My Diary 384 --- You Pain then You Gain; Credit and Equity Inves

My Diary 384 --- You Pain then You Gain; Credit and Equity Investor Talk; The National People's Congress; The Chicken-and-Egg

March 6, 2008

Another struggling night for the markets to swim on the woes around Ambac and the adequacy of potential capital injections…A talk from Goldman's CEO, Lloyd Blankfein said that we are somewhere 2/3 through the current liquidity crisis, implying that we maybe still too early to all a bottom of asset price. Adding to his words, today market rumors around UBS is the bank sold its Alt-A portfolio to PIMCO at 75c per$ vs 4Q07@90c, also implying more markdowns. In addition, data released yesterday portrayed the US economy barely growing and possibly shrinking.

Equity prices were mixed over the past 24 hours (US and HK flat, Nikkie + 1.88%, while Major EU down 1% now on BBG). UST curve steepened further as 2yr yield (1.566) edged down 9bp while 10yr (3.647) moved up 2bp, with 2/10 spread at its widest since 2004. The US Dollar slipped on a TW-basis (73.209) and against EUR at 1.5345, a new height. Commodities also roared back, seeing 1MWTI closed at an all-time high of $104.62/bbl. Industrial metals prices climbed a healthy 2.5%.

However, one thing to be sure, is that the bigger hurdles arrive with the weekly jobless claims figures tonight and the labor market reports tomorrow……but let us look at Beige Book first……

You Pain then You Gain

In the past week, several Fed officials have signaled deep concern about the US economy and deteriorating credit markets, though Most have acknowledged inflation is a risk. But that concern isn't likely to be an obstacle to further cuts in the Fed's short-term interest-rate target, now at 3%. Overnight, market saw ISM non-manufacturing index rebounded from a shockingly low 44.6 in Jan to 49.3 in Feb……that's still below 50, the level above which the service sector is generally expanding.

The “Beige Book” prepared for March FOMC meeting had a clearly recessionary tone to it. 2/3 of the districts said that business activity had weakened in Jan and Feb and the other 1/3 "referred to subdued, slow, or modest growth." Consumer spending was seen as "generally downbeat" across the country, with the majority of regions describing retail sales as "below plan, downbeat, weak, or having softened." The Book also said housing markets in just about every area of the country were weak, and were characterized by low demand, high inventories and falling prices...… No doubt that the Subprime crisis has increasingly threatened to engulf corporate and consumers, not just banks/brokers.

Having read the Fed talks, the market is realizing that investors is living in an very interesting times --- (WSJ, 28Feb) Chairman Bernanke publicly states his expectation on some bank failures due to the spreading financial crisis, then shortly thereafter (FT, 04Mar) he publicly calls on banks to forgive a portion of US mortgage loans made to now troubled borrowers. "In this environment," he said, "principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure"…To the Wall Street and many seasoned financial professionals, this is a call more than an economic puzzle…. Why?

Based on the defined duty, The Fed is charged with protecting the soundness of the banking system, while the safety belt is shareholder equity capital, which is generated in part by income-producing assets known as loans. Now the Fed chairman advised the banks should transfer their shareholder’s money to mortgage debtors, an interesting question to follow up is --- how this transaction can help ease the mistrust at the heart of the current credit crisis, not mentioning this could be a new political risk to both parties.

Well, at the end of day, as the Fed’s Chairman, Bernanke knows that the mortgage crisis is in large part the fault of the Fed's own reckless monetary policy --- low real interest rates for too long created a subsidy for debt that spurred the housing and credit bubbles that have now burst…… now his proposal might send a signal to borrowers that they needn't do anything at all, either waiting for their banker to tell them they don't owe nearly as much as they thought, or waiting for Congress to provide its own mortgage bailout…you see how the American logic works out here…You Pain then You Gain…

Credit and Equity Talk

Positive picture across Asia has underpinned the regional stock markets during the past 2-3 days, but not credit market. One interesting point to note today is that ML David Rosenberg yesterday pointed out the correlation between BBB spreads and the S&P is 0.67 or 0.9 when spreads have a 3 month lead……90% correlation, one can based this figure to start a statistic arbitrage fund…Echoed his comments, one news in the BBG today also called for that stock investors should consider Asian credits because the prices of debt securities are”cheap'' compared with equity shares, according to Morgan Stanley.

