My Diary 412 ---Bear Market Rally or Not; Who is Hu & Who drives

My Diary 412 --- Bear Market Rally or Not; Who is Hu & Who drives who; The Hidden Mines of Debts; The President Hu’s Six Tasks

July 27, 2008

US stocks rose on Friday, paring a weekly retreat, on growing speculation the worst is over given BTE durable orders, consumer confidence and new-home sales. The 0.42% move of SPX will sustain the recent debate over whether the rally since 15 July is a trend of recovery or merely short covering. My answer is the later one and if you spell “short-covering-rally” slowly and word by word, you will get what I mean. Expect for crude oil retracing 22$/bbl in two weeks, there wasn’t any positives regarding the economy, housing and credit conditions.  Instead, there are more signs showing that financial losses are spilling over into the real economy and back via negative feedback loops. My supervisor in UofT, Professor Asher Drory, had a great and precise comment on the current circumstance --- “watching policy markers switching focus in one month from inflation to depression is amazing and suggests to me that we have a much more fragile system, than we think we do.” This suggests that the sharp move of SPX is the jerky behavior of a bear trend, and a harsh consolidation lies ahead.

Looking back, global equity markets contracted 1.7% in the last two days but were up 3.5% from their July 15 low. Regionally, stocks were split, 2% declining in Nikkei, 0.2% lower in EU, but up 0.4% in US. Over the week, Japan outperformed by rising +4% relative to other G3 markets…High CPI seems a positive gesture to the decade-long depressed Japanese stocks. Elsewhere, 1MWTI Oil finished wow $5.62 lower at $123.26/bbl. The price is oil is now $22 below the all-time high set earlier this month. Agriculture and industrial metals prices have also fallen substantially over the past two weeks, falling 9% and 7% respectively. Rates wise, 2yr and 10yr USTs yields popped 11bp to 2.70% and 6bp to 4.10% over the week. Thus, USD strengthened 0.9% vs both EUR and YEN accordingly.

Watching the SEC’s asymmetric rule on “naked short” makes me thinking that bull market is more fun than bear market as the later involves bare-knuckle fights. In my own opinion, the bear market phase I (Housing/Financials) has come to an end due to the short-capitulation caused by the US govt’s “bail-out” action on F&F as well as the SEC’s prohibition on naked-short selling. Bear market phase II (Inflation/Growth) may be just still in its earlier stage, featured by a global slowdown with the deflationary DMs and inflationary EMs. Certainly, the near-term focus remains on financial market developments as earnings seasons continues in US. One of the strategic questions for the 2H08 is that, given the only engine of global growth left now is Asia or largely China, how do you think of global economy outlook? And the key lies on whether “DM drives EM? or vise versa?”

Bear Market Rally or Not

The recent bold movements taken by US govt have raised the uncertainty of financial markets to another high level. However, investors seemed ignoring the above concern rather than calculating whether the oil bull market is over. So far, oil price is more important than credit losses as to many market strategists, their early versions of 2H08 strategies are based on high oil price assumption. If such an assumption is proved to be wrong, then asset allocation and investment strategy would have a 180 degree turn. But in the near term, oil is a really tough call, thus staying in the sideline and waiting for a clearer trend seems to be a good choice.

As I discussed at the beginning of this diary, the street was debating whether the recent rally in the equity market is a trend of recovery or merely short covering. Here I will summarize a few of my observations before we can reach a conclusion --- 1) after the announcement of granting additional credit lines to GSEs and the new emergency restrictions against "naked short selling”, FNM& FRE stock prices rallied sharply by over 96%, along with 49% rise of BOA and 59% of LEH within 4 days. However, market now knew that even the modified bill authoring the US Treasury to inject capital (loan and equity) into GSEs does not change the deteriorating fundamentals as FNM& FRE may need to record more write downs on its $217bn of non-agency securities, including private label holdings (9.2%) and Alt-A (5.8%).

Moreover, 2) the recent 3.5% rally of US market seemed dominating by persistent toxic themes -- banks exploding higher and resources underperforming. Regionally, MSCI AxJ was also up 9% from its low. Such a rally is understandable as the initial growth downgrade is beneficial to stocks through inflation-destruction. But please bear in mind that global growth may drop further (discuss in next session) and historically, a rebound of +10% is not uncommon in bear markets, i.e. during 2000-01, there were 6 times of such rebounds (lasted 10 to 37 days), measured by MSCI AxJ. Furthermore, 3) scanning through the TOP stories on BBG, it seems like a list of tragedy events --- FDIC takes over 2 more banks; Existing home sales drop to 10yr low; Payrolls fell for 7^th month; Fed loans $16.4bn to banks; Ford loss $8.7bn, and so on. If this is not enough, I will add another key indicator that global credit spreads still remain 3.5-4.5X wider than their levels at the start of 2007…So put all these market observation together, it seems that we just had a typical short-covering rally that will yield to further weakness as the market again grapples with growth, financial risk and inflation concerns

