My Diary 382 --- Bernanke, Greg IP and Martin Feldstein;

My Diary 382 --- Bernanke, Greg IP and Martin Feldstein; iTraxx, CMBX and Auction-rate Securities; DXY, VIX and USDJPY

March 3, 2008

The final week of February closed out with sizeable losses as energy price touched all-time highs intra-day( $105/bbl), plus AIG reported a huge loss for its 4Q07 and UBS stated that financials could end up facing $600bn in losses with banks and brokerages responsible for about $350bn ( $163bn reported and further $85bn priced-in according to Goldman). Stock markets saw Dow Jones down 2.5% with all 30 components lower. VIX Index jumped 3ppts to 26.54. Nikkei 225 slipped 4.5% today and MSCI AP Index lost 3%. Asian stocks dropped the most in almost two weeks, almost erasing last month's gains.

Bonds were stronger as yields fell as the Subprime contagion spread to stocks, corporate, and the muni market late in the week. The 2yr yielding 1.583% is at its lowest level in nearly four years, while 10yr @ 3.515%....... I will not be surprised to see another wild one after Friday's NFP figures. Other markets, CRB index made a fresh record high for the 11th straight day at 413.78. Oil futures slipped to $101.82/bbl and Gold futures climbed to a record $982.7/lb. The Dollar weakens to 102.91 YEN and 1.5163 EUR.

An interesting question now is how many people still believing in the V-shaped recovery in 2008, which does not seem to be the case priced –in by the credit spreads……There is no simple answer, but I will try to lay out my points……

Bernanke, Greg IP and Martin Feldstein

Market performance over the past two months echoed closely to Bernanke’s testifying to Congress --- the “sustained disruption of the credit process” is “not near” an end, implying we may have not seen the widest of credit spreads. Under that scenario, equity prices have more downside risk. In fact, a recent survey done by Global Relative Value dated Feb 25, 2008, shows that >57% of voters anticipate the market turbulence will continue through the 2H08. Looking forward, I extend my bearish view for at least another 1 or 2Qs, and I expect myself to be shocked a few more times by What I Don’t Know.

Having said about those “Unknowns”, let us do a list of What We Know and Inquires of topics waiting for the full answers, as without the clarity, markets volatility remain high and risk appetite will continue to swing widely. Here is the “Fact-Inquiry” list

Ø         Whether US Housing foreclosures will increase to levels in excess of current projections?

Ø         What are the total amount of financial sector losses (not just due to Subprime), and will the banks be able to raise sufficient capital?

Ø         How long will the current deleveraging process last (a few months or quarters)?

Ø         How long and deep will the US economy slowdown move going forward? If it comes to a recession, will Asia decouple from that?

Ø         Will concerns around the bond insurers return to us after the recent rating downgrades?

Talking about recession, the BBG columnist Greg IP makes a comment today the two fears hang over the US economy (wrenching recession and spiraling inflation) almost never happen at the same time based on historical experience. And that explains why the Fed for now has chosen to focus on the first threat. However, public survey shows a different view. According to the Brookings Institute, 60% of the public believe the economy is already in recession. Adding to that is --- Martin Feldstein assessment of US economy (BBG interview on last Thursday) --- "A good way of summarizing it would be to say that economic activity reached a plateau. It’s neither going up nor coming down at this point .So the question, what's the next move? If I have to bet, I would say the next move is further softness and therefore that there's a better-than-even chance that we have actually entered a recession".

The market may find some early clues on this Friday after the release of NFP and unemployment rate. So far, survey signals are quite negative, as the Jobs Plentiful and Hard-to-Get indices were at their most pessimistic levels since late 2005. Job losses are likely to come from a range of industries, including construction, manufacturing, and finance. Foreseeing such a scenario, Fed Fund futures moved dramatically and are fully pricing in a 75bp cut to 2.25% by March 18 FOMC meeting. The futures market is pricing in a 95% chance that the Fed Funds rate will be down 100bp to 2.0% by the end of the April meeting……

iTraxx, CMBX and Auction-rate Securities

Credit conditions continue to worsen and deepen. The latest casualty is the municipal bond market. Many credit benchmarks saw spreads hit new bear-market extremes on last Friday. Moreover, short-end spreads (LIBOR to cash) are also again widening. Today, the Asian debt market opened weaker with iTraxx AxJ gapped sharply wider, as we saw HY and IG indices opened 17bp and 7bp wider from last Friday at 607bp and 177bp, respectively.

