My Diary 546 --- The Signs to Watch; Three Reasons to Bid

My Diary 366 --- The Signs to Watch; Three Reasons to Bid; Where to Place Bets; Gold Is Not “Good”

April 5, 2009

“The April Rally: cycles will turn, sentiments will change, and dawn will follow dusk” --- Like it or not, it is just smell like the last April when risky assets rallied all around and later petered out with new lows. Overall, the markets are single-minded focusing on +VEs and desensitised to -VE news, evidenced by markets rallying despite US housing prices fall 19% (largest ever drop), consumer confidence (26) come in WTE, Japan Tankan outlook (Mfg=-51, nonmfg=-30) showed the shocks and President Obama saying bankruptcy is the best way for US autos. In my own view, the difference between this April rally and last one is that the world is at a much lower base now in terms of prices and economic activities…Having said so, over the week global equities edged up 3.3% (+20.3% in 4wk), with +3.26% in US, +3.78% in EU, +1.42% in Japan, and +4.36% in EMs. Elsewhere, UST yields increased this week with 2yr rose 4bp to 0.95% and 10yr ran up 12bp to 2.89%.1MWTI oil finished nearly unchanged from last Friday at $52.51/bbl. On a TW basis, YEN moved down 2.5% this week and USD slid 1%, while EUR was flat. The Dollar closed the week at EUR1.349 and YEN100.3.

Indeed, I dare not to say market is wrong as some leading indicators seemed to have bottomed, including US ISM new orders index, which rose above 40 for the first time in 7 months, although this has not fed through to production as firms struggle to get inventories under control. I feel that the market focus has shifted to whether or not a positive 2H growth will provide the base for a solid recovery next year. However, I can see while some may find comfort in an ISM bottoming sign, others will fear the rising UNE rate. The confusion rests with whether the stimulus and easing plans of central bankers will continue the natural power of business cycles to self-correct. Many professional economists like Dr. Roubini held a firm belief that real economy which is still in severe recession. They argue that the ability for the world to get out of this economic crisis will require more than the action plans of China and the US.

With doubt and confusion in the investors’ mind, politics are understandably returning to be a bigger consideration as the world tries to see beyond the present pain. I agree with the view that all of these signs of economic stabilization are very tentative, and could easily turn out to be a false start. Nevertheless, I have to give some credit to policymakers around the world for their extra effort to combat debt deflation and confront recession. So far, it seems that the Great Recession of 2008 is in a transition phase from a self-feeding downward spiral to a moderating decline. Other notable achievement by politicians is the G20 agree to give the IMF a 1trn warchest - tripled its current arsenal (750+250SDR). This should help to contain any perceivable EM meltdown and contagion. As such, EM spreads collapsed as both Mex and Russia 5yr CDS tightened 35bp immediately after the announcement. Beyond that, FASB changes the rule 157 by allowing companies to use "significant" judgment in valuing assets. The new rule means impaired assets do not have to M-T-M (because it is deemed fire-sale price) but mark-to-model based on future expected losses. It would be interesting to see if this "time-buying" tactic would work, given that banks should be able to generate enough interest income given enough time to plug the capital hole. However, US financial stocks didn't react too much to the news, perhaps noting Ken Lewis' remark that this is "not quite a big a deal as some would think", the change might add "a penny or two" to EPS" but not 20%".

Within my limited observations to the markets, I think the doubt on this April rally is understandable as the growth risk remains on the downside, given the quality of these early recovery signs seems low or fragile as it is basically backed by massive lending and govt bailouts across DMs and EMs. For example, in China the impressive 34% rally ytd is supported by the unprecedented lending by Chinese banks (Rmb1.6trn in March, 1trn in Feb and 1.6trn in Jan!). Of course, the mid-to-long term risk is embedded here with high NPLs, just like it was after the 1997-98 crisis financing. Thus, the recent rally is not just about cheap valuation since 09 March, but more about cheap money and abundant liquidity hunting for yields due to global ZIRP policy and QE programs. On the back of this liquidity-driven rally, I saw no sign out of the leading employment indicators with US weekly jobless claims recording their 27-year highs. In fact, we now had five unbelievable payroll plunges in a row and decline in April NFP is likely to surpass what we saw in March. According to OECD Secretary General Angel Gurria, unemployment in US and EU will reach 10% this year, and expected GDP contraction will reach 4.2-4.3% vs. Nov's forecast of a 0.3% contraction. (Quote: This is unprecedented and we have not seen this in many decades, said Gurria.). The dismal job marker outlook supports the bearish view that in the aggregate price level, US housing price is going to correct another 10-15% in real terms, along with the still high inventory/sales ratio. One last point is for this rally to fail is that outlook for 1Q09 S&P500 earnings are down. Not only had a few banks warned that March earning wasn’t as kind as January and February, but also the overall earning expectation for 1Q09 are down 35.6% according to Reuters Thompson. It is expected that all 10 sectors of SP500 will see the QoQ decline with consumer discretionary leads the drop with an expected 102% fall in the quarterly earnings.

