My Diary 359 --- A Global Pandora Box, The Greenspan Mess, China

My Diary 359 --- A Global Pandora Box, The Greenspan Mess, China’s RRR Hike, Dollar The Next.

November 19, 2007

One by one, global banks and brokers were taking turns to reveal their bad numbers related to CDOs, Level 3 Assets, and so on. Asset write-downs announced over the past week included Barclays (US$2.7 bn), Bear Stearns (US$1.2 bn for 4Q07), and HSBC (US$3.4 bn), with a warning tone of possible further deterioration in the US housing market. In Asia, Japan’s largest banks (Mizuho, Shinsei and Aozora) have reported sharp earnings decline in 1H07 because of subprime exposure, leading to reduced full-year earnings forecast.

However it is clear that not everybody believes that this is all there is. Indeed, the numbers are based on current market conditions and if fundamentals and underlying asset quality weaken further, we could see incremental losses. As a result, market sentiment was ruined again, reflecting by the intraday volatility in the equity markets (VIX hit a 4-year high) and poor investor confidence.

Well, enough for this coming winter and X-mas ... I remember another Chinese proverb --- When Winter Comes, Spring Isn’t Far Away! ... Really, will it also be suitable to financial markets... Let us take a peak...

A Global Pandora Box

Unlike many analysts’ calls in the early of this year, the sub-prime problems are not just a sectorial issue within the US housing finance market. In reality, the developments in the US are even starting to make their way across the globe, with business confidence for the next 12 months generally deteriorating.

An independent survey conducted by Asia Business Council highlighted that 28% of the participants had lower business confidence for the next year, when compared with just 4% a year ago. Echoing this is a similar theme by some 2,800 service sector companies in Europe in a survey by KPMG/NTC. In October, 35% of these companies were reportedly optimistic on business activity over the next year down from 47% in April this year. Equity analysts are just starting to catch wind of this weaker confidence by businesses and have started to lower their earnings estimates.

The ongoing developments are also being reflected in the yen carry trade unwind, gold prices coming off their recent highs and oil prices making their sharpest moves in recent weeks after medias suggesting that oil was about to cross US$100/bbl. That said, the only silver lining is that the latest data out of the US this past week has generally been in line with expectations or marginally better, including retail sales, PPI, and pending home sales. However, the forward indicator of consumer sentiment remains poor, with Michigan Confidence preliminary release falling to 74.0 from 80.9 last month—the second lowest reading since 1993.

Another concern continues to brew—China’s inflation. For the 3rd month in a row, CPI was above the 6% level—this time at 6.5% in October, mainly driven by higher food prices. Although many ppl expect that number will start to ease off after the Chinese New Year due to the demand-supply power. Nonetheless, it bears watching given that China has been an exporter of deflation for a long time and the fragile state of most economies does not embrace China’s export of inflation.... With US slowing down plus China exporting inflation.... the world economy seems to open a Pandora Box for the X-mas....

The Greenspan Mess

A prevailing story in the futures market these days says Fed Bernanke is withholding some vital information: the economy is so bad the central bank will have to lower interest rates at least 75bp to avoid a recession. Moreover, Fed fund futures today show traders see a 90% chance the Fed will reduce its target to 4.25% at its Dec. 11 meeting, 67% odds of another 25bp cut in January, and a 43% likelihood the rate falls to 3.75% in March. Even when Russia defaulted and LTCM collapsed in 1998, policy makers only had to reduce rates 75 basis points... so this time is worse than LTCM crisis... thus, the Fed will not only need to save the financial markets, in very soon they're going to have to start saving the economy...

There is an interesting comments by Joseph Stiglitz, the Nobel-prize winner, said the U.S. economy risks tumbling into recession because of the subprime crisis and a “mess'' left by former Fed Chairman Alan Greenspan...Here are the Quotes ....”I'm very pessimistic... It's not just the housing sector... Americans have been taking money out of their houses to finance a consumption binge... Last year alone mortgage equity withdrawal was between $850 billion to $950 billion. That game is over.''

Stiglitz also said that the US faces ”a very major slowdown, maybe recession... Alan Greenspan really made a mess of all this... He pushed out too much liquidity at the wrong time. He supported the tax cut in 2001, which is the beginning of these problems. He encouraged people to take out variable rate mortgages. That helped create the subprime crisis”... well, I won’t join any camp to comment on Mr. Alan who is one of the best central bankers in the history.... and I think the current Bernanke Fe has no difference from the former Greenspan Fed. When there is a crisis, the Fed’s response is always to deal with the problem first, and then worry about Inflation....

