My Diary 341 --- When Housing Drops, When Fed Chief Talks, When

 

My Diary 341 --- When Housing Drops, When Fed Chief Talks, When RMB Appreciates, When China Buys

 

 

 

 

October 24, 2007

 

 

I really had a great time and enjoyed interesting conversations with with A-shares fund managers and a few close friends in the small beach city, Zhuhai. You know what, the world is so small and I also met with a previous CCB colleague, who was living in the same hotel 10 years ago when we worked in Beijing... Cheers for all the news friends and good buddies...Let's shop&talk, until we drop.

 

In reality, the markets did drop on last Friday. I should start from this point and then move to China before stopping at Commodities....Hula

 

 

When Housing Drops, SIVs Emerge

The week saw a massive 22-42 bps rally in USTs, led by the front end due to incredibly weak housing data, poor corporate earnings and significant losses in the equity market.  The 2yr treasury yields had the biggest drop since 2001, dropped 42 bp over the week, implying the investors’ expectation on the Fed cut again. The market is now pricing in a 92% probability that the Fed will ease by the October 31 FOMC meeting, which has almost tripled since last week’s 32% probability.

 

Following the benign CPI reading this week, inflation has become less of a concern and the focus remains on housing. Data wise, the NAHB Housing Index for Sep dropped to 18, the lowest level on record. Housing starts fell to 1.19mn a 14-year low, 89K below consensus of 1.28mn.  Building permits fell to 1.23mn, with the prior month revised upward to 1.32mn from 1.30mn.  Now, has anybody still doubted that there is a continuous trend of housing data underperforming already lowered expectations?

Credit spreads (CDX HG + 16bp) followed the suit and widened significantly this week as a result of the negative backdrop of the fall in the Dow (declining 367 ppt on Friday, or 2.64%), high oil prices (oil was up $90 a barrel) and continued weakness in the Dollar. Also contributing to a weak backdrop was a slew of weak earning announcements, with companies such as Caterpillar Inc., Bank of America, Wachovia, Hershey and Exxon Mobil all missing estimates. .. this does not end the story as SIV funds added more flavor at this time. In response to the recent crisis in SIV funds, Bank of America, Citigroup and JPMorgan announced the creation of an $80bn fund, named M-LEC, intended to improve liquidity in the market by buying assets from troubled SIVs... When I had all these news and data in front of me early this week, I started to think very hard about the US economy outlook.... and I am pretty sure that I am not the only one out there...

 

When Fed Chief Talks, You Listen

Over the week, several policymakers gave noteworthy speeches. Charles Evans, the new President of the Chicago Fed maintained the recent FOMC emphasis on risk management and the need to guard against "high cost outcomes" for the economy. Recent Fed commentary gives the impression that officials are prepared to cut rates again next week under the assumption that they can "quickly" remove this support if it proves unnecessary…But I would like to go back a little bit to get a hold of Fed Chief in New York.

 

Chairman Bernanke spoke on last Monday night, where he emphasized the downside risks to growth from this expected next large leg down in the housing sector.  He noted that many aspects of the credit and mortgage market are still not functioning properly, and will spill over into business investment decisions and consumer spending.  Here are some of his key points I would like to highlight here:

 

[Bernanke, Oct. 15th speech] "It remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions …nonetheless… "Downside risks to both household and business spending had clearly increased..."

 

There are more “warning” or cautious talks in the Economic Club and what I get from his message is that there is "considerable uncertainty to the economic outlook" over the period of next 12-16 months. In particular, we do not know when the next shoe will drop in financial markets and there is considerable uncertainty surrounding the estimates for real GDP growth, e.g. consumer and business spending estimates.

 

 

When RMB Appreciates, China Cools

The market saw a speculative news on China will allow faster gains in the RMB after a report circulating within the NDRC suggested the country should make another one-time adjustment (20%) in the currency. The RMB strengthened past 7.5 to the dollar for the first time since the currency's peg was abandoned more than two years ago.

 

Personally, I think the idea is not that silly as many street analysts gave their NOs. The reason is quite simple…The currency problems for China is that if we simply ignite the fire of appreciation, but keep it very consistent, then you just worsen the expectations problem. China ends up with even more excess capital, as both foreigners and domestics do whatever they can to increase their holdings of RMB… I think this is what has been happened so far….