To sum up, one of the early lessons I learnt is that in bull markets, corrections are short and sharp. The reverse is true in bear markets, rallies are short and sharp. Admittedly this rally has gone on 15% more than I thought it would. But we’ve been through this scenario 6 times in the past year. A sharp rally into Dec08 extended into the first few days of Jan before turning around again. Will this be more of the same? My own view is that the removal of MTM can't fix this market and that the markets go straight down and then straight back up is ludicrous. However to put my own opinions aside, I must admit that the strength of the move coupled with the growing volumes (HK$75bn, first time since early Jan) do worry me somewhat when I am listening to MC Hammer ---"Yeah, you can't touch this…Too hype, you can't touch this…”

Looking forward, I strongly believe the old mistakes have been repeated. In fact, starting from 3Q07, many people blamed Mr. Greenspan who used cheaper money and easier availability as savoir in every downturn. This has kept compounding the problem and has led to where we are today. However, it seems rightly or wrongly we are slipping deeper in the mess – this time with much higher magnitude and wider geographical spread. YTD, estimates suggest that the total effect of discount window buying, TARP, TALF, CP&UST buy-back program and other smaller initiatives could end up expanding the Fed balance sheet by $3.5trn. Combine this with QEs (modern name of printing money) in UK ($210bn), Japan ($4bn/month bond buying) and Switzerland as Bank of Canada prepares to follow. Analysts now put estimates of toxic assets losses at $1-2trn. Without a doubt, the amount of money released into the system is much larger than that taken away by the credit crisis. Moreover, money pipeline has gotten bigger, and the world is waiting for it to start flowing as credit loosens up. Thus, if my reasoning seems logical, then the world extends our old mistakes and may enjoy another big wave of growth, prosperity and inflation. The consequence is that a large part of value of toxic assets would have been lost for ever and that the new money printed to cover those up will eventually find ways to asset markets thus creating a possible big scare of inflation…Yes it is fearful down the road, but I think one should not be blamed for missing the April-Fool rally at certain stocks. It is largely not about bottom-up but more a "re-leveraging" of the cheap money, ahead of re-loading of real economy. At this moment, asset rotations and technicals appear to have played a more important role than fundamentals…Have fun…

The Signs to Watch

The current economy recession is not only a global consumer recession, but a severe Capex downturn as well. Thus, in tracking the economic development, one should know where to look for signs of (relative) improvement. Following the demand swoon in 2H08, the first +VE sign was the firming in consumer goods demand that took hold near the turn of the year. However, this did not readily translate into better economic performance because companies were focused on unloading inventory. This is why manufacturing continued to plummet. The second +VE sign will the inventory adjustment as production has been cut to such a low level that inventory is falling worldwide. This is verified by the record low in mfg-PMI inventory index and the rising new order index.

However, the key to stabilization in manufacturing is continued resilience in consumer spending. So far, I saw March US light vehicle sales at 9.4mn, a modest rise from Feb’s 9.1mn. But the rest of world showed signs of weakness. Japan March vehicle sales was down 3% mom and German Feb retail sales (ex autos) down 0.2% mom. More surprising was the 2% mom drop in Australia’s retail sales. Indeed, DM consumers have to overcome a deepening labour market downturn. In US, ADP report points to a roughly 700K US payroll loss in March, while in Euro area, UNE rate is reaching 8.5%. Also, I saw Japanese corporate had shed workers for 2 straight months. The chain effect is that these consumer recessions in DMs have hit the export-oriented courtiers badly. In Asia, export orders continue to look horrid with India Feb exports -21.7% yoy (vs. -16% in Jan), Indonesia Feb exports -32.8% yoy (vs. -35.5% in Jan) and Korean Mar exports -21.2% yoy (vs. -18.3% in Feb).

