My Diary 386 --- The Japanese Moral; The Market Prophet; The Chi

My Dairy 386--- The Japanese Moral; The Market Prophet; The Chinese Week; The Next Bulls

March 11, 2008

There have been various signs of increased credit stresses during recent weeks, including failed margin calls at hedge funds, and credit spreads continue to blow out (iTRAXX AxJ HY @ 634bp all-time high) as the Fed’s aggressive reflation efforts so far are being offset by rising risk premiums…All these now lead to further asset prices decline, liquidity shrinkage, de-leveraging and even further MTM write-downs…

However, market always comes with surprises and unknowns, if you see the unexpected rally (intraday +600pts HSI) yesterday in HK with speculation around HSBC-BoCOM and Netcom which sparked a fury of short covering…what a turnaround… Meanwhile, overnight global equity markets stumbled (-1.6%) across regions in EU (-1.2%), S&P500 (-1.5%) and Nikkei (-2%), due to rumors of liquidity problems at Bear Stearn, job cuts at LEH, plus Wilbur Ross’ talk about failures, and AMBAC stock down 20% on MTM losses…Today, Asian stocks turnaround again (intraday ‘HSI +700pts, Nikkei +300pts ) after a WSJ report saying the Fed may consider lending directly to FIs (excluding banks) and purchase debts from Fannie and Freddie......It seems Fed learns from Japanese lessons quickly…Currency wise, US Dollar lost ground on the yen and is steadily approaching 100yen/dollar, a mark last hit in 1995, while Asian currencies fell, led by the INR and the Won, on speculation credit-market losses will deepen. The 1M WTI contract price of oil jumped to a new high of $107.90/bbl. Following suit with oil price gains, the average US gasoline price has risen to $10/bbl (+25% MoM).

It is very difficult environment for traders and PMs to play in such a world filled with inflation and growth concerns…… One can now see real assets up, paper assets down - but the future risk seems skewed to this US problem expanding to other places and the solutions to US credit turmoil are perhaps being overpriced. This has led to an interesting thought on whether the problems in current market are explainable by the balloon theory or the water-dam theory.

The Japanese Moral

The credit markets dissolution continues to play itself out. The market focus was still on tighter lending standards, frozen balance sheets, fears of counterparty risks, higher margin calls and failures associated with them and a general break in financing - all lead to risk aversion. One of the key issues now is there is less and less risk takers or liquidity providers, like hedge funds or proprietary desks etc.), as many of them have been burned by the ferocious reversal of carry trade. But only till recently, an ever-worsening snowball effect showed its power in the process of margin call when the price of collaterals falls, triggering more liquidation orders, causing further downward price pressure, and going on and on.

To many, the buyer of last resort (the Fed) is seen as needed. Yesterday, Bill Gross and CITI have advocated a form of “Quantitative Easing” where the Fed comes in and buys up gobs of agency debt and prime mortgages......”Quantitative Easing” is the Trick only heard from BoJ in dealing with decade-long deflation…According to the Nomura’s chief economist, Richard Koo, that credit crises can only be tackled slowly……”If the recognition of losses is too abrupt, it will simply blow away the financial industry, and the recapitalizing might well be impossible as the size of the problem loans would dwarf the ability of the government to solve it. The reason is that a credit shock is so dangerous is that debts are especially sensitive to broader market conditions as even good debts can sour when the shock is serious enough, meaning good companies start failing along with the bad.”

Japan’s experience shows the sheer trauma of a credit crisis once the debt cycle unwinding. The fact that the US government has recognized the problem doesn't mean it has found the solution. Like in Japan, credit is going to leave the economy, and this will destroy equity and the real wealth. The Japanese moral is that until the government starts creating new equity - or new wealth - to balance the ongoing destruction, the crisis is not over……this is may also be the case now as the estimated cost of the sub-prime related credit crunch have reached US$1.2trn (UP from $150 bn just a few months ago), according to Goldman Sachs. Nobody really knows where the end of story is, but only the spiraling mortgage defaults and falling home prices could bring a tsunami of credit losses, and that will severely test Banks, Brokers and GSEs’ solvency.

