My Diary 413 -- We Cannot Save At the Same Time; Bonds Turns into Burdens; Hedge Funds,
HKEx and HK Land; Twin Deficits May Come Back

August 3, 2008

A slow and deteriorating economy is the last thing wanted when FIs try to heal their wounds. Unfortunately, we DO have it now, if we are not in recession by definition…S&P closed out July on a down note, marking its 2^nd straight monthly loss, and market declines are now spreading through most DMs, along with weaker G3 economy. Recent data flows have proved that EU &JP have recoupled to the US downturn and EMs look set to slow, too. 

Interestingly, markets seemed to have switched toward the conclusion that a lower oil price and slower growth will lead to a sharp decline in inflation later this year and next. This is why we saw a breaking correlation between equities (Up) and crude prices (Up). I think this will be proved to be too optimistic as inflation will be sticky as “high oil prices + financial turmoil” imply both lower demand growth and output growth. But market sentiment does feel a bit changes as stocks do not drop sharply anymore on bad news. This suggests the concerted intervention of FOMC, UST and SEC has suppressed the attack on US financials. Plus recently we have seen the block deals of bulky CDO positions (NAB and Merrill)…Better than prices falling on no volume…But, my first response to ML’s CDO trade is whether this is the bottom-line of MTM CDO losses? If YES, then by using the “mark-to-Merrill” method, investors would see ~$700bn losses (vs. $400bn) for the $870bn CDOs issued just in the year of 2007. Then it comes to another Qs, why ML waited until after 2Q earning release to dump those CDOs and raise the new capital…Does it imply more bearish outlook on this asset class and financial sector or simply because NAB has set a benchmark of 10cs per dollar? One thing for sure is that it is just a mater of time that other houses may have to MTM their holdings down to similar levels.

OK, coming back to the markets, global equity markets declined 0.2% wow with US and EM stocks were strongest, rising 0.4% and 0.9%, respectively, this week. In contrast, EU stocks edged lower 0.3% and Nikkei fell nearly 2%. Commodity complex were fairly flat on the week. 1MWTI climbed $2 to $125/bbl, while agriculture and base metals both slipped ~1% since last Friday. Elsewhere, USTs yield lowered considerably with 2yr dropping 22bp to 2.49% and 1yr down 17bp to 3.93%, both at their lowest in more than two weeks.  Despite the lower rates, USD strengthened 0.9% vs. EUR (1.5567) and stayed flat vs. YEN (107.6).

The recent market patterns looks likely to roll over as short-term bias is to go higher, but will be punched by –ve macro data. I think, beside the risk of counter cyclical monetary policy and the rise of EMs, the biggest difference among this recession and the last ones are there are more damage done to FIs, so doe to consumer wealth as home prices keep dropping and now the normal credit lines are drying…It means the normal function of economy is disrupted and the future outlook is not pretty…Certainly, the wild card remains energy prices and the next week’ s FOMC meeting is especially important as continued softening of data may lead Fed’s outlook back to the old "classic recession" model. Regarding the outlook of major asset classes, stocks will likely to see the reverse of sector rotation as the bounce in banks & consumers and a fall in commodity stocks do not seem to be supported by fundamentals. Bonds are under pressure as inflation remains sticky while other bearish factor exist as well, such as foreign reserve managers selling and a return on the early 1980s style deficits to US, plus mortgage yields are higher than when the Fed first cut and most financials borrowing costs are sky high. In the FX space, USD is likely a range trade between low (US govt fail on GSEs) and high (GSE got fixed and rate differentials). However, one questions mark is whether the recent pike of YEN vs. EUR/AUD/NZD imply the stock market losses are going to widen? Oil side, risk seemed to point to the downside on technical indicators…Given there are so many to watch, including crude oil, macro data; market positioning and earnings, it is a better idea for summer vacation…

