My Diary 418 --- Consumers Down & Exports on Question; Will Bank

My Diary 418 --- Consumers Down & Exports on Question; Will Banks Go Bang; No Fun with Scare Liquidity; Reversing Commodity Currencies

August 31, 2008

Bombed with numerous earnings releases, macro data and international events, I was busy like a bee over the week … Some quick thoughts to begin with. Economic wise, 3.3% US 2QGDP and BTE export does not mean good US demand. Saying this though, credit crisis is hitting the real economy with Jefferson County, Alabama to file the largest-ever municipal bankruptcy. Geopolitics perspective, the saber rattling between Russia and US/NATO regarding the state status of South Ossetia and Abkhazia looks as if the dirty dozen is vying after the magnificent seven. But for now, without solid penalize action, the condemnations made by EU leaders only signal the West's limited ability to confront with Russia in Central Asia. Another negative to oil price is the projected Category-5 Hurricane, Gustavo, is churning toward the Gulf of Mexico. Market side, liquidity remains poor as many players are away, while demand for safe-haven assets remains most strong. In general, there should have no doubts that mean reversion is in action and the evidence is everywhere as analysts’ downgrades now range from commodities to industrials and from China Mobile to Korean Google -NHN. Broker who happily pushed the stock prices all the way up, are jointly cutting their prices all the way down. But it’s not just multiple de-rating. Earnings disappointments and uncertainty are playing their fair part in the downgrades.

Looking backward, global equities were flat on Friday as a 1.3% decline in US balanced gains elsewhere (+2.4% in Japan and +0.3% in EU). Regionally, DM markets rose 0.9% WoW, finishing August ahead 1%. EM stocks also climbed 1% wow but substantially underperformed 5% MoM as a whole. Elsewhere, USTs ended the week a touch higher with 2yr slipped 3bp to 2.37% and 10yr dipped 6bp to 3.81%. USD climbed 0.9% wow on TW basis, up 3.6% in August. Against EUR, the Dollar rose 0.8% WoW to 1.467, surging 6% this month. USD/YEN cross ended at 108.8, -1.1% WoW but 0.8% MoM. 1MWTI oil was up $0.87 this week to $115.46/bbl. Oil has moved roughly sideways for the past 3 weeks but finished the month down about $9/bbl.

Looking ahead, the key strategic question is how far are we into the bear market? The bears argued if the current growth slump continues and banking crisis degenerate into a prolonged recession or even depression, we could see catastrophic fallout in global growth that will bring down everything from EM equities to commodities. In such a bearish scenario, the best choice is cash, but even cash may not be safe due to erratic moves of FX rates. However, I am not feel so doomed as there are some signs that the cyclical bear markets may have entered into a maturing stage --- 1) Bank stocks have dropped +60% and investors being hit hard by relentless writedowns are better prepared for the next wave of bad news; 2) Inflation is no longer a real threat, given the slowing growth and asset deflation; 3) Equity valuations look genuinely attractive with S&P 12FWPE=13X (Yes, earning risks remain). In the flip side, tactically market risk measures like VIX have dripped lower due to reduced tail risk for stocks, lack of HF hedging and technical selling from structured desks. However, an observation worth to be noted is that volatility term structure of S&P is as steep as it was 3M ago, which set up a 1-day 44ppts drop from 1400 on 06Jun and found continuation down to 1214 by mid-July. Such an observation is inline with my assessment to the fundamentals that unless the collateral assets show a sign of recovery, the ongoing/forced de-leveraging process will invariably ensnare more victims. In sum, given that the situation remains risky, I remain cautious to commit large amounts of capital into Longs, but I also believe that i t is too late to sell at this late stage of bear market. The proper strategy is to nibble at some risky but undervalued assets.

Consumers Down & Exports on Question

As I noted in my last diary, global central barkers continue to deliver a divided policy stance. The August meeting minutes of FOMC once again highlighted the divisions of policy calls regarding growth projection and inflation risks. Both of the policy judgment can find their support in the market as l eading indicators (dominated by housing figures) emphasize the economic weakness, while yield curve and equity market say growth will be OK. Having said so, I am unimpressed by the 2Q US GDP as the report also showed that the weak economy is generating less income growth in the household and corporate sectors. In particular, adjusted for inflation, disposal income fell 1.7% after declining 2.6% in June. More importantly, the drop in incomes not only pushed the savings rate down to 1.2% from 2.5% the prior month, but also explained well why consumers spending (-0.4%, adj. by inflation) slowed in July, along with the faded impact of tax rebates and the erosion of purchasing power by high inflation. In addition, the level of initial jobless claims remains uncomfortably high, while continuing claims and the insured unemployment rate are still climbing.

