My Diary 439 --- Easing Cycle is to Come; Money Markets Hold the

My Diary 439 --- Easing Cycle is to Come; Money Markets Hold the Key; Confidence is Weak in China; The Dollar Cycle of 1970s

September 28, 2008

Socialism vs. Capitalism --- If Chairman Mao is alive, he should be very happy as it is the first time since the fall of Berlin Wall that Socialism gets widely discussed in the largest country of Capitalism. But there is a fundamental difference that the ultimate goal of Chairman Mao is to save the "Main Street", while Mr. Henry Paulson is to rescue the “Wall Street”. Having said so, I am also eager for the approval of the $700bn bill as at this stage, government has to intervene because Subprime crisis has turned into a systematic solvency problem, along with the loss of market confidence. Only the US government credit and taxpayers money can stop the death spiral here. However, we as investors have to bear in mind that the Paulson Plan can not delver a quick fix to the economy, given the negative prospect of housing price and unemployment rate. Even though the plan helps to remove troubled assets from the banking system, it does nothing to help recapitalize the banks and kick start lending. Thus, we are not out of wood yet.

Such a judgment can be witnessed by that the enthusiasm seen in the stock market rally has not yet trickled down to credit markets. Simply put, equity market ignored the facts that credit market seizure continued as funding basis, volatility and gold remained at uncomfortably high levels. Not only both the VIX (34.74, near the level of BSC Monday or LEH Monday) and the TED spread (292bp vs 233bp a week ago) remain very elevated, but what is more symbolic of an American loan crisis is that Macdonald is not getting the loan from Bank of America for its new coffee machines…Now we see the spillover impact from Wall Street to Main Street!...Moreover, I saw a series of economic data (Durable Goods, Initial claims, New home sales, 2Q GDP/Consumption) showed US economy further tipped to the downside. With worsened economic data, market now expects Fed to lower rate by 25bp in October’s meeting. Apparently, there are many people remained unconvinced about whether TARP is the most effective way --- why not directly spend on Main Street , bypassing Wall Street. However, one thing is clear that while US is now likely averted a Depression scenario, we are still very much facing a Recession in US (and probably Europe).  All in all, the decisions made this weekend may draw a line under financial tail risk but it does not sound the all-clear for US economy or risky assets, plus the prospect of Capitalism.

This week, let me revert back to the usual market review. On Friday, stocks fell 1.9% in EU, 0.9% in Japan, and were down 1.3% in EMs. But US equities bucked the trend, finishing up a touch. Globally, stocks closed the week lower 3.3%, -7.6% this month. Elsewhere, 2yr UST yield closed at 2.09%, lower 7bp since last Friday, while 10yr ended at 3.85%, up 4bp this week. Shorter maturity yields remain quite low, with 1M T-Bills at just 0.11% and 3M at 0.83%. USD has been fairly stable, hovering around EUR1.46 and YEN106. 1MWTI oil dipped $1 to 106.89/bbl, finishing the week higher $2bbl.

Looking forward, there are infinite shades of grey during the balance of 2008. It is interesting to observe that the current environment is so macro that even the (bad) data and US elections are distractions from the main event, while correlations, trends, themes and performance are smashed all over the place. I think there are a few early judgments can be made here --- 1) We still face a deteriorating economic cycle as the wealth losses in markets/homes and the damage done to the financial system will transfer into pain in parts of the real economy. What markets have so far digested are largely idiosyncratic effects on the financial sector, while there is still a whole other ~70% of US /EU market caps comprising consumer/cyclical/etc companies whose earnings estimates are still too high. 2) Indeed, the coordinated policy measures have prompted a sharp rally as systemic risks fade. But the ongoing deleveraging is likely to ensure uncertainties remain over the extent of the profit decline likely next year, as well as the pace of any recovery. This is because when the cycle bites, credit losses will probably shift from a write-down story to a provisioning story. The possible +ve news may come from global monetary easing. 3) One other big question is -- Is China slowing down already? The answer will be critical to the BRIC theme players in sectors such as Industrials, Materials, Renewables, and Fertilizers.

