My Diary 511 --- The Mark of LIFO& FILO; A Bigger Concern Ahead; Three Economy Watches; Everybody Likes Gold
February 8, 2009
“Winter Blues & Bounty Hunters vs. Dismal Economy & Obama/China Packages” --- Chasing the beta over the week looked to me like someone wants to shoot his way out of the winter blues, given a majority of WTE economy data, performing as the past bounty hunters, trying to find gold buried under the Obama and China stimulus packages. That being said, I think the big picture remains US and major DM countries are hit badly by a homegrown housing-banking-consumer recession, which lately has caused global exports imploded and EM economies weaken markedly.
In real terms, the 3.8% yoy decline of 4Q US GDP did not provided any reason for optimism as to most consumers and companies; it is the trend of nominal values that matters. In nominal terms, consumer spending declined at 11% yoy in 4Q08, the largest contraction since the 1930s. Thus, I have to say that deflation is not a risk, it is a reality, considering that demand, profits and asset prices are all contracting in nominal terms - which are the more important indicators than CPI. In any case, CPI is also in deflationary territory, down 13% yoy in the final 3Ms of 2008. It appears that after two decades of disinflation in 1980-90s and low inflation in the past 10 years, US finally comes to a deflation world…Fortunately, policymakers are already very aware of the severe deflationary risks and negative economic feedback loop from a soaring UNE rate .The magnitude and breadth of global policy support continues to increase. Over the past few weeks, I saw Australia announced an additional fiscal stimulus (1.5% of GDP) along with another 100bp rate cut. In Japan, BoJ announced YEN 1trn equities buyout program for troubled banks. In US, Senate is due to vote on a $780bn economic stimulus package that President Obama needed to prevent a deeper recession. Meanwhile, Asian nations from China to Singapore and India have pledged >$685bn on their own spending programs. In addition, global central banks maintained their easing cycle today with rate cuts in BoE (50bp), SARB (100bp), Czech (50bp), Norway (50bp), Indonesia (50bp) and Romania (25bp). The ECB paused, but Trichet indicated a 50bp cut next month.
Moreover, US SEC is considering the possible changes in its MTM accounting rules and FED extends five of its liquidity programs for another six months. This latest moves are designed to give more time for companies to adapt to the new economic environment. But my own view at this stage is that central banks cannot reverse a crisis anymore, suggested by market performance since Nov2008. The sums of losses are simply too vast for Bernanke and his global peers to meaningfully bring back the markets or the economy in a few quarters. On the other hand, government support is meant to be temporary, aiming at reopening credit markets and coaxing back private buyers. Question is how long can the government continue to support the asset prices? Obviously, it can not do it forever. The longer the government intervenes, the more investors will question its capacity to continue buying. But, for now the Fed shows no signs of backing off. The best example for continuous government intervention is that both UK and US are considering establishing a "bad" bank as a means to speed up the healing process in their financial systems. As the Swedish example shows, official recapitalization and removing troubled assets from B/S are critical ingredients for returning banks to health. However, I would argue that the healing process will still take time, given three challenges ahead of the programs being implemented – 1) how to value the toxic assets on bank balance sheets; 2) how to choose which assets to take from these open institutions; 3) even the above 2 issues solved, banks will not suddenly be willing to expand their B/S, given the macro economy and micro earning recessions. Thus, monetary authorities have to keep providing direct funding facilities for both consumers and businesses and lower private sector borrowing rates in order to bolster economic activity.
