My Diary 363 --- The uncontained subprime, The rising bad debt

 

My Diary 363 --- The uncontained subprime, The rising bad debt, The shifting Chinese Policy, The long-term negative Dollar; The fundamental driven commodities

December 11, 2007

It is another week packed with a series of important data and tonight’s FOMC meeting is definitely under the spotlight as financial conditions have worsened more than expected, witnessed by further upward pressure on borrowing rates. Latest development is that overnight US market closed up (Dow +0.75%) after UBS bailed out from GIC and Middle East investors as well as MBIA receiving capital from Warbug Picus.

The market is obviously worrying about the potential spillover from financial market stress to economic growth in early 2008 and there are three areas to be watched in 2008 --- 1) the resolution of ongoing liquidity concerns; 2) the consequent impact on the US economic outlook due to 1), and the knock-on effect on Asia economy.

Well, there are very board thoughts regarding the macro picture and asset allocation...Hmm…I want some big gift packages for the upcoming X-mas…

The uncontained subprime quake

Last Friday, a solid US unemployment number gave some comfort to the market, along with yesterday’s modest positive Nov pending homes sales. But all these only touched the icing on the cake as the real dessert may come from Thursday’s retail sales, which provides a reality check on the holiday shopping.  It is expected that the US$10/bbl fall in oil price should put some holiday cheer back into consumers’ pockets…… No more poison toy complaints hopefully….

I hate to be the bearer of bad news. However, in Goldman Sachs' SSS review call, the No.1 bonus bank forecasted the most challenging consumer environment over the next 9 months than has been seen in several years. While speaking to the recent weakness in retail stock prices, they noted that of the 4 previous periods on record with equal or worse retail equity performance, 3 of those periods preceded a recession.  Putting all of the pieces together, it is clear that the underlying results are weaker than the headline number would indicate.  Consumers are feeling the pinch of the subprime mortgage/credit crisis, demanding deeper discounts on their holiday purchases this year. 

Thus, even though the subprime quake has been declared contained over and over again... I have to say it isn't contained yet… The worrisome big picture is that the markets just ended a bubble in housing, in housing-related credit, and in all other types of credit. A wonderful age of low interest rates, competition for market share, the continual low inflation, and the widespread use of securitization has gone. In the past, any risk associated with lending could be ironed out by slicing and dicing debt and selling it to investors, who could in turn hedge their exposure to the debt through derivatives. And any remaining risk would be wiped out by growth, perpetually rising asset prices, and a willingness of other lenders to refinance existing debt on favorable terms……. This paradise for credit borrowers and consumers does not exist anymore…

The rising tide of bad debt

What we have now is a rising tide of bad debt across the economy.  Even Fed and Street tried to set a floor to the asset price, the market continues to see --- ABCP rates continue to rise, BBB bond rates have trended upward and last Friday, AAA rates surged 38bp, a sharp break from the stable and softly downward trend of the past two months…Are we just throwing a sandbag into a rising Mississippi River?

There are more and more signals showing the pains are just coming, one by one…… Case 1) The MBA last week came out with its national survey, noting the delinquency rate for mortgage loans on one-to-four-unit residential properties stood at 5.59%t of all loans outstanding in the 3Q07, up from 4.61% a year ago. This figure, which doesn't include loans in the process of foreclosure, is "the highest in the MBA survey since 1986." The pain was concentrated in subprime (16.31% delinquency in Q3), while at the mean time the seasonally adjusted delinquency rate for prime loans rose to 3.12% from 2.73% in Q2.

Case 2): As the volume and price of new home sales continues to fall, home builders are suffering as well. The WSJ reported that delinquencies on loans extended to condominium developers have risen sharply in the past year. In Q3, 5.9% of such loans were delinquent, up from 4.1% in Q2, according to Foresight Analytics. The delinquency rate for builders putting up single-family homes rose from 3% in the Q2 to 4.3% in Q3.

Case 3) : Other types of consumer debt, which have nothing to do with housing and nothing to do with subprime, are going bad, too. The WSJ reported last week that "about 4.5% of auto loans made in 2006 to top-rated borrowers were at least 30 days delinquent as of the end of September, up from 2.9% the previous month,  according to a Lehman’s survey." In October, Fortune Magazine warned that a similar plague may soon afflict credit-card companies. In fact, credit-card giant Capital One reported that the delinquency rate on credit cards for Q3  was 4.46%, up from 3.53% in 3Q06. "Given current loan growth and delinquency trends," Capital One reported, it "expects the US Card charge-off rate to be around 5.25% in the Q4”……

All-in-all, the pains are related to a somewhat macro call, as the market assumes that the Fed is and will remain concerned about the economy and especially liquidity, signaled by  the spreads between Libor, Fed funds, and T-bills. This ushers in further incentives for cutting thus preserving some continued support for risk assets. 

Bottom-Line: with a 25bps fully priced in, I think the market should focus on additional actions taken by the Fed, including the wording of the post-FOMC statement, and how will Fed deal with the continual stresses in the financial markets, exacerbated by year-end demand for US Dollar liquidity and rising LIBOR spreads. Since the longer this goes on, the more significant may be the potential drag-down effects to the real economy, I would bet that Fed may announce further changes to discount borrowing costs.

