My Diary 352 --- The Fed and I-Banks Are Stuck, We Passed August

 

My Diary 352 --- The Fed and I-Banks Are Stuck, We Passed August Height, Yes We Are Seeing It

 

November 10, 2007

I wrote an internal report today with a title – from “not-for-fun” to “no-fun”. Yes, there wasn’t much fun over the past week when the market saw UST rose, stocks fell and USD dropped after Bernanke's remarks were released.

In fact, it wasn’t a funny story that investors initially thought the US economy might have shook off the housing slump and accelerated to a growth at 3.9% in 3Q07, along with payrolls rose by 166K jobs in October and 96k in September. But later on, Fed Chief said in testimony to the congressional Joint Economic Committee --- the US economy is likely to “slow noticeably” in Q4 while high commodity prices and a weaker dollar may stoke inflation “for a time.''

I start to review the predominant theory of “Mid-Cycle-Slowdown” over the 1H07 and here are some of the “fires” currently burning in my brain……

The Fed and I-Banks Are Stuck

Over the past few days, global markets, risk appetite and liquidity conditions are once again jittery, as the daily telegraph of bad news from US financials took a tool on the market. All eyes remain on the “fallout-or-not” of the housing sector into the real economy. So far, the evidence remains scant (if anything, recent US data remains decent), but the markets are not convinced and are pricing in a slowdown and more Fed easing -- 98% probability in Dec vs. 60% 1-week ago indicated by the future market.

After reading through Mr. Bernanke’s speech, there is sth coming up in my mind -- the Fed is stuck. And if the inflation risk wasn't there, then the prospects for the economy suggest much lower interest rates. I think this is why USD fell even after ECB President Trichet, said that the “brutal'' currency moves are never welcome. Regarding the inflation outlook, The Fed chief said it was “subject to important upside risks'' from prices of crude oil and other commodities and the weaker dollar … and “these factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well”… following his comments, gold, a traditional hedge against rising inflation, rose to the highest level since 1980. Crude oil prices also posted record highs in New York last week….. Following “Big Ben” now seems to be a good trading strategy for gold over the past 3 months…

But there are some other things getting even worse, which in some senses re-inspire my previous argument of “deflation”.  According to the Financial Times, in addition to those announced loss of Merrill Lynch (US$7.9 bn), Citigroup (US$8-11 bn) and Morgan Stanley (US$3.7 bn of trading losses), Citigroup projects write-downs of mortgage-related investments by investment banks to reach US$64 bn, which implies there is still US$40 bn that has not been announced yet …Woooow…that really is a big big number …

But this is not the end of my story as changes in accounting rules loom. According to the Rule SFAS157 which require banks to separate their tradable assets into three levels. Level-3 is a category which allows investment banks to continue to mark these hard-to-value assets to model. They then seemingly booked capital gains on these mark-to-models, while presumably taking mark-to-market profits on hedge…and they use it for bonus, I guess….Now the question in the street is how much assets is in Level 3 and the answer is A LOT, both in terms of absolute assets and related to the firm’s capital. Goldman Sachs disclosed last month that the size of its Level 3 assets at the end of August was US$72bn, nearly 2X the bank’s equity base of US$39bn. Likewise, Morgan Stanley, Lehman Brothers and Bear Stearns had US$88bn, US$35bn and US$20bn in Level 3 assets at the end of August, equivalent to 250%, 160% and 156% of their total shareholders’ equity. The next question then becomes how the auditors will want this paper being valued……Now, even with the well-known 16.9$ bn bonus check, is there somebody in Goldman still thinking the Level 3 stuff in the bank’s balance sheet is something for fun?

 

We Passed August Height

As I mentioned, recent Fed testimony expressed a greater degree of concern about the pace of economic growth (growth to slow noticeably) in addition to a heightened degree of concern about domestic inflation (important upside risks).  With the Fed between a rock and a hard place, it is difficult to see how risk assets perform well with market liquidity likely to be depressed for several months as banks will be slow to return capital to fixed income trading. This alone should require an additional risk/liquidity premium, however temporary that may be. However, to my surprise is that although the market was orderly, global credit spreads established a new wide passing August's level… Should we cheers for a new height here …

Housing now is widely expected to remain a drag on the economy and recent new flows are largely negative – 1) in the regulator front, two state attorney generals (NY/OH) have investigated into widespread residential property appraisal fraud, along with lender and broker involvement, adding an additional level of risk to the mortgage market; 2) Fannie Mae made it clear lenders can be required to repurchase loans that don't meet conforming standards, including valid appraisals.  This would be disastrous for WM or CFC; 3) The SEC is investigating Merrill Lynch off balance sheet transactions; 4) Even if financials get a grip on sub-prime/CDO net exposures, Capital One reminded us recently that other consumer receivables (cards/autos) are likely to show stress and earnings will remain stressed for quarters while reserves are built. 

