My Dairy 527 -- A Milder Depression? Buy Gilts Sell Credits; Ch

My Diary 527 -- A Milder Depression?; Buy Gilts Sell Credits; China’s Money and Sector Outlook; The Floor of Euro and Metals

March 8, 2009

Living with Hope, Dealing with Reality and Searching for Bottom --- The March roared in like a lion as US and global equity markets continue to make new cycle lows. Looking back, I start to think 700 S&P is a line in the history soon and the ytd global market performance suggests that investors have doubt on what magic tricks govt/central bankers can use to stop the sliding ski-boards. This week, even after rate cuts (50bp) from BOE& ECB and their QE announcement, I saw no responses from asset markets --- equities -7.1%, oil +1.7%, gold up ~30$, 10Y -14bp. The liquidity injection does not work in a world rushing to deleverage, while the shaken market confidence and technical charts suggest I should be prepared for some more painful levels as a result of asset deflation. The new release of NFP (651K) and UNE (8.1%) on Friday simply reinforce the judgment of how much the market pain translated into the real economy, as h hourly earnings finally shows signs of weakening.

However, the desperate markets never give up hopes. Over the week, equity investors seems to believe in China Story underpinned by Feb PMI (49 from 45.3 in Jan) and the rumor of a possible doubling of fiscal stimulus…Well, the latter point is now confirmed to be wrong… In my own view, I think the current equity rally in China universe is at best tradable for a month or two, as the recent improvement in macro numbers was just a symptom of the policy-driven liquidity in the past few months. My argument is based on two observations --- 1) PMI: the latest release of IP activities, along with other anecdotes (like steel production, power usage, etc.) did suggest that China is somewhat stabilizing. But I have to say that the history of the PMI is short and its correlation with GDP is low. I just can not bet on PMI as the reversal point of the economy and corporate fundamentals; 2) Fiscal Spending: there are no major surprises from Premier Wen’s speech at NPC --- stimulus still at RMB4tn, fiscal deficit at RMB950bn (750bn for central govt, 200bn for muni bonds), M2 growth target at 17%, loan growth target RMB5tn. In the near term, my focus in on the disappointment risks of upcoming macro numbers - trade, IP, FAI, inflation, retail sales, and money supply in the next week. But for sure NPC is the most important policy focus window of 2009.

With hope bursting quickly, the markets returned to the cold front. The latest macro data flows verified that US economy “deteriorated further” in almost all corners of the country over the 2Ms09 as consumer spending slumped and manufacturing decline. ISM manufacturing report and other data suggest that there are more ST economic pain and that much of the inventory adjustment still lies ahead. This implies more production cuts, more layoffs and additional downward pressure on selling prices and corporate profits. Recovery has been pushed further as 10/12 district Feds didn’t expect a “significant pickup” until late 2009 or early 2010. Goldman Sachs economists are now forecasting -7% GDP in 1Q09 and -3% in 2Q, with UNE at 9.5% by year-end 09 and 10% by year-end 10…Pretty Nasty, right!...There is more to come as Uncle Ben said US may need to expand aid to its banking system beyond the $700bn already approved and take other aggressive measures even at the cost of soaring fiscal deficits…In numerical terms, this recession and financial crisis have prompted Fed to start a $1trn lending program and buy $600bn of housing debt, while Present Obama is betting the $787bn fiscal stimulus will reverse the economy’s slide…Well, I have my fingers crossed and I bet most of American are doing so as savings rate has jumped to 5.0% from 3.9% in Dec08. This is the highest pace since 1995 and I think the savings rate needs to go 3-5% higher in order to replenish battered 401K accounts.

The story did not end here ad it is not just US’ pain. The rest of world is converging rapidly as a proof of how integrated we are. The drop in Japanese exports to US at 53% in Jan and -6.2% US revised 4QGDP are nothing different from what I saw in India or Sweden. In fact, many see the global weakness as a return to the 1930’s and “beggar thy neighbor” devaluations in on its way. Perhaps the best measure of this fear remains gold which moved from $875 to $945 (8%ytd). In addition, w ith policy rates nearing zero across DMs, an increasing number of central banks are poised to join the Fed in "quantitative" or "credit" easing. That list now at least includes Fed, BOC, BOE, BOJ and ECB later probably… I think I am waiting for the so-called Depression being announced as I will only know it when things get there. Indeed, MSCI index dropping 14 of the last 15 days may have suggested “D” day is underway or should we wait for more evidence, like higher UNE and lower asset prices. But I did see IMF on 28Jan cut its forecast again for global growth in 2009 to 0.5% from 2.2%. It forecast a 2% slide in economic output from G3.

