My Diary 493 --- The Synchronized Dance; The Broken Credits;

My Diary 493 --- The Synchronized Dance; The Broken Credits; The 1987 Roadmap; The Yen, Dollar and Crude Moves

December 7, 2008

“An early farewell to 2008 & we will miss President Bush” --- This diary would be a long one. It is the last market note in 2008 as I want to put this dismal year behind me earlier so that I could plan for a prosperous 2009…Taking about New Year, one person I will miss is President George. W. Bush… I said so not only because he is the first US leader since Richard Nixon to preside over two recessions, but also because he has shared a lot of funs with us. Some of his misquotes seem to have “implications” on the outlook of global economy and financial markets in 2009. Here list some –- 1) to deflation: “We are ready for any unforeseen event that may or may not occur"; 2) to Fed and Treasury: "If we don't succeed, we run the risk of failure"; 3) to investors: "The future will be better tomorrow"…So would you miss Funny George? Yes or no...Whatever the answer, I would like to take this opportunity to wish my dear friends – Merry Christmas and Happy New Year!

Weekly Observations

Turning back to the markets, global equities declined 4.7% this week, with stock down 6.48% in Japan, 8.1% in EU, 2.4% in US and 5.6% in EM. Elsewhere, 1MWTI oil declined $13 to $40.81/bbl. 2yr and 10yr USTs rose on Friday by 11bp to 0.92% and by 15bp to 2.70%. Since Oct, 2yr and 10yr yields are lower 63bp and 125bp, respectively. USD strengthened against EM currencies, up 1.6%, but slipped 0.4% vs EUR to $1.274 and slumped ~3% vs YEN to 92.7. Economy wise, there are no signs of stabilization. Over the week, the first series of macro evidence for Nov appears to be worse than anticipated and data was weak across the world, whatever from China, Europe or US. Nov US NFP was slashed by over half a million, with downward revisions to previous months, suggesting the upward momentum of UNE rate has not ended. It also seems clearer that the consumer retrenchment across the world has become self-reinforcing, as steep cutbacks in the business sector gained speed. On the back of fears that demand/deflation will further plague, commodities reversed sharply and led the FX markets with oil closing near $40 as OPEC pushed its output cut decision and gold off over $65 below $760.

On the policy front, the deteriorating financial conditions are clearly the target of more and more global authorities. Nowadays, central bankers make Alan Greenspan look like an absolute monetary hawk as 100 apparently is the new 25 and we saw a wave of aggressive rate cuts, including Riksbank (175bp), BoE (100bp), RBI (100bp), RBNZ (100bp), PBOC (100bp) Thai (100bp) and ECB (75bp). As a partial result, government bonds had their best monthly performance. In US, treasury yields fell further on Bernanke's comments on the QE2 and the official recession stamp by NBER. 10yr UST dropped to 2.7% while 2yr dumped to a low of 0.92% and 5yr cruised to 1.69%. But the fact is that the ongoing plunge in UST yields is not translating into lower consumer and business borrowing rates, at least not in a way that has improved credit demand…To be fair, the Fed/Treasury have taken a host of measures to help unclog the credit market, it's just that they have yet to be effective in "normalizing" conditions there…Thus, we heard that Treasury is going to purchase agency debts and MBS backed by FNM, FRE, and FHA, and to reduce Mtg rates to as low as 4.5%.

Having said so, credit markets continue to trade in post-collapse state of dysfunction, especially those in the LE of capital structure. Traditional relationships are dislocated as credit massively underperformed equity, particularly in retail sector, where the broken credits keep getting wider but the broken stocks are rebounding off near zero. That said, the global pain of the credit crunch has been notable in equities – which peaked Oct 2007 and the MXWO is down 44% for the year – wiping out $32trn in capital. Indeed, over the week, the debate was whether the “give-back” theme was more important than the “buy-more” theme as markets saw a host of heavy data pointed to a deeper and darker recession. But believe it or not, stocks are likewise immune to bad news. The rally of S&P in Friday seems like nothing is bad enough to inspire fear…I hold a pretty simple view here to these observation ---1) liquidity remains terrible until, at least, year end; 2) therefore any odd forced rebalance/deleveraging causes much more impact; 3) there’s still plenty of fear out there, suggested by the $86.4bin outflows from stock and bond mutual funds in Nov after a record $111bn in Oct.

