My Diary 367 --- Economic Decoupling and Financial Coupling;

 

My Diary 367--- Economic Decoupling and Financial Coupling; Good Policy Responses Needed; Diversification in Recession

January 17, 2008

Two bombs in Wednesday and global equity markets moved down 1.5% in whole, while Asian stocks saw the greatest decrease (Nikkei plunged 3.4%). Equities in emerging markets have given back all their gains since the start of the credit turmoil and now stand at their mid-summer levels. Stocks are now beginning to question the prospects of a recession and the Fed has now admitted they have been wrong about the economy and they are prepared to move aggressively (better late than never). 

What are bombs? The big banks/brokerages keep announcing bigger writedowns and then acquire more outside capital at generous levels only to have the whole process start all over again. Markets got their first take on the US financial confession season with Citigroup affirming the US write downs, further re-capitalizations and workforce reductions. But the big concern was the increase in provisions for future deterioration in broader credit problems (commercial and personal loans). The markets are now waiting for Merrill's report on Friday… Separately, December US retail sales were also lower than anticipated (-0.4% yoy) which heightened the concerns over whether US consumers have the capacity to withstand the current slowdown.

Here now, news flows, data points and asset pricing have combined to create an increasingly depressed outlook for US growth (and global growth). The question now is, in the near term, have the markets reached the point of max pessimism?... Let us start with the big picture after the data series being reported recently…

Economic Decoupling and Financial Coupling

Economic reports in these two weeks  will help answer two important questions --- 1) whether consumer spending is rolling over in the major economies after a surprisingly strong showing in Oct and Nov, including December retail sales in the US, UK and Japan. What should be factored in the numbers include higher energy and food prices, weaker labor markets (US), tighter credit conditions (US, UK, EU), and falling wealth (US); 2) to how large extent that Chinese economy is slowing and in what manner. Last week, one surprise was the slowdown in China’s exports in Q4, which rose at a mere 2% yoy, the smallest increase of the expansion by far. The growth of FAI is also thought to be slowing. These are substantial drags on manufacturing output, which is drawing support principally from the consumer sector.

Beyond the two questions, the latest wave of global headline inflation has crested at near 4% yoy, assuming oil prices do not turn higher. The late 2007 surge in global inflation was not due solely to energy and food prices. Core inflation also edged higher. Global core inflation reached 2.3% yoy in November, the highest since 2002. However, the energy price movement was a mixed signal as lower fuel prices may buoy consumers spending, while the weak demand that has allowed inventories to build lately may signal that the economy is already weaker than expected.

Nowadays, many investors are hoping the fast-growing economies in Asia and elsewhere can offset US slow-down, but such hopes could be dashed if US demand for imported goods falls more than expected, sparking a chain reaction in which emerging producers like China and India also begin to slow.

Bottom-line: The argument of economic decoupling has waned substantially in recent weeks, while financial market coupling is likely to remain high.

Good Policy Responses Needed

Overnight, the Beige Book showed that US economic growth slowed in late November and December, with districts reporting disappointing holiday sales. In the mean time, residential estate conditions continued to be quite weak in all districts and lenders were cautious in making loans. Having said so, the fundamental picture in the US is undoubtedly bleak as all the major indicators are pointing down and the threat of recession looms large. ISM has dipped below 50 and finally there are signs that the labour market is cracking. Consumption is holding flat, but could easily be the next shoe to drop. Inflation lurks in the background with high oils and commodities in general remain at elevated levels.  The Fed has capitulated and its obvious that we are in for a substantial period of monetary easing.

A positive note is from the policy front, as the potential for a coordinated policy response from both the Fed and from the Federal Gov in the shape of tax cuts/or tax rebate may have a significant impact.  In an election year, it would seem unlikely that the Democratic would stand in the way of a policy response to prevent a serious US recession. With all the policy levers being pulled to boost growth, there is a high probability that equities start to look past the trough and gain traction on a 2H08/1H09 reflation story. 

Furthermore, a major distinction from the last recession post the TMT bubble, is the ever present build up of liquidity in Asia and the Middle East.  When the tech bubble burst 2001, the entire global economy was simultaneously impacted and there were no bright spots to take up the slack. The world is in a different environment this time around. Asian growth remains robust and with oil up at these levels, the Middle East is generating huge amounts of Dollar reserves that have to be put to work. SWFs are in the process of underpinning the financial sector with substantial cash injections and the recouple / decouple debate, whether Asian economies can continue to grow strongly in face of a big slow down in US growth remains open. 

Finally, the valuation argument is also a major factor. Judged by the yield curve, the market has been way ahead of the Fed in this cycle and I would argue that at current levels the maket may have priced in a mild US recession scenario. Its true, when sentiment deteriorates, liquidity dries up and assets are looking for safe haven, valuations do not matter. However, the markets have been in that environment for nearly 6 months now and we may see some relief. 

Bottom-line: I do believe that the front end of the curve will be 50bps lower in the next 3-6 months, and if US consumers can still hold up their purchsing power and inflation comes down, the V-shaped stock market rebound is not far away from us after a continuous policy easing.

Diversification in Recession

The recent fund manager survey done by Merrill Lynch came up with two important results --- 1)  it is the first time that institutional investors have really started to recognize that the credit crunch could lead to a global recession; 2) the vast majority of investors expect corporate operating margins to deteriorate over the next 12 months. Such a macro outlook is starting to make an impact on asset allocation as PMs have cut back their overweight stance on equities dramatically over the past five months. At the same time, they have aggressively built up their cash balances. Given their assessment of the relative value between the two assets, it seems likely that investors and asset allocators are still more inclined to put that cash back to work in equities rather than bonds.

Moreover, at the global sector level, it is more a question on what fund managers do not want to own. Financials and consumer discretionary (such as retail) are the only sectors recording a net underweight position in January. The 'most overvalued' sector this month is the global materials sector and one of the 'most undervalued' is the pharmaceuticals sector.

Interestingly, recession or not in the US is actually seen by many fund managers as a positive for Asia. Just as Asian stock markets benefited last year from a flight to quality following the fallout from the US subprime mortgage crisis, the same scenario is expected to play out in 2008. Certain markets in Asia – particularly Hong Kong, India and Southeast Asia – are expected to benefit from what is largely considered to be their safe haven status from the troubles in the US., while an increasing number of fund managers have been shifting to an underweight or neutral position in China after being overweight for many months due to concerns over valuations, an overheating economy, and rising consumer prices. The biggest consensus overweight in Asia is Hong Kong as HK’s business conditions are strongly influenced by the Chinese economy, which is still booming, but its monetary policy is tied to the U.S. via the Hong Kong dollar peg. In the meantime, the Hong Kong Dollar is coming down along with the US Dollar, which has also helped cheapen Hong Kong assets, making them more attractive.

Bottom-line: Diversification is the key to staying defensive, and being defensive will help cushion the impact on portfolio investments in case the US does get hit by a recession. And Asian currencies may be an important factor in asset allocation this year. 

Good night, my dear friends!