My Diary 375 --- Policy Reflation vs. Economic Deflation

My Diary 375 --- Policy Reflation vs. Economic Deflation; You Beat Us (UBS); No Battle between Equity and Credit

February 14, 2008

It is a happy Valentine Day for stock markets after a bettter reading on consumption (+0.3% vs. -0.4%) eased market concerns on a US recession and 3..7% 4Q07 Japan GDP growth, even as the specter of more credit turmoil echoed on the background. Indeed, with FED easing, Government stimulus, bargain hunting investors like Buffet, SWFs and the weak USD inspired US export, equity investors do have some reasons to cheer up.

However, behind the good news came more fear from credit , including monolines continuing to hang over the market, municipal bond auctions getting headlines, and the LBO market under scrutiny…So credit remains in distress, with inter-bank rates again widening to policy-rates. Adding to that, UBS posted the biggest ever loss by a bank in 4Q07 after $13.7 billion write-downs. Worry about those developments spilled into Treasury markets. All this led to the bond market to continue its steepening trade (2yr @1.91%, 10yr @3.71%), with 2/10 spreads moved to 180bp from 150bp on Jan 31st. Oil (93.76$/bbl) rallied on the usual battle of supply/demand from the EIA stats and on back of Venezuela/Exxon fight. While US Dollar was stronger at 108.23 YEN and 1.46 EUR.

Overall, my sense is that the good mood may flip quickly as we await Chinese data, Bernanke testimony and more from a world that seems strangely happy….Maybe due to a special day with ROSE Flowers….

Policy Reflation vs. Economic Deflation

No doubt, US consumption is the single most important headline overnight. In fact, other than the MoM distortions by motor vehicle sales (+0.6%) and gasoline sales (+2.0%), the US retail sales in January is better than expected. In the flip side, there were downward revisions to 4Q07 retail, a +0.4% growth vs +0.6% estimated by Commerce Dep…I am not in today’s ROSE mood as ( if the market remember) a couple surveys on business and consumer sentiment released on Tuesday had grim results --- 1) Small Business Optimism index fell to 91.8 in January from 94.6 in December, the lowest reading since the 1990-91 recession; 2) Weekly ABC News/Washington Post Consumer comfort index fell another 4 points in the four weeks through February 11 on top of a 6-point plunge last week to -37, the lowest reading since 1993. The 10-point drop over the past two weeks has only been exceeded twice in the 22-year history of this survey…… So the market seems only have RAM installed its memory and do not forget, the $168bn tax rebate will probably begin till May.

Economic wise, the Fed’s rate cuts in January have failed to lower borrowing costs for many companies and households, increasing the chance of further reductions from the central bank …50bps in March?... Future market now sees a 100% chance on March 18 meeting, up from 68% on Jan31. According to BBG, US households are paying more to borrow now than before the Fed reduced its benchmark rate by 125bps based on jumbo mortgage rates, risking further housing price declines as banks and investors are demanding greater compensation for offering credit as losses mount on sub-prime mortgage securities and concerns grow that ratings of bond insurers will be cut. The spread of IG US corporate bonds rose to 2.37% on Feb. 12 from 2.24% on Jan. 21, according to Merrill Lynch. Such an increase in credit spreads has been against Fed policy, resulting in an effective financial tightening. As a result, Mr. Bernanke will have to reduce rates further to revive the economy and he will give an update of his outlook tonight when he testifies before the Senate Banking Committee.

Bottom_line: The US economy is slowdown and the Feds actual easing stance is still data dependent. Hopefully, the policy reflation is catching up with economic deflation.

You Beat Us (UBS)

Two days ago, when Berkshire Hathaway offered to take over liabilities for bond insurers, a few credit crunch related nerves seemed calmed a bit…Really, Mr. Buffet is so kind to the troublesome bond insurers? The answer is NO, he is a good investor as the $800bn offer does not include the subprime related CDOs that are giving the monolines and the markets so much trouble. Today, UBS posted the biggest ever loss by a bank after $13.7bn in write-downs due to rising US sub-prime mortgage defaults. In details, UBS's write-downs included $10.8bn on sub-prime residentials, $2bn on Alt-As, and $871mn on credit protection purchased from monoline insurers. In addition, the bank recorded losses of about $500mn on commercial real estate and about $200mn on LBOs.