We Can’t Save at the Same Time

The recent forecasts for 09 USGDP growth can’t be any more divergent with estimates ranging from -0.5% to +3.9%. This explains why the markets remain trend-less and volatile. But the outlook of global economy appears clearer as we are going to see at least sharp slowdowns in G7 domestic demand and a moderation of EMs growth. My argument of Bear market Phase II (Growth/Inflation related) -- a slowdown spreading from US to EU and Japan, and then EMs has continued to find support in recent data prints…Starting from the IMF report which predicts continuing problems in the credit and housing market that will continue to hurt the financial industry, It says "at the moment a bottom for the housing market is not visible…and the growing concern is that, with delinquencies and foreclosures in the US housing market rising sharply, and house prices continuing to fall, loan deterioration is becoming more widespread. I think the issues now have gone beyond the US borders as S&P also forecasted that 1.7mn UK mortgage borrowers are expected to slip into negative equity as house prices continue to fall. In addition, investors once again found out that banks in other continents are hurt badly too…See the headlines: HBOS 1HNP declines 56%; Deutsche Bank 2QNP declines 64%; Lloyds TSB 1H profit fell 63%; Nomura lost Y153.9bn in 1Q08 and ANZ EPS dropped 25%... my personal take is not the stock price itself rather than the falling share prices are now making it harder for banks to raise capital, increasing the risk of a downward spiral in the global economy.

Regional wise, US 2Q08 real GDP was reported at 1.9% while 1Q08 was revised 0.1% lower to +0.9% and 4Q07 was revised 0.8% lower to -0.2%...You smell the recession yet?...  Moreover, consumption is bound to slow further; it rose just 1.5% in Q2 after a 0.9% gain previously. At the same time, Case-Shiller 10 &20-City indices fell by a record 16.9% and 15.8% in May, along with 10-month inventories of new homes and 11-month supply of existing homes. The number of US foreclosures has also risen by 121% to ~740K properties in 2Q08, according to RealtyTrac. Regarding employment, 1st jobless claims rose  to 448k and unemployment rate stands at 5.7%, the highest in 4years and adding to the evidence an economic recovery remains far off…No doubt, consumers will get some relief from the continued decline in oil ( a $10/bbl = 0.3% of US DPI), but to be sure, the current price of oil is about equal to its 2Q average and so the recent fall is not a boost to spending growth but simply the removal of a severe drag. Price front, outside food and energy, inflation is contained: the GDP deflator rose 1.1% and the core PCE deflator rose 2.1%.

For the Euro area, after the strong 1Q08 (0.7% GDP), a negative Q2 seems to be a done deal as both ECB and the German FM has warned this. In addition, the recent prints of July PMIs and the collapse in business and consumer sentiment certainly seem to be setting the economy up for a very weak 3Q08. The drop in the ESI was the biggest one month drop since 911 while inflation probably rose to 4.1%, the highest since April 1992, increasing pressure on ECB to raise rates even as economic growth slumps. Overall, a perfect storm is engulfing the Euro zone, with the economy hit by numerous headwinds to growth including the Fx rate, tighter credit conditions, weaker external demand, a squeeze on real income growth for households and latterly, higher policy rates…I think we will see a much higher probability of a recession.

Coming into Asia Pacific, economic activity in Japan took another step down in June with IP slumped 2% after contracted ~3% yoy over the past two quarters due to weakening domestic  and external demand. Moreover, the Shoku Chukin index (a timely indicator of SME sentiment) slipped even further below 50 from 40.7 to 39.9, alongside unemployment rate ticked up to 4.1% in June, consistent with the labor market outlook as indicated by the business surveys…Japan has been dead anyway, but a big headache for the regional economy is that Australia may be heading for a housing recession similar to those roiling in US and UK, with prices project by IMF to fall 30% by 2010…So time to buy a Villa there…Plus, Australia’ retail sales plummeted 1% in June, reversing May’s surge and continuing the downtrend owing to tightening financial conditions and rising CPI.  For the rest of AP, things are not doing well too, for example, Korea, consumer goods sales fell sharply in June after dropping in May. Similar weakening in domestic demand in June was reported in Thailand as well as in Hong Kong (TBD).

In sum, this week’s global data flow has brought a litany of woes that have highlighted by weakening domestic demand in DMs and EMs, softening IPs, and declining business and consumer confidence. In my own view, the outlook of G7 counties is going to drift to South and their citizens will save more going forward as CA deficits moderate due to slumping domestic demand. However according to, John Maynard Keynes, that during a de-leveraging cycle, everyone cannot save at the same time. If they try to, what results is a fall in aggregate demand. In effect, this is a prisoner’s dilemma as saving can be beneficial to individual countries, but harmful to the world economy overall.