That said, a rising unemployment, falling stock and house prices and stricter lending rules should be viewed as pointing towards weak growth in PCE during 2H08…A very brief comment is when consumers go down, US down...As a result, with the notions of economic weakness, financial fragility and credit contractions, I do not see any scope for a rate move by Fed. In fact, f uture markets show a 19% chance that the Fed will raise FFTR by 25bps on the December meeting, compared with 69% odds a month ago.

Going forward, another concern to the US economy is that as domestic demand wanes, the US may also be hit by a slowdown in economies abroad that would erode export gains. In the EU area, its confidence (88.8) fell more than forecast this month as the economy teetered on the brink of a recession, along with retail PMI survey firmed in August at a very low level, following the pattern of the manufacturing and services PMIs. In addition, both German IFO survey (87) and 2Qreal GDP (-2% YOY) signal that the German economy is struggling with broader decline in consumer/ business spending, construction and exports. In UK, Nationwide house price index (-10.3% yoy) and CBI retail sales (lowest since 1983) also paint a recessionary picture. In the EM markets, there was more evidence of the downshift in manufacturing, including high-tech. As noted in the GDW cover essay, rising tech inventories are amplifying the slowdown in tech output across EM Asia…Stay tune…

Will Banks Bang?

The US financial institutions are still under siege, as evidenced by widening swap spreads, a continued fall in stock prices and renewed solvency concerns for some of major financial institutions. But the near-term concern is the refinancing risks faced with US financials when the credit supply is now in a full-blown contraction phase, while at the same time, about $871bn of bonds issued by banks, securities firms and lenders will mature through 2008 and 2009, according to JPMorgan. In addition, as bank note yields are at their most punitive compared with UST, the higher refinancing expenses ($23bn more in annual interest payments) will restrict the ability of banks to borrow and lend, further cutting off credit to consumers and business and curbing economy further.

Clearly, so long as banks remain in deep trouble, the overall equity market will be threatened and a bottoming process could give way to a new down-leg, if the financial crisis reintensifies, leading to massive fallout in growth. Thus, it is important to get a better handle on how a banking crisis is typically resolved. Historically, there is no shortage of banking crises over the past decades, including US S&L crisis, Swedish banking crisis, Japanese housing bubble, Mexican Peso crisis, Asian financial debacle and LTCM crisis, and there are several observations as below:

First of all, banking crises have often resulted from or resulted in a burst of real estate bubble, such as the 1991 Swedish bank crisis and the 1997/98 Asian crisis. Second, there is no fixed pattern in terms of the longevity of a banking crisis. For instance, in both the S&L and Swedish crises, the fall out of bank stock price (-45% and -85% respectively) lasted about 18-24 months. However, the Japanese crisis fallout lasted for more than a decade. Third, it seems that FX rate adjustment makes a huge difference in terms of how quickly a country’s economy and stock market can come out of a banking crisis. Except for the Japanese fallout in the early 1990s, all the other banking crises were accompanied by a tremendous drop in the local currency (Swedish Krona -40% in Oct1992-Early 1994 & Korean Won -50% in 1997-1998). Currency depreciation usually introduces stimulus and promotes growth for a crisis-stricken economy. This is why a banking crisis is often followed by an export-led boom. Finally, in most cases, some form of government bailout/rescue package was put in place, including the RTC (Resolution Trust Corporation) package in 1989 and the rescue funds from IMF during Asian crisis.

The key point from reading the history is that socializing bad debt is a common practice when faced with a banking crisis. It is a quick way to bring down risk premiums and contain economic damage. Having discussed bonds, it is wroth to note that the amount of CDOs downgraded by S&P are approaching $400bn. CDOs tied to home-loan bonds and related derivatives represent the largest source of $513bn of writedowns and credit losses reported by the world's largest banks and brokerages since the start of last year. The estimated recoveries of CDOs ranged from 8% to 33% based on different quality of underlying mortgage bonds…So 1 Dollar, 8 Cents…seems same as Merrill Deal….

No Fun with Scare Liquidity

Speaking to traders over the week, the picture I've gotten is regional liquidity is drying up, suggesting that the recent rally is corrective and the market is no fun anymore. According to BBG, the daily volumes traded on August 26 were massively down from just a month ago, including Singapore (-80%), Korean (-78%), Japan (-70%), Australia (-67%) and A-shares (-49.3%). In the mean time, according to EPFR, r edemptions from Global and GEM funds totaled US$5b this month, 8X more than outflows from Asian dedicated funds. In addition, Asian funds’ cash levels increased 50bps, reaching 3%, a level still below historical market troughs (17% in 1998; 6% in 2001 and 5% in 2002). This suggests that fund managers have finally turned bearish after the 31% decline in share prices in nine months.

