My Diary 459--- The Baby-boom of Black Swans; Three Big Question

My Diary 459--- The Baby-boom of Black Swans; Three Big Questions; A Comparison to 1929 -1932; The Textbook EM Crisis

October 26, 2008

Houston, we have a problem ---- The recent market dynamic between the price performance of major asset classes and the unprecedented responses of global policymakers looks so much similar to the conversation between the crew of the US's Apollo 13 moon flight and their Houston base…Indeed, if a main B bus undervolt is the problem for Apollo 13, then the prevailing issue to investors is --- Nothing works at the moment …Credit spreads, TED spread and LIBOR have all started to ease a bit recently, but those have not been a good buy signals for equities …VIX ~45 used to be another good buy signal for equities, but it trades near 80 now...Valuation is cheap for equities, but there are a lot of cheap assets and asset classes in the world at the moment.

Having said so, let me start with weekly market review first in order to get a better sense of the overall picture…Globally, equity markets broadly tumbled on Friday with stock prices collapsed 9.6% in Japan, slumped 4.5% in EU, and fell 3.4% in US. EMs also plunged 7%. Worldwide, stocks fell 8% this week and are now down 45% ytd. Elsewhere, 2yr UST dipped 9bp to 1.51% while10yr edged up a tick to 3.69%. For the week, 2yr and 10yr yields are both lower, by 10bp and 24bp respectively. US conforming 30yr FRM rates also declined this week by 33bp to just below 6%, according to Bankrate. USD rose 3% this week on TW bass, +6% vs. EUR to $1.26 and broadly rising vs. EM currencies, but -7% vs. YEN to a decade low near 94.32. 1MWTI oil sank $7.70 this week to $64.15/bbl as weak global economic data added more downside risk to the demand outlook.

Obviously, we can smell the return of panic. Equity and commodity prices are gaping lower, while USD and YEN continue to surge. Investor sentiment has been crushed and despite extremely oversold conditions and appealing valuations, the bleak growth outlook provides little reason to be upbeat. Indeed, credit markets remain frozen across the globe, house prices are falling in many of the major economies, and the adverse knock-on effects to employment and consumers spending are just developing. In short, the economic valley is still too wide for investors to see across. The implication is that policymakers will continue to work hard to shore up confidence among market participants. I would expect central bank rate cuts, addition fiscal stimulus, further efforts to recapitalize financial institutions, and potentially a blanket guarantee for the liabilities of the banking system.

The Baby-boom of Black Swans

Over the week, there are clearly fat tails in financial markets and we saw a baby-boom in the population of Black Swans. The most dramatic change of market climate is the loss of control in EM. Before last Wednesday, when everybody felt exhausted from weathering the destruction of DM crisis (only a week ago), the serious secondary risk to the EM sovereigns and corporates are brewing. What was once a US Subprime crisis in Oct07, become a Pan-Western credit crisis in Aug08, and it's developing into EM/Asian Crisis as currency and market like the Won /KOSPI get murdered. What is the impact of this EM Sovereign Crisis to us? Definitely, a more negative overhang to the global equities and Asia will also go down due to collateral damage…This is why despite recent Central Banks bailout plans, money market and inter-bank  guarantees, and credit spreads narrowing, we have not seen a bear  market rally this week.

Another consequence is that losses from bad-currency bets are ricocheting through the world's major developing economies, including Mexico, India, Korea and China, with firms like Commercial Mexicana and Citic Pacific lost billions of dollars, due to FX gambles that, in some cases, had little to do with their core businesses. As EM currency comes under steady pressure as a result of ongoing strength in USD, the risk is the longer it goes on, the greater the risk that we will find a repeat of the CITIC Pacific problem. There is highly likely that we could see another ‘black swan’ due to insolvency risk. MTD, I have heard that there would be 1/2 toy manufactures going bankruptcy, and 1/2 coastal manufactures are facing severe liquidity shortage and default due to the overseas counterparties' bankruptcy. Moreover, from now on, a bigger risk is not among corporates punting AUD, but among EM banks that have borrowed in US$.