 

And there is another consequence on asset prices. Today, with the PE for A-shares above 65X, it is difficult to argue that the market is not in a bubble phase, which I think it is a reflection of imbalances in the Chinese economy and the surging trade surplus. As a result, PBOC has to do massive intervention in the FX market and incomplete sterilization has led to liquidity overflows in the Chinese financial system.

The combination of a cheap currency and low interest rates is bound to foster inflation, either in the real economy or in asset prices. Given that productivity/efficiency gains and competition have capped inflation in the real sector of Chinese economy, subsequent liquidity overflows have led to dramatic asset price inflation.

 

Some ppl have suggested that by raising interest rates drastically, asset price bubble and liquidity overflows can be solved. I don’t think that way...Substantially higher interest rates are going to slow domestic demand (consumer spending and investment) and consequently, imports. This will only escalate the trade surplus and provoke even more protectionist measures from the US ... More and Bigger problems.

 

A more viable policy option is to allow for faster currency appreciation. Currency appreciation will curtail the trade surplus by making imports more attractive and capping the export boom. A narrowing trade surplus will reduce the need to intervene and should slow the pace of money growth. It will also help cool down the economy. Although it will have a knock-out impact on low-margin exporters (such as textile companies), this fits with the authorities’ objectives of encouraging export producers to move up the value-added chain and reducing strains on resource utilization.Finally, allowing for faster RMB appreciation will head off protectionist threats from the US....Now we may not need to invite Senator Schumber to visit China again.

 

 

When China Buys, Iron Ore Tops

Very soon, we will see a new round of price negotiation between the world’s major iron ore miners and their Chinese consumers. With the spot market getting ever tighter it seems that Chinese steel makers are in a weak position.

 

Benchmark spot iron ore prices have rocketed in recent months due to an ongoing boom in the steel market. Global wide, Australian and Brazilian delivered prices for spot material have risen by 39% and 71% respectively this year, with the freight charge from Brazil to China more than doubling to USD 88/t this month. The iron ore market has now become so tight that steel production growth is being held back. Iron ore buyers in general, but Chinese steel makers in particular, are now facing a  double whammy of a tight physical market and rising freight rates.

 

This spike in spot prices and the poor position of Chinese steel makers have come about for three main sources:1) the growth in Chinese crude steel production in recent years has been astounding (422 mt in 2006 and 1H07 growth at 19% yoy). China is easily the world’s largest steel producer and iron ore buyer and now accounts for 37% of global steel Output(1.24 bnt in 2006, + 8% 1H07); 2) due to a lack of mining equipment and qualified employees, iron ore production growth has struggled to keep up. Exports from Australia and Brazil combined rose to 487mt in 2006 but growth slowed from 12% in 2005 to 5% in 2006 and 6% in the 1H07. 3) Chinese buyers remain dangerously reliant on imported ore and this weakens their hand at the negotiating table. Chinese iron ore production is forecast by the CMA to rise to 700mt in 2007 and 940mt by the year 2010. However, ore grades for locally produced material are low (30% of grading compared to 64% of imported ore) which reduces the meaning of this growth. As a result, imports as a % of total iron ore demand will rise from 51% in 2006 to 52% in 2007 and 56% in 2010. Another significant source of steel units is the scrap market although this market is not particularly well supplied either. Good availability of scrap is reported in the US but Asian prices for benchmark types of steel scrap have increased from an average around USD 250/t in 2005 and 2006 to USD 370/t in September 2007.

 

Now, with the world’s big steel makers and the major iron ore producers (BHP, CVRD and Rio Tinto) account for about 75% of seabourne trade, Chinese steel makers have already accepted publicly that contract terms will rise for next year’s deliveries starting in April 2008. The main issue now is how big the increase will be. Street estimates are suggesting a around 30% but my Australian colleagues already mentioned a 50% rise to USD 125/t based on some renewed contract terms. ...50% now if Chinese buyers can afford that price spike, whether they can maintain reasonably levels of profitability are to be checked by the market... well.. at least that will give another reason to buy Angang Steel.

 

Good night, my dear friends