My Diary 334 --- No Inflation’s Global Play, The US’ Housing Key

My Diary 334 --- No Inflation’s Global Play, The US’ Housing Key, Bankers’ Lies,  A-Shares’ Party, You have CAD and Here come Commodities

September 29, 2007

There are dark spots even in the white moon (明月亦有瑕) -- this is a proverb my grandfather told me 20 years ago. Interestingly enough, what I found in this Mid-Autumn Festival is that this proverb fits very well into the “party–week” situation of global financial markets recently.

Before last night, the markets appear to be immune to negative headlines and to be single-minded focusing on the Fed’s 50bp rate cut on Sep 18. As a result, I almost feel like the credit/equity markets are set to party like there is no tomorrow. Nowadays, even the weaker US consumer confidence, the falling Case-Shiller housing price index and existing home sales plus a rising commodity prices and an ailing dollar have not made a dent in the credits markets. Moreover, even issues of terrorism and bird flu do not work out at this stage, with recent reports on Al-Qaeda regrouping and bird flu break out in the Guangdong province. Perhaps this party could go on for a few weeks or months, but what is next? An even bigger party …???

 

 

Money Goes Global But Not Inflation

During the past week, global money continues to move towards equities, commodities and currencies, staying as far from the US housing market as possible. In the US, the subprime lenders' stocks hit a new low despite the rally in the S&P 500, while the US Dollar continues its steady downtrend, reflecting waning interest in US paper as a consequence of relatively unattractive economic and investment prospects. Conversely, emerging market equities have completely recovered, hitting a new high. In sum, the environment is the opposite of the 1990s, when the US Dollar and US equities were king.

Talking about globalization, Fed governor Mishkin said in this Thursday that the diminished acceleration of prices worldwide has been achieved "the old fashioned way" -- tighter monetary policy. While theoretically the increasing integration of global product, labor and financial markets could significantly alter the behavior of the economy and complicate monetary policy, "in practice," he said, "the behavior of the US and global economies does not appear to have radically changed in recent years." Perhaps, he added, globalization "has helped spread a common culture that stresses the benefits of achieving price stability" and that increased focus on the issue "has been a key reason for the reduction of inflation worldwide." So, if I understand him well and that means, going forward, the world will continues to rely on Dr. Bernanke and his worldwide fellows… A job security insurance talk :)

 

 

Housing Is still tje Key for the US

US data continue to show the economy stumbled in August, including payrolls, housing, IP and durable goods orders. However, one exception is US consumer. While the 83.4 of Michigan confidence index remains at the lowest level in a year, Consumer spending rose +0.6% (consensus=0.4%) in August, suggesting Americans are as yet undeterred by a softening labor market and higher borrowing costs.  When put the two indicators in the same page, it looks to me that a decline in confidence hasn't translated into a collapse in spending, which makes up more than 2/3 of US economy. So far, I think it is wage gains (+ 0.3%) helped shield consumers from the effects of a worsening real-estate recession.

Regarding the boarder US economy, I have to acknowledge that the ongoing poor state of the housing market has started to damped consumer attitudes and spending. The offsets could come from an increased business spending and an improvement in the current account deficit, due to continued Dollar weakness, keeping growth in the 2-3% area for the coming quarters. However, as pointed out by Fed, given the continued strength in commodities, relatively strong global economy and the recent Fed actions, inflation is likely to tick further out of the Fed's comfort zone.

 

Having said so, the housing market still poses significant risks to the US. In reality, August new home sales were weaker than expected, falling 8.3% to a new cycle low of 795K (consensus=825K). New home sales are down 21% from a year ago and have fallen 43% since the peak back in July 2005. Nonetheless, the continued declines in Housing Starts and Building Permits suggest that any pickup in residential construction will be delayed further, and the already large overhang of unsold homes -- 10 months (the Aug Existing Home Sales report) – may well be exacerbated by tightening lending standards and additional homes for sale due to rising foreclosures. At this point, it is hard to see any meaningful pickup in residential construction before 2Q08 at the earliest.

