My Diary 421 --- Risk is Opportunity; No Gains No Pays; More Doubts & Downs on Earnings; KRW, CRB and USX
September 7, 2008“Birthday Fear vs. Market Fear” --- Today is my birthday and a friend of mine sends a note reminding me to make a wish and saying that she is afraid of birthday at age of 30s due to the feeling of getting older…Well, I am actually happy to be more mature and this is the time I usually want to thank my family members, teachers and friends who have accompanied me through the journey of life and made me feel happy and safe. But the market does not feel the same as there is no place to hide recently in Asia driven by indiscriminate liquidation. I can see the fear replaces greed and fundamental calls offer little help in getting market back to track. I think the broader sell-off is a no-better sign that markets are re-pricing non-US growth very hard. Moreover, I also saw the pattern of classic recession trade --- all sectors went down together, and of a renewed risk aversion as even drug names in the US got hit – a rare case! Aha, seemly that investors are running out of defensive names … One more thing to add, Thailand is in trouble again, and equity & currencies from Korea to Indonesia are under pressure, recalling the episode of 1997-98 Asian Financial Crisis…Fear Factor!
Now let us do a market reality check, globally equities tumbled 5% this week, the worst 5-day stretch since mid-January, more than erasing all gains since the previous global low on July 15. Notably, EMs are down 9.5% since July 15, compared to a slight 0.5% edge up in DMs over that same period. Interestingly, Friday US equities managed to firm 0.4% despite a slightly weaker than expected labor market report. Elsewhere, 2yr UST yield jumped 14bp to 2.31% and 10yr ran up 8bp to 3.71%, both ended the week lower. USD climbed an additional 1.2% this week on TW basis. The EURUSD move has been even more impressive, rising 2.8% WoW to1.427 and +7.7% MoM. Meanwhile, the Dollar weakened 1% vs. YEN to 107.7, down 0.6% since a month ago. 1MWTI oil slid $1.66 to 106.23/bbl, plunging +$9 this week and roughly $40 below its July peak.
Looking at the recent market behavior, USTs rallying, BEs collapsing and YC flattening, it seems like the Japan-style of deflation... Yes, I am not playing the Hitchcock movie…With the new asset deflation cycle, the renewed USD strength (+10% in 2 weeks) and the dysfunctional bank balance sheet, plus the inflation tied-up central banks, we may see a new “Lost-Decade” show…In the near-term I think there are a few things to be watched -- 1) With oil dropped to 5-months low and gasoline dropped 4.2%, the inflation relief should continue coming until prices drop back below 100/bbl; 2) With BRC PMIs and the GLIs are all softening, will EM consumers avoid the pandemic that is ailing the G10s; 3) What are the next calls on rates decided by the policy makers and priced by the markets is the real key…Looking forward, as US recession is gradually spilling over to ROW, the growth should also resume in US (FIFO). Thus, I think long-term investors may start hunting cheaper but structurally healthy assets, including Asia equities and currencies, while in the short run, my strategy remains Long bonds and Short stocks. This is the way to live at this stage…Oh, I can not wait for stock market open on Monday as the US Treasury finally made the brave move by bring FNM and FRE under government control, an old trick of crisis management policy –Reflation…
Risk is Opportunity
The bigger risks, the better opportunities and this is the era we are set to explore when the challenges of macro fundamentals, monetary/FX policy and geopolitical instability all come to us…Over the week, August US unemployment rate rose to 6.1% (5.7% in July), as employers cut 84K jobs, the 8th straight month of declining payrolls. Moreover, according to MBA, the % of US mortgages entering foreclosure climbed to 1.19% in 2Q08, the highest in its survey's 29 years. So did the news from major retailers. Expect for WMT beating expectations because of its big discounts, many teen retailers and luxury chains did poorly. Overall, this implies that the recession is now becoming widespread. With the job market keeps deteriorating (7% unemp. rate not far from here), it is tough for Wall Street to see a rebound in sight for the economy's biggest culprit --- the tumbling housing price. To the housing market, I think it will much depend on the buyers’ expectations, while expectations will depend partly on what is happening in the rest of the economy. Even under an optimistic scenario, the overhang of inventories (11.8 months vs avg 3-4 months) points to further average declines of at least 10-15% on the Case-Shiller index. In addition, the ratios of house prices to incomes or to rents are also suggesting a further ~20% decline to go, if we believe the lows seen in 1997-98 is the ultimate bottom, and we may not see it before late 2009.
What has turned me into a bit positive is that with food prices flat ytd after having spiked up twice (+22%) in Feb and in June this year, if oil prices do reach levels of $100/bbl again, then oil related inflation will also be flat ytd. This means that a large part of the gap between headline and core CPI will likely start to fade. However, this is not suggesting central bankers have felt relaxed. Over the week, FOMC meeting minutes showed that ¼ of regional Feds (Chicago, Dallas and Kansas) lobbied to raise the FFTR in July, while both BOE and ECB stayed on hold. In Asia, high inflation has let Thailand and Philippines raised interest rates by 25bp. In such a scenario, what is clear is that the front end yield curve is unlikely to advance meaningfully until the prospect of a cut becomes more concrete. The caveat however is that concerns about the health of the economy and financial system are unlikely to dissipate anytime soon and there is always the threat of a systemic event to trigger flight to safety flows.