In sum, I think even though the financial market regain some confidence after TARP gets approved, macro fundamentals remain on the downside -- property price decline, domestic consumption slowdown, unemployment rise...The market will then refocus on the US growth outlook, in particular the NFP data. To investors, the crises have always proved to be great buying opportunities in the past and it never failed. But question is --- Have we marked a bottom yet? I think the best answer is --Bear markets do not end on hope. They end on despair, they end when the good news is treated with disbelief -- clearly not the case right now.

Easing Cycle is to Come

As I discussed in previous diary, transfer of illiquid assets will ease the strain on banks’ B/S as well as improve confidence amongst banks, however, the real economy still faces a difficult period ahead as the rebuilding process of household and FI’s B/S take long times according to the history. In other words, this interplay will result in further de-leveraging and hence, I would expect at best a below-par growth for US in the coming quarters. The recent macro data seemed inline with such a judgment --- 1) Aug New home sales 460K, down 11.5%, much lower than expectation; 2) Durables order dropped 4.5%, much lower than expectation; 3) initial claims 493K, much higher than expectation; 4) 2Q US GDP and personal consumption are revised down to 2.8% ( from 3.3%) and 1.2% (from 1.7%), respectively.

I think all the data reflect that US economy is facing two additional drags – 1) the sharp tightening in financial markets sue to the decline in equity wealth and the more restrictive terms and availability of credit; 2) the acceleration of corporate cost-cutting as seen in the sustained rise in jobless claims. In fact, during the congress hearing, Chairman Bernanke effectively downgraded the Fed’s assessment of the economy, pointing to a broad slowing in activity including consumption, investment and exports. He also warned that there may be a significant knock-on effect on spending from the recent tightening in credit conditions. Certainly, he also noted a few positive factors: lower oil prices, increasing stability in housing market and monetary stimulus. But, without stabilizing the financial system, all these positives will go out the window. With worsened economic data, Fed fund rate future on Friday close shows there is 100% possibility of 25bp rate cut on Oct 29 meeting. Indeed, the one thing that the Fed has yet to give the market is a rate cut. Though the official target remains at 2.0%, the effective FF rate has been averaging <1.50% for much of the week...Thus I think it is just a matter of time before the Fed announces a new target. 

Across the Atlantic Ocean, the major EU business/sentiment indexes continued to be disappointing, including French consumer spending & INSEE, the manufacturing and service sector PMIs, the German IFO and the ISAE. According to JPMorgan’s forecast, the regional real GDP growth could head to zero in the coming quarters, sending the unemployment rate higher and opening the door to a potentially extended monetary easing cycle beginning early next year, once inflation has clearly moderated.

Logically, a deeper and more extended contraction in US and EU economies would reverberate through the rest of the world, including Emerging Asia. I believe that Asia is still more vulnerable to this global slowdown than any EM region given the highest trade/GDP exposure (40-60%). On the positive side, the Asian regional economy is now more balanced, supported by domestic demand, services and higher inter-regional trade. However, there is no getting away from the fact that Asia remains most vulnerable to a downturn in global trade. Data wise, the growth of HK export (Aug) has slowed to 1.9% yoy, a sharply down from 11.1% in July. Import slowed 1.5% vs 15.4% in July. With external demand likely to remain weak, I expect exports growth in this region to decline more through the reminder of the year. Aiming at the downside risks of domestic economy, I observe that Taiwan central bank cut 12.5bp on 25Sep, joining China, Australia and New Zealand in easing borrowing costs this month…

Money Markets Hold the Key

Obviously, money market managers do not have the kind of patience of US lawmakers, as their priority is capital preservation and no one can afford position. So I would assume that when the Paulson plan is passed and implemented, the "get me out now" behavior of money managers should begin to subside. Until then, stresses will persist and credit markets will remain vulnerable, and we should keep an eye on the short- term market indicators. Over the week, I observed Libor-OIS spread, a measure of the availability of cash among banks, widened to the most on record, exceeding 200bp (avg 8bp in the 12 months before 31July07). Moreover, TED spread widened to as much as 337bp, the most since 1984, from 233bp a week ago. From 2000 to 2007, before the credit crisis began, the spread averaged 31bp.