(Note: the deleveraging will depress credit supply to the non-bank sector by roughly 15% in the US and 12% in Euro land by 2010. The expected cut-back in credit is likely to reduce US GDP growth by something like 1-1/2 percentage points per year over a three-year period and Euro area growth by something approaching that amount). These estimates indicate that the current credit tightening has the potential to be a significant drag on growth for some time to come)

Bonds Turns into Burdens

Reflecting the fragility of the financial systems, the Fed recently introduced an 84D TAF and extended TSLF and PDCF through to the start of next year. In the Fed's words, these measures are designed to address the still- elevated level of spreads in the interbank lending market. However, while the 1M Libor -OIS spread has stabilized, at longer maturities this spread has been creeping higher, suggesting that Bond investors aren't persuaded that the global credit crisis is easing. This suspicion has been reflected by the rising debt costs of Wall Street, and even the top-rated Berkshire Hathaway has to pay a high borrowing cost as its 40% revenue coming from finance-related businesses. In particular, Lehman has seen borrowing costs for its 5yr bonds rise to 7.7%, up from 5.2% 6M ago, or 4.3% more than 5yr UST, a premium almost double what it was in late January.

Historically, the last big gain in I-banks' credit spreads occurred in 1998 after Russia default and LTCM collapsed. The 5yr note of Lehman issued in April 1998 rose to 7.6% in Oct 1998 from 5.89% in Aug 1998, a 29% increase…If this is not telling you the story, then according to the theoretical VAR measures, the current market would like to see investors reduce positions by 50% to 75%, to capital levels in line with risk, suggested by the mortgage and corporate bond Vale-at-risk models. Certainly, this is not possible for the economy as a whole, but it suggests market volatility will remain high…The risk premium demanded by investors has sent the IG yields widened 26bp this month to 300bps, only 5bp from the record reached March 20, according to ML US Corp Master index. In fact, all three sub-categories of bonds had their worst performance (avg -1%) for fixed-income investors. Compared with 7.17% on average in 2007, corporate bonds (-0.2% ytd), mortgage securities (0.73%) and USTs (1.72%) returned only 0.5% on average in 2008, Merrill’s data shows.

Indeed, the performance of US bonds is a reflection of the environment we're in today, which is a sluggish economy with some inflationary concerns. Now, with CPI rose 5% yoy in June, the USTs don't yield enough to keep pace with rising costs in the economy…So in real terms, investors lost 4.5% on average.  Having said so, futures show traders see a 37% chance the Fed will keep the rate until Dec08, compared with 12% odds a month ago. There's a 93 % chance it will take no action on the rate at its 05Aug meeting.

Local market wise, iTraxx Asia IG and HY are largely unchanged from a week ago at 130bp and 517bp respectively. Recent week has seen ML CDO deal, lower oil prices, strong ADP report and 1.9% US GDP set a more upbeat backdrop. But, the reality is that after one of the toughest years that the financial industry has faced, the current spread tightening in the credit market has not necessarily been viewed positively. Rather, a strong air of skepticism remains among investors, given that 1) a number of Asian CBs started to make hawkish moves in fighting inflation, i.e.  India surprised the market by hiking CRR and repo rate by 25bp and 50bp; 2) the credit rating trends point firmly downward with heightened risks of breaches of covenants. According to Moody’s, 10% of rated AP corporates have a +50% likelihood to breach some covenants over the next 12 months; 3) we have already seen rating downgrades of a few Chinese property issuers, namely Hopson, Shimao and Neo-China. Thus given the lack of liquidity for Asian Credits and the low visibility of US 2009 outlook, Asian credits still have significant tail risks.

