My Diary 377 --- Fly to Simplicity; A Close-look at US inflation

My Diary 377 --- Fly to Simplicity; A Close-look at US inflation; Another Credit-Equity Diversion

February 25, 2008

Over the weekend before Oscar Awards, equity markets rose in the Americas (due to a support plan for bond insurer Ambac) and declined elsewhere (Nikkei -1.4%, EU -0.8%). Meanwhile, credit markets continued to worsen as a whole. Other parts, 1M WTI moved $99.11/bbl, up $3.61 on the week, while US Dollar weakened. 2yr and 10 yr UST edged up by 5bp and 3bp, respectively. In the near term, headline risk remains high as 2007FY reports from European banks continue and the market is preparing for 1Q08 earnings from the broker dealers. The general senses is that 2008 is a challenging year for capital markets, and there is still concern about the "unexpected" charges that may emerge here and there… Who knows where, if you remember Soc Gen and Credit Suisse’s recent losses?

Calendar wise, after the past quiet week, the coming week is extremely busy with focus on Chairman Bernanke's monetary policy testimony. I will listen to his comments on inflation outlook as well as his evaluation on a broad-based worsening in financial markets, including stocks, credit, and sub-prime mortgages that has more recently spread substantially into commercial mortgages, leveraged loans, and even auction-rate securities. Other main releases are consumer confidence, PPI, Case Schiller and OFHEO index on Tuesday and Durable goods order and New home sales on Wednesday, revised GDP Thursday, and personal income and spending Friday...We have a reading week…

When the Fed Chief has a lot of ground to cove and things turn more complicated, one easier solution seems to be --- do something simple and let us start from simplicity……

Markets Fly to Simplicity

Lately, negative headlines related to the monolines, unraveling of structured products, bank earnings, and write-down related announcements have driven credit spreads to a level not seen in recent years. MTD, iTraxx AxJ IG(165bp) and HY(578bp) have widened by 45bp, and 95bp in the current month. For the past 14 trading days, on a net basis Asian credit spreads have ended up wider in almost every day. Beyond the bank and broker earnings outlook, there now seems to have a trading pattern that starting from US brokers 1Q08 results in March, then US and EU banks in April, Japan banks 07FY in May, and then back to US brokers for 2Q08.

Such a negative rotation run should not be any surprise as over the weekend, FDIC Chief Bair has said he sees a "rash" of first-year defaults among Alt-A payment and more "pain" in months ahead for sub-prime due to resets. In simple terms, Alt-a is another form of sub-prime. The difference is Alt-a borrowers didn't have credit blemishes before…but they may have now…If this is the case, further write-downs and capital raising will continue into 2H08, given the expectation of further asset quality deterioration from ARM mortgages, to monoline insurance exposures, commercial mortgages, LBO loans and even personal credits like auto/ cards.

Having said so, global financial markets have recently experienced a sharply deleveraging or de-complicity process, in particular within the hedge fund universe as investors switch to easier-to-understand asset. Such a move has a significant impact on the recent price movements of major asset classes, including gold, silver, oil and soft commodities. Over the year of 2007, soybeans and wheat are up more than 75%, 10yr USTs gained 12.3%, and are up 2.5% since the start of 2008. The logic behind these “new” trading focuses is straightforward --- buy something simple and easily to be priced.

A Close-look at US Inflation

It is a global phenomena that headline CPI has remained elevated, reflecting higher food and energy prices, which partly explains why there is no consistency amongst Central Banks over the direction of monetary policy. In the US, Dallas Fed President Richard Fisher said that recent news of higher inflation is "not encouraging" in an interview with BBG. He said he is hearing more concern about inflation from bank contacts, and that it would be difficult to suddenly raise interest rates to counter inflation after a campaign of rate cuts aimed at buffering the economy from a housing slump and a pullback in lending.

Indeed, according to a piece of recent macro research paper, the productivity growth of US slid sharply during 2004-06, falling to an average of just 1.4%, in sharp contrast with the 3.6% clip over 2001-2003…… this also raised inflation concerns due to limited economy capacity and high unit labor costs as employment caught up to the economy. In the other side, inflation expectations are also moving higher, as measured by market-based 5y5y BE inflation, which has moved up by 30bp to nearly 2.9% in the past few weeks (based on a smoothed yield curve used by Fed).

Having said so, since still-strong EM demands and limited gains in supply side are the major forces behind the rising energy, food and commodity prices, in the near term, fears of stagflation are likely to continue to emerge, witnesses by that inflation has picked up in emerging markets and remains stubbornly high in several industrial economies. Thus the debate will be tied to the evidence of lower inflation when it appears, especially the oil and food prices and the overall supply & demand dynamics…

Credit-Equity Diverges Again

The recent chart-book of equity/credit spreads show another period of disconnection between the two asset classes, repeating what we have seen in last August, early 1990 and 2000. As I said in my past diary, I do not expect this trend to continue as this is a credit-based financial crisis, implying another equity correction. According to ML’s David Rosenberg, historically the trend of credit spread has always been 4-6 months ahead of that of equity market, and when BAA credit spread adds additional 100bps, S&P 500 moves down 300 ppt. Given the magnitude of credit spread widening since last Autumn, the S&P 500 is likely to move down to 1200 level in March.

Regional wide, the MSCI AxJ stays at 14XPE08 with EPSG stable at 16.5%. Bad news is that over the past month, the market saw all sectors downgrades except for energy. Trading activities were stable across the region, however, according to UBS, they have HKEx as the top short idea in its internal Alpha System with a major change in assumption of market turnover (a 19%yoy drop in average daily turnover to HK$71bn in 2008 (from HK$88.1bn in 2007). The bank also indicated that there could be more downside as there would be a big drop in turnover in structured products this year (our product origination was down 90% YTD. Liquidity perspective, EPFR Global suggested that the current run of outflows ($176mn wow ended last Wed), which started in mid-December, have sustained for 10wks so far with a total $10.7bn being withdrawn. This is the biggest outflows in US Dollar terms and the second longest in terms of duration.

Last week, the Citigroup’s regional strategist answered my question on if the Asia market has priced in a recession…the answer is NOT YET, as valuations on PB remain 26% above the overall historic average and 48% above the average lows of the last 2 recessions. EPS forecasts are being revised down but ever so glacially and risk falling much further during Q2-Q3 once corporate results are released. This is not being priced in to the equity market. He thinks that downside earnings risks and above-average P/BV leave markets vulnerable - If EPS growth falls by half as much as in prior recessions, the region would be traded on 19X12MFPE … NOT Cheap!

Talking about Chinese market, A-shares (SHCOMP -4.07%) today fell to a 3-week low on speculation new shares dilution and further tightening by the central bank to order banks to set aside more reserves. The H-shares (-1% today) have retreated by over 26% from October highs, and valuation side, the market is not cheap, trading at 14.5X forward PE, or 12% above the MSCI EM. Meanwhile, it is extremely volatile, with 3M realized and implied sigma at 63% and 49%, respectively. Nevertheless, this market could also deliver outpaced gains vs. other regional markets once investors realize that the Chinese economy could decoupled from the US and deliver good returns……Watch for the buy signals…

Good night, my dear friends!