My Diary 327 --- Month Month Up, Good for LargeCap What if Fed F

 

My Diary 327 --- Month Month Up, Bad for A-shares, Good for LargeCap, Oil Blows Up and What if Fed Failed

September 11, 2007

It often seems that everything is made in China, but certainly not the latest turmoil in the financial markets, because it is until today (September 11, 2007) for the past few tough weeks, A-shares major indices come down around 5%. At the mean time, three “big-mouth” Fed governors’ seemed contradictory talks (Mishkin &Yellen vs Fisher) regarding the US economic outlook brings some confusions on the policy makers’ division on risks and corresponding size of rate cut.

CPI and Copper, Month Month Up!

The generation of 70s Chinese should still remember such a proverb – “Good Good Study, Day Day UP”.  The last three words now are largely applied  to China’s CPI number since July as today’s inflation print surged to a 10-year high, along with the trade surplus widened 33% to $24.97 billion, the second-highest monthly total.

More signal also emerged from the strong import numbers of industrial base metals, According to Bloomberg, China's copper imports, the world's biggest, rose 43% YTD as economic growth fuels demand for the metal used in buildings and power grids.Total imports of copper and copper products totaled 1.91mn metric tons to the end of August as reported by China custom. In fact, China's imports of copper helped prices rise 14% this year  and caused the inventory fallen 25% percent in the same period, while inventories in Shanghai have more than doubled...... See China may help turn copper into another yellow metal ( Gold)!

Overall, all these are adding further pressure on PBOC to raise borrowing costs for the fifth time this year and highlight the divergence between what is driving US and Chinese  interest rates going forward. In the past few weeks, while 1M SHIBOR rates have risen by around 85bps since end July, and the more liquid 7-day repo rates have spiked dramatically from 2% to 16%. Certainly, both these moves seem completely unrelated to the global money market troubles as Chinese money markets are protected by capital controls, and local rates headed lower up until August 27 when most  global rates were selling off.

So the much more recent move higher in  Chinese rates seems to be a function of the central government’s efforts to mop in too much domestic liquidity (via special T-bill issuance and  increase in RRR by another 50bp to 12.5%), rather than a sign that the global money market troubles are finding their way into China.

Bad for A shares, Good for Large Cap!

Today is a bad day for A shares, but I think it is a good time to pick some large cap stocks. One of resonable factors dragged down the A-shares’ index today is beleived to be the accelerated sale of non-tradable shares which in turn increase the supply to the market. And I think the IPO of Bejing commercial bank and CCB plus the recent issuance of Special Treasury Bond also took away a lot of fire (liquidity) underpined the A shares.

To the CSRC and PBOC which are facing the challenge from liquidity, an urgent task now is to effectively control loan growth in 2007. Rmb loans were up 16.6% YoY as at end-July compared to 16.5% YoY as at end-June. For 7M2007, incremental lending reached Rmb2.73trn, equivalent to about 94.1% of the Rmb2.90trn full-year target of the PBOC... Had the PBOC ever been able to control the loan growth?? ...I need some help here!!! ... How will H-shares behave? Positive news if the A-shares fall is because of policys shocks .Remember A-shares fell big time on stamp duty tax hike in June 2007 while H- shares rallied.

The next question within this environment of wider spreads, higher volatility, and increased risk aversion is what should we pick for the portfolios? I think it should be large-cap/growth stocks in stead of small-cap/value ones. For any equity, two components accout for its investment potentials --- the risk premium measured by PER and the fundamental growth outlook. Over the past 5 years, small caps have outperformed due to reduced credit spreads, low vols, and increased risk appetite. In addition, small-cap value stocks has benefited from LBOs and debt-financed M&A activities, which are likely to diminish in the coming years. As a result, large-cap growth now trades at a substantial discount to small-cap value. Empricial research further showed that over longer-term(like 20 years), in the 12M after macro environment change-points, large-cap growth stocks have outperformed small-cap value by an average of 1600 bps...... 1600bps = 16%, that deserves a big WOW!

 

Market Set to Push Wider

Credit Markets are still not in a good mood. iTraxx failed to really push through 40bps and is traded at a very tight range over the last 2 weeks as spreads at current levels remain wide to historicals whilst conditions remain very tough for credit globally.

Reasons, here are two --- 1) the money market remains broken. BBSW and LIBOR rates remaining at near yield highs despite central bank intervention and CP spreads (for those that can print deals) also veryy very wide. This week is a kKey week for the current illiquidity in Euro CP where some Euro 140 billion in ABCP is maturing.  How the system copes with this will be a key test. 2)  Sub-prime bodies continue to wash up on the shore giving support to the view that the fallout from this will persist for some time and potentially weaken economic fundamentals in the US.  Going forward, we should not be surprised to see NF Payrolls turn weaker given the layoffs telegraphed in the housing/mortgage sector alone.

 

Oil Blows Up, Base Metals& USD Soldoff!

Energy prices continued to rally today with crude oil rose to within 50 cents of a record after saboteurs blew up pipelines in Mexico and as some OPEC ministers hinted the producer-group may maintain output. Near-term crude oil delivery rose 1.1% to $78.32 a barrel in NYME today.

Base metals prices sold off across the board, with losses ranging from 9.7% in nickel to 2.9% in copper, driven by sentiment stemmingfrom weaker-than-expected US economic data support, which increased fears of a US slowdown. Precious metals prices continued to rebound, with gold and silver prices increasing by 4.1% and 3.6%, respectively. Rising ETF demand and general return-to-safe-haven buying helped lift gold to US$701/oz — the highest level since May 2006.

The US Dollar is trading close to its lows again against the EUR and GBP. Couple of dirvers are hanging over in the markets --- 1) UST yields are declining as the Fed looks poised to cut interest rates over the next few FOMC meetings; 2) oil prices continue to stay close to record levels, a negative signal for the USD as sovereign money (largely from oil revenues) have a much higher propensity to diversify their assets compared to traditional central banks. As a result, in the near term,  it is expected to see the USD being oversold against the EUR and investor sentiment is increasingly bearish while risk aversion continues to affect financial markets globally. So the risks now are the dollar surprising on the upside.

A supporting factor to USD is that a recent IMF report shows thay central banks still have 64% of their reserves continue to be invested in US assets. However, on the back of the recent weak macro data, the question appears to be whether the Fed will cut by 25 bps or by 50 bps. If the Fed cuts by 50 bps (which is fully priced in by market), it will naturally lead to some relief in the currency markets. But I doubt that we will go back to the massive risk seeking activity seen previously...... Most ppl lean lessons, right?

 

What if The Fed Failed?

The Fed will cut rates because there are growing signs that the US economy is cracking. Booming global growth has been one of the strongest drivers of risk appetite in recent years... Now with the US economy slowing one of the strongest drivers has fallen apart.

An interesting paper I read today showing that a closer look at 1998 and 2001 suggests that the first Fed rate cut usually doesn't restore market confidence in the economic outlook. The researcher demostrated that the market's perception of macro fundamentals stabilizes only when the Fed gets towards the end of its easing cycle.

Now what if the 25 bp rate cut fails to solve liqudity challenges, would it raise notably the possibility of ecoomic recession? I think highly likely as consumer spending may be downshifting and s softer job market would lift further mortgagae deliquencies with implications for the borader risk re-pricing. But the market’s impact on spending may take seveal more months to play out.

Good night, my dear friends