All these proactive government reactions seemed at least give the markets some sort of hope. It is interestingly to observe that markets have start to rewarded growth as most people fear deflation over the costs inevitable inflation. 10yr UST yields have been ripping higher since the mid-Dec lows. The 90bps rally is a combination of concerns over the upcoming massive supply and a secondary bet on economic conditions may not so bad. What cause my attention is that other markets are beginning to reflect that idea as well, including a bounce back in oil (+19%) and copper (+23%) prices since mid December. So did BDIY index. However, I think the recent surge of gold seems more due to currency reserves switching than inflation concerns. Additionally, the ~35bps spike in 30yr Fixed rates and 83bp in 30yr UST won’t help mortgages or get the economy back on track. This also leads me to think about EMs, as it seems the major threat for the recovery of growth in this space is not just trade protectionism, but also about financial protectionism as pointed out by Gordon Brown
As usual, let me look back to the market over the past 5 days before thinking forward. Globally, equities jumped 2.5% from last Friday (-3% ytd), with +5.1% in US, +1.1% in Japan and +4.74% in EU. Notably, ytd EMs are up 1.1% vs. a 3.6% decline in DMs. Elsewhere, 2yr UST gained 5bp this week to 1.00% and 10yr moved up15bp to 2.99%, both at their highest yields since late Nov. 1MWTI oil declined to $40.17/bbl, down $1.51 this week, and lower $4.43 since the end of 2008. USD closed +2.2% against YEN to 91.9, but down 1.1% vs. EUR to 1.294.
Looking ahead, I still hold the view that deflationary aftershocks continue to plague the world economy and financial system. The market consensus seems to underestimate the length of this economy/banking recession, while overestimate the speed of growth recovery and inflation risks. I think the authorities have moved too slowly in 2007-08, and thus now a self-reinforcing collapse has taken hold with weak demand fuelling through unemployment. This has crushed job security and will sustain the pressure to lift household savings to the detriment of consumption. Put it together, it suggests a long road out of recession, even if conditions start to stabilize by 2H09, which implies deflation pressures will persist and the background for asset markets remain poor, if deflation cannot be reversed. My still bearish or cautious outlook is based on several observations below.
Firstly, the banking problem won’t go away quickly as it is now a global issue. Just take a peak of the exposure of Western banks to EMs, one will catch my concern. So far, the proposed solutions including rate cuts, the increased fiscal spending and the jump in government deficits all resulted in only one consensus, which is using gold as an alternative currency. Secondly, as Niels Jensen said, currency devaluation would not help troubled economies like UK and Italy in 1970s. Back to then, there was less economic integration and recessions were rarely global. Devaluations could therefore be used to stimulate exports. The situation today is fundamentally different. Thirdly, according to a recent research paper (by Carmen Reinhart and Kenneth Rogoff), following a banking crisis, asset prices fall more and for longer than most investors realize. On average, real house prices have dropped about 35% over a period of 6 years. Stock markets have lost 56% on average in real prices over nearly 3.5 years. The economy hasn’t fared much better. On average, it has taken almost 5 years before employment has started to grow again and about 2 years for the economy to stop shrinking.
Indeed, this historical works match well with the harsh realities of global economy – 1) Job cuts from financials, retailers and manufacturers suggest that millions more are likely to loose their jobs; 2) Lower earnings guidance and shrinking business Capex suggest that real economy and corporate earnings aren't near a bottom; 3) Loan data suggest that credit, despite extraordinary actions taken by Fed, remains tight. All sum up, I think from the global perspective, China remains the primary choice, rate cuts are the second hope, and more fiscal spending the third. In the mid-term, I think the markets may find that the squeeze of public over private debt will cause real interest rate spike high enough so that we may see another round of deleveraging…As Irvin Fish described in 80 years ago, there is just no easy way out of the debt deflation.