The shifting Chinese Policy

Unveiled by the Central Economic Work Conference, China’s monetary policy is officially shifting from “prudent” to “tight”, reflecting the growing concern over economic overheating and inflation risks…… I think this has important investment implications to China markets going forward as by officially moving back to “tight” belt, China is likely to gradually lift real interest rates into positive zone. More importantly, this is the first time China has had a discretionary currency policy in place to facilitate changes in its monetary toolkit. Thus, it may imply that Yuan will likely appreciate at a faster pace than before. In fact, Yuan is still below its level from two years ago in TW terms.

On the back of this policy change, there are three sectors worth for closely watching. 1) Capital Goods: considering the ongoing sharp correction in global industrial metals prices, the leading indicators for China’s capital spending cycle are mixed, which could imply China’s capital expenditure cycle has finally begun to moderate.  However, the Chinese steel demand, traditionally a good leading indicator for investment spending, remains extremely strong, in particularly the steel exports have dropped significantly in recent months. This could be a sign that investment growth is unlikely to slow substantially anytime soon.

2) Property Developers: There is no sign that China’s red-hot property market is cooling off as YTD real estate prices in major cities continue to surge. Strong income growth and increasing accessibility to mortgage financing are likely to continue to support strong housing demand. The crackdown on developers and restriction bank lending to developers in recent months will likely cause a slowdown in investment in the property sector, and consequently reduced housing supply. All of this means that housing prices will likely continue to rise. It remains watchful on how policymakers will respond to further gains in housing prices in 2008.

3) Stock Market: A-shares bubble is now rapidly being deflated, and more tightening measures will likely create room for further downside for the asset class. However, the government will become very nervous if the stock market enters into a freefall, while in the flip side, the stock market bubble can easily be reflated, as basic ingredients of the equity bubble – negative real interest rates and rampant liquidity conditions – remain intact.

Bottom-line: This recent policy shifting should be viewed as a positive development for China economy’s overall stability and long-term growth sustainability. The major risk is that China’s cyclical outlook is becoming more complex, where overheating risks and deflationary threats co-exist. This makes it difficult for the government to provide proper policy responses. As a result, there could see a period of increased volatility in the equity market going forward. In terms of strategy, I remain cautious on H shares in the short term based on my policy uncertainty and market volatility arguments.

Dollar is long-term negative

Financial sector crisis, Fed rate cuts, a steeper yield curve and strategic investments by foreign investors have all together drew a parallel line between 2007 market turmoil and the aftermath of America's S&L crisis in the early 1990s. Looking forward, three themes are like to dominate FX world in 2008 --- 1) the world will be in grey color as the credit crunch continues, global growth slows and central banks worry about inflation; 2) Major central banks will follow the Fed in cutting rates, including ECB; 3)  Asia is likely to be the only one growth spot.

Having said so, US Dollar has rebounded from 74.85 to 76.17 measured by DXY Index. As I mentioned in the last dairy, the Dollar is strengthening because of a lack of global liquidity - and specifically US Dollar liquidity. In addition, the market has yet to see economic evidence that Europe and Asia are feeling that US impact. According to Merrill Lynch research, the impact this time on Asia in particular will be less than previously given the increasing importance of BRIC, higher inter-regional trade and greater focus on Asian domestic demand … I agree, but keep in mind, the impact will not be zero…Thus, recent US Dollar strength has been more of a correction rather than anything else. The recent rate cut by BOC and BoE are much related to ongoing credit market turmoil as anything else.  A final point is I remain US Dollar bear over the mid to long-term as the current status of  US balance of payments implies that returns on Dollar assets need to rise in order to attract enough capital or that the US Dollar falls sufficiently to make them cheaper.

Commodity counts on fundamentals

Commodity prices have moved higher on average in 2007, however, there has been a divergence between energy, precious metals and agriculture as good performing camp, as well as base metals which have weakened. Looking back over the last 5 years, commodity prices have been supported by three key factors - strong global growth, a weak US Dollar and excess global liquidity. Looking forward, I still believe that the industrial commodity is in the mid cycle of a bull-run, driven by the industrialization of China and India.

Bearing China and India in mind, the generalized US Dollar weakness will continue to support for commodity prices at current levels. With regard to liquidity, the credit problems in the US have cast some gloom over the outlook, but globally interest rates remain low and there is still a significant mountain of funds looking for investment opportunities. So the key risk is a tightening of monetary policy in response to rising inflation. In the near moment, the liquidity squeeze or a significant reverses of risk appetite would affect commodity markets.

Of course, we should not forget oils. Over the past two weeks, crude oil prices have dropped back to a U$85-90/bbl as the US Dollar rebounded, speculative position moderated, demand concerns emerged and geopolitical concerns ignored. US inventory levels have also shown some signs of improvement. The market clearly remains finely balanced. Interestingly,  despite prices still in excess of US$85/bbl, OPEC left its official output target unchanged on 5th December based on two concerns: US Dollar weakness and potential demand weakening as the US still accounts for 24% of global oil demand. Now, the combined impact of an easing housing market and more difficult credit conditions could bring oil demand lower. Overall, the long-term US Dollar downtrend will continue to give some support to oil prices.

Bottom-line: The global conditions are still supportive of commodities but not necessarily providing upward momentum. Commodity price will be more determined by fundamentals than global conditions. In particular, US Dollar weakness will benefit crude oil and gold, while base metals may continue to decline as they are highly leveraged to the economic and construction cycles.

Good night, my dear friends!