Forward-looking Thoughts

Looking ahead, my view remains to stay sidelined for Dec and to wait for 2009. Amid widespread agreement that the global economy has fallen into recession, attention now turns to its likely depth and duration. While the full picture on economic growth cannot be known until well after the fact, the economy’s real-time trajectory can be observed through national business surveys and a handful of other timely barometers. That said, with the Nov surveys and downward momentum on hand, US GDP now forecast to fall at a 2.4% yoy during 4Q08-1Q09—the deepest decline since 1980s. If the surveys do not stabilize after the turn of the year and the downward momentum continues, it would be a strong signal that the economic downturn is turning out to be even more severe than currently anticipated.

Indeed, the extremely weak US payrolls underscore that consumers have been hit by a double whammy: a meltdown in financial and residential asset prices and a sharp rise in layoffs. Given US govt failed to deliver a quick stimulus plan and unfreeze the credit markets, it implies that the recession will deepen and any recovery will be pushed farther into the future. In the words of Fed Chairman, the economy “will probably remain weak for a time” and the Fed may use unconventional methods to spur growth. In short, what Uncle Ben said is the contraction in payrolls and economic growth will persist until there are some signs that policy actions are finally becoming effective...Well, should the recession persist for another five months, consistent with Fed and private forecasts, it would become the longest since the Great Depression.

In sum, I think the big picture is that the hope for a consumer rebound due to the drop in prices was not enough to fight back the investor concerns over LT pictures. We have to acknowledge that the era of US-consumption-led growth has come to an end and US savings rate is on the way up (4% or 10%?), while BRIC or China consumer is not going to rescue the world in the near term. One lesson from what I saw over the past 14 months is the risk of DMs relying heavily on EMs, while the later thinking they can thrive as the biggest ones plunge. The world is so interconnected that, Yes, US started this mess, but the growth stars in Asia may have to pay the biggest price. Thus, I believe the forecaster in ML probably forget the point of synchronization when they predict 1.5% global output next year based on an 8.6% expansion in China.

In my own views, I think we need three things to pull us out of the recession --- 1) to have a group of bold and creditable leaders, who are prepared to us the State power to intervene. China is showing us that market can at least bounce and stay up for a few weeks, if your leaders and the policy are credible; 2) To return credit markets into normal and to continue to make progress in housing are the most important things we should do in 2009. In order to achieve these goals, we do need some sort of State bank to lend; 3) to return the pact between the US and China, which is US doesn’t mind weaker RMB and, in return, China will load up USTs. This pact makes sense because the US economy is interest rate sensitive and the Chinese economy is exchange rate sensitive. And it is clear that US policy makers want to get Mtg rate down as low as possible. But, the side consequence is that US banks will struggle to rebuild their B/S, if US yield curve is going to be very flat.

Asset Allocation in 2009

To better express my expectations on the outlook of 2009, I put down weightings among major asset classes. In general, I think although investors have clearly moved into "depression" stage, which is toward the bottom of any bear market. However, bear markets tend to end with "indifference" and we are clearly not there yet with many people still trying to call the bottom (latest being Bill Gross). Interestingly, while few investors are convinced that Asian markets have definitely bottomed, I found less ultra-bearishness than expected, mainly due to 1) investors feel that the monetary and fiscal stimulus would cause growth to pick up in 2H09, especially in China; and 2) that the bail-out of Citi means surely “too-big-to fail”. As said within the context of this diary note, I have some sympathy with the views, but, since sentiment has not yet reached capitulation (or indifference) point, I do suspect that the worst may not be over. 