The logical following-up question is that, if we are still in a bear market, what are signals indicating we come near the end of bear market. I think here are some --- 1) US housing distress is easing, indicated by foreclosures and house prices; 2) frozen credit markets start to revive, showed by mortgage lending standards; 3) corporate earnings drop lower, as equities should not bottom before earnings downgrade process starts. Looking forward, we may continue to live within the bear markets for a few quarters as 1) investors have not yet capitulated; 2) analysts have only just started to revise down forecasts; 3) valuations are nowhere near previous bottoms (MSCI AxJ PB = 2.1X vs 1.2X in 1999, 2001 and 2003). But, investors also have to keep in mind that although we are not yet to see the above 3 signals at this stage, but bear market could end earlier than investor expect as a turn to lower interest rate will help equity market to bottom before earning cycle bottoms, while a falling inflation expectations could lead to a substantial PE rerating.

Who is Hu & Who drives who

A web-based political joke is President Bush once asking Secretary Rice about the newly elected Chinese President, “Who is Hu”? And she replied “Hu is Who”. Such a dialogue looks funny from the political perspective, but from the macro economy and financial market perspectives, the Sino-US question can be translated into a broader question of "Who drives who", or rather, is DM driving EM going forward? or vise versa. The question has crucial implications on 2H08 investment outlook, as if it is the former scenario, the world economy will head into lower growth and later less inflation, with high down side risks (or policy risks) in the EM markets, while the later scenario suggests higher growth and higher commodity-led inflation, with adjustment risks skewed towards DMs. I assign a little more chance to the second thoughts given that the size of EM economies and the % of contribution of EM to global GDP is much higher than it was in decades ago, alongside the much stronger international BoP and local fiscal status.

Having said so, global inflation reached an 11.5 year high of 4.9% yoy in June and central bankers are more hawkishly inclined everywhere, even in US. Since the rising price is a persistent negative for the real economy, I did a quick round check on the health status of global economy.

Ø         US (weak): Existing home sales =10 year low; Inventory of unsold homes =11.1 months; Housing Future = -15% more in 12 months; Continuing claims ex-Katrina = 5year high; Beige Book =Consumer spending @”sluggish or slowing", Price pressures @ “elevated or increasing’’ in nearly all districts; Core CPI =2.4%, Headline CPI =5%.

Ø         Europe (from Bad to Worse): Weak industrial activities@ PMI (47.5) & New orders (-4.4%); Deteriorating business and consumer confidence (IFO; INSEE); Core CPI =2.4%, Headline CPI =4%; UK retail sales= -3.9% MoM and it faces its worst performance since the 1990s recession

Ø         Asia (signs of slow-down): Japan's exports (-1.7% yoy) unexpectedly fell for 1st time in +4 years, Core CPI=1.9%; HK exports drops (-0.6% vs +10.3% in May), CPI=6.1%, Exports to Asia fell 3.1% yoy in June; China’s export slowed to 17.6%, CPI =7.1%; Taiwan manufacturing output -1.2% on QoQ.

As discussed, recently market concerns have shifted from upside risks to global inflation to downside risks to global growth. In fact, these two issues are actually linked together. Inflation globally may be peaking as commodity prices soften.  But easy money, inflation spillovers and a looser slack-inflation link suggest that global inflation will stay higher for longer. Inflation concerns mean that monetary policy will either tighten or remain on hold in most developed economies. Thus many will welcome below-trend growth to bring inflation down and it is reasonable to expect that growth is softening around the world, reflecting higher inflation, tighter monetary policies and financial conditions, and adverse terms of trade for commodity consumers. To our regional market, the unexpected drop in HK exports to other Asian Countries in June is a bad and unmistakable signal of economic slowdown. This has confirmed that Asia may no longer help HK offset the weaker exports to US.

The Hidden Mines of Debts

The BBG reading of NAB’s CDO provisions reaching AUD1bn once again reminded investors that it is not the time to be aggressive in western financials, along with Bill Gross’ comments on total mortgage losses estimated to be $1tn. Bill’s number is not too far as there are as much as $800bn in unfunded off-balance sheet assets will make their way onto the books of major banks, totaling as much as 40% of total bank capital. YTD, global banks have managed to raise $300bn already by selling to SWFs at deep discounts and big coupons.  But where to raise the rest of $700bn?…Not the SWFs as their investments have down 50%, so maybe Fed in US, EU and elsewhere…

