My Diary 504 --- This Time is for Real; What History Tells Us;

My Diary 504 --- This Time is for Real; Credit Easing vs. Downgrading; What History Tells Us; It Is In Nobodys Interest

January 17, 2009

“The crash landing of a US airplane vs. a flashback replay of 2008 nightmares” --- The week ended with two Hollywood-type scenes. The happy story is that a US Airways plane made a safe crash landing into the Hudson River, after hitting a flock of geese. In the sad side, the week was a painful flashback to the nightmares of 2008 as renewed economic and bank viability concerns returned to the fore. It is for sure that policy and fiscal help are desperately needed, in light of the overwhelming depth and breadth of the unfolding global economic recession.

Global equities staggered lower in the last few sessions due to the morass of ever- increasing negative news – poor retail sales in US and industrial production in Europe, speculation of mega losses/ fresh capital raising by major banks, bad oil inventory from EIA, and so on. I think the broad-based declines of US retail sales (-3.1% yoy) is the most important point as this figure - not adjusted for price declines (especially gasoline)-signals how severely the current recession is. Based on the 6.16% downward reversal of MSCI world index, I think the data flow is bad and probably made worse by the fact that most people in the market these days have never seen a recession. I’m sure there are a lot of people out there who struggle to believe the notable improvements in some credit spreads against the fear that this recession will ever end. My own view is that recessions usually end once corporations have adjusted their cost base (fired enough workers) and restored inventories to an appropriate level. The bad news is that the inventory adjustment process has just begun...And this is not the end of chapter as b ank problems too were front. Globally Citigroup is dismantling after $8.29bn loss in 4Q08, BOA report $1.79bn loss after winning a multibillion-dollar lifeline from US government to help absorb Merrill Lynch, which lost a record $15.31bn in last Q. Elsewhere, DB has a profit warning, RBS is selling assets, and HSBC stock dropped 16% wow after Morgan Stanley predicted it may have to raise as much as $30bn and cut its dividend in half as earnings drop. All these recent bank stocks’ moves highlight that immediate and aggressive action is necessary to stabilize the sector, in particular when the market is selling financials ahead of the re-opening of shorting in the LSEx.

In the rest of world, news wires were also bleak -- Nortel files for bankruptcy, foreclosures are on the rise in California again, warnings for another autos bailout, plus continued Russian natural gas issues, continued doubts about China and its buying of commodities, continued war in Gaza, continued risk aversion moves in FX with EURJPY…I feel truly exhausted after 17Ds into 2009. I think the US and global economies are at a critical stage and policymakers need to err massively on the side of excessive stimulus to ensure that a dangerous debt-deflation does not take hold. So far, they have yet to do so.

Now let us look back at first. Globally, equity prices dropped 6.2% since last Friday with -4.4% in US, -7.2% in EU, -5.5% in JP and -5.9% in EM. Globally equity prices have now moved lower 5.92% since January 1st. Elsewhere, UST yield curve flattening a bit wow with 2yr yield dipped 2bp to 0.72%, 10yr added 1bp to 2.32%, and 30yr moved down 12bp to 2.88%. 1MWTI oil slipped $10/bl to $36.5 even Gaza has not stopping fighting. Measured by CRB index, the commodity space lost 11% over the week on the back of further softness in IP data and job markets. USD rose 1.9% on TW basis over the past 5 days. Against EUR, the Dollar closed at 1.3267, -1.55% wow, while it traded flat against YEN to 90.72, +0.4% since a week ago.

Looking ahead, the focus is centered on the dire state of the world economy and the implications for financial markets. As discussed, global markets remain focused on two key factors --1) the economy recession risk and 2) the continuous deleveraging. The last month of economic data around the globe has been horrific. As evident in US Dec retail sales, US consumers have stopped spending as housing prices are falling fast and people are loosing their jobs. With Europe also entering a deep recession this has dire consequences for Asian exports and growth. Most Asian countries are now experiencing a sharper contraction in exports than in the 2001US recession. With the deep recession in US, Europe and much slower growth in China, Asian exports will contract further. Meanwhile, anecdotal evidence suggests that global deleveraging is ongoing. Some measures, i.e. the % of the Japan call MMK accounted for by foreigners, suggest that almost all of the JPY carry trade has already been wiped out. However, other measures of LT economic deleveraging, such as US bank credit to GDP, may take years to get back to LT-averages. The massive monetary stimulus by major central banks is not able to stop this process as the monetary transmission mechanism does not work properly. The reason is that risk averse banks are unwilling to lend and corporates and individuals are scaling back on investment and consumption plans.

