My Diary 337 --- Waiting for NFP Again, Replaying Credit Stories

 

My Diary 337 --- Waiting for NFP Again, Replaying Credit Stories, Believing “Super” Equities, and Punching the Dollar

October 5, 2007

 

It was inspiring and interesting to attend last night’s art exhibition. At the first glance, there are apparent gaps between the daily life of a New York based, female, oil painter and photographer and that of a Hong Kong male artist. However, that is not the case. In fact, everything around the +40 sqm room was trying to tell the visitors --- what is life. The only difference is the way though which a western lady and an eastern gentleman are used to communicate their insights of an ordinary human being’s life.

 I think the basis of how do we look at the life is quite similar to that of we invest. What makes one different from others is how you implement the strategies, while the ultimate gain is beard in your view of life.

 Well, right or wrong, there is enough side menu today and let us serve the main courses.

 

Waiting for NFP Again

Overnight, both BOE and ECB left rates on hold as expected, but were somewhat less hawkish than expected. The market appeared a bit disappointed that President Trichet did not describe rates as accommodative. However, the ECB has often said that it wanted to get away from using key words. One point worth for stressing is that the ECB stands ready to counter upside risks to price stability, while downside risks to growth were acknowledged but the outlook of global growth was upbeat on the view EM strength would make up for US slowdown, the hawkish bias appears unchanged.

This is quite understandable as ECB wants to give itself a bit more flexibility due to the increased uncertainty over the upside and  downside risks, but given that the UK is more exposed to a US slowdown and given the downside risk from falling house prices, it is difficult to be particularly biased considering the persisting uncertainty.

 Tonight, the curtain will be revealed in the other side of Atlantic Ocean as the NFP numbers could stir market sentiment particularly if it is not in line with expectations after a contraction of negative 4K in August. More than a life signal of US economy, the NFP will be crucial for broad Dollar sentiment. Further down the calendar, the next key event is the upcoming G7 meeting on the 20th October. The continuing stream of complaints from European policy-makers is likely to help us Dollar ahead of the meetings.

Talking about employment, a new research published by JPMorgan saying that the global unemployment rate has trended down since 2003, reaching a cyclical low this past spring. Interestingly, global GDP has been fairly range-bound over this same period. This analysis suggests global potential output is currently rising at a 3% annual pace, with developed and emerging market potential growth at 2% and 7%, respectively…NFP and employment, the markets never being able to ignore them…ever …

 

Replaying Credit Stories

It is time to look back as Chinese proverbs say that one can learn a lesson from the past … (Sorry, my grandparents left too much proverbs in my memory)…To the global credit markets, several key drivers turned more positive in the late September, including interventions taken by central bank, results of brokers’ balance sheet health and signs of improvement in the money and CP markets following the rate cut.

Sit down and be quiet as the scenes of recent credit crisis get playing again…Started from the heightened concerns over US subprime and the potential contagion to Alt-A and above mortgages loans, investors surprisingly found the subprime issues were also causing unexpected repercussions in other markets. Witnessed by European FIs disclosing losses on subprime-linked investments and rising risk aversion in the European money market, investors then saw a rapid withdrawal of liquidity and a growing number of hedge funds reporting increased redemption and casualties due to the market volatility. The only reprieve has been the Fed and ECB stepping in to provide the liquidity needed and in an attempt to stabilize short-term rates. However, despite all these efforts, short-term rates were still staying at elevated levels vs TED. At the mean time, the bearish economic data, the contracting CP and ABCP markets, plus the earnings downgrades for the banks and brokers spilled over into the credit markets… now, the world started to realize that worse may turn into ugly!!!

All the pains have been reflected by the noticeably move of global corporate credit basis versus both Treasuries and Swaps, along with a large new-issue calendar with sizeable concessions causing gapping of secondary bond spreads. Measured by the Merrill Lynch Global OAS Index, it reached 126bp on September 15, a level we have not seen in the global broad market since 2002. The pain was also felt by the Asian credit markets as investors realized that there remains a lack of depth in Asia. Credit markets were awaited for the Fed’s rescue on Sep 18. Later on, given the tightening of credit conditions and the developments in financial markets have the potential to intensify the housing correction and to increase the uncertainty surrounding the economic outlook, FOMC decided to lower its Fed Fund target rate 50b.

