My Diary 448 --- Globalization, Panic, Reflexivity, J.M. Keynes

My Dairy 448 ----Globalization, Panic, Reflexivity, J.M. Keynes, US Consumer Recession; China Outlook

(Note: Global stocks rallied strongly today in response to the widespread government efforts over the weekend to shore up the world's battered financial system. But I believe this is a typical bear market rally after the sharp decline over the past week. And the big concern ahead of us is that global regulators are behind the curve to mop up the mess as all the key money market indicators remained at elevated level --- LIBOR =475bps, TED spread = 457bp and Libor-OIS spread =362bp)

October 12, 2008

Globalization in the wrong way vs. Panic in the same way --- I am not criticizing the progress of globalization which has helped substantially liberalize and improve our lives as human being. But over the past weeks, I saw a wrong way towards the globalization,  ranging from the wipeout of Wall Street to the free fall of Iceland Korna and from the doubled European bank bailouts to the blow out of bank CDS in India. Indeed, one must think very hard to figure out how can Iceland, an island with 300K population and US$6bn GDP, have over US$100bn bad debt? My friend gave me a great answer –when every fishman turns into the currency trader due to the belief of “being a global player", you know how it ends!!! … Aha…It ends with panic, if not desperation! Over the past few days, I saw a year's worth of selling pressure has been telescoped into a few trading days. I could hear everybody on Main Streetlooking at financial assets melting to zero and saying -- I better crystallize whatever is left. With everybody in the street hunting for cash at a speed more rapid than witnessed during any of the previous bear markets, risk assets was set to freefall, the VIX index surged to new all time highs of 65, and people were buying short maturity US T- Bills at negative yield (Pay 102 for zero-coupon @100).

This scenario typically happens when things get out of control. Here are something I have learned this week --- 1) the financial system is breaking down, panic and lack of confidence in any counterparty is rising sharply and investors have totally lost faith in the ability of policy authorities to control the meltdown; 2) the process of simultaneously deleveraging does not happen at a constant gradual pace but rather it's a sequence of events that more resembles a nuclear chain reaction; 3) the world is now in a secular credit contraction that is going to involve debt pay-down, asset liquidation and rising personal savings rates, and this deflationary process is very likely to last well into 2009 and quite possibly beyond. 

A naturally follow-up question is what can we do to stop the panic from spreading out? In the past two weeks alone, global central banks executed emergency interest-rate cuts and pumped more cash into markets, the Fed said it would buy US CPs, European governments bailed out banks and the UK and US said they would start taking equity stakes in financial companies. But money markets remain gridlocked as 3M LIBOR stayed at its highest level this year even after coordinated interest-rate reductions worldwide. What left in the governments’ policy briefcase are quantitative easing, market closures, bank nationalizations, a sovereign guarantee of G8 inter-bank transactions... you name it…but given the sovereign involvement in this crisis is so deep that they better make sure these toolkits can break the loop of negative feedback before it has done catastrophic damage to the global financial and economic infrastructure. As a result, I am not surprised at all to read the BBG headlines of “Berlusconi Says Idea of Closing World's Markets Being Discussed” and “G-7 Commit to All Necessary Steps to Stem Crisis”. However, I do think even if all of the extra cash and lower policy rates will ultimately help in restoring some calm in financial markets, the jump in borrowing costs has strangled consumers and companies. In short, it’s too late for growth, and Asia will feel the chill, too.

On the back of these observations, we take a peak of market performance. Globally, stocks declined 4.98% on last Friday, collapsing 23% mtd and 42.7% ytd. Regionally, equities were down 38.8% in US, 43.8% in EU and 45.5% in AP region, year-to-date. UST curve steepened with 1M @ 0.06%, 2yr @ 1.63%, 10yr @ 3.87% and 2-10 spread widened to 226bp this week. Since last Friday, USD is 5% lower vs. YEN (100.67) and 1% lower vs. EUR (1.3409), but up 4% against broader EM currencies. 1MWTI oil decreased ~$9 to $77.7/bbl, down $24 this month and is currently at its lowest price of the year.