What are the implications for asset markets? I think in general, as deflation risks prevail in 2009 and leverage has further to unwind, asset markets are still at risk. Fundamentally, the prices of US housing market will not stabilize until inventory overhang is cleared. With broad measures of credit ( like ABS & CP Outstanding) still contracting, the recessions for DMs will extend longer than we anticipated based on historical experience, while growth for EM will be much slower amid the speed and magnitude of the credit and economic crunch in DMs. As BBG headlines showed, the US government will eventually adopt “ good-bad” bank model in order to remove toxic assets from lenders’ B/S. Historical evidence during Asian financial crisis and Sweden banking crisis have showed that this is the only effective way to resume the banking/credit growth. Thus, in near-term, I still expect recession risk and deleveraging will continue to provide fundamental support for USD and JPY.

This Time is for Real

The deflationary pressures in global economy are spreading in a real version. In US, headline CPI may not be WTE, but -0.7% in Dec represented the fifth consecutive mom drop, the longest in 60 years, while core CPI was also negative, posted a 0.3% yoy decline in the last three months, which has not occurred since 1960. In addition, the capacity utilization rates in manufacturing have also fallen to 70%, levels not seen in more than a quarter-century. All these suggest that while the government is rapidly expanding its B/S and Fed is dramatically boosting liquidity, they can only partially offset the $50trn household B/S, which is contracting at an unprecedented rate and it is the household that ultimately determines the demand and pricing level of goods and services.

In Euro area, inflation also is sliding, with Dec headline and core CPI confirmed at 1.6% yoy and 2.1% yoy, ECB has cut rates 50bp to 2% and left the door open to additional easing in March when new staff forecasts will be presented. In Japan, the most striking release of macro data was the collapse in Japanese machinery orders in Nov (-27.7% yoy), which along with similar index from US and Germany, pointing to 44% decline in G3 orders on a QoQ basis as of Nov2008 vs. a 16% decline in shipments. In China, some key measures of economic activity, including exports (-2.8%) and imports (-21.3%), have been quite weak recently, adding to fears that an important engine of global growth is misfiring. However, the Dec uptick in Chinese M2 (+17.8%) and loan growth (+18.8%) provides certain optimism that monetary policy stimulus may be starting to kick in. I think it is premature to conclude that the Chinese economy has passed the phase of maximum weakness, as growth in the major economies slumps.

All these macro forces are posting challenges to stock selection. Globally, corporates are facing a potent cocktail of credit contraction, rising unemployment, over-capacity, battered confidence and a potential fundamental change in consumer spending habits. On the flip side, margins will slowly benefit from the fall in inputs, wages and interest costs, but these all take times to be reflected in the bottom line and the current issues is demand.

Credit Easing vs. Downgrading

Based on 13Jan09 speech, Chairman Bernanke has been crystal clear on what the Fed policy is looking to accomplish -- credit easing vs. quantitative easing…”The Fed’s approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006”…”Credit spreads are much wider and credit markets more dysfunctional in US today than was the case during the Japanese experiment with quantitative easing. To stimulate aggregate demand in the current environment, the Fed must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally”… In other words, it isn't quantitative easing, it is "credit easing" they are focused on... With already 53X gearing at Fed’s balance sheet, it argues for purchase of corporate bonds at some point, as with funding issues fully vanquished, spreads (and not the size of its balance sheet) are the only metric that the Fed is focused on…

However, I believe if 2009 goes horribly wrong, it's probably because of a destabilizing run on a major currency/ a government bond market than because of a wide scale corporate defaults. Over the week S&P affirmed AAA ratings of US, while noting that risks are rising. The US creditability and USD trend is important because a weaker US$ is unquestionably better for Asian equity markets than a stronger dollar. However, S&P’s warnings on Spain, Greece and Ireland debt rekindled discussion of the tail risk event for EMU breakdown. S&P said it may cut Portugal’s AA- credit rating. As a result, the spread between benchmark 10yr German Bund yields and other Euro zone yields exploded to new records, i.e. the Portuguese/Bund spread jumped to 113bp. Moreover, S&P downgraded its outlook to New Zealand's foreign currency rating, currently AA+ (one notch below the top level), to negative from stable. Essentially, the ratings agency is highlighting the risk that New Zealand's very large current account deficit (8.6% of GDP) could potentially dissuade foreign investors to continue to invest in the country…So stay tuned..