The Mark of LIFO& FILO
The BTE 4Q GDP, due to a modest rise in inventories, simply means that 1Q09 GDP decline will be WTE. Such a bad feeling also based on data flows which continuously look terrible, including jobless claims (626K), factory orders (-3.9% mom), NFP (-598K) and UNE rate (-7.6%), all suggesting that 4Q weakness will continue into 1Q. Given that there is no bottom in sight for payrolls, labor and income insecurity will continue to keep consumers from spending. In fact, US real consumer spending has fell 2.9% in 4Q08, despite a continued rise in real disposable income. As a result, the personal saving increased to 3.6%, a level not sustained since the late 1990s. Other big consumption items reflect the same gloomy picture. At a 9.5mn run rate for vehicle sales, not only will US have to shut down more plants, but also one start to guess how long it will be before GM & Chrysler go begging again? On a yoy basis, sales plunged over 40% for GM and Ford and more than 30% for Toyota. In addition, the bad news of housing remains supply – home vacancies are at the highs, home ownership participation rate drops to 8 years lows and the renter vacancies top 10.1% - all point to almost 2mn homes of supply. According to BCA Research, all these inputs of Phillips Curve now suggest that, the output gap in US would expand to a peak of -6% by the end of 2009, the largest amount of excess supply in the post-war period except for the 1982-83 period. It takes more than a year after that to restore a positive output gap, even with an aggressive assumption about the pace of economic recovery.
The rest of major economies also continue to churn out dreary data. Germany factory orders lost 7% mom in Dec08 and 18.5% in 4Q08. In Japan, Dec employer’s survey showed that labor income growth is grinding to a halt, reflecting a simultaneous slowdown in the growth of employment and wages. With the economy collapsing, this trend is set to intensify. Looking at December, data from US, Germany, France, and Japan not only showed substantial declines in consumer spending, but also the additional confirmation of a deeper downturn in business spending in G3 counties. Capital goods orders in G3 were down 44% yoy in the three months to November. In addition, the labor market adjustment also is broadening its reach beyond the US, as UNE rates have started to climb across Europe and Japan (-4.4%). That said, firms outside of US were slow to respond to the downturn in demand and have a lot of job shedding to do in coming Qs. The collapse in global goods demand and the deep declines in IP have led to a plunge in manufacturing capacity utilization. In EU, utilization nosedived 6.4% points to 75.2% in the 3Ms to Jan09. In US, capacity utilization stands at just 70.2%. The prospect of a lengthy period of above-avg UNE and below-avg manufacturing utilization is going to be an important factor in the inflation outlook in 2009-10.
For emerging markets, recently IMF cuts forecast for Asian growth to 2.7% from 4.9% two months ago. The move came after Australia and Japan announced their new stimulus measures. I think most EM Asian economies which suffered domestic banking/economic crises in 1990s are now better positioned to weather the storm and recover. Back to then, China managed to grow fairly well in Asian Finical Crisis. In fact, China was one of the first economies to emerge from the downturn early this decade and even accelerated before US recovered. This past record gives the confidence to people who believe that Chins/ EM world being in a LIFO position, whereas US/DMs will be FILO.
A Bigger Concern Ahead
The January Fed’s SLOS shows that a large number of US banks continued to tighten lending standards in the past 3 months, although the % generally edged down. For larger firms, the % of banks tightening standards for COM/IND loans dropped to 64.2% from 83.6% and for smaller firms from 74.5% to 69.2%. Moreover, the majority of banks again reported loan demand was extremely weak with the net percentage for large and medium-sized firms fell to -60.4% from -16.7%. Interestingly, banks overwhelmingly blamed the worsening economic outlook, rather than capital adequacy, as the main reason for additional lending restraint. On balance, this latest data imply that the credit crunch is still in place. Thus Obama and his team will continue to draft news plans to free up the credit markets and restore some functionality to financial intermediation. But there will not be any early return to easy credit. Given such a backdrop, I do not expect a quick snapback in economy growth, and thus I think the backup in government yields is unsustainable. The US stimulus package will help limit the depth and length of US and global recessions, but private sector borrowing rates are still too high and must come down in order to reinforce the fiscal expansion. As a result, it seems high-quality non-government credits should be focus of duration exposure.
