My Diary 409 --- The Japan’s Lost Decade; The Latin American Debt Crisis; The Speculation against Premier; The Rules of Oil Correlation
Sunday, July 13, 2008
This morning, reading the headline of “US Govt shut down mortgage lender IndyMac” makes me feel again that the worst of the worst is upon us, just as I felt on March 17th. This is because if US is the jewelry of the capitalism crown, then Fannie and Freddie are the diamonds fixed in the forehead of modern US systems…I know that US lawmakers will not allow them to fail, but there are immediate implications to the financial markets – 1) Fannie and Freddie's demise mean I-banks can't do any more securitization/liquidity rollover for a while…This is why Fed extend Wall Street lending access to 2009; 2) the freefall of Fannie and Freddie (YoY market cap dropped from $65bn to $15bn) did and will undermine the confidence to and credibility of USD…Indeed, the 10yr CDS of USTs rose to the highest (18bps) in almost 4 months vs 19bps on March 17, according to DB; 3) the latest concern over GSE raised a more broad-market-based question, that is, where is the bottom line of the uncertainty regarding the ultimate exposure/potential write-downs associated with sub-prime and other ABS…At least, I don’t see it ending soon as CME housing futures (Case-Shiller Index) are now projecting a further 15% decline over the next 12 months. Thus the nationalization of FNM & FRE seems inevitable and even the likely sale of LEH ……
Well, take a break and let us look back…Over the week, 1MWTI ended above $145/bbl on the geopolitical concerns over Israel and Iran as well supply concerns over a strike in Brazil and the militant activity in Nigeria…You never expect a peaceful time in Oil market…Global equities lost in the 6th consecutive week with MSCI World dropping 1.6% wow, EU -2.36%, US -1.85% and Nikkei -1.5%. The biggest gains are on China universe with A-shares up7 .7% and H shares climbed 9.64%. Elsewhere, UST slid with 2yr yield adding 22bp on Friday @ 2.603% and 10yr widened 14bp to 3.95%. The curve flattened 10bp over the week. The rise in bond yields did not help USD as it lost 1.5% to EUR (1.5937) and 0.5% to YEN (106.27) respectively. Gold surpassed 960 level driven by higher oil and slumping equities.
The first two weeks of market performance enhanced my ytd concern over growth as the growth related asst classes were falling, including commodities, Asia equities and large/small cap in US. Certainly, to a larger extent, the market volatility is still highly correlated with oil price, but the headache right now is --- where to find a safe haven as tolerance for risk and earnings estimates are still coming down…My short cut answer is to buy Gold, USTs and Utilities while avoid Consumer, Banks and Credits. My feel is that we are going to have a long bear market … Why? Let me roll over today’s note….
The Lesson from Japan’s Lost Decade
I read three times of the article -- Japan's Lost Decade May Become Global Norm, written by William Pesek over the weekend, and I do not think he just wants to attract the eyeballs…History is something happened before, while the younger generation may not want to know/learn... In the early 1990's, by delaying the liquidation processes, the level of GDP growth in Japan is no higher today than it was 12 years ago and Nikkei is still 68% below its late-1989 peak. What we have learned from Japan’s decade-long suffering is that resolving a banking-sector crisis must react quickly and should involve government outlays because of implicit/explicit government guarantees for banks. However, because it is politically sensitive and difficult to use taxpayers moneys to save the over-greed banks due to their own commercial wrong doings, the government tends to delay resolution, as we saw during S&L crisis. Thus, the US financial system is once again in a critical stage…Here is the quote from Alan Greenspan (Lessons from the Global Crises, Sep27, 1999) -- Speedy resolution is good, whereas delay can significantly increase the fiscal and economic costs of a crisis.