What History Tells Us?

There is universal consensus that the economic outlook is terrible, probably as bad as it has been since World War II. But what exactly it means in the historical context? Here I did some comparison…The worst post-war recessions were in 57-58, 74-75 and 82-83, during which US real GDP fell 3.7%, 3.1% and 2.9%, respectively. In these recessions, NFP fell 4.4%, 2.8% and 3.1% 3.4%, respectively. So far, payrolls have fallen 1.9% from the peak. So in GDP and job terms, we might only be about half way through.

However, the earning decline has already been very severe. As of 3Q08, non-financial earnings of S&P were down 21.4% from the peak. How does this compare? In USD terms, peak to trough, non-fin profits fell 21.1% in 73-74 and 22.7% in 82-83, respectively. So the current profits recession is already up there with the worst “recessions”. However, non-fin earnings fell a whopping 45.6% in 00-01. Thus 2000-01 was the worst recession for corporate earnings. So it seems there is not a strong link between the severity of GDP recession and the severity of profits recession. In addition, historically financials were only hurt in 81-82 recessions (-53%) and fell 40.1% in 90-91. In the current downturn, fin earnings were down 36.9% as of 3Q08.

But the real question is would earnings lead this recession, just like what happened in the 74-75 and 80-81, or lag the trough in GDP just like what happened in 90-91 and 2000-01? I think the later one is more likely as FY2009 consensus forecast is still on the optimistic side and the great unwind of shadow banking system has a long way to go. Lastly, valuation wise, MSCI China is now traded at 9.6XPE09 and 4.1% EPSG, CSI 300 at 13.7XPE09 and 5.8%EPSG, and H-shares at 9.1XPE09and 2.4%EPSG, while regional market is traded at 11.2XPE09 and -11.2% EPSG…

It Is In Nobodys Interest

History shows that following the bursting of a credit bubble, policy makers can either deflate their economies or devalue their currencies. During the 1930 Great Depression, the UK devalued Pound in 1931 and the US devalued Dollar in 1933. Industrial production was quicker to recover for these early movers compared to the gold-standard holdouts like France. In1990s, quick currency devaluations in Sweden and Finland following the bursting of their credit bubbles fostered rapid economic recoveries. In contrast, the Japanese economy languished as BoJ was slow to ease policy after the real estate/equity bubble burst at the end of 1989, and YEN strengthened until mid-1995.

Since the financial crisis first erupted in 1H07, US authorities have been reactive rather than proactive, unable to get ahead of the curve. But as the gravity of the economic malaise finally sinks in, policy makers now move to a "whatever it takes" of mindset. In fact, it is in nobody's interest for USD to collapse for three reasons --- 1) USD crisis would be associated with rising US rates, undermining economic prospects not only in US but around the world; 2) foreign governments do not want their currencies to appreciate sharply, given weak demand and growing risks of deflation; 3) no one wants the value of their FX reserves to collapse. Historically, in the post-Bretton Woods period, central banks have consistently stepped in to prevent USD crisis, I think they will do it again and this underpins the view of a gradual decline of USD.

[Appendix]

US Dollar and Asian Equity --- The US$ index is now sitting on an exact 61.8% retracement of the move down from late Nov. The Dollar trend is important because a weaker US$ is unquestionably better for Asian equity markets than a stronger dollar. This is so because a weak dollar is reflationary (FX intervention when the dollar is weak creates US$ liquidity, i.e. boosts the global supply of US dollars. Also the intervention boosts the money supply in intervening countries to the extent that it goes unsterilized.). By contrast, a strong dollar is deflationary. Since global FX reserves now dwarf the US narrow money supply, movement in the dollar tends to be the most important driver over the medium term of global US$ liquidity conditions. I do not want to see this strengthening trend in the US$ persist.

