Market Update

Stress Test Results, GE, and Earnings Foster Optimism

Stocks finished the week on a high note following the release of the results of the European banking industry's stress tests, which showed only seven of the 91 institutions that were tested failed. However, uncertainty regarding the rigorousness of the stress tests still lingers as it revealed a total capital shortfall of only 3.5 billion euros and that the scenarios tested did not involve a sovereign debt default. The positive reaction by the market, albeit muted at first, may show that investors are anxious to move past the event and focus on earnings season, as Dow members Microsoft, McDonald's, and American Express posted positive reports, as well as Ford Motor Co. Also boosting the Dow, General Electric increased its dividend and restarted and extended its share buyback program. Elsewhere, Dow member Verizon Communications provided favorable wireless results, soothing the sting from a revenue shortfall, but Amazon.com fell far short of the Street’s forecasts. In M&A news, Sanofi-Aventis has reportedly made a move to acquire Genzyme. Treasuries finished lower as there were no US economic reports scheduled for release today.

The Dow Jones Industrial Average jumped 102 points (1.0%) to close at 10,425, the S&P 500 Index gained 9 points (0.8%) to finish at 1,103, and the Nasdaq Composite posted a 24 point (1.1%) increase to 2,269. In moderate volume, 1.2 billion shares were traded on the NYSE and 2.4 billion shares were traded on the Nasdaq. Crude oil fell $0.32 to $78.98 per barrel, wholesale gasoline lost $0.02 to $2.12 per gallon, and the Bloomberg gold spot price decreased $7.50 to $1,187.45 per ounce. Elsewhere, the Dollar Index-a comparison of the US dollar to six major world currencies-was 0.2% lower at 82.49.

Dow member Microsoft Corp. (MSFT $26) announced fiscal 4Q EPS of $0.51, four cents above the Reuters estimate, with revenues increasing 22% year-over-year (y/y) to $16.04 billion, which came in above the $15.3 billion that analysts were expecting. The company said product momentum continued during the quarter with the successful launch of Office 2010, and strong performances from Windows 7, Windows Server, Xbox, and Bing. Shares were lower.

Fellow Dow member McDonald's Corp. (MCD $70) posted 2Q earnings of $1.13 per share, one penny above the Street's forecast, with revenues increasing 5% y/y to $5.95 billion, which was just above the $5.91 billion that analysts were anticipating. The world’s largest fast food chain said each area of the world generated higher same-store sales-sales at stores open at least thirteen months-and traffic and profits. Global same-store sales rose 4.8% y/y, with the US rising 3.7%, Europe gaining 5.2%, and Asia/Pacific, Middle East and Africa advancing 4.6%. MCD finished lower.

Also, Dow member Verizon Communications Inc. (VZ $28) achieved 2Q profits ex-items of $0.58 per share, two pennies above the Street’s forecasts, as revenues dipped 0.3% y/y to $26.8 billion, which came up short of the $27.1 billion that analysts were expecting. However, shares moved higher despite the soft revenues as the company said it added 1.4 million total net customer additions, including the addition of 665,000 postpaid customers, or customers under contract, which are the industry’s more profitable group of clients, topping the Street’s expectations.

Rounding out the earnings reports within the Dow components, American Express Co. (AXP $45) announced 2Q EPS of $0.84, seven cents above the consensus forecast of analysts, as revenues increased 13% y/y to $6.9 billion, slightly exceeding the $6.8 billion forecast. The company said it saw higher cardmember spending, offset by a smaller loan portfolio and lower yields on both the securitized and non-securitized portions of its portfolio. AXP also said its provisions for losses-capital set aside to absorb losses-fell 60% y/y, reflecting continued improvement in credit quality. AXP was higher.

News from the Dow also came from outside the earnings front, with General Electric Co. (GE $16 ¹) increasing its quarterly dividend by 20% to $0.12 per share. The company added that it extended its share buyback program, which was set to expire in December this year, through 2013, and will resume the repurchase program-which has $11.6 billion remaining and was suspended in September 2006-this quarter. GE said it was able to restore its dividend at a historical payout level earlier than previously anticipated and extend its share buyback program because of continued strong cash generation, recovery at GE Capital, and solid underlying performance in its industrial businesses through the first half of 2010. Shares were higher.