The chill of economy reality leaves investors looking for some dry hays in the raining days. They began this year expecting that the new US administration was pulling together a clear and actionable bailout plan for the banking system after the inauguration ceremony. They are disappointed as last week Bernanke said the banking system has not yet stabilized. And I think AIG and Citi has pulled the last penny of confidence as I can not see how long the US govt can struggle between sth "too big to fail" but too costly to save? With major US banks’ ratings downgraded by S&P or under review by Moody’s, one thing is clear that a second wave of credit problems has started, worsening the financial sector's capital shortage. Citigroup, which had a market value of $277bn at the end of 2006, has tumbled 98% since then, leaving it valued at $5.6bn. Some index analysts are talking about that financial companies may fall to 7% of the S&P 500 before losses in bank stocks end, extending a drop that already cut the weighting in half.

The searching for equity market bottom was officially clamed by President Obama who said that "buying stocks is a potentially good deal if you’ve got a LT perspective". I am not sure he is right or not as the records of politicians making comments on asset markets are very poor. Examples include India finance minister, Chidambaram, calling buy Indian equities Jan08 when the Sensex was 16K vs. currently 8427 and Lee KuanYew in Singapore saying that stock appeared cheap…What I learned from Warren Buffet over his 2008 Shareholder statement is that we (I'm) are only human and born to make mistakes! Guess if the world's best ever investment guru is making big investment mistakes in buying oil stocks last year and the world's safest and most conservative bank HSBC bought US Household by mistake, then we shouldn't be too upset at ourselves in making investment mistakes. Here I quote two investment principles I like the best – 1) “I liked you better before I got to know you so well” - on the General Re investment back in 98 but still applies to many companies at present, and 2) "It's not just whom you sleep with, but also whom they are sleeping with" - on counterparty risks of derivatives.

A long inks above and let me switch back to the markets as usual…Global equities closed the week 6.4% lower than last Friday and down 20% ytd. The MXWO index is now at its lowest level since 1996. Regionally, US lost 24% ytd compared to -20% in EU and UK, -19% in Japan, and -7% in the EM. Elsewhere, UST yields rose with 2yr, 10yr, and 30yr all gained 7bp to 0.96%, 2.88%, and 3.56%. YTD, the 2yr yield is up 19bp, 10YR up 66bp, and 30yr up 89bp. 1MWTI oil rebounded $2 on Friday to $45.52/bbl. Oil has been trading toward the upper end of its 2008 range ($34-49) over the last week. USD closed the week at EUR1.265 and YEN98.3. On a TW basis, USD has risen 7% ytd, compared to roughly 3% decreases in EUR and YEN.

Looking ahead, my concern is not the deteriorating global economy, but the momentum of its decline which is tracking the most bearish LEIs. If the real economy stays on this track, there will be further significant D/G to consensus economic and earnings forecasts. Beyond this broad picture, equity markets are at new lows and market conditions are arguably more favorable than last autumn, given the further advanced monetary and fiscal policies and the more appealing valuation metrics. However, I think these conditions, plus macro indicators, may suggest that the bear market is maturing, the bleak earnings backdrop will continue to create anxiety for investors. The road to recovery is still a long way unless I see the decisively turn-up of LEIs and the stabilizing of housing prices.

In the near future, I think there is high probability that a conclusive market sell-down could happen. Using the SPX as a reference, I think the next identifiable support levels below are from 1996 at around 633 -600, a level would hold for some time. Using Robert Schiller’s fabulous database, at 600, S&P would be down 50.5% from its 10YAVG. This compares with the 67.2% absolute decline in 1932 when we had deflation. In inflation adjusted terms, the S&P fell 59% from its 10YAVG in 1932. If the S&P fell to 600, the real decline in this bear market would be around 56%...But I am just an observer and human being! Who knows what is the next, but certainly this bear market is starting to get into very interesting territory. I think if S&P does get down to those levels, I would need to be wary of an aggressive move to QE by Fed…That said, with BBB credit spreads approaching 600bps again, and hence factoring considerable ratings drift, IG markets could turn very rapidly on an aggressive shift from Fed. As my long-held view, credit markets need to turn before I can claim a bottom in equities…Putting it together, from asset allocation perspective, I would continue UW Equities (40%), given the lack of a clear outlook for global economy, while maintain 25% weighting on Bonds, and OW Cash to 20%, with the rest 15% on Gold, leaving 0% on Commodities.