That said, this credit de-leveraging process is having massive unintended consequences…More Black Swans?! … Markets in the last few days are in meltdown mood, liquidation of global risk assets and a rhythmical contraction of long positions with a fall in one asset class triggering a fall in another as EM contagion spreading out. Many market indicators now reach their highest level since 1930 and let us take a peak:

Ø         Credit: the iTraxx Asia indices (IG =578bp, HY=1729bp) was more than twice as bad as they were in Sep08, in terms of size of moves. In fact, current HY spreads indicate a 46% annual default rates over five years. Globally, while the Sept loss of 8.3% in HY should happen only once in every 27,000 years, the first 9 days of Oct were even worse (down another 9.1%). Some biggest EM sovereign credit is trading like corporate junk bonds, i.e. Russia CDS=1200bp, Turkey=900bp, Korea =689 and even China =290bp;

Ø         Currency: there are 5 sigma moves in the FX majors, especially the YEN crosses. USDJPY surged to a 13-year high (94.32), while GBPUSD fell the most in at least 37yr after the UK economy contracted more than forecast in Q3;

Ø         Equity: +$10trn market value of equities has been erased so far this month, accounting for about 1/3 of the total value wiped off stocks YTD. MSCI World index plunged 48% in 2008 and is heading for its worst year on record, while Nikkei only needs to fall about 600ppts to be back at a level last seen in 1982;

Ø         Rates: The 30yr USTs fell to the lowest level in more than three decades and the decisive decline of 10yr yield <4% (3.68%) may seriously indicate the debt deflation ahead of us. In the short end, the LIBOR (128bp, +7bp), TED (270bp, +13bp)and Libor-OIS spread (263bp, +9bp) rose as the increased likelihood of a global recession even after policy makers pumped record amounts of the USD into financial markets.

It is clearly now that to recover the confidence in financial markets is not simply an issue involving balance sheets, but also including the economy fundamentals. I think the remarkably anecdotal evidence that LOCs are not being issued/honored in global trade is an ultimate indicator that the global financial crisis has turned into a crisis of confidence to global economy, which in turn has stalled trade flows, witnessed by the freefall of BDIY index (1102, -86% since 18Aug). Having talked so, the view is corroborated by the sudden collapse of shipping costs i.e. the cost of shipping iron from Brazil to Japan dropped from $100/ton to $15/ton in a matter of few months. More to say is that the markets do need more cooperation or coordination around the world. It is good to see the heads of +40 Asian and European governments “pledged to undertake effective and comprehensive reform of the international monetary and financial systems'', after a two-day meeting in Beijing, before they gather with leaders from around the globe meet on 15Nov in Washington to assess the global turmoil. However, I am still wondering whether they can reach consensus on what steps to take as US and EU/Asia leaders have been sparring over the causes of the credit crunch and how to cure it.

Three Big Questions To Watch

It is clear that investor psychology is intensely focused on slashed earnings guidance and the extent of the depth/duration of the recession. The price action in global financial markets this week shows that the broader deleveraging process has yet to run its course. Not only   have stock markets in developed economies resumed their decline, but the unwinding of positions and the flight of capital from emerging markets has accelerated. From my point of view, 1) the biggest problem going forward is not the ‘credit freeze’, but rather a ‘player freeze’, as hundreds of hedge funds will fail and policy makers may need to shut financial markets for a week or more as the crisis forces investors to dump assets, according to Roubini. In addition, investors have withdrawn a record $43bn from hedge funds last month, according to Trim Tabs.

The second biggest question facing investors is whether the current levels of stock markets have priced in all the pain that goes along with a recession. I think Not Fully In…The steep decline in the stock market is another indication of more trouble ahead, if you follow the rule of thumb that investors are typically making their decisions based on what things will look like in six to nine months. Sentiment wise, investors who bought last week on improvement in credit indicators are now hurting and this would probably result in everyone staying away for the rest of 2008 and the early part of 2009. Moreover, major indexes could slip even further if the market is sideswiped by a disappointing batch of economic news or dour corporate earnings. By the time all Q3 results are in, the combined operating profits of 1,500 companies tracked by S&P are expected to be 13% lower yoy. For all of 2008, the operating profits for the same 1,500 companies are expected to be down 26.5%t. Timing wise, historically bear markets are meant to demoralize investors, and hence do not end until the majority give up, throw in the towel and capitulate. Nobody was even thinking of buying stocks at the bottom in 1974 or in 1982, periods where people hated equities, even though the PE for the S&P 500 was only 8X vs. 11X now.

Another critical question is how aggressive the major central banks will move? Whatever the case, it seems that the world economy is deteriorating, financial fragility continues to increase and central banks are lagging. One silver lining in this dark global cloud is that inflation is about to collapse (oil is near $64/bbl) and this prospect is freeing central bankers to support growth. However, past experience shows that so long as policymakers remain behind the curve, equity prices will continue to have a hard time bottoming. There is no question that the Fed has been aggressive in dropping rates, but this does not mean that Fed policy is ahead of the curve. Historically, the US yield curve on average needs to be steepened by as much as 350-400bp during recessions. With 10yr bond yields at 3.6%, the Fed Funds rate may need to go to zero in order to get the steepness in the yield curve necessary to shore up the banking sector and the economy as a whole. Having said so, policy easing outside the US has barely started. At 3.75%, ECB policy is still chocking growth. Certainly, markets are actively debating the likely magnitude of impending rate cuts by the Fed, the ECB and the BoE. One thing for sure is that rates are much lower in US than in EU, thus this might lend more confidence in the chances for aggressive moves in Europe.