Looking ahead, as indicated by “The Theory of Reflexivity” we are entering a different dimension that will be ruled by new, and unknown, principles of finance to be discovered by experimentation as we go.  As George Soros wrote in his book in1994, “...In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy”…Yes, someday this will end, but when does it end? I only know it won't end because stocks have had 8 days down in a row, or because valuations are cheap, or because this is the worst week ever (40bp less than July 21, 1933, -18.6% wow then).  The simultaneous bursting of this super bubble is not about just stocks, it's about deleveraging the system of all excess assets --- housing, equity, bond, credit, commodity, hedge-fund and private-equities and even better- performing economies such as BRIC are at risk of “a hard landing.''  So all the pain will end when enough asset have been purged to get leverage down to tolerable and sustainable levels.

J.M. Keynes and J.K. Galbraith

Having presented the above observations, I think the worst is probably ahead as this  credit crisis broadens out into the real economy, although we have seen enough “the worst” things. Over the past few days, US stocks fell for 8 straight days, with the Dow capping its worst week since 1914, Nikkei had its worst weekly drop in history, and MSCI World Index was set for its biggest weekly decline since records began in 1970.

Just after many investors were inspired by Warren Buffet’s deals with Goldman Sachs & General Electric, there were +$4trn been erased from global equities this week, amid the stock market's worst yearly slump since 1937. Even the world’s richest person has seen his instant paper profits on GS ($437mn) and GE ($566mn) wipe out…Right, to a super, long-term investor like Warren Buffet, this is the time to buy more than other times, and this is one of those times where it buys more. But for most of the traders and, they may not have his leisure of time and performance measurement pressure. I think for now, all traders need do is watch the LIBOR (+7bp to 4.82% on Friday) and the TED spread (423bp) to gauge the extent of likely deleveraging. Equity markets will not turn until we start to see some relief in the money markets…Keep in mind that normal indicators of stock market bottoms are broken in this environment.

Earning wise, street analysts now expect a 7.5% drop in 3Q08profit at S&P 50, according to BBG, with earnings at financial companies to slump avg 74% in the same period. However, according to David Rosenberg, during the previous bear markets, a typical peak-to-trough decline in profits is around 25%, and during the actual economic contraction phase, earnings go down 15% on average...Thus we has 50% more to go at least and that is not even the case for non-financials as consensus earnings expectations for the non-financials component of the S&P 500 are still centred on prospects of around 20% earnings growth through 2007-'08.  As US economic growth falters, there is high possibility for earnings risks of non-financials turning to the downside, underscoring another downleg for global equity markets yet to be seen (Reminder, we have seen bad number from BOA, Alcoa and MetLife, and the cut of profit forecast from Macy’s Inc and CBS), Historically, what we have seen is that since 1855, a normal recession lasts 18 months and from the start of the recession to the low, the S&P 500 is typically down another 15%. 

Thus, we now ask ourselves two important questions: 1) do equities still look cheap?  No, until the negative feedback loop is interrupted; 2) when will it end?  I still don't know, but it will have at least 6 months to go…Oh, I got it from John Maynard Keynes --- “The market can stay irrational longer than you can stay solvent”, and from J.K. Galbraith (The trouble with Prosperity) --- "The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximise the suffering." (Note: MXCN is trading at 7.5XPE09 and 13.5% EPSG, CSI300 at 9.8XPE09 and 18.3% EPSG, MXHK at 9.7XPE09 and 5.4% EPSG, compared with MSCI AxJ at 8.6XPE09 and 5.1% EPSG

Two Signals of US Consumer Recession

Over the week, global central banks finally eased in a coordinated fashion with even the PBOC joining the party. While few expect the rate cuts will have immediate benefit in terms of stimulating credit growth (except in China), the good news is that the bond market viewed the rate cuts as inflationary, reflected by that 10 year UST yield rose 16bps on the back of the rate cut, which is unusual. The bad news is that the co-ordinated rate cuts and the UK bank assistance package (3.5% of GDP) did nothing to stem the upward move in LIBOR, implying there is no quick fix. What has dragged down the risk asset prices is the threat of a global financial meltdown which could result in a decade- long ''L-shaped'' recession -- like Japan's after its real estate and equity bubbles burst. If this turns into truth and demand falls, the next challenge may be deflation as the world faces a glut of excess capacity and goods.