U/W European and Commodity Currency --- Expect to see more aggressive policy easing from ECB, BoE, RBA and RBNZ as external demand and domestic economy continue to fall apart sharply. This presents further downside risks to all these currencies against USD. Also, keep an eye on BRL and RUB.

O/W UST and Duration --- Expect UST issuance to explode in the coming years, as Fed and Treasury are pursuing the unprecedented debt swap, which will continue until the credit market starts functioning again. In addition, I expect Treasury will join the Fed in buying MBS, creating huge convexity/duration demand.

U/W European Sovereign / Corporate Credits --- Expect to see more bankruptcy filings and default of coupon payment, given the risks of refinance or bank debts roll-over. In addition, the markets are not particularly liquid, as it looks very odd that AAA-UK-corporate CDS traded 120 when the Sovereign trades 125.

U/W Commodity and O/W Gold --- Expect a slumping demand for commodities as China is a huge source of demand for commodities and now its slowdown is a key reason behind it. But I expect gold to outperform, given the risk of fiat currencies being widely debased as DM governments nationalize banks/companies.

O/W CSI300 and Nikkei --- Do not expect a sustained re-rating of equity markets, given the volatility of business cycle has returned. But I do believe creditor countries like China and Japan deserve a premium, especially when JPY looks to strengthen to 85, whereas RMB looks set to stay around 7.

The Synchronized Dance

From US to China, the global economy is in free-fall mood, but the key issue is higher level of synchronization than it has been since the 73-74 recession. Over the week, NBER designation means US was the first country to have slipped into a contraction. While definitions differ, both EU area and Japan fell into a slump in 2Q08, making it the first simultaneous recession in G3 since postwar era.

Looking at details, incoming data continue to underscore the weakness of capital spending and manufacturing. In US, factory orders contained a substantial downward revision (-4.4%) to core capital goods shipments and orders. In Japan, MOF 3Q survey was notable as corporate profits declined 22% yoy. This is likely to result in a deeper labor market adjustment, as well as deeper declines in Capex in coming months. 3Q EU GDP expenditure breakdown also shows that FAI (includes housing) fell for a second straight Q. The manufacturing slump has been complemented by an equally sharp contraction in global trade flows. Several indicators from trading powerhouses in EM Asia are especially striking. China’s export orders fell to 28.0 last month. Korea’s merchandise exports collapsed at a 45% annual rate in Nov. India recorded the largest fall in exports in 10yrs @ -12.1% yoy in Oct...That said, Asian exports are highly pro-cyclical, and the declines may get much bigger judging by the early 2000s experience. It is also true that at least a portion of the recent slide reflects price pass-through from lower commodity prices.

With respect to consumption, the yearend spending season is set to be the biggest bust in several decades, as consumers have been hit by a double whammy: a meltdown in personal wealth and a sharp deterioration in job security.  In US, Nov Retail Sales is headed for drop. According to the MasterCard survey, sales fell 20% yoy at apparel and dep. stores combined, 24% at luxury stores and 25% at electronics stores. This trend of consumer retrenchment is highly likely to move forward as credit-card companies will cut available lending by 45% or more than $2trn over the next 18 months, according to Oppenheimer analyst Meredith Whitney. That will mark a “broad-based decline” in consumer access to capital and a “dangerous and unprecedented” move for US consumer spending, said by Whitney. The same scenarios are to be repeated in EU and Japan as suggested by the decade low level of consumer confidence and the tough-like US job markets, on the back of the fastest pace of contraction in manufacturing and service industries.