The implication is that we will see a prolonged period of deleveraging, increased government regulation, and near-term disinflation. Therefore, it is too early to bottom-fish equities. Looking foreword, global equities could either test previous lows or make new lows. And In whatever case, hedge fund liquidation is adding to the intensity of the financial tsunami. I think there are two signals in the near term worth being watched – 1) as long as CBs/IG credit/Loans deliver better than unleveraged equity returns, stocks remain a sell; 2) until a package of bailouts for EM sovereigns is announced, stocks remain a sell.

A Comparison to 1929 -1932

The world is experiencing the most profound shock since the 1930s and the global housing bust is perhaps the largest burst bubble in history. As the current crisis brings us into unknown territory, there is a tendency for us to compare the current crisis with the crises over the last 100 years. When compare the histograms of S&P 500 daily returns across past bear markets, we can find that the structure of the current bear market differs from all past patterns, but the 1929-1932 bear market is potentially the closest. Both are long (311 days and counting currently) and extreme, with fat distribution tails, left (severe daily drops) and right (large daily gains). The Great Depression was followed by a long but calm recovery, taking almost five years to reach an index level of only 60% of the pre-bust peaks. However, all four post-war downturns lasting more than a year were followed by remarkable bull markets in which the S&P 500 climbed to 75%-125% of the pre-bust peak levels about twice as fast as it fell towards the bottom. As equities tends to fall slower in bear markets than they gain in the subsequent recovery, going long the market too early is not always severely punished. In terms of EPS growth, the current crisis resembles more the one we experienced at the turn of this century.

Sector behavior --- As currently, macro factors come to the forefront and correlation shoots up, leading sector allocation to account for the bulk of equity portfolio returns. Apart from the intuitive conclusions (e.g. Defensives outperform in bear markets and lag in the rebounds), there have two key take-away points: 1) there is usually a lull after a bear market has ended when sector dispersion remains limited but forthcoming out performers emerge: there is no need to rush into sector allocation, but an opportunity to spot the potential leaders and laggards in the post-lull full-blown market recovery to follow; 2) When we cross past performance with current conditions, retail seems the most likely outperformer once the current bear market ends.

Equity volatility --- Scrutinizing 20th century US equity market recoveries after bear market lows points out a two-year delay before volatility reversed to pre-crisis levels from its peak. The Fed Fund real rates/30M lagged S&P 500 realized volatility model also signals that volatility may remain high for about 24 months. Therefore, we feel comfortable that future short-term equity volatility may revert from its current climax to a historically high regime - from 20% to 30% - for months, but not below that mark.

Portfolio Positioning --- As consensus is that the end is approaching, how will we will position ourselves? Be on alert for the typical one-month lull that emerges after a bear market ends, which has more often than not proved an opportunity to reduce exposure to traditional Defensives and stock up on cash plays like consumer-related sectors such as retailers.

However, we now know that we are in global recession, but we don't know how bad it is. The LEI suggest it will be at least as bad as 1990-91 but most expect it will be longer and deeper.  Given this sentiment, which is unlikely to change soon, what is a worst case scenario for reasonable trading bottom for the HSI? This would be a trading bottom which allows participants to anticipate a 40% trading range above the low in a worst case scenario. One benchmark might be to take the SARS low for HK property. At the SARS low, the P/B low for SHK was 0.62x, while that for CK was 0.55x. The present P/B of SHK is 0.75x, while that of CK is 0.74x. So, if it gets as bad as SARS for HK property, the ultimate downside might be another 21%. Interestingly, that would take us down towards the 2004 low on the HSI at 11,000, which was well above the actual SARS low at 8,000. That seems fair as a worst case low because commodity prices were enormously lower in 2003 than now. Even under a worst case scenario, I don't see copper anywhere near the 60 cent level it traded during SARS or crude oil back to the US$20-30 range? 

