Thursday, February 4, 2010

February 3, 2010 Investment Perspectives — US and the Americas

Mind the Gap: Even Record Slack Won’t Crush Inflation

Disinflation risks limited. Record ‘slack’ in the economy — a 10% unemployment rate, a 7% output gap, and operating rates lingering below the levels in past downturns — suggests
near-term downside risks to inflation. Indeed, although rising energy quotes have boosted headline inflation back to as high as 2.8%, measured by the CPI, ‘core’ inflation by any metric is now at or below the Fed’s presumed comfort zone of 1½-2%. But in our view, those downside risks are limited: The slackinflation relationship is looser than in the past, slack itself its narrowing, strong global growth is pushing up commodity and import prices, and some measures of inflation expectations are rising. As a result, our inflation views are unchanged: We expect core inflation to decline towards 1% over the next several months, but to rise back to 2% in 2011.

US Economics US Budget Forecast Update: The Song Remains the Same

We are updating our US budget forecast to incorporate the CBO baseline estimates released recently and some of the policy proposals outlined in President Obama’s State of the Union Address. Also, we consider the long-run budget picture. The bottom line is a slightly more pessimistic assessment of the US government’s fiscal situation over the next few years than previously thought and a dim view of the longer-run outlook. For the current fiscal year, we expect the US budget deficit to be $1.325 trillion (or 9.1% of GDP), compared with our previous
estimate of $1.25 trillion. The deficit is expected to decline gradually over the next few years as economic recovery takes hold, tax rates rise, and stimulus-related spending slows. In 2011, our deficit estimate is $1.16 trillion (7.7% of GDP), and by 2012 we see the deficit at $930 billion (5.9% of GDP). While the declining trajectory of these projections might seem somewhat encouraging, it should be noted that further progress beyond 2012 would be grudging at best under current policies.

Occidental Petroleum Growth, Returns, and Oil Leverage; Pullback Provides an Entry Point; Overweight

Upgrading OXY to Overweight in the context of our bullish oil outlook and recent pullback in the shares. We have introduced a $100 price target and would be buyers today. We have transferred coverage of OXY from Stephen Richardson’s US E&P universe to our Integrated Oil group; we have co-covered OXY since October 2009.

We like the stock at current levels. We believe an investment in OXY represents a 2:1 reward-to-risk into 2010. We believe $65 per share (our Bear Case) is a likely floor valuation, having been fundamentally lifted since March 2009 (based on our constructive view of crude and Occidental’s recent exploration success). Further, we believe the risk-reward is even better on a longer-term holding as Occidental has visible and higher longer-term growth potential

The Blackstone Group Overweight — Don’t Measure in a Vacuum; LP Decisions Matter Most

Initiating coverage of BX at Overweight with an $18 year-end 2010 price target. We believe that the Street under- appreciates Blackstone’s business model and relative strengths: Ultimate value should be driven by the size of funds raised across private equity, real estate private equity (PE), funds of hedge funds (FOF), and credit. Decisions by LPs (pension funds, endowments, sovereign wealth funds, etc.) on allocations to alternatives and managers are far more important than quarterly marks/public market’s view of investments cycles. Blackstone can (largely) only control its performance versus other managers. What the Street thinks of Blackstone in a vacuum matters little to its ability to create long-term value, as long as LPs continue to allocate to alternatives and believe Blackstone is generating outperformance.

Morgan Stanley Research
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