As pointed out by Goldman Sach’s analyst, the key significance of FNM and FRE in the current economic climate is their ability to soften the impact of the credit crunch. The reason is that ~50% of total $25tn of lending capacity to US private sector is either stagnant or shrinking. As a result, the other half, of which $5.3tn FNM and FRE B/S is the biggest component to provide some credit growth over time…I think the key message here is that without credit growth, the US is likely following Japan’s road map. In the other side, adding $5.3tn debt should not sharply worsen the US govt’s creditworthiness, as the $5.3tn is not pure liabilities, but depreciating assets like mortgages and loan guarantees. However, there is a few key differences of this case compared with the “JPM + BS” deal as 1) US lawmakers are not making commercial decision like CEO Jamie Dimon; 2) FNM and FRE are much bigger than BS and if one worried about moral hazard, they should worry more now…
Having said so, global economy is posed toward more downside risks suggested by a series of key activity data from US to EU and Japan in the recent weeks. This DMs weakness inevitably will spill over to EMs…Data wise, the latest reports of steep declines in May IP in France and Italy echo the previous drop in Germany. Combined with the slide of June EU PMI (below 50), the Euro area economy is coming down in 2Q08…In addition, the manufacturing activities of EM (a proxy of GDP growth) based on data through May is of a significant deceleration in Latin America and in Emerging Asia, excluding China and India, where IP growth has stayed strong. More importantly, EMs inflation increased in June across board -- Brazil (6.1%), Romania (8.6%) and India (11.8%). Looking forward, the focus shifts to the two biggest economies in both EM and DM world over the next two weeks --- China: June CPI, IP and Q2 GDP growth; and US: PPI, Retail Sales, CPI and Housing Starts.
The Tricks of L.A. Debt Crisis
USTs got sold off a bit on Friday due to the flight to quality trade. I think the overnight widened CDS (+1.5bp) on USTs and the big jump of 2yr USTs yield (+22bp) signals the lost of confidence to USD assets, as it can not be fully explained by --- 1) YTD, foreign official holdings of UST have risen by 12% to US$1,374bn; 2) oil has stay +$135/bbl for quiet for a while…Why not? When Fed is extending “Trash for Cash”, foreign central banks are doing the reverse... You see how US is taking advantage of the rest of the world…Having said so, the risk of owning Asian govt bonds is also the highest since 2003 SARS, resulting from the consequence of fighting inflation in the local economies. The CDS of Malaysia sovereign bonds rose 25bp MTD to 137bp, while Korea sovereigns added 24bp MTD to 127bp. Measured by HSBC ADB Index, investors lost 2% last quarter, the first decline in a year. Sector wise, IG fell 0.8% while HY slumped 2.35, the biggest slump since at least 2005.
Looking forward, one would assume that it's credit positive if the US govt guarantees GSE debt but then again it also indicates how bad things are out there. So far markets haven't reacted aggressively as people are confused as to whether it's positive or negative…In addition, I think history does repeat itself and we will see the same tricks adopted by central bank during Latin American Debt Crisis…In 1980, every major bank in the US was technically bankrupt, as the size of Latin American bonds in their portfolios was far larger than their capital base. When the Latin American countries started to default, if the Fed had made the banks mark their portfolios to market, there would have been no American banks left standing. The US economy would have gone into a deep depression…Instead, with a wink and nod, they let banks keep the bad bonds on their books at face value, which they all did. Then in the latter part of the decade, starting with Citibank in 1986, banks began one by one to write off the bad loans, but only when they had enough capital to do so. It took 6 years (or more) of profits and capital raising to clean out the mess… Today’s banking crisis and central banks’ policy compromise will be only different in the details…The trick of American Politicians is if the current rules do not work out, then change the rules…
The above observation of history enhanced my belief of a long bear market to come. The fundamental difference of this economic recession that it is not a policy induced economic downturn, but a consequence of the overleveraged B/S of financial institutions (20-30X) and households (1.4X Debt/Disp. Income). The problem is that to fixed balance sheet takes times as we learned from the 1980s. Moreover, for financials institutions, the quick way to fix the problems is to raise capital and sell assets…But many cash rich investors, including CIC and Ping An have all got burned, while the assets in the books of western banks are still depreciating…who is going to catch the falling knife in this round?....CIC SQUARE?...To retail investors, selling assets is the only fast option, but normal investors tend to become long-term investors during bear market, according to the behavior finance…Thus we only have one option left, making more money…this is difficult as well and it takes more times… So a long bear market will be a logic conclusion….