The Textbook Emerging Market Crisis

Last week, we see Hungarian and Ukrainian authorities have been raising interest rates to defend their currency markets. These two countries are experiencing a classic emerging market crisis due to excessive borrowing in foreign-currency debt. It seems that with these two economies plunging into recession and their local currencies collapsing, debt moratorium is just a matter of time. However, after Argentina's nationalization of the US$29bn private pension system and Hungary raised interest rates by 300bps, I think there are more problems to come. I think we should not continue to underestimate the impact of deleveraging in the G7 on emerging markets. With global credit markets still fragile and commercial banks unwilling to lend, the evaporation in bank lending is now beginning to hurt sovereign borrowers as well as corporates. Countries that have run large CA deficits financed by ST capital inflows are now facing the unappetizing prospect of trying to either raise IRs to attract inflows or attempt to issue debt at punitively high interest rates in overseas bond markets.

However, since EM borrowing costs neared a 6-year high after S&P threatened to cut Russia's debt ratings, (i.e. CDS on Korean sovereign debt is trading at nearly 600bps vs around 25bps pre global crisis suggesting that Korea may default on its sovereign debt), Iceland, Ukraine, Hungary, Pakistan, Vietnam and Turkey are all either looking for IMF aid or likely to need it soon. Eventually most could end up with getting the help from the IMF. The bad news is, with the recent onset of this current EM crisis, the G8 themselves are not in the same shape to boost the IMF as in previous times when confronted. Moreover, this EM crisis is not localized like it was in Mexico 1994, Thailand 1997, Russia 1998 and Argentina 2001. But what we learned is sovereign crisis can cast off a decent amount of radioactive damage outside their boarders.

It absolutely cannot be ignored, too -- think of the lessons from the Lehman failure -- as a few sovereign collapses could have very nasty feedback to the G8's already compromised health.  Before last Wednesday, things outside the G7 ring-fence have spoiled the relief that should come from the authorities preventing the sky from falling. But they are also now bearing the brunt of the stress and the problems brewing in EMs, including Argentina, Hungary, South Africa, Turkey, CE4, and Russia… It seems that the recent EU and US measures to restore confidence in domestic banking systems may have come too late to reverse capital outflows from emerging markets. As the house of cards continues to unravel, funds are pulling the plug on EMs, pushing the US$ higher and pulling commodities lower. Of course, Eastern and Central Europe is now the epicenter. Unfortunately 85% of banks in Eastern Europe are foreign owned so this is falling back on the Western Banks yet again. The current scenario looks just like 1997 - once Japan turned the faucet off and stopped lending to Asia, it caused the 1997 Asian Financial Crisis. Well, today, with credit markets frozen, Europe has stopped lending to Baltic and CIS countries. Hungary, Poland, Romania all screwed now.

In general, the long-standing EM virtuous circle of strong growth, rising commodity prices, buoyant capital inflows, firm FX rates and low inflation is now operating in reverse, with many EM economies facing a sharp adjustment in economic activity. The countries most at risk are those with 1) large current account deficits (many located in EM Europe); 2) heavy private-sector reliance on external financing or other x exposure (e.g., Korea, Russia, Brazil, Mexico); or 3) spendthrift commodity exporters (Argentina, Venezuela).  Looking ahead, the spreading financial crisis is likely to claim causalities in developing Europe (Baltic and CIS). High credit growth and current account deficits have been financed by hot money attracted by high nominal rates and asset inflation. To date, emerging market collateral damage has been limited, but in many countries with high credit growth through current account deficits there is a growing probability of dual banking and currency crises.

In addition, EM currencies are still extremely vulnerable. For EM currencies, the worst is not yet behind us, unfortunately. The world is still ultra-long EM, and the structural EM story needs to be fundamentally, comprehensively and critically reconsidered. The prospective collapse in capital flows into EM will deal a major blow to EM currencies, but the fundamental thesis on EM being stress-tested is likely to be especially damaging for EM. The previous lessons is even good country fundamentals do not prevent currency collapses. In 1997/98, Indonesia had one of the best sets of fundamentals anywhere in the EM space, and certainly superior to many other economies in Asia. Yet at one point the IDR lost 80% of its value. Similarly, this time KRW also lost close to 50% of its value, although it didn't have terrible fundamentals. Likewise, in the current sell-off phase, country fundamentals are likely to matter less than global forces.  

The implications for global equity investors are numerous. Ignoring exchange rate moves on their portfolios, by raising interest rates, the economies in a number of these countries will be tipped into recession. Asian and European exporters would be particularly hit. Second, since a number of the banking systems have a significant duration mis-match, there is a growing probability of a domestic banking crisis. This is particularly important in countries where foreign lending has been an important part of domestic loan growth. Hungary and Poland have experienced high rates of foreign credit growth. Third, as the velocity of money within the global financial system contracts there is a growing probability that the credit crisis observed in Europe and the US will spill over into a fully fledged emerging market crisis - raising the risk premium in all economies irrespective of their health.