The record lows of short-term yields suggest that investors are shunning away commercial papers in favor of T-Bills. In fact, over the past 5 days, investors yanked $224bn from MMFs, according to iMoneyNet. The CP markets shrank by $52.1bn to $1.7tn for the week ended 17Sep, the biggest weekly drop in 10 months, according to Fed data…The importance of ensuring the normal function of CP market is that if investors are fleeing away from these short-term loans that many companies use to fund daily operations, the ripple effects for the overall economy would have been swift.  A highly likely scenario is that companies have to quickly scale back routine operations, furlough workers and even fail to pay their employees. This is why the US government announced a separate initiative on Friday to temporarily provide guarantees to MMFs. My general conclusion here is that banks and risk assets are still vulnerable as long as the gap between real funding and perceived funding levels continues to widen.

Looking at the long duration markets, credit now looks attractive to equities (SPX 08 yield =7.5%). The HY bond yields have rose to distressed levels for the first time since 2002, with spreads at 1025bp according to ML HY Master II index. Historically, HY spreads were so wide was in the aftermath of Enron collapse earlier this decade. In addition, the default rate among non-financial HYs may rise to 23.2% by 2010, the highest since 1981, according to an S&P report released on 25Sep based on its worst scenario. With respect to the IG bonds, spreads also widened to a record 459bp, according to Merrill's US Corporate Master index. Regional wise, Asian credit market maintained a cautious tone with iTraxx HY spread widened 44bp wow to 871bo and iTraxx IG added 6bp wow to 217bp.

Confidence is Weakest in China

Over the week, investors felt somewhat excited as value investors like Warren Buffet started nibbling at stocks and equity buyback programs were accelerated, underscoring that the market is reasonably priced. But I do not think that stock market will resume a sustained bull market, even the central bankers begin to ease monetary policy. Looking at the big picture, uncertainties over the economic environment and the impact of bank de-leveraging on the pace of any recovery are likely to keep a cap on prices for a while yet. According to Morgan Stanley equity strategist, a fall back in profits to long-term trend since 1980 (a further fall of 20%) and a mean reversion of margins and ROE would push the market back down again by around 10%. Such a market forecasting has been supported by the recent Merrill Lynch report, which revealed that the downward trend in AP earnings expectations continues in Sep with 3M ERR falling from 0.60 to 0.49, which is approaching the 2001 cycle-low of 0.44… So there is still room for more downward revisions as regional ERR reached an all-time low of 0.34 in 1991 and toughed at 0.35 during the Asian crisis in 1998. During the same period, HK ERR experienced a large fall in September collapsing from 0.75 to 0.40. Moreover, earnings downgrades continue to outnumber upgrades in all AP sectors. Utilities, Insurance, and Media are the only sectors which experienced marginal improvement in earnings expectations. The Ratio is currently highest for Energy and Software, and weakest for Media and Diversified Financials.

After earning revision, Let us take a look at regional valuation metrics, MXCN is trading at 11.2XPE08 and 19.1% EPSG, CSI300 at 14XPE08 and 19.2% EPSG, MXHK at 13.2XPE08 and -8.8% EPSG, compared with MSCI AxJ at 11.3XPE08 and 4.3% EPSG…Valuation vise, although the majority of markets in Asia Pacific are trading below their long-term average prospective PE levels, most are still trading on a premium to their trough valuations. Investors are drawing parallels to the sharp recovery following the Asian financial crisis, but the difference is that PB levels and the earnings base at the time were significantly lower, the two preconditions that the current market environment does not share.  In sum, I expect 2009 earnings are gradually revised down as global growth slows, but valuations normalize to recent ranges…

As mentioned above, the growth outlook of China holds the key for many EM-related investment themes. For the three drivers of GDP growth, export has little hope given the weakening global demand and the rising inputs cost, lets face it, US and Europe is a basket case. Consumption can never be stimulated as long as the social security (and Medicare/education) system is not in place; so only hope is investment. However, I think the government’s fiscal power is limited and also most of the infrastructure is already in place after massive construction in the past decade, the best way stimulate investment is to let private sector come out. And the most efficient way to do so is to loosen the tightening policies on property sector to unleash the genuine demand...This expectation has driven all the A-share property stocks traded limited-up in the Friday PM session…CICC macro team estimated that if there is no policy change, property investment growth could drop from +20% plus this year to negative next year.

