My Diary 396 --- US: Where Do We Stand; Asia: W

My Diary 396 --- US: Where Do We Stand; Asia: What Do We Expect; Stock: What are Key Drivers




April 13, 2008


My gut feeling says that the recent bear market rally may have come to an end after Wall Street stumbled the most in five weeks on Friday. It is the second phase of the game, so-called earning contraction caused by a credit market crisis and the subsequent economic slow-down (if still not a recession yet), that steps up in the whole bear market show…Recalling the list of recent disappointing 1Q reports, we have seen a cross sector weakening trend, including General Electric, UPS, Alcoa, AMD and Washington Mutual…Adding salt to the soft sentiment is a 26-year low of consumer confidence.

As a result, equity prices were down broadly in western markets, sliding 2% in the US, 1.6% in Canada, 1.2% in the UK, and 1.3% in the Euro area. By contrast, Asian equity markets were up, with Nikkei +2.9% and HSI +1.9%. On balance, global equities slipped 0.8% today, bringing the YTD contraction to 10.2%. Elsewhere, volatility remained largely range-bound this week (21-22). UST curve steepened a bit with 2yr@1.74 and 10yr@3.47. In the credit side, HG and HY CDS ticked up this week with iTraxx AxJ HY +15bps wider to 550bps, while HG index out by 11bps t to 136bps, but both are well off their mid-March highs. 1MWTI oil price held onto its recent gain at $110.14/bbl, precious and industrial metals also drifted higher this week.
  
There are many topics to be discussed after the beginning of 1Q08 earnings season brought a halt to the recent rally. Overall, I maintain a short bias, given the expectation of more negative fundamental news as financial deleveraging is unpredictable and on-going, US and global economic growth is now under high pressure and investors remain cautious toward any unexpected shocks. Echoed to my judgment, the G7 Finance chiefs said that “the chain of bad news may not have come to an end “(by Italian FM Tommaso) and “the market is still adjusting, the turmoil has not yet settled down'' (by Fed Vice Chairman Donald Kohn) …… So I think it is fair to say that it's still a fragile situation out there……


US: Where Do We Stand?
To bring an end to the credit market turmoil and restore confidence in financial markets, the No.1 question is how much loss we will suffer from the write-down on Subprime assets. An easy answer is there are still more to come as the US economy slows. In reality, total Subprime-related write-down have now surpassed $300bn and many Wall Street CEOs expect that process would seem to be >50% finished. However, the pace of total write-down may not slow in the coming Qs given market estimates of another $200bn in losses to come on Consumer and Corporate debts…Certainly, there could have some “Unknown” losses pop-up in the coming future as economic fundamental deteriorates  and house prices shows no sign of stabilizing …Thus, given the aggressive measures taken by the Fed and a significant government bailout package provide by US government, questions remain on the market transparency and the credibility in the financial sector, plus the resistance of other major central bank to ease in the face of high inflation…As a result, we should not foresee a resumed and widespread risk-taking activities from investors.

Having said so, US earnings season began on Monday with a weaker-than-expected report by UPS and Alcoa. Further negative earnings disclosures by AMD in the semiconductor space and Washington Mutual ($3.5bn 1Q loan loss provisions) also weighed on sentiment. The most surprising miss came from GE, which reported its 1Q profit decline in 5 years and slashed 2008 forecasts due to weakness in its finance unit. On the consumption front, generally weaker-than-expected SSS numbers and accompanying downward guidance revisions provided further evidence of the persisting consumer slowdown…Macroeconomic news also provided little support with soft pending home sales data (-1.9%). Given that housing-related concerns have not left the market, S&P downgraded the mortgage insurers this week. In addition, weak consumer confidence (63.2, lowest in 16 years) and jobless claims (+38K to 407K, highest since 2005) provided a picture of the Squeezed consumers. Inflation (+4.5%) now is running ahead of the growth of wage (Hourly earning +3.6%), plus $110/bbl crude price and avg $3.32 gasoline price so far, consumers must struggle to maintain the living standards. No wonder retail stores shed 12K jobs last month and US light vehicle retail sales are down by 20% yoy… Wow, this is just the start not the end of the process argued by some private economists, as the US labor maker is rolling over …Why? The birth/death ratio has made the BLS job data overestimating the jobs when the economy is slowing down (Actually there were negative revision of totaling 67K jobs in the first two months).

According to the BBG, the GE report marked the 3rd straight Qs of declining profits for S&P500 as analysts has reduced estimates for the14th straight week on concern fallout from the US housing slump will spread beyond financial companies. Earnings at companies in the S&P 500 are forecast to fall an average of 12.3% in 1Q08 and 3.8 % in 2Q08. However, I have to acknowledge that performance is differentiated across sectors and companies with the pain has so far been in the financial sector -- earnings are contracting and share prices have dropped 35% peak to trough, compared to still positive earnings growth and only a 15% decline in non-financials (peak to trough).

Bottom-line: The current rebound may have trouble to move head, given the weak economic backdrop and sticky credit spreads. In terms of positive indicators for US economy and broad equity markets, a decisively narrowing of credit spread, a stabling housing fundamentals and a sizable correction in energy and commodity prices would be on my watch.


Asia: What Do We Expect?
All the above discussions should have some important implications to what will happen in Asia. As many pointed out, Asia is much safer than it was in 1997-98 as our consumers, corporates and governments’ B/Ss are not dangerous leveraged any more. According to the CLSA, the net gearing of AXJ companies has dropped from 58% in 1998 to 15% in 2007. However, such a B/S improvement does not imply the Asia will immune from the current downturn led by the US since the risk of US consumer turning from a spender to saver represents a deflationary shock to the world economy and the export-driven Asia (Exp/GDP: China =40%, Korea =40%, India =15% LTM vs. China =20%, Korea =30%, India =10% in 2001).