To sum up, the US economic slowdown worsened significantly this autumn, and the outlook is grim for 1H09. As payroll data is set to stay negative for at least another six months or so, most economists believe, so there does not look to bee anything that will qualify for a recovery anytime soon. This reflects the fact that the nature of this recession is somewhat worse than the typical one, given the severity of the financial crisis. So this might look more like the 1982 situation (or worse), rather than 2001, 1990 and 1980…With the focus on 4Q08and 1H09, the world is looking at China to provide a large part of the incremental growth next year. However, according to David Cui, the China strategist at Merrill, domestic consumption, in particular rural consumption is the lever that the government is focusing on. This is witnessed by the recent government initiative -- to sell farmers 480mn units of household appliances (Rmb920bn) at discount in 4 years to spur domestic demand. But wait a minute, is it a bit ironic as “the world is hoping for some of the poorest people on earth, i.e. Chinese farmers, to spend and save us”…Having said so, the consensus forecast for global GDP during next two Qs is -2.4%, the deepest drop since the early 1980s (4Q81-1Q82).

The Broken Credits

To the fixed income markets, the dominating theme in 2009 would be deflation. According to Professor Nouriel Roubini, deflation is dangerous as it leads to a liquidity trap, a deflation trap and a debt deflation trap because nominal policy rates cannot fall below zero and thus monetary policy becomes ineffective. I think we are already in this liquidity trap since effective FF rate is close to 0 as the Fed has flooded the financial system with liquidity. Thus, it is reasonable to expect that by early 2009, FFTR will formally hit 0. Practically, I think to move policy rate to zero does not bother FOMC or other major central banks anymore, as at this stage of global credit crisis, inflation risks over their forecast horizons are being thrown aside, while their main worries are over a deep economic downturn. Measured by market based BE rates, inflation expectations have collapsed and if anything, given the worsening economic leading indicators in all these economies, could fall further.

Unfortunately, fighting deflation is far more difficult than combating inflation, as the experience of Japan has shown. Thus, it is time to forget the Greenspan put, as Bernanke put is way more explicit. Over the week, the scholar of great depression said, “for now, the goal of policy must be to support financial markets and the economy”…Big deal, the Fed talking openly about supporting financial markets!...Ben also said that he has “obviously limited” room to lower rates further and may use less conventional policies, such as buying USTs…Yes this is Japanese style QE and if my memory serves me right, the last time the Fed did this was in the mid-1930s…Ben concluded by saying that” the Fed’s B/S will eventually have to be brought back to a more sustainable level. However, that is an issue for the future”…Across the ocean, ECB latest statement provided heavy hints that a more pronounced fall in inflation in mid-2009, for which indicates that the risk of deflation is very high. As a result, ECB actually mildly surprised the markets by lowering 75bps. The decision was anchored by staff projections that inflation would fall well below 2% based on current futures pricing for EURIBOR and growth of between 0 and -1%. Given such growth expectation for next year, I anticipate further rate reductions to 1% by 1H09.

On the back of deflation and proactive responses from central banks, UST market has garnered a 10.1% total return YTD, with +5.4% in Nov, making this the best month since 1981 when yields were hovering around 14%. The long bond (30yrs) has also generated a phenomenal 27.8% return, with 50% of gain taking place in Nov as well. Historically, the last time the 30yr bond rallied as much as it has this year was 1995, as optimism grew that the Clinton administration was poised to turn budget deficits into surpluses, allowing the government to reduce debt sales. This year’s surge comes amid different circumstances, as US govt is expected to post a deficit in excess of $1trn as it attempts to fund bailouts for banks and fiscal stimulus programs to jump start economic growth! The prevailing question is that whether the surge in federal borrowing is a negative for the bond market? The answer is No, because all the new federal govt borrowing is only offsetting the contraction in credit demand in other parts of the economy. According to Fed, the total credit growth in US (8.5% a year ago) has slowed to 6.7%, even with the fiscal largesse out of Washington. That means, all the efforts from the Fed are working to cushion the blow, but are not enough to fully reverse the debt liquidation process…In short, it has obviously been profitable to have remained long UST and duration over the past year and I would carry the trade into 2009.