Furthermore, I am not as pessimistic at this stage as while the global economic outlook is uncertain, default risks remains subdued and I think Asian corporates are well-positioned for a potential downturn as liquidity from profits, cash balances, and local banks remains ample. But one thing for sure is that capital markets risk aversion will limit companies from making debt funded investments, as indicated by the new issue pipeline in Asia which the market refused to absorb...

China’s RRR Hike

A-shares continued the soft trend, sliding down today when PetroChina (-1.93%) was included in the SHCOMP index. Although concerns over the expected interest rate hike have been released, the benchmark index still unexpectedly declines. In addition, correlation between A-shares and regional equities has picked up lately.

Over the weekend, a lot of media talks were focusing on the PBOC’s recent RRR hike. Indeed, after the most recent adjustment, the RRR stands at 13.5%, a level that has surpassed that in the early 1990s when the Chinese economy was mired in an inflationary mess and bank lending was expanding at a 40% annual rate. On the contrary, interest rates and the currency are only marginally higher than the levels broached in the late 1990s when the economy was struggling with a deflationary slump after the Asian crisis.... it is interesting to note that even after the RRR ratio has been raised 12 times, a total of 6% since the beginning of 2006, compared with only seven interest rate hikes by just 171 basis points, the trade-weighted RMB has in fact depreciated by 1% in the past two years.

To my own viewpoint, I think the impact of tightened RRR is very limited --- 1) increasing RRR does not help remove liquidity, as massive foreign reserve accumulation resulting from inflows of both trade and capital accounts is the fundamental reason for the liquidity overflow in the economy; 2) restricting bank lending does not discourage capex as retained earnings have become a major source of investment. Looking at the Chinese banking sector statistics, current loan growth at 18% does not seem excessive, compared with a 16% nominal GDP growth. The loan-to-deposit ratio is hovering at a record low and reserve deposits plus central bank notes account for +20% of major big banks. All of this means that banks’ lending capacity has already been aggressively scaled back. Further tightening in RRR will only likely start to cause liquidity problems for some small banks... So continue to buy ICBC & CCB.... the bigger, the better.....Meanwhile, I also believe China’s excessive domestic savings are mainly due to a lack of a basic social safety net, and are not sensitive to interest rates.

Having said so, I also believe that the outlook of H-shares should go well with a combination of lower interest rates, weaker USD, and solid corporate earnings. The lower interest rate, resulting from a series of US Fed fund rate cut, is expected to boost HK’s asset price further and potentially ignite another round of asset inflation. In addition, based on 3Q07 numbers, corporate earnings are so far in-line or better than expected, except for steel sectors. Going forward, corporate restructuring, mergers and acquisitions, as well as asset injections should continue to drive corporate earnings momentum and improve quality of earnings and assets... thus, we should not turn away from the Hong Kong as where else can one buy the growth......

Dollar The Next

As discussed, the latest market development has caused a increasing cross market volatilities. While gold sold off, equity volatility increased and government bonds outperformed. High-yield spreads over UST widened. What about the US Dollar, Its going DOWN (DXY=75.87) and fell to 110.18 Yen today.

This is not surprise to the market as the US is slowing while other countries and regions continue to experience strong growth and are seeing increasing signs of inflation, albeit to varying extents. This is particularly the case in countries where the central bank has been repeatedly intervening to stem local currency appreciation against the US Dollar. US Dollar weakness has also fed through to rising commodity prices, which in turn have boosted resources-rich countries like Australia, New Zealand, Canada and Russia. Moreover, the economic impact of US Dollar weakness is being felt via a number of different transmission mechanisms – through the trade and current account, through consumer and producer inflation and through falling margins.

In the near term, I think the market will continue to focus on a combination of nominal interest rate spreads, risk appetite to risk assets and inflation differentials. Pegged currencies will also continue to come under pressure because of broad US Dollar and rising inflation like RMB. A key question is where the US Dollar goes from here. In my view, the US Dollar is likely to remain weak into year-end, given relative growth and interest rate gap, plus policy rate expectations. Moreover, the US Dollar is typically weak in Q4 for tax reason.

Good night, my dear friends!