My Diary 408 --- Waking Up to the Recession; The End of Economic

My Diary 408--- Waking Up to the Recession; The End of Economic Conundrum; The Asian Casinos; All Depend on Oil

July 6, 2008

The month of June 2008 was a “stagflation” month as both stock and bond markets went down, while the only winner was Jim Rogers and his favorite asset class -- commodities. Yesterday, The Economist magazine posted an article with the title -- Almost Everything That Could Is Going Wrong for World Stockmarkets …This is quite similar to the title of my trading diary in June 27, but it may not be far from the reality. One can tell it from the BBG headlines, saying MSCI World Index had its fifth weekly drop, the longest retreat since August 2007.  The negative wealth impact is huge as >US$11tn has been erased YTD. Now, to many still-on-hold investors, a dilemma is whether it is too late to sell equities or if it is best to wait for a rebound as a better exit point…

Looking at the past week, 1MWTI fell from near a record high to 144.18/bbl after Iran softened its stance. Global equities moved down further, dropping 2.26% in Japan and 2% in EU and 1.6% US on the wow basis. So far, major US, European and Asian index have broken their March lows, denying the hope of a market bottom drawn by the Bear-Stearns bail out. Elsewhere, UST yields were mixed, with the 2yr slipping 8bp to 2.53% and 10yr adding 2bp to 3.98%. USD strengthened since Thursday ECB meeting vs EUR (1.5706) and YEN (106.8), while remained flat wow vs the two majors.

I have to make a note here that the poor June performance of stocks is all about inflation and growth is a side issue. It is not only that higher inflation and CB panic to hike rates added massive risk premium to equities at a time when sentiment has never been this negative, but also that Inflation continues to put a cloud over the outlook for earnings and economic growth. As a result, investors found steel/coal/base material stocks in the US and EU got hammered, dropping 10% or more…Is this an early sign of demand destruction due to skyrocketing commodity prices? If, Yes, then it will be negative to growth and commodities, but good news for inflation expectations. However, looking forward, what the stock market needed is ironically the weaker growth expectations, dragging down inflation risk and holding back the central banks…If this also Yes, then it is a huge positive signal for equities…We will have to wait and see how it goes…

Waking Up to the Recession

The “Yes” sound that reverberated around the globe was a collective sigh of relief on Thursday after ECB meeting and US NPF released. In fact, ECB got exactly they wanted by raising rates (+25bp to 4.25%) without furthering upward pressure on the EUR and thus commodities prices. However there was troubling news as US Jobless Claims scampered past the 400k mark and with downward revisions to prior NFP months. The US lost 62K jobs in June and unemployment rate stuck at 5.5%...Keep in mind that this is unwelcome to the labor market outlook —1) if the participation rate remained unchanged, the unemployment rate would have been 5.7%; 2) the net revisions for payrolls for the previous two months were -52K; 3) claims data indicate job losses will accelerate in July and beyond. Beyond job figures, further consumer retrenchment was another negative hammer as Starbucks announced 12K lay offs and the closing of 600 stores…This also happened across the Atlantic Ocean as in UK, Marks and Spencer surprised the market with a disappointing revenue update (sales fell 5.3% in 2Q08).

Well we are not having all the bad news as this is may only be the end of the beginning. Last week, BusinessWeek had it cover page marked with "Waking Up to the Recession", and do you remember when was last time we saw the similar cover-title in the major newsprint. The answer is on March 24, 2001, the first month of the 2001 recession, The Economist ran with "Can the World Escape Recession"… Hmm, the world is eventually accepting the fact that we are in a recession…But this raised a question mark over ECB as survey data signal sharply slower growth in Q2 and Q3 (PMI below 50, the weakest level since 2Q03). Certainly, the ECB’s focus is to anchor inflation expectation. Although core inflation has stayed below 2% since 2003, EU CPI hit 4% yoy in June, up from 3.7% in May and the pipeline inflationary pressures remain elevated (May PPI climbed 7.1% from 6.2%). In addition, M3 growth (10.3% in March-May) remains far above the ECB’s 4.5% 3MAG. More worrisome is that wages accelerated to 3.3% in 1Q08, breaking out of the 2-3% range of the previous 4.5 years. This is a warning signal to ECB as compared with the last round of wage acceleration in the late-1990s (strong growth, falling unemployment), this times Europe has to face 1) contracting PMI manufacturing and services indices; 2) weakening business and consumer confidence.