Nowadays in Asia, high-yield bonds pay investors an average yield of 9%, which is >4X the dividend yields on shares and the highest ratio since 2001. And equity investors in Asia and elsewhere who are comfortable with asset valuations should start considering credit as a significant opportunity. The CDS indexes now suggest a 12% default rate among Asian IGs and 30% HYs, a level similar to those of the 1997-1998 Asian financial crises.

I think the Morgan Stanley analyst does lay down some valid points here. Given the US economic gloom, Asia’s growth prospects remain relatively more appealing, if you take structural factors into account. But I think there are still good chances with US equity market. One thing for sure is that till the housing headwinds abate and credit markets begin to function properly, equities with earnings leveraged to the domestic economy are likely to remain at risk and under-perform their global-play counterparties. It means US large-cap and growth stocks, which tend to be globally exposed, are well positioned to outpace small caps and value stocks in the next few quarters…...Just compare HSBC with Citigroup, you can get some feeling out of their F/S… Moreover, large caps and growth companies should continue to benefit from the downward adjustment in the US Dollar.

National People's Congress

Nothing is more important than the political agenda. This is something I know as a Chinese, but I think more and more foreign investors understand it as well…… Thus, there is no surprise that the 11^th National People's Congress has attracted so many journalists and cameras.

Apparently in this year’s “Work Report”, Premier Wen Jiabao emphasizes that the rising uncertainties and potential risks in the global economy will have bigger impact on China as the country has opened it door for more than two decades. He also makes it clear that inflation control is the primary task for the government. The implication is negative to A-shares as without a clear sign of economic slowdown the monetary policy will remain tight through a combination of credit control and the adjustments of interest rate and exchange rate. To counter external uncertainties, the government still has significant potentials to stimulate domestic demand, adjust economic structure, encourage innovation, and improve people’s livelihood…Thus, there should have no so-called “hard-landing” scenario in 2008.

More eye-catching part is regarding the housing policy. The Premier mentioned four key strategies of the national housing policy, including 1) strengthen the housing protection system and to provide adequate small-to-medium sized units; 2) provide enough financial support for middle income family; 3) high-end market demand and supply dynamics to be market oriented; 4) and provide adequate affordable housing for low-income class……Well, there is nothing new so far, but it is interesting to see that the government is still leaving the high-end demand for to market forces, which could imply some potentials for the big & government supported developers, like COLI and China Resources Land.

The Chicken-and-Egg

Many headlines have been devoted to the potential "collapse" of the US Dollar lately. It seems that currency traders have drawn the reasonable conclusion that steady depreciation of US Dollar is in everyone's interest. In fact, the US Dollar decline is acting as a shock absorber (or a stimulus) for the US economy and financial system without unduly harming the rest of the world.

However, the investors only believe what they have seen…starting from a huge US balance of payments deficits, in which stock and bond markets run in the face of capital flight; and then a credit crisis caused by housing and Subprime mortgage, in which the net long-term portfolio inflows has collapsed at a time when the Fed is cutting interest rates…as a result, a backup in Treasury yields, even when US Dollar drops, would warn of a rising risk premium on US assets. Thus, even though USTs remain well bid and SWFs continue to show interest in US assets, it would be safer to maintain USD short positions, against EM or Commodity currencies, as the US growth expectations have ratcheted down significantly and I do not want to bet against a possible recessionary outcome.

Having said so, the commodity story remains a key focus and oil surged once again yesterday, rising a remarkable $5 a barrel to a new record over $104 after the government reported a surprise drop in crude oil stockpiles (EIA, -3.1mn bbl) and OPEC held production levels steady. Interestingly, there is an ongoing chicken-and-egg argument regarding crude oil, commodities and the US Dollar, and there are various forms of analysis which show one market leading the other. But importantly, some global monetary officials are citing USD weakness as one factor behind oil price gains. But whatever the results, at this extremely price levels, I think the generally high correlation between crude and the EURUSD would imply that oil moves in either direction, it would increase the risk for similar movements in EURUSD…… You see why the US needs to stay in the Middle East……So the chicken-and-egg argument will be --- green backed oil, or oil backed green money?

Good night, my dear friends!