My Diary 368 --- The Smell of Fear and Panic, The Start of Bear

 

My Diary 368--- The Smell of Fear and Panic, The Start of Bear Market, The Dirty Word of Credit!

January 21, 2008

One thing for sure over the weekend is that the market did not hide its disappointment following President Bush’s fiscal stimulus outline that lacked details and credibility. This is not what Mr. Bernanke may have hoped, something that would ease pressure on the Fed to cut rates aggressively. Futures markets now price a 72% chance of a 50bp cut at the next FOMC. Remember, we have had three negative months of leading indicators now. Someone had better take notice here…

Meanwhile thanks to more liberal accounting rules, the markets have yet to see international write downs anywhere near the size of US write downs. The lack of transparency in the structured financial markets appears to be preventing anyone from seeing the ultimate end result. But ACA, AMBAC, and MBIA are teetering on the brink of default in spite of numerous attempts to recapitalize. Another scary word on the street is that UBS is liquidating their prop desk (anyone wants to guess the size of their book). Moreover, the consumer is struggling with recent retail sales weak… Risk is certainly pointing to the downside.

Looking ahead, there is little economic data over the coming week and a half. Questions in my mind are --- Is there a lot priced into the market? Absolutely!  Can things get worse? You bet.  What I learned from the recent market reactions is the financial pyramid scheme that has been in place across the world is slowly being unwound…… Starting from Big Ben’s pictures …

The Smell of Fear and Panic!

It was a very tough week in global markets if you see Ben Bernanke’s “Worrying Man” pictures from his recent Congressional testimony. I think it was also a rough week to other central bankers with below consensus economic data reported out of the US and weak results reported by US financial institutions including Citi and Merrill. Our CIO said this morning that he has not seen this kind of ugly weekly performance for years. Having said so, there is a pervasive smell of fear and panic in the markets  after a shocking Philly Fed number, and amid growing fears that monoline insurers are about to go belly up due to credit downgrades. The later is a big issue as it clearly has the potential to drive a fresh bought of risk aversion, credit and equity weakness and renewed flight to quality…... HSCEI down 7.07% and ‘HIS dropped 5.5% today…Now the European markets open with 5% decline cross board……

Another interesting note for the past week is the Fed’s former chief and current chairman are under talk again. I think, whether Greenspan was right or wrong is part of the history now. What really matters is an acknowledgement during Bernanke’s hearing that the economy is weak enough to need some fiscal medicine. The risks are high and I am not very much encouraged by the policy markers who just start to take all the levers available to prevent the US economy plunging further into the abyss……To me, it means we are already in deep troubles……  A fiscal package of some magnitude is a done deal with broad consensus from the Fed and the Congress, and my skepticism is how quickly it can be implemented. But it is going to have a material impact on the 2H08--09 growth outlook as US$150bn plus the multiplier effect is more than 1% on GDP ….This is not a small beer…  There is the risk that the news flows on monolines deteriorates further and if this occurs then many big money account will be forced to take risk off their table…I feel the chill in my back now……

The Start of Bear Market?

There was a huge amount of money has gone……more than $2.5 trillion has been erased from the value of global stock markets since 01Jan 2008. From what I observed from the Bloomberg screen, there is no decoupling of the financial markets as Asian/EU markets have fallen inline with the US. Nikkei 225 slid 5.56%, the worst start to a year since Bloomberg began tracking the data from 06Jan 1970. I also the worst one-day sell-off of China stocks listed in HK since the Asian financial crisis. The last time when we had a similar scare was on 17Aug 2007 and the market was saved then by anticipation and subsequent confirmation of QDRI/QDII.

In addition, unlike Aug07 when corporate earnings outlook was improving (FY08 EPS for HSCEI has been revised up by about 25% since  then), I believe corporate earnings in China is facing strong headwinds caused by 1) a weakening global demand for Chinese products; and 2) a slow down in domestic demand growth due to credit tightening plus asset quality concerns as property price drops. I think this time only an end to the global sub-prime crisis may bring any sustained recovery in the share price of HSCEI constituents. Although CSRC has sped up approval of QDII funds in recent weeks, retail demand for such products has cooled down considerably as Rmb appreciation accelerates and A share market recovers.

Does the current market movement imply a start of bear market? Both the Hang Seng and Singapore's Straits Times Index have slumped about 25% from their October peaks, a drop some traders consider as a bear market. I think the real debate is lying on whether the recent stock market problem is cyclical or secular in nature? Is it a V-shaped, U-shaped, or L-shaped market down the road?

A secular bear market requires a major bubble, a subsequent bust and a massive policy error, such as Japan stock market. In comparison, the burst of the dot-com bubble qualified as a severe cyclical bear market, but not a secular one, because the duration of the bear market was cut short by aggressive Federal Reserve reflation…... But this seems not the preferred option in the desk of Mr. Bernanke…:(

The Dirty Word of Credit!

Following the initial round of 4Q07 earnings, escalating rating and business uncertainty surrounding US financials, US macro data have also indicated recession risk has risen materially. But the bad news doesn't end there. The big monoline bond insurers are expected to be downgraded in the next few months and Moody's is forecasting that credit defaults will rise from 1% in November 2007 to 4.5% by the end of 2008. Having said so, US HY Corporate spreads has widen out ~300bps over past 12 months and volatility will continue to be high. At this point, I want to question whether the credit market has priced for potential large corporate defaults as we saw in 2002.

The base scenario seems likely the credit bear market is to continue through 2008 as it typically lasts for years rather than months, and this one should be no different.Three rationales stand behind this judgment, including weakening economic fundamentals, deteriorating financials and corporate earnings outlook as well as empirical cyclical indicators. Economic wise, there expects a rising unemployment rate in the context of the difficult housing and weakening consumer credit environments. Historically, a rise of 0.5% unemployment has always been associated with a recession. These pressures, together with negative wealth effects emanating from falling real house prices, are likely to keep US GDP growth on the soft side through most of 2008 at below 2%.

In addition, more write-downs are to come as the lack of transparency in the structured financial markets appears to be preventing anyone from seeing the ultimate end result. Troubled financials have successfully attracted capital from a variety of sources. However more may be needed despite the reduction of dividends and share repurchase activity.  Moreover, corporate fundamentals will deteriorate in 2008, and earnings expectations are far too high as financials now under-reserved against non-mortgage consumer credit assets. The upcoming earnings remain critical and we will have to wait for several weeks before retailers report. 

Bottom-line is current spreads can move even wider, probably 400-500bp more, given that street liquidity remains problematic.

Good night, my dear friends!