My Diary 345 --- Can Fed Cut, More Questions than Answers, Rotat

 

My Diary 345 --- Can Fed Cut, More Questions than Answers, Rotating Chinese Shares, Oil-Sweater Swaps

October 29, 2007

It will be data-heavy week with numerous important releases throughout the next couple days. The market's focus now is on the FOMC meeting on Wednesday with a pricing in more than 25bp cut However, today’s BBG head line news indicates the Fed remains cautious in signaling a more aggressive monetary easing, even though recently there are more evidence of economic slowdown in the US has emerged.

Now it is a time to make judgment call and let us start with looking at the Fed’s capability to cut rates, and then see if we can figure out why the stock market is so excited before we take a glance at oil (93$/bbl) … I am thinking to FedEX some sweaters to my friends in Toronto and New York for this winter.

Can Fed Cut?

Over the past two weeks, the markets continue to hear many debates on the Fed is able to cut rates further during this cycle because of heightened inflation risks as a result of high commodities prices and weak Dollar… I think by and large the answer is YES.

Two reasons I can offer – 1) Fed has no control over commodity prices as they are determined by an increasingly inelastic supply curve(I will talk about it later in Oil as well) in the base materials, implying that a modest increases in global demand can generate outsized increases in the prices of copper, corn and crude oil. Moreover, what underpinning the commodity price is the emerging markets’ growing appetite, instead of US economy. 2) Dollar wise, exchange rates are set in the open market and in part reflect the relative growth prospects of each country. If currency is a leading indicator, then the Fed should cut rates more, not by less.

In addition, as I wrote in my previous diary, inflation is lower than it was. Although food, materials and fuels’ prices are getting higher, the reality is that inflation, both core and total, is lower today than it was on the eve of every other Fed easing cycle or recession dating back to 1960. On average, headline and core inflation were hovering near 6% year-over-year at the onset of Fed rate-cycles and recessions. Not only is core inflation basically 1/3rd of where it typically is at prior starting points, but total inflation is less than half… So the Fed can cur rates more, it is the question of when or how much the FOMC members agree to cut …Wanna a bet for 100HK$ …I call 25bps this time….

More Questions than Answers

Adding the weight for my call for a 25bp cut is that market sentiment has deteriorated recent in the fixed income side. Not only did the fresh ratings downgrades of mortgage-related debt, more bad housing news, and earning disappointments from some major banks remind investors that the risks remain elevated, but also investors realized that $100bn "Super Fund" designed to avoid forced asset sales by SIVs, will help much. As a result, the 2yr&3M UST yields are falling like a rock and over the past couple of days, implied volatilities have moved higher, carry trades have begun to unwind (114.26 Yen) and government bonds have rallied.

I am saying that a bear market in risky assets is likely as global economy remains decent and further monetary easing will be provided by Fed, but further downside is probable in the near term. My outlook remains relatively unchanged -- the US economy is at the beginning stage of a housing sector led slowdown and the Fed will continue to cut rates. The latest rally in the front end has taken the 2yr to fresh cycle lows (3.77). In the coming days, the markets should have more information regarding

fundamentals – GDP figure, PCE index, ISM surveys and the next payrolls are going to be very important.  Ahead of these data points we get the Fed rate decision which is another massive event. In terms of the data, as I have already stated, longer term, I expect payrolls to decline and the unemployment rate to rise above 5%. However, given the volatility of this number, how would the market react to another +100k number?  The same applies to the ISM, new orders seem to be trending lower, but is the survey going to be negative enough to give the market another boost at these levels? More than that, how is the Fed going to react to the latest round of volatility? What is their latest assessment of the trajectory of growth in 2008? At the moment, I have more questions than answers …Maybe I should send this inquiry list to Mr. Bernanke and his colleagues tonight… well, they may already have the same list of questions … they are smart and experienced elders anyway….

One thing for sure is that tighter credit conditions, along with a slowing US economy, a rising unemployment rate and risk aversion by US households will all contribute to slow existing home sales further … When housing price drops, we should take profit in the H shares and buy a house in US…

Rotating Chinese Shares

Hong Kong seemed not stoppable today with HSI closed are 31586, up 3.89%, and HSCEI up 3.3% led by Banks and Materials. A-shares market rebounds as investors cheer solid corporate earnings, with over 70% stocks book gains with Banks are the leaders (ICBC  +7.22%, China Life +6.72%, CCB +4.22%). Steel and Non-ferrous sectors also join today’s rise, led by Jiangxi Copper +9.99%, BaoSteel +7.11%,  and Angang  +6.29%

With the new earning season, I think China’s valuation @25X 12M FWPE of MSCI China is expensive but not a bubble level, considering its strong EPS growth profile. PEG is just around 1 for MSCI China. So far, for the A-shares PMs I met, they are in general more relaxed on valuation compared to their western peers. A-share market cap has gained US$3 trillion in the past two years, in which the government has roughly 70% share. As a result, Chinese government is very unlikely to impose capital tax to burst the balloon, instead of sing its policy package, including 1) continuing monetary tightening, 2) increase of share supply and 3) encouraging capital outflows (US$100-200bn per year).

Sector wise, given the coming wave of QDII, we should overweight big-cap sectors (energy, banks and telecom), particularly banks in the 4Q due to seasonality pattern. If inflation outlook could improve through the rest of year, then IPPs might be the next place for rotation.

Oil-Sweater Swaps

YTD, the crude oil prices have nearly doubled as CO1 contact climbed from 55$ to now 90$ per bbl.  In fact, I am not interested in the debate on 100$/bbl, but whether current oil prices are sustainable. Once again,  Largely YES… along with a trapped US government in the troublesome Middle East, The KEY reason is that a structural increase in emerging market demand is being met by only a muted supply response.

Demand is accelerating, particularly in China and the Middle East (power and petro-chems) and in these geographies demand is not price sensitive. We are still in the early stages of the structural increase in Chinese energy demand because auto ownership is still at low levels. Meanwhile, the supply growth has been muted. Over 50% of non-OPEC countries have already hit peak oil production. Supply growth will come from OPEC (almost flat for 30 years) and non-conventional sources such as the oil sands in Canada and biofuels. The most important market driving factor is that OPEC’s current spare capacity is not enough to cover a supply shock such as the loss of Iran or Venezuela.

To sum up, current LT average +65$/bbl oil prices are sustainable for three reasons --- 1) inventories remain at below average levels; 2) the cost floor is rising. Finding and development costs have increased from $4 per barrel to $16 per barrel; 3) governments are becoming more involved in the energy business. For example, Russia and Venezuela are increasing their ownership stakes in energy companies, which will hamper outside investment… For friends in Canada and US, if you guys can swap the WTI or Oil Sands with Chinese sweaters for the coming Christmas…it should be a good deal …

Good night, my dear friends