I had a discussion with our Sales Head, we all agreed that the world needs more to rebalance the deflationary DMS and the inflationary EMs, and during this process (which just began), there are the many huge uncertainties/risks, ranging from the commodity price, to US consumption slowdown and to a new EM currency regime, etc… We don’t think anybody now has a clear picture of what the future looks like, but all these will lead to a massive re-rating of risk, so the near term picture should not be pretty, if not scary... Put into details, it is clear that US growth is quite slow and Europe is slowing, while Asia growth has not slowed materially yet, but what linked all three regions is high inflation. And that will means something going to change in Asian currencies….

The End of Economic Conundrum

In Asia, strong growth and higher inflation portends for higher IRs or stronger currencies. However, I do not think IR hikes will temper inflation, as inflation is imported and it is more attributed to food and energy prices. So perhaps the best way for our regional governments to address inflation will be through currencies appreciation and this move seems more likely to happen now as both US growth and interest rate spreads are not supportive for USD anymore. Over the past decade, USD weakness was in large part a function of soaring global excess liquidity, resulting from a boom in money supply growth allowed by central banks. The excess liquidity was in turn a major factor in supporting global asset markets, boosting spread products such as EMs. Certainly, the money found its way to Asia, causing the USD depreciated and encouraging local central banks to intervene to limit local currency appreciation. As a result, this spurred local market liquidity, just like adding fuel to the fire. In return, local banks used USD they bought to acquire US assets, keeping US yields low, and diversify into non-US assets, keeping the USD weak.

Now, the re-emergence of inflation will ended the once named “Economic Conundrum” by Alan Greenspan. Suggested by June CPI in India (11.4%), Thailand (8.9%), Philippine (9.6%); China (7.7%), Korea (5.5%), Taiwan (3.8%), Singapore (7.5%) and Indonesia (11%), rising inflation is a key driver for Asian currencies going forward. This is because Asian CBs are seen by the market to be behind the curve and investors are nervous that if inflationary pressures get out of control without raising IRs aggressively. Currently, all major countries still have negative real rates -- India (-2.9%), Thailand (-5.6%), Philippine (-4.4%); China (-0.2%), Korea (-0.5%), Taiwan (-0.2%), Singapore (-6.2%) and Indonesia (-2.3%). This is in sharp contrast to other EM real rates, such as Brazil (6.65%), Mexico (6.65%) and Turkey (2.8%).

To think it through, the Asian inflation is likely the pass-through effect from asset market to consumer inflation from the macro perspective. Our local central banks, once sat on their hands, are now starting to deal with inflation by hiking IRs, RRRs, and intervening local currency depreciation. This is necessary so that country like China could start to reverse the FX-related liquidity inflation and the trend is look encouraging as recently liquidity is now flowing out of Asia. YTD, foreign portfolio investment in regional equities are leaving at a quick pace, relative to the past few years – India (-$6.5bn), Korea (-$21.7bn), Taiwan (-$3.5bn) and Thailand (-$1.66bn). All in all, the structural impact of all these capital flow or currency appreciation on global markets is huge and we will see 1) rising yields; 2) rising volatility; and 3) more downside growth surprises.

The Worse to Come?

Having talked about “rising yields”, USTs had its worst quarterly return (-2.1%) in 2Q08 since June2004, according to Merrill Lynch, as investors questioned whether Bernanke will be able to contain inflation. However, 2yr UST gained for a third week as traders now speculated that declines in the labor market and a service industry contraction will make it harder for the Fed to raise interest rates this year. Futures show an 18% odd that FOMC will lift rates on 05Aug, down from 77% in 3-weeks ago. In addition, the 2-10yr spread had increased 7bp to 145bp on Friday, the widest since June 6…A positive sign to crying banks…

However, overall corporate debt sales fell to the lowest in 18 weeks as HY issuers now paid higher rates than previously marketed as overall yields rose to the most since March 19. Measured by Merrill Lynch US HY index, the credit spread has climbed 22bp to 763bps, the highest since April 15, while average yields rose to 11.09% from 10.94 % at the end of last week... Would the widened spreads, plus increased market volatility and a lack of liquidity caused by the recent round of risk reduction signal that there are worse things to come? ITRAXX Asia IG (149) is now 48ps wider from one month ago, while HY (565bp) is 85bps wider than June 02. It seemed that the local credit market has certainly priced in a WTE 2H08, but as a long-time market observer, I never expect the credits will get to these levels so quickly… If the momentum continues in the next few weeks, then I am not surprised to see a re-testing of March wide@ 650.