Next month, Hong Kong will welcome the 25th anniversary of its currency peg regime, which helped HK avoid the turbulence in Indonesia, South Korea and Thailand during Asia's 1997 currency crisis. This time, a renewed shockwave has been felt almost across the board, including the politically instable Thailand and Japan, and the equity and currency pressures existing in Korea and Indonesia. However, I do not see a repeat of 1997-98 Asian Crisis due to 1) a much stronger economic fundamental for most EM Asia countries, witnessed by less leveraged corporates (19.7% net D/E) and consumers (avg 50% saving rate), more opened & competitive regional markets as well more prudent fiscal and monetary policies; 2) a much better position of external payments, suggested by 2-12X larger size of Asian central banks’ FX reserves; 3) A much smaller bubble in the asset prices, especially after the 30-60% correction in Asian equity prices since Oct2007.
In sum, I think Thailand is not the only potential crisis-trigger in Asia, given the financial crisis in the West is perhaps only half-way through, while the shadows of recession in the G3 have just emerged. The cyclical difficulties of high inflation and slowing growth will be with us for at least another quarter or more, even though inflation in many countries might have already peaked. But to investors, we should be aware that the same trigger of short-term crisis could present a window of long-term opportunity…Sharpening your weapons now…
No Gains, No Pays
Having talked about inflation, conditional analysis does show that sustained weakness in energy prices tends to be followed by lower BEs. Indeed, the 10yr BE is 1.93% now, the narrowest since Aug2003, compared with 2.60% on 03July, the widest since Aug2006. So is 5yr TIP BE. The spread has contracted to 1.57%, the narrowest since July 2003, compared with 2.74% on 03July, the widest since May2006…This is not much surprised to me as when the prices of oil and gas keep falling, other deflationary forces are well in tact. In the US, along with new foreclosures (1.19%) rising above 1% (1st time in almost three decades) and the total inventory of homes in foreclosure reached 2.75% (~3X higher since 2005), overdue mortgages loans in 2Q rose to a seasonally adjusted 6.41% percent, an all-time high, from 6.35% in 1Q08…More worrisome is the bonds backed up by consumer credits, given the concerns over falling household incomes…No gains, No pays…According to American Express, the uncollectible debt has rose to 5.3% from 2.9% a year earlier and will climb as the year progresses. The company has to pay 130bp more over 1M LIBOR in its last sale of AAA-rated 5yr credit card bonds on Aug2008, according to BBG. American Express paid only 4bp over LIBOR on similar debt sold in July 2007.
Another significant change I saw over the week is the change of ECB collateral rules, which signal an important change in stance by ECB with respect to the ongoing assistance it will provide the European banks. The major changes included higher haircuts for all ABS's (at 12%, max 16.4%), uncovered bank bonds will be singled out and will have a haircut 5% pts above covered bonds, and additional rating agency documentation will be required. Overall, collateral requirements are stricter and some high exposure banks may need fund raising again and market saw European CDX moved wider.
Back to Asia, HY spreads remained underperformed with credit spreads blew out 342bps to T+848bps compared to a widening of 145bps in LATAM and 130bps in EMEA over the last 3 months. However if one digs a little more, we will find the key reason was not macro but largely sector specific --- the Chinese property alone contributing around 100bps (with 17% market Cap)…Well, after a multi-year boom and tightening policy measures from the govt, Chinese property is now back in the doldrums, quickly reversing its position of being the best performing sector (3 months to 21July) to being the worst over the last 3 months. Going forward, I can see tougher business conditions is threatening the big misses on 2008 revenue targets for many Chinese developers. Thus, investors who worry about Chinese property bonds can seek the ex-property Asian HY universe as it has outperformed its peers since the middle of June. This makes fundamental sense as from a top-down approach, market points to the continued relative robust growth in the Asia. Last but not the least, the Chinese government bond yields also fell sharply over the week, with the 15yr yield dropped to 4.346 % from 4.679%, according to BBG, signaling economic growth slowing down!
More Doubts &Downs on Earnings
The widespread slowing down has brought new doubts to the relative resilience of earning growth to the non-financial US corporates, relying entirely on the strength of overseas earnings. In reality, national income data show domestic profits are in deep recession, falling almost 20% yoy to 2Q08, while profits from overseas subsidiaries have risen for 22 consecutive quarters, and with persistent double-digit annual gains. However, going forward, it is unlikely that overseas profits can sustain the pace of recent gains as the USD has stabilized in recent months and foreign demand has slowed - especially in Europe, the source of 50% of US overseas profits.
