My Diary 329 --- Market has a human side, Who can beat A-Shares,

 

My Diary 329 --- We’re not out of mud yet, Market has a human side, Who can beat A-Shares, We learn from the History!

 

 

 

September 14, 2007

 

 

PE, BSC, ABS, CDO, HF, ABCP, CP, SIV...If ever there was a time to learn about acronyms in the financial industry, this summer was certainly the school-time, and surely it has been learning the hard way. The only relief that has soothed the nerves of investors has been the FED and ECB‘s stepping in to provide the liquidity the banks have needed and in an attempt to stabilize short-term rates…. But as what Jamie said --- the credit collapse remains complex.

 

 

We’re not out of mud yet!

Some people felt better today as market was firm O/N witnessed by the equity rally, bond sell-off and EUR/JPY move, and various factors, including CFC securing refinancing, strong claims data,  LIBOR dropping and rallying USTs contributed to the better sentiment. The recovery in risky assets (sell off in Treasuries) seemed to come back due to a slightly firmer data and the emergence of some stability in the money markets as huge volumes of CP rolled this week…… Cheers but wait a minute, buddies!!!

 

As I wrote, the credit collapse remains complex and the problems are quickly shifting as the markets see the news that a UK mortgage lender Northern Rock (stock price down 24% today) is in trouble. The new sub-prime victim cries due to a "severe liquidity squeeze" then goes he BoE as lender of last resort. What I learned from the “rocked” UK lender is that the global nature of this credit crisis has been underestimated over the past few weeks as many ppl think the hits remain a US risks only.

 

In fact, the advances of broad indices are not worth for cheering!! Their recoveries are based on low volume and led by those most shorted in equities namely financials and consumer discretionary. This suggests the moves are a squeeze on the basis trades rather than a massive shift in sentiment. Moreover, The 25 vs 50 debate for FED CUT appears to have ended with 25 being the expectation. But what happens after that is now the question? How much more? Is this insurance or a new easing program? With next week coming quickly and there is a plenty of investment banks announcing and the Fed Sept 18 meeting, I can't clearly and comfortably see the Treasuries selling off hard into these risk events and I believe investors could sell more risky assets… that s what I mean we’re not out of mud yet!

 

 

Market has a human side!

Over the week, the market indeed saw a more balanced spread performance outlook in the next two weeks, primarily due to significant headlines over the next week that have the potential to drive spreads either way in magnitude. The current OAS reflects both fundamental and technical stress in the market, and ppl must recognize the repricing that has taken place.  The long list of concerns in the last 6M has nearly all materialized, with a large corporate default the last unrealized fear.  This is unlikely to happen in the short run.  However, in the short run we must recognize the real possibility the credit markets rally in magnitude sufficient to hurt performance, as the Fed and Wall Street may provide risk takers reason to run.  But what could the Fed do if credit keeps reprice wider, keep rates stable?  Not likely…..

In fact, bank capital has taken a big hit in the last couple of days. Tier 1 bonds have moved up to 60bps wider this morning. Rumors of capitulation trades are combined with the ABCP rolls, the fear of new issuance and lack of any liquidity from the market makers. Fitch and S&P have both put out reports to try to help stabilize bank debt in the last week. In fact, it is in their interests to support spreads as it is their AA rated bonds that are dropping like stones and the EU has commissioned an investigation into the behavior of the rating agencies - but that's another story.

Both agencies summarize that banks can cope with the capital and liquidity implications of the unwind of leverage that has built up over the last couple of years. With USD2.9 trillion of equity in the US and USD3.4 trillion in Europe, the numbers simply means that at current estimated levels of writedowns, banks would lose about 3% of their equity in this downturn. Banks have been earning 15% ROE over the last few years and therefore overall, we are looking at the loss of about 1/4yr earnings. Fitch have also tried to estimate the impact of taking all the SIVs and conduits back on balance sheet. The current Tier 1 ratio average is 8.1% - it would drop to 7.9% if the assets were brought on. Bear in mind that the regulatory minimum is 4% and the buffer looks credible.

All this says that logically, banks will be OK. But both reports don't factor in the human side of financial markets (Hey, these quant guys put too much love to their models, but not people!!!) Right now the banks are stockpiling cash to provide for the worst case scenario. This is a bit of a self-fulfilling prophecy and money markets are still struggling to return to normalcy. My bottom-line is still same ---it is very difficult to estimate the amount of leverage still left to be unwound.

 

Who can beat A-Shares?

I bear a question in my mind for a whole day, and that is who can really beat down the A shares? Overnight, a economist's talk from Mr. Xu Xiaonian (“the risk at A share market at this moment is very high”) and CSRC’s warning to fund companies (“even blue chips can have serious bubble”) and rumor on interest rate hike ( It turns out to be truth today), basically has little impact on the sentiments.

 

Markets appear to have shrugged off Chinese inflation data a on the basis that most of the rise was food-related and SHCOMP up 1.64% to 5312. Sector wise, Airline is the best with Air China (+10%) and  Southern Airline (+10%), following by Alcohol like Wuliangye (+8.71%)..... Do Chinese Airlines allow ppl who travel in the National Day golden week bring a bottle of Wuliangye? Hmm, looks likely from stock market...:)

 

Another reason I can think about is that the RMB’s consecutive appreciation will help airline companies to bear less USD debt pressure. Actually, this brings my another point that with China's latest 6.5% yoy inflation print , the authorities are  nowhere near tightening enough. (Note: real rates are now around -3%) A negative number! As a result, I still hold a view that currencies will eventually be used as a primary tightening instrument.