Staggering into the credit markets, they are just as bad as the macro data. Let me show you how broken the credit markets are…Spread wise, credit keeps widening as job markets are WTE and personal consumption continues to deteriorate fast…Last week, EU Xover broke through 1K, which was 160 in Feb07 and started the week @ 890. The NA IG11 closed 39bp wider wow @ 294bp. In fact, there is no single significant event recently, but it's more a confluence of small bad news. The most recent trend is a rolling series of new issues coming out wider and wider and credit repricing sector by sector, from Telco, Chemical and then the whole sector. As said, the retailer credits have blown off as many mid-tier retailers have already gone in to administration, such as Woolworths, MFI, Circuit City and Linens.

Most troubling, I think, is the lack of improvement in inter-bank spreads last week despite the improved price action in equities as showed by LIBOR-OIS and TED (+17bp in 2 weeks). These stubborn figures show that system pressures remain intense, mitigating the stimulus effect that Fed wants to pass through into the real economy. Lately, Bernanke urged using more taxpayer funds for new efforts to prevent home foreclosures, outlining 4 possible options, such as buying delinquent mortgages and providing bigger incentives for refinancing loans.  Markets took it well and 30yr Fixed Mtg rate dropped 80bp to 5.6%. That is below its avg rate since 2001 and near the low since late 2004. Indeed, some analysts already called for the stabilization of housing market, but I think this argument has two weak assumptions –1) the economy and financial markets are stable (Seems Not yet !); and 2) the affordability ratio is reasonable. However, we all know that current lending standards are much tighter than historical level, so does the down payment requirements. Looking forward, this is the biggest matter to US economy, as until problems are fixed in housing, we’re going to have at best slow growth…That said, within this credit sector, the key point of strain increasingly seems to be CMBS market and the meltdown in commercial real estate, as retail sales further slowing down and more retail stores breaking down.

Other broken sectors are mainly on the govt and muni credits. In terms of later one, US Munis has slipped into the abyss of collapse after AAA-rated NY Port Authority failed to find a single bid on a competitive $300mn bullet deal on last Wednesday. In addition, the fact that CDS for 10yr USTs jumped to 56bp is another good example. I think in these two sectors, credit spreads don't reflect expectation of default, just the uncertainty over the enormous cost to the government and the lack of B/S capacity for dealers and investors to add more risks.

All in all, the key barometers to bear in minds are the rating migration and default rates. In our home markets, according to S&P, as of 28Oct2008, ratings with a negative bias represented 18.9% of the total portfolio while those with a positive bias made up 5.0%. This translates to a negative-to-positive bias ratio of 3.8 to 1, implying that ratings are 4X more likely to be downgraded than upgraded. I think the story does not end here, as I expect the realized default rate in HY space to reach at least the same level as it was in 2001, 10.56%, based on Moody’s record.

The 1987 Roadmap

Over the past two weeks, one of the negative features associated with 15.7% rise in S&P, and 7.8% rise in MSCI AxJ is the weakening volume. Based on BBG data, S&P avg daily T/O has fallen to $32bn this week from $44bn in Oct, while AxJ daily T/O has declined to $14bn from $20bn in Oct. I think these shrinking transaction volumes signal that the recent equity market moves are relief rally, but not the end of the bear market, as obviously investors hesitated to make big bet on stocks. Indeed, according to several US mutual fund surveys, although the forced selling by hedge funds and liquidations triggered by fund of funds redemption may have come to an end, the risk of more redemptions from retail investors is still a big overhang to LO funds.

Another negative is the illiquid markets seem terrible for traders who are forced to trade technical or rebalance, as S&P swings will be 3X more than its average in 1H09. According to Volatility futures, it seems that S&P to rise or fall at least 2.8% a day through June2009. The last time the benchmark index moved that much during the same amount of time was 1932, when it happened 38 times, according to BBG. That being said, markets are more and more technical & news driven in the near term, before the economy reality settled in again. One interesting reference is that based on the GBP/Yen vs S&P, it seems that S&P is likely to retest its 2008 low and a drop below that level would likely mean a decline to 738.3, representing a Fibonacci 38.2% reversal of the rally that began after the 1987 crash, according to Merrill technical analyst.