But I think the bigger concern ahead is the rising sovereign default risk, suggested by the rising CDS spreads sovereigns and the recent divergence between gold prices and the EM currency basket. Over the past few days, S&P downgraded the sovereign ratings of Spain (to AA+ from AAA), Greece (to A- from A) and Portugal (to A+ from AA-). This has led to a widening of interest rate spreads within Euro Zone. In my own views, I do not expect any country to leave EU, but there is likely that one country could default its sovereign debt. Other rating agencies also followed the tide. After S&P, Fitch also downgraded Russia to BBB with outlook negative. Moody’s changed Ireland’s AAA rating outlook to negative and that has encouraged EURUSD lower as credit ratings will remain a key factor in the FX market. In Asia, Fitch recently revised the outlook for Taiwan’s and Malaysia’s LT local currency rating to negative from stable, based on the expected worsening of both countries’ fiscal positions due to the economic recession.
The recent wave of EM sovereign rating downgrades is definitely an overhang for HY spreads (HY Asia +40bp wow to 1505). According to Professor Altman, a multiple regression analysis shows the default rate in 2009 could be as high as 11-15%. This seems in line with a KPMG report that suggested as many as 5000 U.K. companies may file for bankruptcy in 2009, a jump of 55% from 3225 in 2008. In Asia, debt refinancing will be a key issue within the next 12 months, as around $800mn of CBs will come due. As offshore credit markets remain volatile and illiquid, refinancing through new bond issuances looks very challenging. This implies that the best time to buy HY debts won't arrive until later this year or even 2010. At the meantime, any concerns about an issuer's ability to service or redeem bonds could weigh heavily on stock prices.
Three Chinese Economy Watches
The S&P 500 closed on Friday at 868. Earnings side, profits decreased 41.6% for the 236 companies out of S&P500 that released 4Q08 results since 12Jan. EPS estimated (06Feb2009) is now downward adjusted to $41.88, $6.64 less than it was in October 14, 2008. That makes the PE ratio at 20.7X, which is by-no-means cheap relative to historical average. Nonetheless, the risk for market re-rating can not be ruled out as earnings could be WTE for the coming quarters and investors could simply despair in this summer. In Asia Pacific region, earnings expectations remain low as well, with 3M ratio of earnings U/G-to-D/G plunging to a new record low of 0.27 from 0.30 in January. Meanwhile, 2009 earning guidance looks too optimistic to me with +5% for Korea, 6.5% for China and -7% for AxJ. For China market, if current ROE (15%) falls back to the level of last cycle (9-10%), it means that EPS09 could fall another 15~20% at least.
Regarding China, CNY retails sales has been released which on average is 6.6%, lower than 13% growth in 2008. Fundamentally, I think retails sale will continue to slow down, particularly in the Tier-1 cities given the surge in unemployment causing by a sharp slowdown in economic growth (13% in 07 to 6.8% in 4Q08), the shut-down of export-oriented manufacturing and a slowing property investment/ construction activities. I think there are three critical macro trends to be watched in the coming months – 1) Corporate investment, which is a key variable to Chinese economy as capital spending accounts for >40% GDP. Some analysts estimated the lost capital spending this year could be as much as 15% of annual GDP due to profit decline and retain earning is one of the key sources of capital for business spending over the past three years. Weaker private-sector investment means China's growth this year will be even more dependent on the success of the government's big spending plans; 2) Corporate profit, which is likely to be quite bad, given the gloomy global and domestic economic growth. Broader official surveys back up the trend. Profits of industrial companies plunged 27% in 3Ms Nov08, a sharp reversal from a years-long string of 20-40% growth. Recently, a string of dire profit warnings has also signaled a rapid deterioration of earning outlook. Companies, in particular blue chips like CSCL and CIMC have warned profits for 2008 fell +50%. Businesses focused on China's domestic market are also in trouble. SAIC Motor and Angang Steel warned of a profit decline of >50% on weaker sales. China Life hammered by the stock market decline and tougher competition also expects a +50% drop in profits; 3) Bank credit, which is viewed as a LEI of economy. China's bank loan growth rebounded sharply in the last 3Ms to Jan09 with outstanding credit up by nearly 20% yoy. But I think this loan surge won’t last long, based on my past experience in CCB. Normally, Chinese banks grant 40-60% of whole year loan quota in 1Q, not mentioning that there is a long list of delayed projects due to the PBOC’s credit quota control in 2008. In addition, to these listed banks, earning pressure with push them look for volume growth as they face the squeeze of interest income and rising provision,