Inventory adjustment is also the key to watch for housing market. In US, outside of all-cash deals in the foreclosure auction market, demand for residential real estate is basically dead, according to ML research. Importantly, the unsold inventory overhang in the resale market remained at 9.7 months' supply in Feb, and considering that an estimated 15% of the existing inventories are not included in the data (as bank-held subprime properties), the real inventory number is closer to 11.5 months supply. The backlog of unsold new homes is also stuck above 12 months. The worst this inventory metric ever got in the early 1990s real estate meltdown was 9 month's supply. In general, the signs stabilisation in US consumer demand and the housing market need to be seen in context of haemorrhaging corporate profits, collapsing IP and rapidly rising UNE elsewhere in the world.

Three Reasons to Bid

Good news from the rates market is that Mr. Bernanke is delivering what he promised five months ago --- record- low Mtg rates and a refinancing boom. According to Freddie Mac, the 30yr fixed mtg rates fell to 4.78%, the lowest in records since 1971. Mortgage applications in US also rose for the fourth straight week in last week (+3%), and the Fed’s efforts may give consumers as much as $25bn, according to Moody’s…However, fixed income investors are still nervous as the world is in the midst of a high stakes tug of war between debt deflation and policy reflation, and the tail risks are abnormally wide. Moreover, the LT outlook for govt bonds is quite bearish as 1) G7 sovereign yields are well below fair value, 2) govt deficits are set to mushroom in the years ahead; and 3) aggressive QE policies have heightened the LT inflation risks.

Nonetheless, there are three reasons to expect bonds to stay well bid in 2009. First, global growth conditions remain extremely weak and the recovery will be benign. Although fiscal support will help stabilize the G7 economy during 2H09, the history of past housing and financial sector busts suggests that the recovery will not be V-shaped. Consumers will continue to focus on rebuilding their B/S over the next few years rather than spending. Second, deflationary forces will persist over the next 1-2 years. Even after we exit the recession, the world economy will continue to grow below potential for an extended period. Third, household savings rates are starting to surge and should help offset issuance concerns. Meanwhile, policymakers will forcefully cap bond yields until credit markets are repaired and it is clear that the global economy is in a sustainable recovery phase.

To the investors, the key point is that IG corporate bonds could deliver equity-like absolute returns in this cycle and history suggests that investors should already be OW corporate bonds and equities relative to cash and USTs, if one can be confident that an economic recovery will begin in 2H09. In contrast, deteriorating corporate health, tight lending standards and economic contraction all warn against an OW in HY debt. Nonetheless, this cycle is unusual and treacherous enough to warrant more than a usual amount of caution. A sustainable economic recovery this year is far from assured, given the massive loss of household wealth and the unprecedented plunge in global trade. And the street also does not know what lasting damage has been done to the global economy by the seizing up of credit markets. Given this backdrop, I think it is better for a multiple-strategy portfolio to gradually scale into risk with OW IG corporate bonds, but no more than an EW in both equities and junk bonds.

Where to Place Bets?

Market performance wise, SP500’s 18% rally in March was the largest since 2002. Financial were up 17.6%, contributing 8.5% advance to S&P 500 during the month. However, S&P 500 concluded 1Q09 with -11.7% losses. In China, A shares lost 65% last year but up +30% in 1Q09 as the best performing market in the world. HSI -5.6% in 1Q and down 5 quarters in a row which is unprecedented since 1969. HK ranks the top 3 worst performing market in Asia together with Japan and Vietnam in 1Q09…In my own view, a further extension of A-shares depends on whether listco’s earnings have hit the bottom. Based on the 695 listcos which have reported results by Sunday, 1) total revenue was up 20.4% yoy but earnings dropped 18% yoy. On a quarterly basis, the downward trend is quite eye-catching with1Q08 +12.1% yoy, 2Q08 +4.7%, 3Q08 -20.0% and 4Q -57.3%. Sector wise, Telecom equip. saw the biggest bottom-line decline, -96.3% yoy, followed by oil & gas mining, -86.1% and power ranked as the 3rd, -77%. More importantly, the MoF data suggests 1Q09 earnings recovery will be driven by lower cost rolled over from 4Q08 inventory and less write-downs, rather than sustained top line growth. Thus, it is still too early to conclude for sustained earnings recovery as Mar08 had a high base effect and the benefit of tax unification will disappear this year.