My personal view point is that the huge fund outflows should also be attributed to the relative performance of global equities and asset allocation decisions. In particular, the cumulative performance of global equities and USTs continues to diverge since beginning of 2008. YTD, S&P500 has underperformed that of USTs by 17.6%. In addition, measured by local currency returns, YTD EAFE (-18%) is lagging S&P 500 by 6% and by 7% in USD terms. To global investors, EMs exposure is now showing a 22% loss YTD according to the index, reflecting another 6.5% loss in August, after -10% in June and -5% in July, almost twice as bad as S&P 500 performance (-12.6%). As a result, with respect to the tactical rebalancing, investors who were raising their INTL/EM equity allocation at the expense of US equity exposure in the last few years are reversing the target weights. But I think as we approach 4Q08, global funds may start to restore their target allocation. Furthermore, asset allocators are another category of investors that looks at relative equities vs. bonds performance as yield spread remains below its 7YRAVG of 2.5%...A two-way thought here is that a narrow spread suggests that equities appear more attractive relative to bonds. However, the narrow spread could also imply the heightened level of risk expectations for equities relative to bonds.

Back to China markets, the month of August proved to be another difficult time for A-shares with SHCOMP Losing 15% MTD. Going into September, the share overhang from DXF release will be much lighter with RMB 52.1bn in market value, the smallest in 19 months. One a positive note is that several Nobel Prize winners (Joseph Stiglitz, Robert Fogel and Robert Mondale) in Economics recently expressed their optimistic views on the sustained growth of China based on a good foundation in manufacturing, infrastructure, services, science and technology. But they also pointed out various challenges facing China, including innovative economic system, export competitiveness, market oriented reform, rural-city income gap. However, my own attention was paid to the new Bank-Property guidance issued by PBOC, saying a project will not get bank loans, if MOLR decides that the land has been idle for +2 years. In addition, the 1H08 developers’ GFA inventory in Guangdong was up by 8% with Shenzhen’s up by 95.7% (by 670k sqm) compared to 2007 YE…96% up, Woo, and the watch-dog is paying a close attention to loan qualities as CBRC required banks to stress test by using assumptions of property price down by 10%/20%/30% and IR up by 1%. Lastly, MSCI China is now traded at 13.5XPE08 and 19.8% EPSG, CSI 300 at 14.5XPE08 and 22.6% EPSG, and H-shares at 13.7XPE08 and 19.5% EPSG, while regional market is traded at 12.5XPE08 and 6.9% EPSG.

Reversing Commodity Currencies

As I discussed in last diary, USD looks overdone on technical indicators. DXY index shows a small double top on 77 level and MACD is showing the first SELL signal, turning down from the highest levels in around two years. In line with all of this, oil appears to have found a short-term floor ahead of its 200DMA@ 111. Thus In the near term I would bet on the retrenchment of USD.

Having talked about short-term correction of USD, those "commodity currencies" are under significant pressure due to the concerns over global growth. Over the past few years, commodity currencies have benefited from rising IR expectations, favored terms of trade and surging capital inflows. But all in all, the fundamental factor of these positives is the same – excess global liquidity, or essentially USD liquidity. As MS growth soars in the 2000s, the value of the USD is de-based because of S>D. This even turns the USD into a funding currency of carry trade vs AUD, NZD and ZAR. Moreover, the value debased USD is causing investors to seek harder alternatives, including commodities. As commodities gain, so do commodity currencies. However, as I pointed out in Dairy 375, the recent deceleration of global USD supply has put this virtuous circle of capital flows and commodity currency gains into reverse. YTD, against US Dollar, CAD has depreciated by -6.56%, the AUD by -2.31% and the NZD by -9.89%,.

Crude market wise, oil price recently was affected by both downward pressure from rising USD and by upward pressure from increased threat of Hurricane Gustav. Hurricane Gustav’s impact proved to be larger as Gulf of Mexico accounts for >20% US oil production. But t he recent correction of oil is not yet over as it need some time to unwind the economic/demand damage of past oil price strength, including a sharp contraction in miles traveled in US, along with a meltdown in US vehicle sales. Even in China, auto sales appear to be peaking, under the drag from higher domestic fuel prices. In addition, global leading indicators are slowing, which also confirms that further weakness is likely.

Good night, my dear friends!