The implication of credit spreads to stock markets is quite straight forward.  Equity multiples have historically expanded during Fed easing cycles. However, risk aversion remains high and so the drop in government borrowing rates has not resulted in lower discount rates. Therefore, it will take an improvement in credit conditions and a narrowing in corporate spreads before equities can benefit meaningfully. To facilitate this process, we have to see 1) central banks become less hawkish, which in turn requires an easing in headline CPIs; 2) investors and banks need more clarity on the extent of losses from the US housing crisis. To this end, it is slightly worrying for stocks that corporate spreads have not really narrowed lately…Thus, to those badly damaged balance sheets, debt funding this year turns out to be a burden!

Hedge Funds, HKEx and HK Land

Last week, the Finical Times posted an article of "Hedge funds are having their worst month in eight years”. The monthly terrible return was due to the emergency ban announced on 15 July triggered aggressive unwinding of long-oil-short-financial trade. This is a crowded trade and it turns out to be a classic short squeeze, a race to cover shorts, not buying because everything that went up was the most shorted. Having said so, the recent sector rotation out of resources and into financials and consumer seems to be more about positioning as fundamentals had changed. In general, banks remain vulnerable to further capital raisings and declining ROEs, while oil stocks are traded with low PEs & high CFs with the ability to grow dividends. Thus, I think when the dust settles, markets will return to the old themes. This is not a difficult mathematics as when economic growth slows, banks will face continued headwinds in maintaining earnings due to falling credit quality, declining fee income, high funding costs, and exposures to monocline and mortgage insurers.

On the other hand, half the companies in the S&P 500 had made their bearish forecasts on Q3 earnings. According to BBG, 291 companies had reported quarterly results through July 30, and earning had dropped averaged 24%, the deepest decline since at least 2Q1998.  This erosion of earning growth has also seen in AP region as the ERR fell in July from 0.82 to 0.51, the lowest reading in 6 years, according to Merrill Lynch. In comparison to the -24% S&P earnings, half of A-share companies have provided interim results guidance with 70% expect positive earnings growth and 58% with above 50% earnings growth. In the mean time, MSCI China's major sectors such as financial, telecom, energy and consumer staples continue to have positive 1M, 3M and 6M earnings revision momentum. But whether this trend can persist is the key question to many regional or global PMs. In fact, the China politburo meeting has decided to prioritize "to ensure stable and rapid economy growth and curb excessive price upsurge", as opposed to "Two Prevents" set by in Dec07. While the reversal of A-shares on Friday was due to a rare speech delivered by President Hu Jingtao, that China needs to maintain "steady and fast" growth…I believe that the market will start to evaluate the government’s likely response to the rising growth slowdown risk, expecting the government to relax its tightening policy. However, given the high inflation risk, this is not likely to be easy, and we could expect low earnings visibility for the market ahead. In addition, PPI is rumored to hit 10% in July…Rise PPI + Decline CPI = Margin Contraction?

In addition, local markets have seen another historical low turnover in this year. The turnovers of both China A-shares and HK stocks have dropped over 30% with the lack of participation by institutional accounts. Overall, in such an uncertain market environment, if LO fund managers have been sitting on their hands, hedge fund managers may have been running fast to stand still. Industry data show 2008 performance across all HF strategies to have been flat to end-June. 1H08 seems almost to have been designed to put active managers in general out of business. The good news, perhaps, is that a flat outcome in a volatile climate may suggest that hedge fund leverage may not have been as high as feared. Furthermore, low volumes may be a clear feature as the holiday seasons starts to have a greater impact, but it also suggests that shorts have been covered given risk appetite has dampened as macro credit concerns persist…according to the HKEx, the DTO for HK market in 1H08 was 87bn, an increase of 40% yoy, however, the pace of decline was accelerating and the current AVDTO was only 66bn, so unless we have a substantial improvement both in turnover and IPO markets in 4Q08, we may see an HoH decline or even YoY decline in turnover…Short 388 HK as the price is assumed HKD100bn DTO for 2008 which seems too aggressive and the stock is trading at 23X PE…In short, I will look for a volume pick up and a broader long only participation to confirm a sustainable rally.