A Milder Depression?

The latest print of Fed Beige Book was more colorful than usual, using terms such as "broad based", "pronounced" and "steep" declines in economic activity. The report noted accumulating economic slack that has contributed to widespread retail discounting and some cases of outright reductions in labor compensation. Meanwhile, there was no improvement in the availability of credit, with CRE loans bearing particular scrutiny. Meanwhile, it is alarming that credit market conditions more generally have deteriorated anew in recent weeks and Treasury yields have backed up…Across the pond, European Commission survey highlighted that Euro-area economic, business (both industrial and services) and consumer confidence measures all fell more than anticipated in Feb to new historical lows. In short, business activity has collapsed, providing an ominous outlook for profits. Correspondingly, corporate cutbacks will ensure that the regional job outlook continues to darken. Indeed, regional unemployment rose MTE in Jan to 8.2%, further undermining consumer sentiment and spending.

In Japan, economy is falling into hell…IP plunged 10% in January and output has contracted a mind-boggling 25% in the past 3-months, exceeding the rate of decline in US production at any point during the Great Depression. Unfortunately, more pain looms in light of the spectacular surge in the inventory ratio, to the highest level on record. Firms will have to respond by cutting production sharply. In addition, this week’s export data reinforced how difficult the current situation is for Japanese producers, with overseas sales down 46% yoy. I think policy is unlikely to provide support in the near term for Japan economy…That being discussed, it seems to me that G3 or US economy has sunk into a milder depression. Although the recent economic indicators don't project a depression, economic data in 1929 didn't show that the stock market crash was about to lead to years of economic misery, either. The current downturn has many of the 1930s characteristics, including being primed by big stock market and real estate booms that turned to busts, at least.

Buy Gilts Sell Credits

One of profound changes to European bond markets is that BOE lately joined Fed and BoJ in quantitative easing, while ECB indicates it may follow. BOE lowered policy rates to 0.5% and announced £75bn of asset purchases to be carried out in the next few months, the majority of which will be purchases of medium and long maturity GILTS in the secondary market. The more traditional QE approach of the BOE, which is aimed at spurring bank lending, is quite different from Fed, which has established numerous lending facilities which bypass the banks to directly improve the availability and terms of credit to the nonbank sector. As a result, Gilts are posting huge gains with 10yr yields crashing through the early Jan low of 3.20%. The focus is back on 3.00%. meanwhile, the short-end has been left in the cold, partly because these maturities are not in the current QE remit, whilst very short maturities don"t really have anywhere to go with yields down at 75bp already.

With good news circling around govt bonds, credit markets are bracing for a new round of downgrades for financial names, including GE, banks and insurers in AA area that used to be regarded as solid. Over the week, JPM ratings outlook was cut by Moody’s to negative from stable. Moody’s also said it will review LT debt ratings of Wells and BOA on concern higher credit costs may damage capital ratios. S&P downgraded JPM, Wells and BOA, along with 11 other banks on 19 Dec and cut BOA again. AA rated insurers also watched their rice drop after S&P downgrade 10 life insurers on the prospect of further investment losses. As a result, I saw local benchmark credit spreads widened amid low liquidity. The iTraxx Asia IG10 added 30bp to 465bp and HY closed 30bp to 1350bp. The CDS sub-index of HSBC FCI hits all time high over the week, reaching 3046 vs. its October high print of 2609. With realized default rates are forecasted to hit 16%, higher than it was in 1930s, I would sell HY credits in near Term.

China’s Money and Sector Outlook

The CIO of Invesco AxJ, Paul Chan, has a great comment on the problem of forecasting S&P500 profits --- it is everybody's guess when it comes to S&P estimates for 2009, because of the enormous uncertainty surrounding financial sector earnings. Indeed, according to BBG, earnings at the 466 companies in S&P500 that have reported since 12Jan dropped 58% on average. But analyst forecasts see a wide confidence band for 2009-2010. Bottom-up analysts are forecasting EPS $67 for 2009 and $80 for 2010, while Top-down analysts, in contrast, are projecting just $48 for 2009 and $47 for 2010. Personally, I am more inline with top-down assumptions as these are at least more consistent with the contraction in US and global GDP this year. And one thing for sure is that before I see LEIs are hooking up, both bottom-up and top-down analysts will continue to cut their 2010 earnings estimates.