My INVESCO colleague Frankie Tai commented that --- I am not surprised the Fed is taking GSE ABS as collateral. I think they have taken a page off the books from the RBA. Australian banks have been busy restructuring their balance sheet (basically packaging loans into ABS and then dump it to RBA for liquidity), so the RBA is actually the ultimate bearer of risk for Australian mortgages, so is the Fed……He is right and if you wanna know more, please read today’s Barron’s cover on “Is Fannie Mae the Next Government Bailout?”… I think the bottom-line is who dare to let GSEs fall-down as “the agencies support some 55% of all mortgage originations and +50% all outstanding mortgages…Thus the US government would have no choice but to step in and back all of its debt and guarantee obligations…But one point caught my attention is -- “too much of the paper is owned by our major creditors, such as China and Japan” …Anybody knows how much the +2trn China and Japan’s US Dollar reserves are actually in GSE ABS debts…

The Market Prophet

The stock market is testing its January lows. At this tipping point, there is a critical question that --- whether or not the latest drop in the stock market price is part of a continued bottoming process? If you get the answer wrong, it will be costly in such a difficult year. However, human’s ability to foresee risks and potential threats is always limited, and the nature of a financial crisis is that things tend to move very fast, and even the broad macroeconomic landscape, thus we as normal human beings and investors need a prophet or the leading indicators of market movements…

Here are some important ones in my humble views: 1) Breakeven inflation or inflation expectation --- this is easy to understand as high inflation expectations would stall the Fed’s reflation efforts; 2) Oil prices and bond prices --- the recent negative correlation (about -50%) between bond yields and the crude price in fact suggests that financial markets are treating rising oil prices as a deflationary shock, or in other words, the impact of high oil price has been mitigated, or a least partially offset, by lower bond yields. If this relationship reverses, it could be a major negative for stocks, meaning rising oil prices are more inflationary; 3) Yield curves --- the current shape of yield curve is still in stage of bull steepening, but if the 2/10 spread begins to flatten with the falling short rates, it would signal a deflation or recession, which is always bad for profits and therefore share prices. In the same token, the reverse of front-end spread also implies that the Fed is losing the reflation battle.

Overall, the three indicators did not suggest the current policy environment in the US is getting worse as declining stock market is not accompanied with widening 2/FF spread. Certainly, as I wrote in last email, the relationship between US Dollar and bond yields is not only an indicator of global confidence to US dollar denominated assets, but also the twin-decline is also help the equity market. So far, global savings glut is still pouring into US, in particular the central banks……So in the near term, US Dollar is still safe…

The Chinese Week

This is Chinese Data week as both NPC and CPI are the hot talks in the street… today, headline CPI inflation reached 8.7% yoy in February, beating market expectations, as food shortages proved to be more severe than expected in the aftermath of the snowstorms, lifting food prices by 23.3% yoy. In addition, PPI inflation also accelerated to 6.6% yoy in February and higher prices in coal and steel were the main drivers of the higher PPI.

While some argue that the snowstorm is the major contributor to the high February readings, I think that rapid money supply growth still hold the key as inflation in theory is a consequence of M/S as big banks have showed no signs to slow down lending during the past two months. As a result, I would bet CPI to remain at high levels in the near term even after the temporary weather-related impact wanes.

Externally, while no other economy is projected to follow the United States into recession this year, we now see China's Feb export growth was only 6.5% yoy, the lowest in the past 6yrs. Of course, as analysts point out that Feb number is seriously distorted by snowstorm and more importantly the high base effect in last Feb due to the expiration of export tax rebate. The slower export has implication to China port sector as during last US recession in 2000-2001, China's export growth fell from 12% in Q1, to -1% in 4Q. Moreover, the lagging effect of China exports to deteriorating US economy may suggest a weaker trend ahead…and I think this is why defensives play well again this week as we saw street upgrades CLP and buy Zhejiang Expressway…with respect to the growth, my bottom-line is that Chinese government is able to deliver significant fiscal support, aiming at speeded up infrastructure investment, to cushion the slowdown in exports and keep GDP growth around10%.

The Next Bulls

Commodity markets are quiet high recently as they are highly correlated to US Dollar weakness, at least until the past few days. One interesting observation is that while equity markets may slip to the bottom, a mania in commodities and energy may have been developing alongside sagging share prices. Historically, a financial mania is usually built from the burst of bubbles and economic slumps, including the 1970s gold bubble, 1980s Nikkie bubble, 1990s dot-com bubble, and the US housing bubble is growing from the 2001-2002 recession…Thus it is logical to expect the bull market in commodities and energy plus emerging markets to evolve into a mania from the Subprime crisis.

In the book of Manias, Panics and Crashes, Charles Kindleberger pointed out that all financial manias in history are the byproducts of substantial economic dislocations that often capture the imaginations of investors. Financial manias almost always start with a bull market that is based on substance and a true story. Only when this bull market becomes the object of mass speculation does it inevitably become a mania. The story of commodities and energy is also true and has lots of real grounds based on the industrialization of China, India and other emerging market economies. This would make commodities and emerging markets perfect candidates for speculation.

However, the very different point is that commodities are tangible assets whose price increases have real economic consequences as for example, the rising energy and commodity prices will eventually chock off economic growth. The remaining question is how long before we reach the stage…... several factors suggest that prices are more likely to move up than correct significantly ……The Dollar is weak, the Supply is tight and the global liquidity is ample and the car sales is booming in emerging Asia.

 

Good night, my dear friends!