Back to Asia, consensus earnings still look too high based on IBES with 4.2% EPSG09 for Asia, 10% for MSCI China and 7.3% for H shares. Valuation wise, AxJ is traded at 9.8XPE09, 9.5X for MSCI China and 9.3X for H shares. Domestically, CSI300 is traded at 13XPE09 and 11.8% EPSG, while ‘HSI at 10XPE09 and 2% EPSG…No doubt, earning would have further downside risks, but I think the key concern for China liscos is their 17.1% ROE (2008, based on MXCN) which is too high relative to its 10yr avg @ 9.5%. Looking from another angle, given that China ROE usually has 6-9 months lag to US, ROE of S&P, which peaked one year ago from ~17%, has sharply tumbled to 9%, far below its avg 14% of the past 20 years...Thus, I would remain sidelined, if not based on relative performance…Moreover, as investors look to position themselves for next year, it is worth to refer to the recent HSBC quarterly PFS survey of LOs.  In short, it smells like sentiment is less bearish as 56% of PMs were now bullish on AxJ (up from 44%), while U/W stayed flat at 22% due to the attractive valuations. Risk appetite is also returning a bit, with only 25% of PMs O/W cash, down from 38%. Flow side, while regional funds redemptions from Intl and GEM products totaled $4bn during the past 3 weeks, inflows to China funds were big, ~US$841mn, according to the latest EFPR report. However, such a big inflow seems unlikely to be put into work in near term as 63% of PMs have a neutral view on China, with U/W up from 0% to 13%. In my own simple view, that is, not until we see a rally in corporate credits will we see one for equity market, given overall economy and capital structure is so distressed.

Lastly, based on the previous discussion, the current environment shares many similarities with the 1980s, thus what happened after post-1987 crash may provide a rough roadmap for how we would play out in 2009. In the fall of 1987, the equity market effectively stopped trading due to investor panic and forced selling of derivatives ( A bit similar!), then monetary policy abruptly shifted from tightening (due to inflation scare)  to easing aggressively (Also similar!). Policy remained easy until the following spring and USD dropped significantly (On the way!). However, although the market troughed on 04Dec87, investor was slowly coming back, even though consumer confidence soon recovered as policy stimulus quickly stabilized conditions and the economy got back on track in 1988. In comparison, the economic backdrop today is far grimmer, implying that a longer, more volatile, version of the 1987-88 period seems probable this cycle. In short, a sustained advance in equity should only come after there are clear signs that policy reflation and economy have gained the battle of recovery.

The Yen, Dollar and Crude Moves

Since July, both USD and JPY have been strengthening for months mainly due to the broader stresses in financial markets and investor repatriation associated with deleveraging. In addition, currency positions are among the most preferred, liquid and transparent methods for speculators to actually "trade" in less liquid assets, like HY credit, CDS, or even equity markets. Looking ahead, I think both currencies should continue to gain ground into 1H09 as this process continues. Certainly, relative change is another key to bear in mind as actions taken by US need to be judged against those taken elsewhere. I think recent measures by the US govt are impressive and wide ranging, but pale in size in comparison with record leverage and 10 years worth of US and Japanese investor diversification. In this regard, investor who looking for USD collapse may be disappointed. In addition, G10 policy rates are converging towards US and Japanese levels, reducing the incentive for carry trades, as we saw in those previously HY currencies. To FX traders, risk has risen substantially due to higher volatility, while reward is slashed at each central bank policy meeting. From these perspectives, it seems that the intervention risk by BOJ may well begin when USDJPY across 90 level.