 The market reacted positively on the 50bp cut of Fed Fund rate…everybody cheers, especially equity guys… Some stability seemed to be returning, with decreased volatility and tighter bid-offer spreads providing a better tone amidst a continued recovery in equity markets. This latest rally has been led by Asian HY corp tightening by 40bp, HY sovereigns by 30 bp and HG by 6 bp. In short, the past few weeks were characterized by the ebbs and rise of confidence as investors remained sensitive to headlines on subprime impact to US economy, but at the same time, recognized that Asia fundamentals remained intact… But what is the next?

 Overall, I think once the world manages to pass through the current liquidity crunch (still in EU, AU and UK), the focus will shift to the impact on the real economy, future growth rates, and politics.  In the US, the market focus will likely shift from subprime headlines to economic/corporate earnings as 3Q earnings estimates for US corporates have been trending downwards, according to Bloomberg. The areas of weakness are likely to come from the banking sector booking their losses to CDOs and related exposure, but should for the most part be manageable. I continue to believe that, while we may have already had the biggest shock so far, tremors will remain through the rest of 2007… Stay alert, guys and bankers…

 

Believing “Super” Equities

Even when credit markets stays in mud, the equity markets continue to show “super” resilience across regions. However, if looking through the recent equity performance in both the US and Asian markets, there reveals some very interesting trends. Using the Dow as a benchmark, US equity market’s performance has been primarily driven by companies with strong overseas earnings benefiting from a weak dollar… What does it mean? It partially implies that investors buy the view that the growth in the overseas markets has decoupled from US. While, the resilience of the Asian equity markets would suggest that growth remains intact and this is reflected in high growth stocks outperforming defensive issuers.

However, I think the recent rebounds look like somewhat overdone, witnessed by MSCI China (mainly H-shares) is up 57% from the trough and MSCI Hong Kong is up 29%.... too much in too short period… and I think the markets are forgetting the risks. There are couple of things to keep in mind, 1) credit markets in general remain destabilized which is likely to result in a rise in corporate borrowing costs; 2) the US could slow further; 3) The soaring HK market has been propelled by expectations of further Fed cuts and funds flowing in from the mainland, both of which may be over-optimistic.

Having said so, the overall Chinese-related stocks, including H-shares, red chips and Singapore-listed have all shot up in recent weeks on continued expectations of domestic liquidity spill-over. In fact, we shouldn’t overly concern about valuations of Chinese stocks at the moment, for the following reasons: 1) although valuations are stretched, but by historical standards (red-chip bubble in 1997 and the global tech bubble in 2000) they are still not at extreme end; 2) stocks with superior growth outlooks demand a “growth premium.” And by these criteria, some Chinese sectors could arguably be cheap; 3) H-shares are much more attractively valued (+50% premium) compared to their A-shares counterparties for investors who want to maintain China exposure in their portfolios.

 Overall, valuation is historically a poor indicator to pinpoint a major market top, while in the near term, liquidity and earning growth will continues to justify the move to upside.

 

Punching the Dollar

Today, US Dollar headed for the first weekly gain vs Euro since August on speculation of a rebounded NFP, weakening the possibility of further interest-rate cuts. In the IR futures markets, there is a 72% chance FOMC will cut additional 25bp on Oct 31, down from 84% one week ago. The Dollar closed at EUR 1.4124 and 116.48YEN, following several district Fed presidents are expressing skepticism about the need for further rate cuts in the past 10 days, including William Poole, Charles Plosser, Dennis Lockhart and Richard Fisher

One interesting observation is that the relationship between surprises from US payrolls and the direction on EURUSD appears to be a good indicator in recent months. But, I still think even tonight we see a fair NFP number, there still exists downside risks for EURUSD movements. Number one, the perceived downside risks to US growth have increased, along with the more pronounced decline in the housing market, shifting relative growth differentials out of the US Dollar's favor. Moreover, relative interest rate differentials have also moved away from the dollar.

Surely, these developments do not preclude a technical upward correction in the US Dollar in the near term. However, the medium-term trend in interest rate differentials appears likely to continue, especially with the Fed now in rate cutting mode. Bottom-line: enjoy the US Dollar recover here if this is the case in the coming days, but be prepared for a weaker dollar going forward… for those Canadians who want to buy cheap in their Northern border, Hurry up or just wait for Christmas…..

 

Good night, my dear friends