That being said, I think it is going to be a volatile business cycle and to see increasing inflation without much growth in the major developed economies. I expect the US economy rolling over again by late 2010 and the market may see an unfolding fiscal crisis in US, with -ve impact on USD and a UST crisis. As a result, I think asset plays, not earnings plays, will be the winner in such an environment. As a result, in HKCN space, I think it is worth more to O/W Property and conglomerates than betting on the cyclicals earning outlook. With March sales volume in SH and BJ (~1X mom) resuming and secondary market avg price backing to Rmb9000/sqm (=2007 avg), some developers with cash on hand are looking at buying land again. This suggests to me that the risk of having major developers going bust has declined drastically. In addition, I am neutral on Chinese banks in the near term. China March incremental loan will be around Rmb1.3-1.5trn, far beyond market consensus (Rmb600-800bn), indicating 25-26% yoy growth. This amazingly high amount of loans suggests that liquidity is still huge in the A-share market. However, I do not foresee this sector’s out-performance due to 1) their market Cap is so huge, and 2) the economy, NIM and credit cost concerns. Certainly, it is not the time to go aggressively and thus I will keep overweighting on Consumer, IPPs, Capital goods, Insurance, Cement, and maybe IT…Lastly, valuation wise, MSCI China is now traded at 12.6XPE09 and 1.6% EPSG, CSI 300 at 18.6XPE09 and 11.3%EPSG, and Hang Seng at 13.2XPE09 and -24.4%EPSG, while regional market is traded at 15XPE09 and -10.1% EPSG.

Gold Is Not “Good”

The FX world this week focused on the ECB and G20 meeting, plus US March UNE. It looks to me that ECB will cut its refi rate 50bps to 1% and buy private sector debts (CPs and corporate notes) to improve company funding and to encourage bank lending. However, ECB is unlikely to begin buying govt bonds as direct purchases are not allowed. As such, the ECB should not be as aggressive as the Fed in terms of monetary expansion. Thus, I think in the short-term, EUR should stay above1.35 levels.

In the commodity space, the expectations for economic recovery overcame the negative fundamentals. While S&D fundamentals on oil are not supportive of high prices, WTI crude rallied nearly 9% to $52.51/bbl. Crude inventories climbed 2.84mn bbl to 359.4mn in the week ended March 27, the highest since July 1993. Base metals also traded higher, copper closed at $4310/ton. Gold fell to $893/oz as market is expected IMF to sell as much as 403 tons of gold in order to fund the stimulus plans. Meanwhile, negative news came from India, the once world’s number 1 gold importer has effectively imported zero tones of gold in Feb and March of this year, compared to 23 tones and 21 tones for the same period in 2008. I think the correction of gold price was also because investors become less risk averse, reflected in recent declines in VIX (39.7) and EMBI Sovereign Spread (630bp). Looking forward, I think any sustained rally in global equities will encourage investors to reassess the outlook of gold as it has started to underperform more risky asset class alternatives. Given that global inflation may not emerge in 2009, even if CBs print more Dollars, and a sharp fall in USD may not happen in the horizon, Investors who bought gold to hedge against USD/Inflation may be disappointed.

[Appendix]

As noted above, the correlation between economic growth and commodity prices is highest for base metals, followed by energy and then agriculture. This hierarchy matters a lot for consumer inflation. As we learned anew during the 2000s expansion, movements in oil and agricultural commodity prices feed through quickly to retail energy and food prices. This drove a wedge averaging 1% pt between the rates of headline and core inflation during the 2000s expansion. In contrast, base metals do not have any counterpart at the consumer level. Movements in these prices affect the broad complex of producers’ prices, but their influence diminishes along with their percentage of value-added further down the production pipeline.

39 out of the 42 HSI companies have reported results and 11 saw profit growth  while 25 saw decline. NWD, Cathay and Citic went from profit to loss.  We mainly saw 7% growth across the board.  30 year average HSI PE at 14.5x, and when HSI rallied above 30,000 in Oct07, PE was at 24.3x. PE is now around 12x   (up from 11x last month), and fair value should be around 14x which means HSI can trade up to 15962.  Brokers year-end HSI targets are ranged from 9100 (Citi) to 17200 (Credit Suisse.) I am on the other hand have kinda gave up of predicting the market until I find my crystal ball back. In the meantime, I suggest you go with the flow and make trend your best friend.  *HSBC rights was 97% taken up and new shares will be available to sell in HK this Thur. Total share outstanding will increase by around 40%.

Good night, my dear friends!