In general, credit risk is cheaper now relative to interest rate risk as IRs has declined substantially and UST became one of the richest assets in the world... the other is commodities… Certainly, within a “mini-Staginflation” environment, we have to generally cautious of credit risk, and I think the 1H08 results and outlooks will be the key driver for local markets.

The Asian Casinos

A BBG commentary by Michael R. Sesit viewed that it is BAD for Vietnam, Pakistan and Taiwan to boost their sagging stock markets by using govt money, following HK's 1998 equity buying spree. He also said many Asian markets resemble volatile gambling arenas more than capital-raising enterprises. Why should taxpayer funds bail out a casino? Well, Michael’s view may not sound too extreme if you saw CSI 300 plummeted 49% in 2008, after soaring 162% in 2007 and 121% in 2006, and Vietnam Stock Index has plunged 53% YTD, following returns in the past 4 years of 23%, 144%, 29% and 43%. India had the same yo-yo show as Sensex index was down 34% ytd, following a 42% rally in 2005 and 47% in each of the past 2 years. In addition, unlike US and EU, most Asian equity markets are largely owned by governments, families and endowments or restricted in other ways. For instance, the so-called free float equals 90% of US GDP, 110% of UK GDP and 57% France GDP. By contrast, China's free float equals 17 % of its GDP, India's 20% and Pakistan's 4%...This is why when XinHua News Agency called a market bottom, we saw A-shares rallied for a few hours…

Having found out the irony part of Asian stock markets, MSCI AxJ is down 25% since the start of the year. Question is should we be more bullish on equities now than 6 months ago? Sadly, the global economy has worsened, souring the outlook for earnings growth, and rising inflation bets higher interest rates. A recent strategy report released by Citigroup argued that on a 3M horizon, valuations in AxJ still look unattractive as P/B currently at 2.1X indicates at least 18% downside if using 10yr and 30yr average of 1.8x as benchmark…Well let us take a look of major index valuation as a reference check…MSCI CN ended 13.3XPE & 2.3XPB, CSI 300 at 15.9XPE & 2.9XPB and H shares at 12.7XPE & 2.1XPB. The MSCI AxJ is averaged at 13.4X PE & 1.6XPB … It looks like we are a bit expensive PB, but isn’t that ROE for China and H shares (18%) is much higher than the AxJ (12.6%)…

Having said so, the regional market sentiment is week. Volume wise, in OCT2007, regional trading volume averaged US$46bn, while it nearly halved to 1H08 at US$27.7bn. In June, the volume is US$21.6bn, 20% less than 1H08 average. The number of IPO also dropped significantly with 2008 ytd at 322 issues ($33bn) vs 1282 issues ($164bn) of the year of 2007…25% less in issues but only 20% in Dollar terms…Moreover, in 2007, investors generally are willing to pay 300-500% of premium in order to get a hand into “China Play”. Today, the animal spirit has gone as we have seen many POs dropped under water since their debut …So far stocks looked not a good bet for investors…

All Depend on Oil

To answer the dilemma question at the first paragraph, I think the outcome is still dependent on oil price and the short-term risk is huge. Despite oil price is already very high from the historical price standards, it has not corrected and have broken out to new highs. This move now is offsetting the impact of the Fed easing, crippling global economic growth and causing share prices to fall.

Talking about oil, people will argue about USD weakness as the chicken-egg logic seems partially correct. Indeed, USD weakness has been a factor from time to time, but prices are up 10% in EUR terms as well… It is more than that … Crude oil also has knock-on effects on some agricultural markets through the potential impact from bio-fuels. What I can see is that in the near term, fundamentals are little changed—1) weakening US demand and more production from Saudi are offset by further sabotage in Nigeria; 2) and there is no doubt that geopolitical risks surrounding Iran and expectations of tighter fundamentals in the future are “upward-bias”. The key is as long as China keep its growth pace, oil imports has to continue and the energy crisis could get much worse before it gets any better…So a substantial slowdown in Chinese economy may be a positive to equities then??…Well in the near term, as I listed in the above sections, all the forces supporting energy/commodity consumption remain more or less in place, including -ve real rates, accommodative Fed policy and a still-strong Chinese economy…Simply blaming those speculators is not quite convincing at this moment, at least, I am not in that camp.

Thus, it is likely that a long bear market may come to us, just as the last one we seen earlier this decade, even though markets have average down avg 10-20% in DMs and 30-50% in EMs. So I have to conclude on my answer to the “Stay or Sell” question … what I learned from books, the senior PMs and my own practice is that investment is all about surviving in circumstances where you are wrong. From time being, capital preservation is a better strategy, while cash and bonds are better choices.

Good night, my dear friends!