Back to Hong Kong, I am a bit worrisome on it economic outlooks as recently HK Land although delivered an impressive interim result (+56%), the key to note here is 1) the sluggish rental income growth of +12.6% HoH; and 2) the negative guidance from the management which is a sharp contrast to their "usual" bullish comment. To echo the company’s guidance, an interesting data point is the hiring expectation survey...the latest is 42% vs. 57% from the previous quarters and most importantly is the high correlation between the such index and the rentals for the Grade A offices. In addition, HK's apartment transactions (6.1K units) fall to a 10-month low in July, then could drop further, on concerns that accelerating inflation and a slumping stock market may push prices down, analysts from Centaline said. This is important as historically home values have tracked HK economy, peaking in the 2Q1997, and then crashing in the Asian financial crisis, leaving many homes worth less then their mortgages for years. The 2000 dot-com bubble burst, the 911 terrorist attacks and the 2003 SARS epidemic caused prices to fall as much as 70%t from the peak. The rebound started in late 2003 and prices doubled in the past four years. Enough history, we finally take a peak of regional valuation MSCI China is now traded at 14.5XPE08 and 22% EPSG, CSI 300 at 16.7XPE08 and 24.7%EPSG, and H-shares at 14.4XPE08 and 21.6%EPSG, while regional market is traded at 12.8XPE08 and 11% EPSG…H shares trading at a 12.5% premium to the region

Twin Deficits May Come Back

USD has been strengthened relative to major currencies recently. Some of the conditions contributing to the USD's bounce include s lower oil price, the confidence backstop provided by the US govt's GSE bailouts and increased concern about growth abroad. But I am not convinced those factors will be enough to help the USD sustain and extend its gain. In essence, the most recent stock market losses have not been enough to spark a widespread risk reduction in the FX market may be because leverage has already been cut, suggested by the breakdown in the previously close relationship between the VIX index and EUR/JPY (formerly a key barometer of FX market risk appetite). Going forward, the risk is that the "twin deficits" could come back to haunt the USD at a most inopportune time. As discussed, home prices are likely continue to decline, implying that existing MBS securities are at risk for further mark-downs and in that event, it will have negative consequences for the  holders of that paper going forward, i.e. China and Middle East reserve managers. Remember, in recent years, a material portion of the US CA deficit has been financed by selling ABS to foreign investors. If that source of funding is diminished, the US will have a more difficult time funding its external deficit, and that could represent a considerable problem for the USD going forward.  And that could be  further complicated by the deterioration on the US fiscal front, as  increased spending for items such as fiscal stimulus programs and the new GSE bailout program, combined with lower tax revenues (slower growth) increases the US budget deficit. Last week, White House said the budget deficit will likely rise to 3.3% of GDP in 2009 from the estimated 2.7% deficit this year. 

To whatever stock, bonds or currencies, oil remains a key wild card in the current environment, particularly as ST forecasts seem less reliable, or in other words, it's not at all clear where oil will go from here. However, technically, downside risks for oil prices persist in the near term, given several moderating influences –1) slowing Chinese economy will reduce its oil consumption, which has been the main driver of the change in global oil imports since 2002; 2) the energy demand destruction is accelerating across DMs, signaled by the plunging US vehicle sales and miles traveled; 3) both OPEC and non-OPEC supply are rising with the increased world rig count; 4) oil prices are overshooting its fundamental "fair value”=$80/bband the strong negative feedback loops from both financial markets and policymakers have began during the final upleg in crude prices.

Thus said, the recent pullback in crude oil prices from $147/bbl provided a much-needed relief for global asset markets, helping to put a floor under stocks, bonds and EM currencies. A sharp and sustained rise in oil prices impacts asset markets in three ways: inflation, trade and USD --- 1) high oil prices boost PPI expectations and may eventually pass-through to the consumer, leading to persistently higher CPI levels; 2) net oil importers see a significant increase in import values, which causes trade and current account balance deterioration; 3) As oil price has risen, this has led to deterioration in the US trade and current account deficits, which in turn has caused the USD to weaken. In sum, higher oil prices have been an important factor in causing EM currencies to weaken and USD-EM exchange rates to strengthen. Net-net, the rise in inflation and the trade balance deterioration are likely to cause a rise in nominal yields. Whether or not this triggers a depreciation of the local currency will depend on economic policy credibility, the structure of the balance of payments and market positioning.

Good night, my dear friends!