Ford Motor Co. (F $13) reported 2Q EPS ex-items of $0.68, well above the $0.40 that was anticipated on the Street, with revenues gaining 16.8% y/y to $31.3 billion, versus the $30.2 billion that was forecasted by analysts. The automaker said it is ahead of where it thought it would be despite still-challenging business conditions, with profits improving across its global business operations. Although the company cautioned that its second-half profits will be lower than the first half, it said it does expect even better results in 2011. F traded nicely higher.

Amazon.com Inc. (AMZN $119) announced that its 2Q earnings came in at $0.45 per share, but below the $0.54 that analysts had anticipated. However, revenues at the online retailer grew by 41% y/y to $6.57 billion, which came in slightly above the $6.54 billion that the Street had expected. AMZN issued 3Q earnings guidance that was short of analysts’ forecasts. Shares were lower.

The Wall Street Journal is reporting that France-based pharmaceutical company Sanofi-Aventis SA (SNY $29) has made an "informal acquisition approach" toward biotechnology firm Genzyme Corp. (GENZ $63) citing people familiar with the matter. Those cited in the report said that the talks are in the early stages and any deal is far from being completed. Neither company commented on the story. SNY finished lower in US trading, while GENZ surged over 15% on the news.

US economic docket blank but focus is on corporate earnings and euro-area banks

Treasuries finished lower on Friday as some risk aversion continued to dissipate on another round of favorable corporate earnings reports and better-than-expected economic data out of Europe. The US economic calendar was void of any scheduled reports Friday, allowing traders to focus on the profit reports from the corporate sector and the release of the results from the stress tests of the European banking sector. The yield on the two-year note gained 2 bp to 0.58%, the yield on the 10-year note rose 5 bps to 2.99% and the yield on the 30-year bond increased 6 bps to 4.02%.

European bank stress tests disclosed

Following the close in European trading, the Committee of European Banking Supervisors (CEBS) released the results of the stress tests of the banking sector in the European region, revealing that seven of the ninety-one institutions that were tested failed. Also, the overall shortfall of capital of banks that failed totaled 3.5 billion euros. According to the methodology of the tests, banks failed if their Teir-1 capital ratios fell below 6% under either of two scenarios-the first an adverse scenario; the second being the adverse scenario with the addition of a sovereign debt component. The CEBS said that its adverse scenario included a one-in-twenty-year probability, which compared to the stress tests conducted by the US, which included a one-in-seven-year possibility. The adverse scenario includes a 6% increase in unemployment, a 6% rise on markets’ interest rates, as well as currency swings, however, some were disappointed that the sovereign scenario did not include the impact of a default.

The CEBS said that for the institutions that failed to meet the threshold for this stress test exercise, national authorities are in close contact with these banks to assess the results of the test and their implications, in particular in terms of the need for recapitalization.

Meanwhile the economic calendar in Europe continued to yield some favorable data, with the German Ifo Business Climate Index increasing from 101.8 in June to 106.2 in July, and the gauge of business confidence in Europe’s largest economy topped the 101.8 reading that economists had expected. Also, the UK reported that its advance report on 2Q GDP showed a 1.1% expansion quarter-over-quarter (q/q), well above the 0.6% increase that economists had expected. On a y/y basis, UK output rose 1.6%, also exceeding forecasts, which called for a 1.1% increase. Other reports in the region included Italian retail sales unexpectedly declining, but Italy's consumer confidence unexpectedly increased, while Spain’s producer prices rose slightly as expected and France's consumer spending surprisingly fell.

In the Asia/Pacific region, Australia reported a higher-than-expected rise in 2Q import prices, while Taiwan’s industrial production jumped 24.3% y/y in June, after a 30.99% y/y surge in May, and above the 22.00% increase that was expected by economists.

Solid gains as earnings and economic data help stocks overcome Fed testimony pains

With overhang of the looming release of the results of the European stress tests and recent lackluster US economic reports, which had stymied the beginning of 2Q earnings season, stocks managed to post sizeable gains courtesy of some friendly US earnings and global economic data. After financials came under pressure last week due to negative reactions to early season earnings reports in the sector, much better-than-forecasted reports from Goldman Sachs Group Inc. (GS $147), Morgan Stanley (MS $27), and Wells Fargo & Co. (WFC $27) added some support for the group to help pace the advance. Technology issues also received a boost, with Apple Inc. (AAPL $260) blowing away earnings estimates, but industrials stocks were the best performers on forecast-topping releases from Caterpillar Inc. (CAT $69 1)-which highlighted a slew of mostly better-than-forecasted reports from members of the Dow Jones Industrials-and United Parcel Service Inc. (UPS $63 ¹).