Talking about economy recovery, Premier Wen said that stimulus package in China is taking initial effects as suggested by some indicators, such as power demand (+13.2% MoM) and the rising share of consumption/GDP (from 38% in Nov08 to 45% in Jan09). However, in my own view, I think these are still tentative signs. To sustain the current economic recovery, China needs to do more on domestic consumption and to prevent deflation expectations, as exports and external demand are yet to see the worst. As a result, I am happy to see the re-allocation of China stimulus spending, including low income housing (+120bn), infrastructure (-300bn), health care & Edu (+110bn) and innovation (+210bn). I think these adjustments are aligning with the LT structural reforms China has started.

Sector wise, if market believes in a further improvement of PMI, I would OW H-share banks as banks loans and earnings are highly correlated to GDP, which is the lag indicator of PMI, as well as valuations are acceptable at 1.2PB09 on avg. In contrast, I remain cautious on real estate sector based on policy coldness and inventory overhang. That said, I am not surprised that real estate is missing from the list of the 10 industries t revival plan, and it is clear now that central govt's goal is to boost volumes of mass-market, but not the price. I think the govt is right on this policy gesture as official statistics showed inventory (sell-approval obtained) at BJ, SH, GZ and SZ are 148K, 166.6K, 142K, and 532K units respectively and SH & BJ’s total sellable area is 39.55mn sqm in total. According to 2008 sales volume, and not considering new projects to be finished in 2009, currently inventory period is 2yr for BJ, 4-9mths for SH, 3-5mths for GZ, and 1yr for SZ. Moreover, Centaline said top-10 developers are holding inventory of 19.72mn sqm, or about 13mth sales. Assuming they have 10% market share, national inventory is ~200mn sqm. Regarding energy and raw materials, I remain bearish in the near future as over-supply/capacity is still the problem and stimulus plan can not reverse the cycle amid property and auto sectors immediately. In the physical markets, I observe steel and coal price are still trending down with Baosteel just cutting April contract price by RMB200/ton, while spot coal price is expected to down by 10-20% in the following months amid low season. Local headlines showed Big-3 oil names are under price war across major cities in order to sell more diesel and gasoline.

Valuation wise, with H-shares falling by 25% from the Jan highs, its historical PE for H shares has once again dropped to just 8.7X vs. 6.6X during 27October low. The historical DY has also risen to 4.6%. Regional wise, MSCI China is now traded at 10 XPE09 and 0.3% EPSG, CSI 300 at 16.5XPE09 and 7.7%EPSG, and H-shares at 9.8XPE09 and -2.1%EPSG, while regional market is traded at 12.1XPE09 and -9.1% EPSG.

The Floor of Euro and Metals

The recent driving factors in FX markets was dominated by the asset market developments and credit issues/concerns as traditional growth and IR influences have been diminished given that many countries are converging towards zero at the very front end of the curve. Having said so, stock markets obviously remain the critical focus for everybody including currency traders. However, given the severe stresses in US and global equities, and the presumed support for the safe-haven USD, it is interesting to observe that EURUSD has not made new cycle lows alongside the new cycle low in stock prices. Indeed, EURUSD has not even broken 1.2510 support established just recently on18 Feb. I think it is perhaps just a matter of time for us to see the 1.25 level gives way. My rationale is the problems in EU and Asia have gotten a lot more attention recently, pressuring their currencies in the process. Meanwhile, EU leaders are unable to agree on some type of coordinated aid package for CEEs, as well as a more pronounced shift to QE by ECB, if deflation advances.

Moreover, with the big picture in mind, I think it is too early to buy base metals or energy despite low prices. The bounce of BDIY earlier is a hopeful sign instead of the stabilizing demand for commodities. The uptrend of BDIY has not been sustained, nor has been confirmed by other broad-based leading economic and trade indicators. In addition, the recent tentative recovery of Chinese PMI components (export and IP) also point to a glimmer hope. In short, both supply cuts and demand from China have perhaps put a floor under some commodity prices, but these +ve factors on their own are not enough to spark a bull market.

Good night, my dear friends!