The risk has been compounded in recent months by the deterioration of trade terms caused by the surging commodities prices. Moreover, the weak external demand has made it increasing difficult, if not impossible, for such companies to pass rising input costs to end users as the domestic consumption is suffered from the high inflation. In fact, the consumption of BRIC is only 33% of US consumption and will continue to rise as US economy/consumption slows down. But it is far from large enough to say the decoupling story completely... Thus we are going to see the margin squeeze of Asian exporter and manufacturers and the whole chain effect will be lower US/EU domestic consumption  slowing import growth to US & Europe  slowing Asia export growth and falling export prices  margin squeeze. Having said so, sectors like Industrials, materials and consumer cyclical are most at risk.

Painting a weak forward-looking picture does not darken the good FY07 earning results from China universe. 55% of MSCI China so far has reported a 24% EPSG in 2007, slightly lower than market consensus +28% (mostly dragged down by the energy sector). Excluding Oil/gas sector with policy-induced earnings losses, the FY07 EPSG is around 40%. However, there is a widespread concern on whether the Chinese list-ed companies can sustain its (+30%) profit growth rate? Risk factors like high inflation, policy uncertainty and weak external demand are still cloud in the sky, along with the above mentioned – a squeezed growth outlook/margin. YTD, the market has seen companies like China Communication Construction (120bp drop of its construction and port machinery business), MengNiu (GPM dropped 40bps) and Nine Dragon reported rising costs rising costs were cutting into profit growth. In addition, last week, the weak traffic growth reported by Air China may flag a slowdown warning (RPK declined from 10% in Feb to 1% in Mar). China Southern Airlines also reported softening growth recently.

Having talked so, some broker houses have started revising down the earning outlook of China/HK stocks. UBS last week reveals that its 82-stock HK universe will see 2008 pre-exceptional EPS forecast fallen by 12.92% from Sep07, while its 97-stock China universe will only find 5% drop from itsDec07 with major downgrades coming from expressways due to the impact of the snowstorm and Chinese IPPs due to rising spot and contract coal prices.


Stocks: What are Key Drivers?
Continuing the macro and micro debate, so far an obvious risk factor to Asian stocks is the earning expectations, given the realities if commodity-driven margin squeeze and slowing external demand. YTD, an interesting observation is that Asian stock market has underperformed its US counterparty with MSCI AXJ -14.7% vs MSCI USA -9.8% on early April. Certainly, this can be explained by the profit taking from investor as Asian markets have been the biggest winners since 2003 and risk aversion rises globally caused people to reduce the positions in the high beta risky emerging markets. The deleveraging or profit taking has made the local Price Multiple dropped from 19.4X in Nov2007 to 14X last week.

But I think the dominant factor for the difference of equity performance across the Pacific Ocean is interest rates, which tend to lead profit growth and therefore often dictate the direction of stock prices (If you see the Chart of FFR and S&P500). Importantly, a change in interest rates affects the discount factor for stocks as well as relative pricing of various asset classes. Therefore, the impact of interest rates on stock prices is “exponential”, while the influence of profit growth on equities tends to be “linear”. This is the key reason why S&P do not react to falling EPS when FED is aggressively cutting interest rates, while Asian companies are taking margin shocks.

However, the Fed’s interest rate tool box may come to an end as we are sitting on high commodity price and CPI figures. The Fed has continued to cut rates aggressively in the last 2 months but the credit market and the mortgage market has shown little if any positive reaction to the lower cost of capital: credit spreads remain high and US mortgage rates are edging up since Jan-08. In Asia, junk spreads are still 150bps higher than Dec07, while global HY spread are at levels consistent with recession. If this continues, then I think the rise in credit spreads will eventually lead to an increase in equity risk premium. Remember, the credit market is usually one step ahead of equity market…..

In the long run, stock prices are driven by two factors: earning growth and/or price-to-earnings. Thus, another important issue relating to stock market outlook has to do with P/E ratios. Multiple expansions have been the main factor behind the prolonged stock market boom since the early 1990s. P/E ratios rose sharply between 1980 and 2000 on falling interest rates and inflation. From a structural viewpoint, however, this period has probably come to an end with core inflation around the world has dropped to a low level (2.2%). Subsequently, interest rates have also lost their downward trend in DMs. Both of these developments suggest that expected equity returns should be in line with earnings growth over the long haul. This probably explains why P/E ratios for most equity markets in the G7 world have stayed more or less steady since 2003. Stock market returns in most G7 markets have been roughly in line with their respective corporate profit growth…Now, here come back to our base-line argument --- profit growth.

Having come up with argument around valuation and growth, let us doe a reality check on regional markets… As of Friday, MSCI AxJ dropped –9.3% YTD in US$ term, while gained 13% from its recent trough. China and India lost the most, -29% and -24% respectively. Valuation wise, MSCI China is trading at 15XPE08 with 24.9% EPSG vs. MSCI HK at 17XPE08 with -0.7% EPSG and MSCI AxJ at 14XPE08 with 13.8% EPSG. Earning side, financials saw the broadest downgrades with utilities the deepest cut followed by IT and energy.

A last note on RMB as it broke the 7 level. Overall a stronger RMB is positive for HK listed Chinese stocks, which is heavy in financials, commodities and utility concerns. The reason are 1) a stronger currency takes some pressure off interest rates, which allows the cost of capital to stay at much more simulative levels than otherwise would be - a clear positive for banks' profits; 2) a stronger RMB helps reduce import costs of natural resources, benefiting the profitability of Chinese utility and energy companies.


Good night, my dear friends!