At the meaning time, economic wise, things are not exciting as well… 1) recent retail sales have been below soft guidance and earnings expectations for consumer related names are declining; 2) Oil continues to press higher without major geopolitical issues; 3) recent jobs and GDP data were bolstered by questionable inflation and birth/death model influences - few believe jobs were added in the Financial sector.  The household survey showed significant employment contraction during October, temporary position trends are weakening (leading indicator) and consumer confidence is declining; 4) at the mean time, currency traders were asking around --- is China done reshuffling its currency reserves? … Now, US may have to exchange Taiwan with China for the hundreds of bns of US dollar debt …this deal may be better than a military war between China and US….

So far, it seems more likely now that the market has not priced in these risks.  The market needs to puke, and I don't want to be at the table when it happens. To the fixed income investors, the real problem is the recession / no recession debate (and imbedded in that is the inflation debate).  Without recession, bonds are cheap and may give us a double-digit type total return year.  With recession, the market is still rich.  As I said at the beginning this notes, I am not fully convinced by the theory of “Mid-Cycle-Slowdown”. It is now being severely tested by the global financial markets and I would like to keep a closer eye on it… and here comes why……

 

Yes We Are Seeing It

When I say “we are seeing it”, I refer to three things -- consumer spending, retail sales and business spending. So far, all signs seem to be pointing toward a weak holiday season this year as the credit crunch and housing market woes continue to pressure home-related sales and other discretionary spending.

According to the October numbers, US retail same store sales increased only +1.6% vs. consensus +2.0% and a prior-month rise of +1.7%. The themes driving weakness in September continued into October as the weak housing market pressured furniture, home goods and other discretionary spending, and warm weather hurt sales of outerwear and other seasonal items. Geographically, there is notable weakness in the West Coast and Florida where home prices have been hit the hardest…On average, the 14 largest US retailers missed lowered consensus SSS estimates by 0.8%. Additionally, none of them guided earnings higher with only two confirmed guidance (TJX and JCP) and the others did not comment.

To be noted here is that  the October bank lending surveys reveal a sharp tightening in credit standards in the US and Euro area. As a result, I believe that household spending is likely to grow more slowly as tighter credit, weaker home prices, and higher energy prices damp sentiment. Saying about the energy price, the continued rise in world oil prices will put more upward pressure on retail energy prices, notably gasoline. While the US consumer is most vulnerable to this purchasing power squeeze because, net of tax, gasoline purchases comprise a large proportion of US consumer spending than in other developed countries, whereas most governments in the emerging world regulate or subsidize domestic energy prices… Thus this is quite consistent with Fed’s outlook --- the prospect of sustained higher prices is casting downside risk on in 2008. 

Adding fires of downside risks is that the heightened uncertainty about economic prospects could lead business spending to decelerate as well…News from bbg and Reuters today saying that Cisco is warning of weak orders from US banks. This  was  a  blow  to  Wall  Street as ppl  think that  the  technology  sector  is  immune  to  the  credit  crisis  shaking  the  rest  of  the  market.  Tech  stocks,  which  have  been  a  safe  haven  for  investors  escaping  the  banking  and  real  estate  turmoil,  tanked  on  Friday  with  declines  ranging  from  software  maker  Oracle  Corp  to  computer  services  company  IBM  to  data  storage  maker  MC  Corp.   

Ironically,  analysts  said,  Cisco  may  prove  the  most  resilient  to  weak  US  corporate  spending  as  the  top  maker  of  routers  and  network  equipment  only  counts  on  US  Enterprises for 13%  of  its  business. But now, we heard that Mr. John Chambers said ---- Yes, ladies and gentleman, we are seeing it.


Good night, my dear friends!