My Diary 416 --- Net-Net, No U-Turn; A CMBS Storm To Come;

My Diary 416 --- Net-Net, No U-Turn; A CMBS Storm To Come; Less Customers in Pubs; Commodity, ROE and PB

August 26, 2008

Overnight, US stocks fell the most in a month due to renewed concerns over financials in the wake of the 9th bank failure, dwindling M&A speculation surrounding LEH, as well heightened fears of ratings downgrade at AIG…I think these are nothing new and the Street and financial media focused too much on the anniversary of the “credit crisis” over the week, while overlooked the two most profound events in the worlds --- The Ranking of Olympic Medals and the Georgia War.

From my viewpoints, there is no need to debate whether US/China should be ranked as the No. 1. Put it simply, the rank of total medals (110 /100) indicates that US still reserves the leading position based on its comprehensive capabilities, while the rank of gold medals (36 /51) symbolizes Beijing Olympic is not just a nation’s coming-out party, one that would presage the Chinese Century. In addition, I think the Georgia War between US/NATO and Russia may be another sign of the collapse of the modern Dollar system. My personal view here is that the strength of Dollar is derived from the “American Triangle” based on its economic/financial strength, international political power and global military base. However, all the three legs are being weakened/challenged internally and externally due to the on-going housing/credit blowups, the surging of EU/Russia/China as well the resource-dragging wars in Iraq and Afghanistan. More importantly, the seemly self-enhancing philosophy, “Weaker Dollar -- Stronger Commodity – Louder Russia/Iran – Weaker US”, looks to me that Georgia is not just a US-backed “Southern Energy Corridor'' that connects the Caspian Sea region with world markets, bypassing Russia.

Looking backward, 1MWTI oil sharply reversed course, dropping $6.07 since 21Aug, to finish yesterday at $115.11/bbl. With the Georgia spike, oil has been “flat” between $112.87 and $116 for the past two weeks, while WoW metal (4-5%) and agriculture (7%) prices gained healthily as a whole. In addition, MTD global equity markets were split, turning lower in Asia (6.9%), falling in EU (2.6%) and staying flat in US (-0.4%). Viewed more broadly, worldwide equities have moved down 2.94% since July31. Elsewhere, USD gained 6.6% on a TW basis, 1.61% vs. YEN, and 6.47% vs. EUR. USTs regained with 2yr and 10yr yields declined 8bp and 9bp, respectively, to 2.32% and 3.78%. Both yields are down more than 30bp since a month ago.

My recent observation is that the market continues to show symptoms of a manic-depressive disorder as a result of the combination of thin summer volumes and the significant uncertainty related to financial sector and global economy. Going forward, there are a few things to keep a close eye on. To Uncle Ben first, his speech in Jackson Hole is basically translated into no changes in monetary policy any time soon. Second is the speculation and discussion around the KDB/LEH deal and GSE bailout. Third is oil price. Kenneth Rogoff pointed out that over the period 1800 to 2006, peaks and troughs in commodity price cycles appear to be leading indicators of peaks and troughs in the capital flow cycle, with troughs typically resulting in multiple defaults. However, my foremost concern now is to central banks and their policies. It seemed that the disagreement between central bankers and scholars emerges one year into the financial crisis, witnessed by the blame from Dallas FED Fisher, a critique from former BOE member William Buiter and the 3-way split among BOE policy meeting. There is only one thing they did agree on – they don't believe the financial crisis is necessarily over or close to being over…. Good luck and let's be careful out there.

Net-Net, No U-Turn

In this year's Fed Symposium, Chairman Bernanke' stressed the fact that Fed policy has conditioned on the judgment that commodity prices would stabilize owing in part to slowing global growth. He also defended the Fed's role in the rescue of Bear Stearns, arguing that given the current fragilities in market arrangements, the likely collateral damage from a failure of Bear Stearns were large enough to justify the Fed's response. The rest of his remarks focused on the Fed's role in containing systemic risk...These themes are old topics…But US LEI (-0.7% in July provides a fresh reminder that a domestic recession is underway and policy efforts to stimulate growth have been short-circuited by a collapse of risk-taking in the financial markets. This is within my expectation as high mortgage rates and excessive inventories underscore that the housing slump will persist, while rumors of a Govt bail-out to GSEs underscore the seriousness of the banking and financial crisis.… Other sign of global slow down mostly came from EMs. Including Taiwan & Thailand, 4 of 6 EM Asians that have reported their 2Q GDP experienced a decline.