However, China is now a crowded OW and A-shares over the week have been buoyed by expectations of continued policy support, a liquidity boost from govt funds buying, the asset relocation from bonds to equities by domestic PMs and the leakage of funds into equity markets following the surge in new loans in Jan. But without fundamental improvement, this sounds to me like a short window of trading opportunity prior to new found of macro data and earnings release in March. Lastly, valuation wise, MSCI China is now traded at 10.8XPE09 and 2.5% EPSG, CSI 300 at 15.5XPE09 and 6.4%EPSG, and H-shares at 10.4XPE09 and 0.5%EPSG, while regional market is traded at 12.3XPE09 and -7% EPSG…
Everybody Likes Gold
Global FX markets remain focused on three key factors --1) global recession risk, 2) massive fiscal and monetary stimulus, and 3) increasing focus on bad news outside of US. As discussed, exchange rates have been driven by individual sovereign risk, excluding US due to USD's reserve currency status and liquidity premium. Indeed, USD and YEN are the out-performers over the past few weeks, and virtually all other currencies are being sold. In general, renewed strength of USD is not a sign that US growth is relatively better than elsewhere but rather a signal that US policy reflation is not yet biting. Historically, during the aftermath of the tech bubble, the Dollar was unresponsive to aggressive Fed easing until 2002, when policy started to gain traction. Dollar weakness was also associated with an eventual bottom in the equity market and a cyclical economic recovery. Today's dollar strength, coupled with the plunge in equities, is sending a clear message: policymakers remain behind the curve. Correspondingly, policy announcements over the coming weeks will prove pivotal. In the bear-term, I think USD and JPY will remain well supported versus major currencies due to global recession risk, investor repatriation, converging monetary policies, and increased focus on bad news outside the US. In particular, JPY may rally to 80 per dollar by March, the strongest level since April 1995, as a credit crisis in US and Europe increases its appeal as a reserve currency, according to Barclays Capital. That percentage may rise to 10 percent as central banks and governments convert $150 billion into YEN said Toru Umemoto, chief currency strategist at Barclays in Tokyo
Gold has been the focus for everybody in the market. During the commodity bull and the early stages of last year’s pullback, gold prices moved with other resource prices, which in turn coincided with trends of USD. Since the failure of LEH on Sep15, 2008, however, gold has been able to rally despite USD strength and slackening jewelry demand. The potential for years of massive budget deficits, along with growing mistrust of the banking system among retail investors, is sparking safe-haven flows that are pushing up gold whatever expressed in USD, EUR and YEN. Most interestingly at this moment is the changing correlation of gold prices with fundamental forces. Gold is on the verge of becoming more than just a reflation barometer. For an increasing number of investors, the yellow metal is becoming a hedge against the debasement of fiat money in countries with devastated banking systems. This process is only occurring at the margin, but there are anecdotal reports that orders for physical gold are getting backlogged.
[Appendix]
In recent years, there has been a strong positive correlation between EURUSD and the BDIY Index, crude oil prices, and S&P500, and a strong negative correlation between EURUSD and 10yr yields on TIPS. This reflects that EUR is a pro-cyclical currency, whereas the USD is a countercyclical currency. Charts of EUR-USD and the Baltic Dry Index, crude oil prices, and S&P500 put ‘fair value’ for EU-USD below current levels. However, it is worth noting that the Baltic Dry Index, crude oil prices, and S&P500 all appear to have found a floor which could suggest that EUR-USD has limited downside risk from current levels. In addition, 10yr yields on TIPS, which peaked in Oct-Nov 2008 when deflation expectations were at their highest level, have come off. This signals upside risk for EURUSD from current levels.
Good night, my dear friends!