 

Talking to the regional CIO  today, we basically agreed on that asset allocation sounds more difficult in Asia now, compared to three months ago, as US growth is slowing, investors are avoiding risk, valuations are expensive and markets are volatile. This is why the market will stay nervous for a while longer. In this environment, we advise investors to focus on markets and sectors with good stable growth and low risk, and cut down weights in tech and cyclicals, shifting to sectors such as telecoms and consumer staples.

 

But, whatever happened in the credit markets, the H-shares market is still buying several stories --- 1) the A-H discount theme; 2)the cheap industry leader theme (China Mobile, Lenovo, Yurun and Mengniu); 3)the asset-injection theme (Shenhua, Shenzhen Intl and China Travel); and 4)the A-share issue theme (Shenhua, China Coal, Zijin, COSL, PetroChina and so on). Some street analysts even predict that the QDII investment will become the price setter for many H shares and we'd better change how we pick stocks according to their preference. Their reasonings are 1) global funds tend to be more sophisticated in valuation but domestic funds know fundamentals of the Chinese firms better and are much quicker in obtaining information, and 2) experience with A/H dual listing stocks shows that A- share price tends to lead H-share's.

 

 

Dollar will be back but Oil remains Strong!

The dollar has sold off sharply since the Fed change its bias and the market finally priced in aggressive rate cuts after the pending house sales and NFP shocker. However, the sell off appears to run out of steam today after having made a new all-time high indicating that the long dollar squeeze has finally run its course…What a difference a day makes let alone a week!!...... The key question is how long will this new-found optimism last?

 

In the commodity world, Oil seems not stoppable like A shares recently. According to the Merrill Lynch, the combination of strong global energy demand and a 650K b/d world oil output contraction in 3Q07 propelled the WTI market. And this situation could continue until 2008 for three reasons. First, inventories at Cushing are low and new storage capacity is now available, reducing the marginal value of storage. Second, the availability of refining capacity has increased, pushing crude oil inventories down further. Third, ML estimates that the full pass-through of OPEC's output increase into prices to be around 5 months. Thus, US soldiers in Iraq may be better off by staying in the desert and enjoy the real Crude…J 

 

In general, the global economic momentum still favors commodities. Tactically,  the super-cyclical indicator, the Baltic Dry Index, continues to hit new highs, highlighting the strong demand momentum in the commodity sector as well as the underlying supply constraints. Except for a relatively minor increase in volatility, commodity markets have barely experienced any adverse effects from the credit crunch, and ML believe that global economic activity will remain firm in the face of a US economic slowdown..

 

 

We learn from the History!

US economic weakness is not news now, but what matters for getting markets right is what the exact magnitude of the slowdown will be. I do not know the exact answer to this question, but I think I can learn something from the history.

 

There have never been two periods in global financial markets that have played out exactly alike. The last two times when there was major turmoil in financial markets, the Fed cut interest rates only to begin raising them again within a matter of months. As it turned out, neither the October 1987 stock market crash nor the Russian debt default in August 1998, which caused bond markets to seize up around the world, depressed US economy growth as was widely expected. But no one can be certain how the current turmoil will affect the economy in coming months, even some economists. What makes this time more complicated is in neither instance was the economy coping with a severe housing contraction. So things may turn out quite differently this time.

 

There is another big difference is the current crisis of confidence in financial markets differs from that during the 1998 failure of LTCM. That institution was involved in a portfolio of significantly leveraged transactions involving bond/swap spreads and the unwinding of these had a knock-on effect throughout the financial system. Conversely, the current financial crisis is different in that securitization technology has facilitated purchasing of the underlying collateral - namely subprime mortgage receivables - and repackaging it into an array of diverse securities that have found their way into a much broader investor universe. The issue right now is one of not what we know, but what we do not know --- who holds them and what is their exposure?

 

Sure, there are also a number of similarities to the global economic and financial environment in 1990s. In early 1990, the US was entering a recession caused by previous Fed tightening, while the real estate crisis and the oil price spike due to Iraq’s invasion of Kuwait were also weighing on US growth…Sound so familiar -- Iraq, Oil, real estate…this is the history, oh, no… it is today too.

 

Doing a scene replay quickly….in the 1990 selloff, US stocks were down 20% with bank stock prices collapsing by about 40%. Importantly, the plunge in US share prices in 1990 preceded the contraction in US demand, and the bottom was associated with the beginning of a Fed rate cut cycle. Furthermore, share prices trended higher despite the fact that the US economy and employment contracted in 1991. An important lesson draw from history is equity valuations then and now. The P/E was 15 for the S&P. Later, the rally from the 1990 bottoms was driven by multiples expansion at a time when earnings had slowed. Today, US market PE is 17X and as the Fed eases and growth slumps, equity dynamics are likely to evolve in the same way. So if Fed reflationary policy is proved to be effective in its history, I will repeat some words again --- History is repeating itself!!

 

 

Good night, my dear friends