Obviously, US is not the only place under investors’ strict scrutiny. In China, net profit at 863 SH-listed companies and 488 SZ-traded ones rose 16% yoy, compared with 69% for Shanghai and 99% for Shenzhen last year, according to the exchange data. However, if we exclude all financials (banks&insurance), total net profit only up 1% yoy!!! ….And don't forget the tax rate is reduced from 27% to 20% this year, if we assume the tax rate unchanged, the result is definitely not pretty. In addition, looking beyond the reasonable set of 1H08 results, the worsening CFOs might be early warning signal to earning quality, as we are still in an early sign before an economic downturn. However, although inventories, accounts receivables and capital expenditure have increased, the gearing of Chinese companies is not too high at 16%.
Going forward, I think given that most A share brokers still hold the consensus profit growth 16-18% in 2008 (< 10% in 2009), implying Chinese companies have to maintain their 2H08 growth at above 20% !??... Should Be Hard as I believe there could see another round of earnings downgrade, given analysts are slow and do not want to deviate a lot from market consensus...Same judgment applies for H shares and red chips as well as HSCEI and HSCCI now trading at 12-14xPE (30% higher than historical trough) with 18% and 36% 2008EPSG, respectively, compared with regional market traded at 11.7XPE08 and 1.5% EPSG.
Liquidity wise, both China and HK market continue to see significant outflows. The SH Securities Journal & SYWG Securities Research Institute jointly launched the latest --- stock market monthly financial report, showing that in August 2008, A-share markets stock funds record a net outflow of RMB 42bn. In Hong Kong, we saw a 17-month low of HKD41bn turnover on Monday, down 50% from ytd market turnover (HKD 80bn) and 07 avg (HKD 87bn)…One question mark is that turnover has already retraced 50% but index level has not. Looking at the 20 year HSI chart, one can see the previous 3 bear markets that HSI has retraced around 50% from high before hitting a bottom (vs. -35% from high @31958 so far).What's more is this bear market is probably the worst we've seen for years. If you look at the 20 biggest stock markets in the world, every one of them is down ytd and it's probably the first time that this has happened since 1973 (oil crisis.) During the Asian financial crisis in late 90s, US and European markets were fine. And during the tech bubble in 2001, Australia and Korea markets were up. To sum up, the 50% retracement of HSI indicates the market bottom is at 16000 for ‘HSI and we are getting more close to a full BUY. To A shares, I do not think A-shares market is acting like a barometer domestic economy, but more due to the continued monetary/liquidity tightening and price controls, which usually have led to free fall of the asset prices. I remain positive on the China and I think the first sign of China equity rebound should come when government gives up price controls on various sectors.
KRW, CRB and USX
Whilst the sell off in commodities has dominated recently, its relationship with equity and FX markets is also important. Looking back, the peak in crude prices on 11July triggered a sharp rally in major stock index. However, since then the S&P has failed to sustain the rally much beyond 1300, closing down to 1,242 on Friday. It seems the marginal positive impact of falling oil prices is fading as investors take more serious account of the gloomy outlook of global economy. As investor risk aversion is coming back, a falling WTI price is good for oil-importing Asia, but has not helped Asian currencies so far. In particular, the market is concerned on that South Korea is heading toward a full-blown currency crisis…Remember, 1997-98 Asian Financial Crisis started from Thai baht crisis!!...The KRW has been under tremendous, falling to its lowest levels in four years on a combination of factors –1) a significant deterioration in Korea’s external balance, reflected by its record high CA deficits in 1H08 and foreign investors have been significant net sellers of Korean assets in 2008 (YTD $28.95bn); 2) the restrictions on FX borrowing at the end of 2007 created a shortage of USD liquidity onshore, compounded by a significant FX demand due to repatriation by foreign funds; 3) markets have been confused this year regarding Korean official FX policy. In general, I think doubts remains over whether BOK will return to its previous ultra aggressive FX intervention stance…The key level to watch are KRWUSD @ 1190 and KOSPI @1400.
Back into hard assets, CRB index is down 20% since early-July, and some of the notable components in that index goes even further, including gold (-17%), oil (-25%) and natural gas (-44%). In short, commodity complex has suffered from a slower global growth (i.e. less consumption), the reversal of a speculative bubble and, most recently, the forced liquidation of commodity positions by leveraged hedge funds. On the back of falling oils, USD rose to the highest level against EUR in almost seven months, given that traders speculated that the Fed will help the US economy outperform EU and Asia. Other factors to consider for the USD strengthening are relative growth and interest rate developments, and the associated central bank responses. Some key levels to keep an eye on are 1) USD Index @ 80; 2) JPY@ 107-108 and 3) EUR@1.40. To the EURUSD cross, although ECB Trichet will announce the new staff projections which are expected to show a measurable downgrade to the GDP forecast, Keeping in mind that the ECB has a single mandate (price stability), the inflation forecasts should ultimately carry more weight with the currency.
Good night, my dear friends!