Corporate Default rate --- Corporate liquidity shows that pure Corporates are far less indebted than Households and Financials. Their short-term liquidity (in 2009) is not a major issue and on aggregate well covered by cash, expected free cash flow and available credit facilities. If the economic slump continues into 2010 then liquidity will start to become a problem. However, current credit spreads more than price in such an outcome anyway. Corporates do have some time for authorities to get things `right'. Defaults by corporate borrowers worldwide may rise to 15.1% in the next 12 months as economic conditions turn more “perilous,” according to Moody’s. About 300 companies will fail to meet their obligations this year; equivalent to a rate of 25 a month, New York-based Moody’s said in a report today. The rate was 4% at the end of 2008. Moody’s last month forecast a global default rate of 10.4% for the end of 2009.

EMU Credit rating downgrade --- S&P warnings on Spain, Greece and Ireland debt rekindled discussion of the tail risk event for EMU breakdown. S&P also said it may cut Portugal’s AA- credit rating. The first thing that happened was in bonds. The spread between benchmark 10-year German Bund yields and other Euro zone yields exploded to new records. Spain's yield spread versus Germany jumped 10bp to over 100, as did the Greek/German spread to 245bp, the Portuguese/Bund spread to 113bp and the Belgian/Bund spread to 98bp. Even the French/Bund spread hit a new Euro lifetime high of 58bp. These spreads moved into the CDS market - 5yr Spanish sovereign CDS were quoted at 109bps for example. That leaves the market hunting of cheap ways of expressing a black swan risk – and the EUR was the clear victim as it broke the key 55-day moving average at 1.3215 and ran to 1.3140 today with many now calling for 1.30 and 1.27 in short-order.

The past Recessions -- The worst post-war recessions were in 57-58, 74-75, 82-83 and 53-54. From peak to trough, US real GDP fell 3.7% in 57-58, 3.1% in 74-75, 2.9% in 81-82 and 2.7% in 53-54, respectively. In these recessions, non-farm payrolls fell 4.4%, 2.8%, 3.1% and 3.4%, respectively. The most severe post-war recessions for employment loss were 1945-46, when employment fell 10.1% and 1949, when employment fell 5.2%. More recently, the 90-91 and 00-01 recessions saw modest GDP declines of 1.3% and 0.4%, respectively. The Q4 GDP data will likely show a peak to trough decline of about 1.4%. So far, payrolls have fallen 1.9% from the peak. So in GDP and employment terms we might only be about half way through or slightly less. However, the profits decline has already been very severe. As of Q3, non-financial corporate earnings were down 21.4% from the peak. They might be down 25-30% when the Q4 data is released. How does this compare? In dollar terms, peak to trough, non-financial corporate profits fell 28.8% in 57-58, 21.1% in 73-74, 22.7% in 82-83 and 26.3% in 53-54. respectively. So the profits recession is already up there with the worst “recessions”. However, non-financial earnings fell 20.2% in 90-91 and a whopping 45.6% in 00-01. Thus 2000-01 was the worst recession for corporate earnings. There is not a strong link between the severity of GDP recession and the severity of profits recession.

Financials earnings are even less linked to the severity of a recession. Financials earnings did not fall at all in 57-58 and fell just 2% in the 53-54. They fell 9.6% in 74-75 and 53.1% in 81-82. Thus, financials were really only hurt in the 81-82 recession. Financial earnings fell 40.1% in 90-91 (the trough came in 92) and by 9.8% in 00-01. Financial earnings fell 18.3% in 1998, and 24.5% in 2005. In the current downturn, financial earnings were down 36.9% as of Q3 2008.

With the exception of the 74-75 and 00-01 recessions, post war recessions have troughed within 2-3 quarters, usually two. This one looks like lasting four. Financial earnings have become increasingly volatile relative to earnings in the non-financial corporate sector. In summary, when we get the full data for Q4, it will likely show that this is already the worst post-war recession for financials earnings and already close to the worst recession for non-financial corporate profits. The recessions in GDP and employment will likely look as if they have a two more quarters to run. It looks as if earnings have led this recession. This was what happened in the 74-75 and 80-81 recessions. In the two more recent recessions of 90-91 and 2000-01, the trough in the profits recession lagged the trough in GDP by several quarters. That experience might be coloring current market sentiment and might affect how the equity market trades through weak GDP and employment data in coming quarters.

Good night, my dear friends!