Having said so, I did a quick check of the two engines of global demand, US consumers and China’s domestic consumptions. Both of which does not look optimistic. With respect to the importance of US consumers, some simple statistics can tell the story. American consumer is now more than 70% of US GDP and 18% of global GDP – it is bigger than the entire economy of Japan, China, Russia and India combined. I think the next phase of the profit downturn is going to be more fully reflected by the real economy, because even though the housing recession began over 2 years ago, and even though the capex recession started just 6 months ago, the intense leg of the consumer recession is only starting in 3Q08. The early warning signal is that consumer credit outstanding fell by $7.3bn in August -- and June and July were also revised down by a net amount of $1.4bn. This was the first outright contraction in credit in over 10 years and the largest ever, reflecting the balance sheet repair underway in the household sector. Another signal should simply be the unemployment rate, which has a historical -ve correlation of 70% with the S&P 500, a +ve 70% correlation with bank loan delinquency rates, a 60% inverse correlation with 10yr yield, and a 50% correlation with the direction of credit spreads. If we going back 6 decades, the unemployment rate typically goes up an average of 300bp when recession starts. Amazingly, the jobless rate has already risen 140bp from the cycle low to 6.1%, and it’s still far from certain that a conventionally defined recession had begun before the tail end of 3Q08. Indeed, some people may argue that Fed will continue to cut policy rate to boost growth (Yes, Fed Fund Future is pricing at least 50bp cut by the Oct 29 meeting), but I do nor how taking the target rate from 2% to 1% achieves much, given we've already gone from 5% to 2% in the past 12 months without positive effects.

Asia, China and IMF Outlooks

Globally, there are two global business cycle indicators pointing to further downside risks. One is the plunge in Japanese capital goods orders. In the recent quarter, US, Japan and Germany orders and shipments of capital goods are contracting when measured on the QoQ basis. The shipments data, in particular, track global equipment spending very closely and they are pointing to the first drop in global equipment spending since 1Q03. The drop in equipment spending and the recent erosion in global labour market indicators point to a shift toward business retrenchment in 3Q, which is a key reason why the global economy tilted into recession even before the market crisis erupted in September.

The second one is the collapse of September Taiwan exports (-1.6% yoy, the first time since 2002). Remember, Taiwan is a bellwether for emerging Asia as a whole, as exports in 2007 hit a record of >45% of pan-regional GDP – up more than 10% from the share prevailing in the mid-1990s. That left the world's fastest growing region more dependent on external demand than ever before. And with the American consumer in trouble, Asia's export-led growth dynamic is now at risk. In fact, many aspects of the growth characters for emerging Asia since 2000s ---rising commodity prices, strong economic growth, robust net capital inflows, buoyant domestic markets, rising FX rates and low inflation—are now operating in reverse. This is why we have seen BRIC equities down, Asian growth themes (machinery/metals/construction) down, Copper down and Grains down.

Talking about Asia, we can not ignore China, the largest population of consumer in the region. Again, numbers do not pain a promising outlook. With respect to domestic demand, MOC indicated last week that 59 countries saw their exports to China dropped yoy in the first 7 months of 2008. In terms of corporate confidence, NBS data shows that confidence among the listed-co saw the biggest drop of 11% to 145.6 pts. In addition, the property sales in Sept/holiday sales point to more dismal outlook, with average Sep transaction volume in major cities down 64% yoy, sending the first nine months’ volume 46% below the same period last year. As a result, investors are expecting some pro-growth policy/stimulus package from the 3rd CCP Plenary meeting. it is report that the party summit is expected to announce measures that could support the industrialization of agriculture production, more hard infrastructure investment in rural area, strengthening rural social infrastructure, and possibly taking steps to reform the urban residential registration system that can facilitate the continued migration of rural labour force into urban area. In general, the above steps are going to be helpful for China to find new domestic demand growth engine in the rural area for the long term, but not a near-term stock market solution, even though a shares has come down 70% form its peak.

Put all these analysis together, it makes more sense to understand why IMF, in its recent World Economic Outlook, said that US will expand just 0.1% in 2009 after 1.6% growth this year. And, the global economy is now forecast to expand 3% next year; that's down from the initial forecast of 3.7%.

Good night, my dear friends!