Data wise, here I present a few key macro leading indicators and sector statistics to access the growth prospect for China:

ØElectricity: Electricity demand went up 5.4% yoy in August, much lower than the 14.4% seen same period last year; In addition, Huageng told clients in a recent conference about the -ve electricity demand growth for coastal areas, PRD and YRD;

ØProperty: Sales in Sep is worse than expected, which is a bad sign as normally Sep & Oct sales accounts for ~35% of full year sales;

ØSteel: Baosteel lowered steel price by 13-16%; China ISA said China will not buy from VALE in the near future;

ØExport: China’s exports to US drop below 10% yoy in the first 7 months, first time since 2002. This could mean negative volume growth (net of RMB appreciation and inflation);

ØGDP: State Information Center expected 4Q08 GDP to fall below 9%, a level considered the bottom-line to ensure employment;

ØPBOC 3Q08 Survey—1) Future Income Confidence Index: 19.3%, down 1% QoQ and 4.5% yoy, weakest since 2006; 2) Interest to Purchase Properties: 13.3%, lowest since 1999; 3) Interest to Buy Stocks: 8.2%, down 8.6% from 2Q, a sharp decline compared with 44.3% 3Q07 when A share at peak.

ØCorporate Earnings: 38.4% of A-share companies expect lower yoy earning in 3Q08, compared with 28.4% in 3Q07 and 31% in 1H08.

To sum up, the PBOC National Household Survey shows the weakest residents’ confidence on China economy and worries over individual income. This is negative to Consumption and Property sector.  As a result, I expect concerns on real economy will shadow the market in coming months, with A-share bottom at ~1900 (SHCOMP). Sector wise, the domestic sentiment to buy property will remain weak in 6-12 months, further price cutting is thus necessary but may not warrant significant real buy interests.

The Dollar Cycle of 1970s

A week may be a long time in politics, but it is years for the FX market. If we fast forward a week, the market’s focus has changed materially. At the start of last week, USD remained strong, supported not only by robust economic expectations, but also by a strong US policy reaction, contrasting with policy paralysis elsewhere. Moreover, investors were focused increasingly on economic downside surprises outside of the US, notably in EU and Asia. In comparison, USD now is sharply lower as central banks have added significant USD liquidity through 1) swap arrangements and 2) the US authorities have proposed a de facto bailout plan. The first of these two recent moves has significantly reduced USD overnight rates, while the second will result in significant fiscal easing. Fundamentally, the combination of monetary and fiscal easing should be offsetting for a currency in terms of its effect on real yields, under the Mundell-Fleming model of exchange rates. (Note: The Mundell-Fleming Model adds a balance of payments equilibrium condition (and a BP curve) to an IS-LM Model.)

As always said, I remain bearish on the USD vs major currencies as I am not convinced that fundamentals there have improved. Although both the EU and Japan are teetering on the brink of recession, they benefit from a more stable CA balance than the US, but both are likely to see CA balance deterioration as US consumption slows down. One interesting point is if we compare the current cycle to that of the 1970s, we see some similarities --- Then too we had a major up-trend in global commodities and we had an extended period of USD weakness (following the break up of Bretton Wood). The last USD weakness was punctuated by two sharp DXY rallies - from June 1973 to Jan 1974 and from March 1975 to June 1976. Having observed so, the long-term trend of the USD is clear - lower because of CA balance and inadequate return potential to fund that deficit. But the short- and mid-term trends are more complex. Short term, USD looks set to fall further on lower US rates, improved liquidity and positioning, while mid-term, we are set for a further bout of USD strength once this liquidity effect is out of the way.

Appendix: Fed =RTC

The Fed’s balance sheet is now growing very rapidly. Last Wednesday, the Fed held $931bn in various credit securities. By yesterday, it probably grew to well over $1.1 trillion (new data will be released this afternoon). The $200 bln addition likely funded new loans to foreign central banks, further drawdown’s on the AIG loan and likely increases in discount window lending.  The Fed’s special funding and liquidity programs launched in the past year now add up to over $750bn! This includes loans to Bear Stearns and AIG, and many “troubled assets” that are being pledged as collateral in exchange for loans. If that’s not an RTC, we don’t know what is!

Good night, my dear friends!