 

All these mean that the Fed is not done cutting rates. In the future market yesterday, constracts showed 90% odds the Fed would lower its target by a quarter point to 4.50% at its next meeting Oct. 31, compared with 72 percent a week ago. Also, since we cannot expect much from the housing market for the next few quarters, the economic outlook really depends on the labour market. So the next key release is the Sep Employment on 5 Oct.... Keep you eye wide-open next week!!!

 

 

Inter-bank Markets Don’t Lie, but Bankers Do

Let us take a look at the most suffered CP markets. Things look getting better, but please hold on a second and take a deep check... Yesterday, the US commercial paper release showed ABCP outstanding continued to taper off last week, but at a much diminished pace. The spread between jumbo and conventional 30yr mortgage rates has fallen 25bp over the past month and is now at its narrowest point since mid August. While this is encouraging, the current spread of about 80bp has a long way to go before it reaches the typical 25-30bp spread prior to the early August rise.

This does not end the story. The cut in the disc rate by Fed did capped 1M LIBOR, which has fallen to 5.12% at present from 5.50% a week ago and 5.81% two weeks ago, but it is still far from normal as there is still a big premium to borrow in the market as seen in the spread between 3M LIBOR and the target funds rate, notwithstanding the absolute decline in rates in the past week. The same scene can be seen in the EUR spread too, which has remained stubbornly around 75bps between 3M Euribor and the refinancing rate. Given that the ECB has for some time now been adding liquidity to the market in the 3M area, and given the economy’s relative resilience to the sub-prime problem, the persistence of that spread may indicate that central banks have already done all they can to ease the bottleneck in money markets. Thus, this is what I called “ dark spots”, implying that it takes more time to restore confidence further from here for banks to taking more counterparty risk.

 

However, one uniquniess of the recent slow recovery is how regional it has been. This regional asymmetry, combined with the continued volatility of interbank lending rates—especially for overnight borrowing—highlight the continued fragility of the credit market recovery. I still hold my view that eventually, investors will refocus on downside risks to US growth and global credit markets. The troubles in the US housing and credit markets are of course not resolved by the 50bp cut in Fed Funds target rate. Neither will future Fed cuts provide the same stimulus to risk taking activity as they will be more expected by the market... If it takes one more year to see another “ Round Moon” and I think it also takes more time to slove a problem which was accoumulated since the beginning of this decade!!

 

One more “a dark spot to this “look-like” bright market is a Bloomberg news regarding Taiwan Banks --- “additional exposure to CDOs through CBO holdings (which had not been disclosed previously! ..why and where were they?) have recently been revealed. According to Lehman Brothers’ research, there is around NT$2.5 billion holding in the equity tranche of Fubon bank would be at risk of MTM losses, which is about 14% of the estimated EBT in 2007. To be honest, I feel a bit annoyed by just looking at how banks lied in this credit crisis and this is why the 3M inter-bank rate still enjoys a premium. Last time, we lost trust to big 4 accounting firm and CEOs due to Enron& WorldCom scandals that option incentive scheme. This time what we lost faith is to rating agencies and now some called commercial bankers. I have to ask myself how the world could function like this way --- “Liar loans + Liar banker + Loss liars +…???” … Oh yes, there is only one answer: Greedy, the ultimate nature of human beings. So stay cautious view on the Asian banking sector in general.

 

 

The Party of A-shares Continued

How many times I use “Day Day Up” to picture A-share markets over the past? It must be everywhere. Even after cross the 5500 level, A-shares market never cools off, with QDII funds now are sold like hot cakes. On Friday, SHCOMP index hit new record highs @5827, witnessed by 85% of the listed shares recording gains. The CSI300 index YTD has returned 173% and my HK colleagues comment – what a money making market!  .. Wait a moment again….Have you ever heard a stock market can make money for all investors all the times???

Turning into Hong Kong, the past week’s performance of H –shares looks to me like that it is the A-shares now becoming the bechmark of HK, instead of the reverse. But whether you beleive it or not, it is the way market thinking now. One truth is that Chinese liquidity flows to HK have remained a major focus in recent weeks. And there are some early signs that the process has already started --- 1) portfolio inflows to China have started to slow after a massive increase earlier this year, while equity capital inflows to HK have accelerated significantly; 2) the negative interest rate spread between HK and the US has started to widen in the past few weeks. Now, we may have entered into a mania-building phase, where price gains could be explosive, but with potentially tremendous volatility... Question is for the investors who have taken profits, would they come back again?