The Speculation against Premier Wan
Talking about the bear market, since 31Oct peak, MSCI World index has decreased 20.01% and stocks in the US, Japan, China, France, HK, Germany and Australia have all retreated +20% from their peaks. The legendary Merrill Strategist Bob Farrell (+40yr experience) has a famous “3-stages chart” of bear market – 1)sharp down; 2) reflexive rebound; and 3) a drawn-out fundamental downtrend…I would argue we will soon see the “Stage 3)” as we are now entering month 2 of what is on average a 10 month long recession …Echoed to Bob’s comment, investors are now entering the second tough earnings season (usually last 4Qs in bears markets) as the coming week will bring the first big wave of results from America's largest companies, including 7 Dow Jones components and 53 members of S&P500. According to Thomson Financials, US financials’ earnings are forecast to fall by 69% yoy, and consumer discretionary is expected to fall by 19%. If we remove financials and oil, the rest of S&P500 would see 4% growth, but this is nowhere near what the market has seen in past years…A note here is that the last consecutive profit declines spanned 5Qs and ended in March 2002, as the US was emerging from an eight- month recession.
Last week, China markets o showed their anti-gravity, posted 7.7% gain (CSI300), the 1st time since 28Apr. However, I doubt how long this trend will last as each of the move is associated with investors’ speculation – 1) a possible loosening of macro tightening associated with new rumors of LTE June CPI; 2) a news from a Shanghai local journal which said the govt is likely to ease property developers' funding difficulties, sparked a rally in the property sector…I will bet the market is wrong as 1) from the macro perspective and beside the relative price shock, China’s inflation is likely the pass-through effect from asset price to CPI, due to the exchange rate policy and global excess liquidity. Thus tightening bias is necessary as 7% CPI is still too high; 2) removing the price control should go first, as this distorts the whole economic system; 3) Sector wise, prices are down, sales are down and even Vanke, the only “light-asset” developer has been hit, then how can those greedy/overleveraged ones still see prices jumped +10% in 2 days…So the rally is based on speculation and sentiment, but who can successfully speculate against Wan Qishan, a successor of ex-Iron Premier, Zhu Rongji…
In addition, historically the correlation between China's domestic stock market and economic performance is weak. Stocks fell by +50% between 2001 and 2005, while real GDP growth accelerated from 7.6% to 9.9%. Thus, falling stock prices will unlikely have significant damage to the Chinese economy –1) the wealth effect on consumers should be marginal as only about 7% of Chinese households have meaningful exposure to the equity market; 2) there is little systemic risk in the banking sector as financial leverage in equity investments is strictly prohibited; 3) equity financing remains largely a privilege of SOE and there is no direct impact on the private sector's cost of capital...It seems that the deflating of stock market is not on the top priority (Olympic, Sichuan and Inflation) of Chinese Senior government officers. It was the volatility simply concerns the market regulators then this means speculator will sooner or later got penalized, if they go too far…Last as usual, we reviewed the regional valuation. MSCI China is now traded at 14.1XPE08 and 22.7% EPSG, CSI 300 at 18.6PE08 and 25.3%EPSG, and H-shares at 14PE08 and 23%EPSG, while regional market is traded at 12.4XPE08 and 10.3% EPSG.
The Rules of Oil Correlation
It is more than fair to say --- Oil rules the world today. As long as oil prices keep rising, stocks will be under pressure, central banks will be hostaged and the risks of recession will grow. However, several signs form the financial markets have made me believe that high energy prices have become a burden on the global economy, including the correlation among oil prices, bond yields ,stock index and USD.
Until recently, oil prices and bond yields were positively correlated, suggesting the markets are more worried about the inflation than the growth risks. However, in the past 2 weeks, bond yields have diverged with oil prices suggesting that a turning point may have reached. Nevertheless, the correlation between oil and stocks has also changed recently. Between October 2002 and July 2007, S&P500 rose 100% and MSCI World Index jumped 135% in USD, while oil prices climbed 159% during the same period, suggesting rising oil prices posed little problem for the global economy. But nowadays, the rise in oil prices has played an important role in depressing global equity markets. Before oil prices broke through $120, the 20DMVG correlation between daily changes in oil and equity prices was close to 0, on average. However, since prices spiked higher, the correlation has moved to -70% vs world equity index and -80% against S&P 500. This is another indication that the world may not able to live with current oil prices, raising the chances of a significant correction in crude price.
Furthermore, a weak USD co-existed with rising crude prices and equities for most part of this decade as the falling USD was a positive factor to US economy because a cheapened USD stimulated growth. This is no longer the case. A falling USD is becoming harmful for the US because if fans up energy cost, as evidenced by the recent dramatic change in the correlation between the dollar and US equity prices…Nice or worse, holding a barrel of oil does mean sth real in one’s pocket…
Good night, my dear friends!