Inflation front, global CPI surged to a 12-year high of 5.2% in July, spurred by spiraling food and energy prices. But July is likely to be the high-water mark for global inflation due to a slowing growth of oil demand, increased agricultural yields and the stronger USD. Having said so, the underwater trend is encouraging. Measured by MoM or QoQ basis, global inflation is forecasted to slide from 6% in 3Q08 to 2.3% in 4Q08. The prospective decline in sequential inflation will provide a powerful boost to household real income into year end. However, significant drags on consumption remains, such as negative wealth effects, weakening labor markets, credit constraints, and payback in the US for the tax rebate benefit. Net-net, we may not see the U-turn of US economy until 1H09.

Looking ahead, the remainder of the week is heavily filled with a wide range of information about the global economy. For the US, we will get updates on existing/new homes sales, house prices, durable goods orders, PCE and revised 2Q GDP. In Euro area, I am waiting for CPI, unemployment, IFO survey and 2Q German GDP. Japan will also report most of its July activity data and August business surveys. I am waiting for Shoko Chukin small business survey which is the single best gauge of economic activity.

A CMBS Storm To Come

As I wrote in the last diary, money markets show there's no end in sight, and it may even worsen, as suggested by LIBOR-OIS spread @ 77bp. A narrowing to 25bp of the spread would be viewed as a positive, but forward markets signal that won't happen until sometime after June 2010. Historically, the spread averaged 11bp in the 10 years prior to August 2007. In the other hand, money markets may soon begin to price in additional rate cuts, if current trends continue - namely deteriorating global growth, decelerating global inflation, escalating rate cut expectations at foreign central banks and a further appreciation in the dollar - then the Fed will also have to become more dovish. In fact, the Fed, ECB, and MPC Dec09 rate expectations have shed 100bp, 120bp, 165bp respectively. Based on the observations, I think a sudden surge in LIBOR could lead to an expansion of the $150bn TAF program and an increased turmoil in the money markets may again serve as a catalyst for a surprise rally in USTs like the one in 2007. A slowing economy and more limited access to capital (via higher credit spreads and vastly tighter lending standards) should ensure this trend remains in place, thus adding to the downward pressure on bond yields.

Another possible storm may come from commercial real estate as CMBX continues to come under a significant amount of pressure, particularly at the higher parts of the cap structure. Recently, the highest part of the cap structure (AAA, AJ, AA) widened significantly, approaching their March wides while lower parts of the cap structure have surpassed March (all time) wides. With major banks holding billions of CMB exposures (LEH =$40.2bn, Citi=$19.1bn, MER=$14.9bn, JPM=$11.6Bbn, BAC=$9bn, MS= $6.4Bbn), I now have a question that whether these banks still have the cash to buy back ARS from the public, at face value… Back to Asia, sentiment weakened in the Asian credit market after US equities declined on weak housing data and speculation that major US mortgage firms would fail to raise enough equity to offset credit losses. The iTraxx AxJ HY returned to 563bp and IG index was out by 7bp to 162bp.

Less Customers in Pubs

From the calls made by Mark Mobius, it comes to a point with a split between technical investors and long-term investors at this stage. According to ML’s proprietary indicator of global profit and consumer/business confidence, we are in an emphatically negative profit cycle and we are going to see continuing slowdown in both D&S side of the global economy. While the global economy and earning outlook remains weak, equity valuations look attractive for long-term investors. Based on Goldman’s data, the 12MFWPE of EU area is just 10.5X, close to the lows of the early 1990s, with 5yr implied growth only 0.5%. In comparison, US equity market also looks attractive with 12MFWPE of S&P500 is at 12.9X, a level not seen since Sep1995 and well below the 20-year historical average of 15.6x, and implied growth is only 1%. Moreover, EM equities (vs DMs) now enjoy a sizeable valuation gap, a level not very far away from the levels seen in late 1998. However, investors may need to wait for further clarification on whether market has priced in enough downside risk, given that – 1) EMs is coming down gradually; 2) earning revisions continues to mover lower; 3) credit spreads remain under pressure while oil is still a wild card.

