My Diary 389 --- A Barely Standing Company; The Bottomline of F

My Diary 389 --- A Barely Standing Company (BSC); The Bottom-line of Fed’s Toolkits; The Chinese-Share Falls;    A Million Dollar Question

March 17, 2008

As pointed out by Messrs. Bernanke, Mishkin and Kohn recently, the risks of an "adverse financial market feedback loop" to the real economy is still a long way from over…… These comments underpinned my arguments in previous diaries that global financial conditions are about to undergo another round of tightening …and I am not so surprised to see the Bernanke Fed was busy and creative to ease crisis, supporting Bear Stern liquidity needs, funding JPMorgan acquisition ($30bn), creating the PDCF program, reducing window discount rate (3.25%), and extending allowable collateral range and maximum maturity (from 30D to 90D) … an interesting point is such an announcement preceded the open of TSEx, which may imply that Fed officials see these problems as global in nature ... Oops plus the Daily Telegraph reported yesterday that Goldman Sachs will reveal $3 billion in write-downs…The last giant will joint the tearing camp…

Over the past 48 hours, the markets saw a massive sell-off in shares across the board. S&P 500 down -2.08%, Nikkei down -3.71%, Hangseng today down 5.18% and Europe now down +3% average…Moreover, sentiment was further eroded as the US Dollar plunged to a record low against the EUR(1.5783) and YEN (96.708) when I write this note, while the oil price climbed to a record high (1MWTI=110.14$/bbl). USTs rallied, pushing the 2yr (1.349%) down 28bp and 10yr (3.382%) down 14bp. Implied rates from Fed funds futures contracts also moved lower, pulled down by credit market woes as well as the soft inflation report. Gold moves up 24.3 at $1023.8……Judging from the sharp market movements, it seems all the markets are in a real panic right now…

There are more to come……According to BBG, US stocks now provide 1.62% more in earnings (vs 10yr UST yield), the widest advantage since at least 1986. My question is --- the market is definitely cheaper, but is it cheap? Maybe NOT, as with stresses in the banking and broader financial system likely to remain, or even worsen, markets are worrying the systemic risks after the collapse of Bear Stearns.

A Barely Standing Company (BSC)

Last night, it was announced that the Fed will provide up to $30bn in a special lending facility to JP Morgan, to help reduce the liquidity risk associated with taking on Bear Stearns less liquid assets, mostly mortgage related securities. And JPMorgan agreed to buy Bear Stearns for about $240mn, less than a 10th of its value last week, after a run on the company ended 85 years of independence for Wall Street's fifth-largest securities firm…

The case of Bear Stearns is critical for two reasons --- 1) its scale and speed. Bear Stearns is the 2^nd-largest underwriter of mortgage-backed debt in the US and its inability to secure market funding intensified rapidly; 2) Bear Stearns is not a bank, yet it has been given access to the Fed’s lender-of-last-resort facilities. This underlines that the current credit crisis cannot be neatly contained, as the innovated financial industry requires a more innovated/or innovating Fed as the lender of last resort……Maybe the FASB should also give the Fed the benefit of accelerating R&D depreciation……

But I think the key information embedded on the BSC collapse is that even the most aggressive rate cuts in a credit crunching world cannot solve liquidity thirsty, if no one wants to lend……Reality check is supporting this argument as 30yr Fixed Jumbo have been rising since mid-January and increasingly, floating-rate loans are also starting to become more expensive, such as 5/1 ARM now +35bp vs last week 5.35% …You can see these number in the Yahoo Finance easily…… The break-down in capital market operations is due to the falling availability of money when the ability to securities new loans falls, plus less and less liquidity in the secondary MBS market …...Worse thing is that when credit crunch continues, risk-free rates are becoming more and more irrelevant because fewer and fewer borrowers are believed to be free of risk. Measured by TED, the 3M spread has climbed 60bp today, indicating that banks are less willing to lend to corporations. In such an environment it pays to be skeptical of the benefits of interest-rate cuts because the key problem is that you just couldn’t access liquidity at all …… Just like a thirsty-to-death person standing in front of the Mississippi River in James Butler's painting…

The Bottom-line of Fed’s Toolkits

The Fed announced one of the broadest expansions of its lending authority since the 1930s in an effort to stem the current credit crisis…In fact, it is quite annoying to observe that the Fed's initiatives had succeeded in quelling the inter-bank liquidity crisis in last December, but then a solvency crisis more broadly had developed, and in the last week, it's transformed in part back into a liquidity crisis. The failure of Bear Stearns is simply telling a simple truth that when your creditors ask for their money back in masse, a liquidity crisis can quickly become a solvency crisis……you then have to sell yourself cheaply, say $2/share, even though your BVPS=$80/share.

But this does not end the whole story, as Mr. Bernanke may be facing something worse --- waning faith in the ability of the Fed to turn around the economy and the financial markets anytime soon. Indeed, the Fed is attempting to catch some of the spillover and plug some of the holes in the system. However, it looks to me that the housing-led-deleveraging and risk reprising process is more like a Water-Dam problem, of which one leak will ruin everything. The Fed now has reached the bottom of its toolkit to come up with innovative ways to restore some calm in credit markets……but frustratingly and cumulatively, they haven't yet had lasting impact on bringing down credit costs and setting the stage for economic recovery …. In particular, the housing market so far has proven resistant to the Fed's monetary medicine ... Builders in the US broke ground in February on the fewest houses in 17 years as home buyers are unlikely to put down offers on houses that they think will lose value --- no matter how much the Fed does to lower mortgage costs … Banks with mounting loan losses will shy away from lending to borrowers they think might go bust -- no matter how much money the Fed pumps into the financial system … And investors will remain jittery --- even after the Fed throws a lifeline to struggling financial institutions, as it did last week with Bear Stearns.