In AxJ, a key theme is the relative value derived from each country’s domestic vs. external demand. Currencies which heavily tied to foreign trades, like KRW and INR, should at least stabilized, given the collapse of crude and commodity price and  an improvement in external balances. However, the spot light is definitely on RMB. I think RMB is likely to stay around 7-7.1 range, given the desire for Chinese govt to protect the export sector but not to trigger undesirable consequences, including 1) trade protection from US and EU; 2) competitive devaluation in Asia currencies.

With the last few inks on energy and commodities, I think energy prices have rapidly downshifted to reflect widespread demand declines. Based on the global LEIs, which have weakened rapidly, and the above average US oil inventories, which may well rise further as the economy contracts, I think OPEC has lagged behind the supply and demand curve with only one cut. Last week, I saw the open interest peaked on crude option contracts, allowing the holder to unload oil for delivery in Jan/Feb/March at $30bbl…I think this is when Merrill initiated the $25/bbl call…Furthermore, from fundamental point of view, the key risk factor for commodities is the growing risks of deflation. The lagged impact on the US savings rate is gaining pace to exert a deflationary impact on global demand. This why we have seen Copper dropped to $1.56, down 65% from the peak on 05May and all the resource-based currencies remain under downward pressure. Entering into 2009, I will keep an eye on indicators like US vehicle miles traveled, inventory levels, consumer confidence and the LEIs to signal a turning point.

[Appendix]

1.        House of cards

Ben is now talking about the use of public funds to stop "avoidable" foreclosures. The plans include  -- 1) "Permanent" loan modifications, not temporary; 2) Principle write-downs for "badly underwater mortgages"; 3)  Reduce up-front insurance premium paid by the lender, as well as the annual premium paid by borrower, when refinancing a delinquent borrower into a new FHA-insured fixed rate mortgage; 4) Congress could subsidize interest rate of restructured loans; 5)  Use streamlined process to aim to reduce interest payments to 31% of borrowers income (govt to offer incentives); 6) Govt buys delinquent or at-risk mortgages "in bulk". Contract out the work to GSEs…

2.        NBER and Recession and S&P

By the time the NBER gets around to announcing a recession has begun, it also usually means the recession has nearly ended, if one looks at the record of the past thirty years. The recession that began in March 2001 was announced by the NBER in November 2001, the exact month that the recession ended and therefore the expansion began. The recession that started in July 1990 was announced in April 1991, one month after the recession ended in March 1991. The recession that began in January 1980 was announced in June 1980, and the recession ended July 1980. There was one occasion in the past thirty years, however, where the NBER announcement was followed by still more pain. The recession that started in July 1981 was announced in January 1982, and that recession only ended 10 months later in November 1982.

It is interesting to note that over the past 30yrs, by the time the NBER gets around to announcing that a recession has begun, it has also nearly ended. The S&P rose an average of 10% in the 2nd year following a peak in the US business cycle, based on the start of 13 prior recessions in the S&P’s 80-yr history. The biggest advance (52%) occurred between 1982 and 1983, while the steepest loss (35%) was between 1930 and  1931. The S&P gained 8 times and fell 5. Anyone wanna hazard a guess whether its going be like 1983 or 1931?  Given the volatility of the business cycle going forward, one should not look for a sustained re-rating of equity markets. We are back to old fashioned valuations because we are back to an old-fashioned business cycle. In this kind of world, perhaps only the creditor nations deserve to trade at a premium to the rest – that’s China and Japan. But these two are different. Over coming months, it looks increasingly as though the Yen looks set to strengthen to 85, whereas the Yuan looks set to weaken modestly back above 7.