Having said so, I think Bill Gross may not have counted for some other big numbers, or so called  “Hidden Mines” of debts, which include --- 1) Consumer debt. We all know now that US consumption has been fuelled by debt “because real income has remained flat for the last 30years and HEW unlocked over USD1tn in equity for consumption.” With that gone, the last defense for buying oil and food, the US consumer’s credit cards, is the next risk. Some renewed numbers form banks confirmed this worrying trends as JPM’s provision for consumer debt has jumped from 5% to 90% and Citigroup consumer business dropped 67% in their latest results; 2) Other forms of debt, including commercial, infrastructure, etc. This also worth for an ink as recent data shows that in term of financial excess (mortgage mainly) , the US ranks only 13th behind mostly EU nations. While smaller, their collapse will likely be equally as spectacular. In addition, the notional derivatives (Nets matter only when you’re unwinding” are over $600tn vs $60tn in global GDP, or 10X. Given derivatives are USD/EUR/JPY denominated, the multiplier is closer to 20x the GDP of G3 economies …This is a over-leveraged world…Fine when defaults were low, not so fine when global growth slows and default rates raise dramatically.

In rates world, following Paulson's pledge to provide backstop capital for F&F, a heightened risk premium in USTs and the possible increase in supply created by the GSE bailout have contributed to the recent sell-off in UST securities. Certainly, inflation expectations fell last week as 10BE inflation narrowed to 2.32%, an almost three-month low. The 2-10 curve spread widened to 144bp from 136bp two-weeks earlier as traders reduced bets for an increase in FFTR. Futures show a 93% chance that Fed will keep 2% target rate at the Fed's Aug. 5 meeting. In the local credit market, fortune has favored the brave of late. The best performing sector in the AxJ HY Dollar bond market over the last 3 months was property (+5.7%), while the worst segment is sovereigns (-4.6%). This comparison suggests that with 20% yields, investors may ignore the anxiety facing Chinese property developers and price pressure from global market weakness. In general, investors maintain a generally positive view on Asian HY in a 12 months horizon as they believe that the sector’s implied default rates(9%) is too high compared the market forecast at 4%. Having said so, local investor should remember that the overcall US credit markets remain in deep water as sluggish growth, tight lending standards, rising unemployment and deteriorating consumer wealth ensure that corporate default rates and consumer delinquency rates will continue to rise.

The President Hu’s Six Tasks

Excluding financials, the recent earning report for S&P components shows an 8% yoy growth, which is not too bad. But, the street consensus is expecting a structural and longer decline in profitability due to three key drivers --- the commodity cycle, earnings leverage, and wage restraint. Such structural factors suggest that margins need not fall as far as in prior cycles, but continued earnings downgrades are almost inevitable. As earnings downgrades dominate, equity returns will need to be driven by PE multiple expansion, a process that will require confidence about macro prospects…This seems difficult to achieve given the policy dilemma between low growth and high inflation.

Having discussed so, since China officially changed their monetary policy stance from "prudent" to "tight" at the end of last year, PBOC has raised interest rates by 18bp, allowed the TW weighted RMB to appreciate by 3.5%, increased RRR by 300bp and stepped up scrutiny on commercial banks' lending activities. Now, slowing exports, an escalating energy crunch and domestic stock market implosion will likely prompt China to change its tightening stance. This policy change has been summarized by the six points raised by president Hu JingTao over the weekend -- 1) to maintain steady and relative fast growth; 2) to effectively control inflation; 3) to encourage agriculture output; 4) to move the economy up the value chain; 5) to continue the reform and opening up, including the financial market; 6) to protect the welfare of the mass people, including earthquake reconstruction, employment, low income families….I think the message is obviously showing that the tone of Chinese macro policy has been revised to further emphasize growth.

Regarding the regional fund flows, with Asian markets rebounding 7.8% wow ended 23July, inflows to offshore Asian funds resumed (US$803mn), according to the EPFR data. However, this is not going to help ease the selling pressure Asian funds are facing, given their cash weights remain low at 2.5%. The biggest change in country positions at Asian funds has been in China with consensus now 260bp U/W vs 140bps a month ago and GEM funds' regional weight in Asia fell to the lows last seen in year 2000. Globally, market weighting may reverse if commodity prices continue to cool down so that the narrowing performance gap between Brazil -Russia and India-China will change the market allocation of GEM funds.  Three preconditions seems to play a role here is 1) the price of oil goes below $120 a barrel; 2) China's CPI slows to 5%; 3) US banking crisis comes to an end. Domestically, according to Goldman Sach’s survey, A-share local funds’ gross sales continued to experience sharp declines (down 34% qoq and 61% yoy) with light equity positions at 68% of blended funds. Local fund managers remain a cautious stand as they all slightly underweight financials  due to bearish outlook on China macro…Finally, valuation wise, MSCI China is now traded at 14.5XPE08 and 21.7% EPSG, CSI 300 at 17.2XPE08 and 25.3%EPSG, and H-shares at 14.3XPE08 and 21.5%EPSG, while regional market is traded at 12.8XPE08 and 12.6% EPSG…

Good night, my dear friends!