Away from the distressed US financial sector, the debate on the state of the US economy has moved on. Market pundits are no longer debating on whether the US will be in recession in 2008. Instead, the shift has been to the length and depth of this recession. The mainstream view has been that the recession will be a mild one. However, the comparison to the recession that Japan underwent throughout the 1990s is commonly used as a reference point on where the US economy could be heading. The concern is that the tight liquidity and falling asset prices could be followed by an acceleration in the sale of assets to raise liquidity, further depressing prices. The spiral effect applies to housing prices with consumers under pressure and similarly structured products with hedge funds getting margin calls from their prime brokers. Against this worrisome backdrop is a rising inflationary environment which seems to be losing some steams as recent CPI is flat 2.3%.

Bottom-line: the Fed has no choice but to meet or exceed market expectations now......As a result, we may see the bottom of the Fed easing cycle at 1.00%, and I expect the Fed will cut 100bp tomorrow, instead of a 75bp cut.

The Chinese-Share Falls

Along with the 1152ppts drop in ‘HSI and 7.18% dip in HSCEI today, we saw the Niagara Fall of domestic A-shares, even though CSRC approved 3 new funds and one QFII on Friday to boost the sluggish equity market. SHCOMP index lost 3.6% to 3820pts while SZCOMP slumped 6.34% to 1158pts. Having said so, my old friend Kevin in China said he has felt the steady deterioration of corporate fundamentals due to the changing cost structure along the value chain, of which low-end manufacturers were the fundamental comparative advantage of Chinese economy…

Well, it may takes quarters to verify his points, but about 406 A-share listcos will report FY07 within 2 weeks, including most blue chip names in all major sectors such as ICBC, BOC, Ping An, China Life, PetroChina, Air China and Chalco. With the decent results are already priced in, so if results are in-line then it may give some support to the market……Elsewhere, two broader-based concerns are hanging over A-share markets, including 1) the political uncertainty caused by the Tibetan, hurting investors’ sentiment Chinese investable shares; 2) the reported US$460bn hot money could withdrawal in sync, causing financial crisis in China, according to China Securities Journal.

Leaving China markets, we then take a look of regional equities…with the US credit loss impacting not only domestic but also global economies, investors are now cutting back their exposure in other EMs as well. Last week, EPFR Global reported that redemptions from GEM funds rose 2.7X wow to US$2bn, while flows to EMEA turned negative for the 1^st time in 4 weeks. However, foreign investors continue to plow money into Taiwan funds (primarily ETF) with inflows up 60% wow, compared with increased outflows from Hong Kong and Korea. Valuation wise, MSCICN (13.8XPE08, 30.4% EPSG) and MSCIHK (16.4XPE08, 4.4% EPSG) are more reasonable now and the regional MSCI AxJ is traded at 13XPE08 & 15.1%EPSG. However, concerns remain on the earning side, as 1) the street is cutting 2008 China GDP growth forecast to 9.5% from the previous 10%, given a hawkish policy environment and worsening export performance; 2) analysts are downgrading China consumer sector to U/Wt with the growing risk of private consumption slowdown, and 3) over the past 4 weeks, we saw a large scale of earning revision has spread from Financial (12MEPS –23%) to industrials (12MEPS –8%) and utilities (12MEPS –3%).

Having said so, HSI continues to be correlated to Yen moves, and with 24% drop ytd and 33% loss since last Oct, people now try to figure out --- what to bet for a rebound in a near term? Some strategists suggest a list of candidate, high-betas, property stocks, FAI-related, and even the IPPs …… Well, it worth a bet, but all recommended sectors has a common ground --- highly sensitive to the near-term uncertainty of Chinese macro and policy stance…

A Million Dollar Question

The financial markets have recently demonstrated a high degree of correlation among various asset classes and markets --- falling stock prices, rising bonds, a strengthening YEN and rising credit spreads…Yes, they are “deleveraging Trades”……But a point to note is that -- when US stocks are on the brink of the broadest bear market in 4 decades, why investors ignore the strongest buy signals in almost 20 years? The retreat of S&P 500 has pushed the index down 18% (Now 1277 @ my BBG screen) since its 09Oct2007 record and 7% lower since Jan2001 (SPX=1371)…Can you believe that …the plunge resembles declines in the 1970s and 1930s, the two worst periods for US equities in the past 80 years. The last 6 times the index has fallen by 20%, and only once, the Black Monday in 1987, has the sell-off been so encompassing.

Another interesting question emerging now is that between corporates and equities, which holds better value? …This is a definite a Million-Dollar question to the asset allocators…On the surface, HY spreads are approaching recession levels, but the S&P500 has only fallen by 18% from its previous high. Many investors have suggested that corporates bonds may represent better value than stocks, but a new research suggests the answer is not clear cut as stock prices behave during recession varies widely, ranging from a 20% decline in 1990 to a whopping 50% fall in the last bear market. However, the HY spread is always consistent; it needs to widen to 1000bp before a recession is definitely signaled.

Currently, the HY spread is about 740bp, suggesting growth will be very bad but may not be deadly recessionary. By the same token, the downturn in share prices has also been shallower than the typical bear phase in a cyclical recession. Therefore, it is ambiguous whether credit is a better value than stocks, or vice versa. The key thought here is that, if just like the opening remarks I quoted in today’s diary -- the risks of an "adverse financial market feedback loop" to the real economy is still a long way from over --- then the corporate credits, measured by HY and IG spreads, has much further to go …... Also remember, if the US is indeed heading for a deep recession, the corporate default rate is coming with a lag……Let us see …

Good night, my dear friends!