Now, listen to what the UBS Chairman Marcel Ospel and Rohner said --- the problems that the financial industry faces have not evaporated with the turn of the year, and 2008 is likely to be another generally difficult year…No surprises, with $13.7bn write-downs in one quarter, it is a tough year to any CEOs. Having said so, global investment banks are reportedly cutting back on lending to hedge funds among other investors, sparking forced sales across a range of asset classes. The deleveraging could be particularly long lasting, given the major hit to the investment banks’ capital base. YTD, the estimates of total financial losses for subprime-related debt range from $300 to $400bn. Of this, about $175bn has been realized and reported.

My final point to note is that this is not only a problem in US banks, you can find similar problems in UK, Spain, Italy and France. What's happening is that the collapse in capital markets' willingness to hold securitized products (and fund Off B/S vehicles) is forcing loans back onto banks' B/S. It's becoming clear that banks are struggling to accommodate the assets coming back on their balance sheets. This is very important as there is a anti-monetary-policy effect. Moreover, S&P warns half of Europe's LBOs companies have exceeded its debt forecasts and 53% missed earnings targets, making them more vulnerable to default.

Bottom_line: It is no surprise that the collapse of a bubble in a major asset class, such as US housing, could negatively affect the economy and financial markets. Nonetheless, the extent, depth and breadth of the damage to financial assets around the world, and the complex way that the shock has propagated through the credit markets, has caught many investors off-guard, sparking a potentially prolonged period of deleveraging in the major countries.

No Battle Between Equity and Credit

Today, stocks rallied around the world. MSCI World added 1% and Nikkei jumped 4.3%, the most since March 2002.MSCI AP added 3.7%, set for its steepest advance since Jan 25. Our HSI also climbed 3.7%, with HSCEI up 4.65% leading by Angang Steel and three China shipping companies, as well China Moly…Of course, this has got a lot to do with a better US equity tone over the last few days and I still hold a view that it will be quickly undone again, if intra-day sentiment turns like it has on any whiff of pessimism or negative conclusion on economic data.

Looking back a little bit, it is interesting to see that we are back to the "battle" between the equity and credit markets. The credit markets clearly took the lead with the first selloff in last August. However, this past week has shown that equity markets seem to now be driving sentiment in the credit world. What is increasingly clear is that the views of credit and equity investors are being increasingly aligned: lower earnings are negative for equities, as reflected in lower share prices, and for credit quality, resulting in wider spreads.

Globally, on the earnings front, Citi has released its view that it is highly likely that US analysts will be cutting their bottom-up forecasts aggressively through 2008 on S&P500, on the top of assumptions that there is no significant write-downs ahead in 2008, which in turn assumes that the monoline insurers will be bailed-out. In fact, the write-downs at two financial companies alone in Q4 were enough to cut full year S&P earnings in 2007 by around 4%, plus GMs accounting loss in Q3 took 5% off the 2007 total. Hopefully, the low base effect could be large enough to more than offset a standstill in profits growth elsewhere: over the year to 4Q08.

Within Asia, investors are witnessing equity analysts cutting price targets and earnings estimates. Goldman Sachs is going through a round of sector downgrade rotation in recent week - starting from basic materials to transportation, conglomerates, China banks, China insurances. Now, the next sector to downgrade/short will be consumer or infrastructure. UBS Asia also has downgraded 73 HK stocks' 2008 EPS by 7% since Sep last year and 96 China stocks' 2008 EPS by 2.2%. More than these downward negatives, emprical research of the last US recession in 2001 also revealed that EBIT margins fell by 2.4% in 2001, while UBS bottom up analysts are forecasting a 0.7% rise in EBIT margins in 2008E.

Bottom-line: despite the 4000 points correction in Hang Seng Index in just a month since mid-Jan and Fed rate 125bp rate cut, even I have not seen any equity strategists bullish enough to recommend that this is a level to BUY or not given the very low visibility.

Good night, my dear friends!