I talked about US equities as a recent research by CS showed that Asian equities are most correlated to the Nikkei, liquidity flow, breadth of EPS revisions, US ISM Manufacturers, risk appetite indicators and US equity indices. Having mentioned fund flows, EPFR Global has reported that net redemptions from some 960 Asia equity funds totaled $451mn last week (vs $421mn WKAV in June). Meanwhile, aggregate weekly outflows from GEM and Global funds is totaled +$1.5bn in the past two weeks. More striking data is in 12 of the 34 weeks when inflows were recorded YTD, a total of $9.4bn of fresh money was invested in AEFs. These investments on avg face a loss of 15%. For those who bought into the April/May rebound, losses would be as much as 22% over 3M to July/August….Basically, the later one is translated into a annualized return of -80%-plus…WOOO…

Back to Chinese equities, there are rumors and speculations all around. The most powerful one is regarding the fiscal stimulus package, which spurred a +7% rise for A-shares. But at the end of day, investors find out that the news is not new and its impact on the equity market so far is relatively muted. To HKCN universe, A-shares still focus on “Da-Xiao-Fei”, while H-share focus on corporate margin. In addition, CSRC recently shifts its guideline focus from earnings growth to dividend payout growth (>=30% cash Div in 3 years). I think this signals that the domestic stock market is in the process of finding its intrinsic value with real cash flows to investors. Valuation vise, MSCI China is now traded at 12.8XPE08 and 20% EPSG, CSI 300 at 14.3XPE08 and 23.6%EPSG, and H-shares at 12.8XPE08 and 19.5%EPSG, while regional market is traded at 12.2XPE08 and 4% EPSG.

Having said so, I think the 55% drop in SHCOMP has been in response to deceleration in the domestic economies. A recent broker visit to DongGuang sent out a key message that slow down is very obvious in Guangdong (14^th in the world by PPP terms of GDP). The channel checks from listed companies to restaurants to pubs all show that things don’t look great— there are less and less customers…WOOO…Do you know where the top pick for Chinese business ppl to strike a deal?…There is no doubt that economy is slowing down, and we can not only see it from DG Pubs, but also the early signs of asset quality deterioration in 1H08 banks reports (CITIB > CCB > ICBC > CMB), as well as the 6-week drop of steel price on the back of potential further slowdown on property construction (25% of steel demand). Beyond that, monetary conditions in China have tightened markedly and have probably reached a choking point. However, I still believe in the structural growth forces in China, such as urbanization, moving up the value chain, rising credit penetration and favorable population dynamics are still positive. These reasons as well as markedly improved valuations in A/H stocks and lightened positioning suggest that investors should resist the temptation to become too much bearish on China stocks, despite continued near term volatility.

Commodity, ROE and PB

Finally, Dollar hits new high. But I think the recent bull run of USD might be due for some correction due to the ongoing GSE saga, higher commodity prices and the lack of any decent correction to the USD rally. The direction of USD is crucial as a weaker currency tends to boost the commodities complex as a whole but the relationship with gold is particularly strong. Gold’s correlation with the EUR/USD averaged 0.34 in 2007 but rose to 0.48 this year. However, the recent gold correct is more related to the physical demand as investor holdings via ETFs fell from 706 ton in mid-July to 651 ton in mid-August, a drop of 8%. In addition, according WGC, world gold demand dropped 19% in 2Q08 due to high and volatile prices, with Jewelry demand drop 47% yoy in India and 12% in Middle East. While this is a concern for gold market bulls, recent anecdotal evidence suggests that the 3Q is likely to be a lot stronger.

To the black gold, the deflation of oil bubble is evident in the shift of positions in the CFTC data. Net spec positions flipped to a net short a few weeks ago and are now at their largest net short position in roughly 1.5 years. On a relative basis, the current net short of 9.1K contracts is still relatively small, especially considering net longs were 22K just before the bubble burst in July, and even that is small compared to the 2008 average weekly net long of roughly 53K contracts, prior to the July correction. In that instance, it could be that oil prices might not fall much more.

Overall, given the back drop of global economy, I think the correction has further to run but there is no suggestion that commodity markets have begun a bear market that could take prices all the way back to their levels in 2002. This is highly important to Asian equity investors as historically our regional ROE tends to correlate very strongly with commodity prices. This suggests that Asian ROE might correct back to the level of 2005 but not all the way back to where it was in 2002, implying that we may not see the market push back to previous trough PB levels.

Good night, my dear friends!