 [Appendix]

Financial markets are at critical levels, and a breakdown from these levels will signal the worst-case scenario:

Ø  Emerging market share prices in U.S. dollar terms and real terms (deflated by inflation) are back to their mid-1990s highs (Chart 2). If the structural story of emerging markets is true, as we hope it is, share prices should find a bottom at current levels, and a sustainable breakdown past these levels should not occur.

Ø  Chinese H shares are back to their 2005 levels when the slope of the bull market steepened

Ø  Global semiconductor stocks are at their lows in 2002, when the epicenter of the problem was the technology sector

Ø  Japanese stocks are also at their 2003 lows, while emerging market sovereign debt spreads are at their highs since 2002.

Ø  Global mining and energy stocks are also approaching their 1990s highs.

Ø  Finally, U.S. long-term bond yields are flirting with their past lows (Chart 5). If yields break decisively below 4%, it will imply debt deflation.

Major currencies are a measure of confidence in the system:

Ø  Aus Dollar is a measure of global growth/strength in commodities, which weakness is evident in the collapse of oil price.

Ø  Kospi is a measure of the strength of exporters, which is inversely affected by weak consumption in developed countries.

Ø Nikkei inversely correlated to yen, an inflation proxy, hence suffer during a deflationary environment. 

Ø  Taiwan dollar an indicator of risk on the tech sector;

Ø  and while HKD is pegged to USD, HSI/HSCEI is a proxy to China growth, which we have downgrade to 7.3% next year.

JPY - the global indicator of risk aversion

High yield spreads, specifically in the cash market, are well past their previous cycle wides.

Ø  With spreads approaching 16% and all in yields near 19%, implied default rates suggest that almost all the names in the index will have defaulted over the next five years.

Ø  The most extreme historical reference is the era of the Great Depression, when there was no such thing as a high yield market, and defaults maxed out at 16.2% in one year.

Ø  Current spreads indicate a 46% annual default rates over five years. Worth noting is that cumulative three year default rates have never even exceeded 40%.

Ø  S&P said it expects the default rate for HY borrowers to reach 7.6 % in the next 12 months. Seventy-five companies missed payments as of Oct. 15, affecting $226 billion of debt, S&P said.

Ø  nvestors are demanding an average yield of 8.87% to own IG corporate bonds, or a record 5.98% more than Treasuries of similar maturity. Average yields reached 9.06% on Oct. 20, the highest since August 1991, when the Fed's target interest rate was 5.75 percent, 4.25

The Fed Balance Sheet

Ø  Stabilization in counterparty risk is only the first step forward, and it will be critical for bond spreads to narrow and for banks to stop hoarding cash. However, offsetting this positive has been an uptick in government bond yields.

Ø  If credit spreads narrow due solely to rising Treasury yields, then no economic relief will occur. The Fed needs to make it clear that policy rates will stay low in order to anchor Treasury yields. Moreover, bailout efforts need to proceed to ensure the banking system starts functioning. Stay tuned.

Ø  The central bank's assets, which include a loan to insurer American International Group Inc. and a pool of investments once held by Bear Stearns Cos., more than doubled to $1.772trn last week from a year-earlier total of $873bn that comprised mostly Treasuries. There's more to come. The Fed announced this week a backstop for money-market mutual funds to which it will commit another $540bn. A commercial-paper program approved Oct. 7 could buy up to $1.8trn of securities.

Ø  When the Bank of Japan fought deflation and a banking collapse earlier this decade, its balance sheet ballooned to more than 30%of GDP as it pumped money into the economy, Hatzius said. He predicted ``further rapid growth'' in the Fed's, which is now equal to 12% of U.S. GDP.

Hedge Fund redemption

Ø  The hedge fund industry is stumbling through its worst year in two decades and posted its biggest monthly drop for a decade in September.

Ø  With the average hedge fund down 18% this year, as measured by the HFRX Global Index, Hedge funds are aggravating the worst market selloff in 50 years as they dump assets to meet investor redemptions and keep lenders at bay. 

Ø  U.S. hedge-fund managers may lose 15% of assets to withdrawals by year-end while their European rivals shed as much as 25 percent, Huw van Steenis, a Morgan Stanley analyst in London, wrote yesterday in a report to clients. Combined with investment losses, industry assets may shrink to $1.3 Investors withdrew a record $43 billion from hedge funds last month, according to TrimTabs Investment Research in Sausalito, California.

Good night, my dear friends!