 

Sector wise, China Telecom’s share price has soared 20% in the past two days on a rumor that the Audit Commission will start a major audit of the five Chinese Telcos. The market suspects that it will serve as the basis for making telecom-restructuring decisions. Personally, I do not believe that story. This action is more like a tax audit as the telecom sector is one of the most profitable and cash-rich industries in China, and a business audit is warranted given that there will be significant tax cuts next year ( from 33% to 25%).

Another sector has been moving up in Steel despite all the negative tax changes. robust demand growth in China, combined with low inventory levels following the summer export surge have kept steel prices high. And many stell analysts are expecting this trend will continue. The real driver is actually demand growth, which is at 19% Cagr for the past five years. This is quite comparable to Japan, a country which has gone through a 20-year industrial revolution with a demand Cagr of 12-13%. If China can sustain similar levels, then current 20X PE might be reasonable compared to the global average12X PE.

 

Do you have Canadian Dollar?

 

I asked the question to my new colleague who just returned from Canada to HK, and he looked confused. I then said it is one to one now. Yes, after five years in a bull market, the CAD has finally reached parity with its US counterpart. Although, technically, a correction seems likely, but I think the long-term fundamentals behind the CAD remain favorable. The high price of oil,  along with a healthy current account surplus are ongoing positives for the currency. Furthermore, a narrowing interest rate spread as the Fed cuts rates and the BoC stays on hold, will add to upward pressure on the Canadian Dollar.

Across the earth, the Yen rose against the US Dollar (115.29) slightly on the back of strong industrial output (+ 4.3% yoy) in Aug, the fastest pace in almost four years and a rebounded household spending (+ 0.5% yoy / Consensus -0.3%).  But the recovery is unlikely to come in a straight line and I would tend to sell further rallies in the carry trade, as the global growth is peaking while inflation risk still remains. But the risk of my judgment is the hawkish stance of the BOJ and an upside surprise in the October meeting should support a sizable Yen rally.

 

 

Here come Commodities!

Commodities had the biggest monthly gain in 32 years, led by wheat, crude oil and gold, as the dollar's slump enhanced the appeal of energy, grains and precious metals as a hedge against inflation. Certainly, China is never been neglected in this sector as prices of oil and metals gained on speculation a further interest-rate cut in the US and faster expansion in China will sustain demand for raw materials.

Now, bring some numbers home for your weekend. The CRB Index was up 8.1% this month, the most since July 1975. Wheat reached a record $9.5125 a bushel; Crude oil climbed to $83.90 a barrel, the highest ever, on Sept. 20 and approached the record today. Gold rose as high as $752.80 per ounce, the highest since January 1980.

 

Seeing the Crude oil prices toying with all time highs in nominal terms recently, I tried to sort out all the possible drivers, which includ 1)  threats to supply in the Gulf of Mexico; 2) USD weakness; 3) persistent demand growth and investor interest. Looking at fundamentals, the crude oil market is currently adequately supplied and OPEC has indicated that it will review its production targets if WTI remains over US$80pb for an extended period, suggesting that this is an effective ceiling for now. US inventories may be falling but they are falling from very high levels and are a consequence of improving refinery run rates, which are easing some of the product tightness, and Potential shut-ins in the Gulf of Mexico tends to be short-lived.

 

On the demand side, US gasoline demand has been persistently strong, despite high prices. China’s import demand continues outpace. The IEA has revised down its demand forecasts, but is still expecting positive growth this year and next, in particualr the demand growth outside the OECD.  As a result, investors are still positive on oil, not least due to the positive roll return generated by backwardation in the forward curve, witnessed by the sheer increase in volume of non-commercial futures positions on the NYMEX.

 

Botom_line: the +USD80 oil prices are now too high and not reflecting the fundamentals of the market. Once the US hurricane season has passed and OPEC’s production increase becomes a reality, prices will move lower in the USD65-70 range  again..

 

Good night, my dear friends