3.        Deleveraging and Personal Saving

Investors fled from stock and bond mutual funds for the third straight month in November, removing $86.4 billion as signs of a worsening economy drove them out from all but the safest investments. Shareholders removed $52 billion from stock funds and $34.4 billion from bond funds last month, said Conrad Gann, chief operating officer of TrimTabs Investment Research, citing preliminary data compiled by the Sausalito, California-based firm. While outflows were less than a record $111 billion in October, investors are still scared. Taxable money-market mutual fund assets surged to a record of $3.657 trillion in the week ended Dec. 2, according to IMoneyNet of Westborough, Massachusetts.

Private sector entities have become so risk-averse and so cautious that they are boosting their demand for cash at an unprecedented rate. Just look and see what happened to the personal savings rate in September and October - it went from 0.6% to 1.0% to 2.4% in one of the most pronounced increases on record - households socked away $372 billion of their depleted income base over those two months, which was almost unprecedented. Over the year to 2Q, the Fed flow-of-funds data show that households added 5.5% to their currency & deposits over the past year while their other financial assets declined 4%. The same holds true for businesses, which boosted their holdings of time/savings accounts at a 30% annual rate in the second quarter

4.        Deflation and Risks

Deflation is dangerous as it leads to a liquidity trap, a deflation trap and a debt deflation trap: nominal policy rates cannot fall below zero and thus monetary policy becomes ineffective. We are already in this liquidity trap since the Fed funds target rate is still 1 per cent but the effective one is close to zero as the Federal Reserve has flooded the financial system with liquidity; and by early 2009 the target Fed funds rate will formally hit 0 per cent. Also, in deflation the fall in prices means the real cost of capital is high - despite policy rates close to zero - leading to further falls in consumption and investment. This fall in demand and prices leads to a vicious circle: incomes and jobs are cut, leading to further falls in demand and prices (a deflation trap); and the real value of nominal debts rises (a debt deflation trap) making debtors' problems more severe and leading to a rising risk of corporate and household defaults that will exacerbate credit losses of financial institutions." - Professor Nouriel Roubini of New York University

5.        Deficit and Inflation

The surge in federal government borrowing is inflationary and a negative for the bond market. Wrong, wrong, wrong. All the new federal government borrowing is doing is offsetting the contraction in credit demand in other parts of the economy. Indeed, in the past year, federal government debt has accelerated to a 7% YoY rate from 3% a year ago (according to second quarter Fed flow-of-funds data). Corporate debt growth has slowed from 11.4% to 9.4%; the pace of household debt has throttled back from 8% a year ago to 4.3% today; state & local government borrowing has been sliced from 10.4% to a 4.7% trend currently (oh yes - see "Cities and States Feel the Squeeze" on page C1 of last Friday's WSJ). The net result, much to the chagrin of the legion of bond bears, is that total credit growth on the economy, which a year ago was bordering on an 8-1/2% annual trajectory, has slowed to 6.7% even with the fiscal largesse out of Washington. All the efforts from the Fed are working to cushion the blow, but are not enough to fully reverse the debt liquidation process.

Thirty-year Treasury bonds are returning the most since 1995 as investors bet the Federal Reserve will buy the securities to help bring down long-term borrowing costs. The so-called long bond has returned 27.8 percent this year, including a 15.6 percent gain in November, Merrill Lynch & Co.index data show. The debt is poised for the best annual performance since rallying 34 percent 13 years ago.

6.        Japan Experience on FX

One could look at the strength in the USD and conclude that the currency responded positively to Bernanke's comments. In other words, we're skeptical Bernanke's speech and the chances for QE directly contributed to the USD's gains. That said, there is the understandable and legitimate comparison to Japan's experience with quantitative easing which began in 2001 and lasted through 2004. During that period, Japan's monetary authorities bought government debt outright, injected extra funds into the money market (increasing the bank's current account balances) and, at times, engaged in unsterilized FX intervention, selling JPY and then leaving the extra liquidity in the money market. Initially, those efforts coincided with a weaker JPY, as USD/JPY rallied to 135 during Q1 of 2002. But the JPY then rallied for the better part of the next three years, through the end of 2004.

Good night, my dear friends!