Materials issues also paced the advance as the group posted a steep gain aided by the sweetened sentiment from the earnings front, while also catching a tailwind from the global economic calendar. Manufacturing and industrial orders out of the euro-zone and Germany-Europe’s largest economy-exceeded economists’ expectations, while Friday's stronger-than-anticipated UK 2Q GDP, and a separate report showing UK retail sales advanced more than forecasts, added to the improvement in global economic sentiment. Also, smaller-than-expected declines in US existing home sales and the Index of Leading Economic Indicators, along with a higher-than-forecasted increase in building permits, which helped overshadow a larger-than-projected increase in jobless claims and a bigger-than-anticipated drop in housing starts, supported the optimistic backdrop and contributed to the strong gains in the equity markets.

The aforementioned data proved to be too much for the bears to overcome this week, though they did not go down without a fight, as they orchestrated a mid-week sell-off that threatened a positive week in reaction to Federal Reserve Chairman Ben Bernanke’s semi-annual monetary policy testimony on Capitol Hill. Markets were unnerved as he noted that the economic outlook remains "unusually uncertain," and there was little new information provided, such as the possibility of further easing as some had hoped for, instead he spent a considerable amount of prepared text devoted to the "exit strategies" only offering that the Fed continues to assess developments, and remains prepared to take further actions "as needed." Bernanke reaffirmed the Fed's view that the fed funds rate is likely to remain "exceptionally low" for an "extended period," with the progress in reducing unemployment slower than expected and that financial conditions were somewhat weaker in recent months due to fallout from the European debt crisis.

Economic calendar to shine light on rate of US economic growth in 2Q

The economic calendar starts off with Monday's release of new home sales, expected to show a 4.0% rise month-over-month (m/m) in June after plunging 32.7% m/m in May to an annual rate of 312,000 units. Sales of new homes, considered a timely indicator of the housing market as sales are recorded as contracts are signed, fell to the lowest level since 1963 in May, to an annual rate of 300,000 units. Housing data continues with Tuesday’s reading of the S&P/CaseShiller Home Price Index, which lags the sales data by a month, and is forecasted to rise 3.8% y/y, and increase 0.1% m/m in May.

Durable goods orders will be reported on Wednesday, expected to have risen 1.0% m/m in June after declining 1.1% in May, while ex-transportation, orders are forecasted to have grown 0.4% m/m, after increasing 0.9% in April. Additionally, the Federal Reserve's Beige Book will be released mid-day, wherein Fed staffers summarize anecdotal economic data from all twelve Federal Reserve districts in preparation for the next Federal Open Market Committee (FOMC) meeting scheduled for August 10, and is used as an input to the Fed's decision on whether to make any changes in monetary policy.

The headline economic release will be Friday's first reading of 2Q gross domestic product (GDP), expected to show a 2.5% quarter-over-quarter annualized rate of growth, after expanding by 2.7% in the first quarter. Personal consumption is expected to have grown 2.3%, down from the 3.0% pace in 1Q. Inflation is expected to have remained benign, with the GDP Price Index anticipated to have risen 1.1%, the same pace as in 1Q, and the core PCE Index, which excludes food and energy, is forecasted to increase 1.0%, up from the 0.7% rate in 1Q.

Growth estimates for the US economy have been revised down over the past month, as retail sales, new home construction, inventory building and net exports have come in weaker than expected. While some economies could contract (notably in Europe), we believe most will avoid a double-dip, which is a rare occurance. Growth in emerging economies, which have grown in importance and contribution (nearly 50% of global GDP on a purchasing-power basis), should enable positive global growth. However the outlook is likely to remain hazy for the foreseeable future, while trends in Europe, the US and China are sorted out. Despite the release of the European stress tests today, tensions over government debt will likely remain.

Other US economic releases include the Richmond Fed Manufacturing Index, the MBA Mortgage Applications Index, weekly initial jobless claims, and the final University of Michigan Consumer Sentiment Index for June.

The international economic calendar next week will include consumer confidence, import prices, CPI and retail sales from Germany, PPI from France and Sweden, both PPI and CPI from Italy, housing data from the UK, while the euro-zone will report business and consumer confidence and CPI. Further east, Japan will release retail sales, CPI, industrial production, employment and trade balance figures, while China will report the HSBC manufacturing PMI.