Apart from the economic consequences of credit distress, the recent moves point to more sizeable mark-to-market write-downs, witnessed by the AAA CMBX has widened from 65bp to 212bp over the same period. In BBG headlines, MBIA and Ambac’ filings show Subprime write-downs ($10bn FY07) will extended into 2008. The two bond insurers also said that they have written little new insurance since their ratings came under scrutiny…So further earning revision is down the road…

The importance of bond insurers can be seen in the auction-rate securities of which market conditions has changed dramatically in mid-February as sellers overwhelmed potential buyers, causing widespread auction failures for the first time. Market wise, the factors, resulting in the unraveling of the auction rate market (largely liquidity squeeze but not a rise in default risk) include, (1) severe pressures on bond insurers due to heightened concerns on their credit ratings; 2) constrained B/S at banks that historically provided liquidity during periods of supply/demand imbalances; and (3) concerns that penalty rates too low to allow the auction to clear.

The auction-rate market started falling apart last month as banks from Goldman Sachs to Citigroup permitted thousands of auctions to fail by not buying bonds that went unsold. At least 60% auctions failed to attract enough bidders since Feb13, based on BOA and BBG data. This is a significant change since the auction-rate market has operated smoothly for almost 25 years and there were fewer than 50 failures in total from 1984 through 2007, according to Moody's…… Consequence? YES, more deleveraging as hedge funds sought to sell as much as $3 billion of municipal securities last week after averaging $600 million the past 90 days, according to a Bloomberg. Top- rated, 30yr municipals offered yields that were10% higher than comparable-maturity Treasuries, the most in more than 11 years…AUCH!

Greater China, HSCEI and A-Shares

Regional stock markets rallied mildly in Greater China area (+4%), led high-beta sectors like materials and energy and industry. Over the February, earning continues to be revised down for all sectors, excluding staples and energy. Valuation wise, MSCICN stands at 16XPE08 with EPSG 29.1% and MSCIHK 18X PE08 with EPSG 8.4%. Volatility remains high as HSCEI and ‘HSI realized vol hit61.3 and 48.6….. Sit tight with your wear safe belt….

In local market, HSCEI rebalance process has taken place, with adding China Railway and CNBM, as well the deletion of Sinotrans, ZTE, and Weiqiao (effective as of March 10). A short-term trading strategy is to BUY the stocks entering the index, as empirical analysis shows that during one-week holding period (before the last trading day preceding the effective date) , the strategy had an average return of 2.24%, and 82% success rate of positive returns since 2002. Meanwhile, HK market keeps a close eye on the earning season, including HSB WLB, CHB, HKEx, PCCW, Swire and SHK…and then Chinese companies…

Mainland A-shares, the near-term focus is on the National People's Congress starting on Wednesday and more news on Telecom industry restructing, property price and stock market reform. Market consensus for the bottom of A-shares is around 4200-4100 and some believe now is the perfect timing to buy, but the sentiment is not easy to recover, if one looks at the average trading volume in Feb, which dropped by over 50% MoM. Local news say securities firms are starting to cut commission to attract clients again… thus, stay cautious on A-shares given their high valuations and low earnings visibility, while remember that the further deflating of A-shares is a positive signal to H shares.

DXY, USDJPY and VIX

The US Dollar got absolutely hammered this week, as expectations of a deeper and more prolonged US recession increase. As a result, Investors are using metals to preserve their buying power as the Dollar falls to a record and inflation accelerates. In the metal complex, precious metals have risen at least twice as fast as the EUR and YEN in 2008 and returned 6to 20X as much as USTs … Looking forward, I do see the price run can persist as fundamentally commodity prices should reflect underlying global economic growth, which is slowing, even outside of the US. What we are seeing is that commodities have become an alternative and a default safe-haven asset class as well as a hedge against a weaker Dollar. Near term, high commodity prices is like a tax to US consumers and businesses, which does not contribute positively to the growth as well.

Talking a little more about US Dollar, the DXY index touched 73.531 today, the lowest since its start in 1973. The broad based sell-off finally caught up to USDJPY with the Currency pair falling to its lowest level in nearly three years (102.94). To equity investors, one of the interesting points to note is that the relationship between equity market volatility and USDJPY has not recently been as strong as it was during much of last year. The recent decline in the S&P VIX has declined while the YEN has strengthened against the USD. While there is no solid conclusion about the apparent breakdown in this relationship, it is not a stretch to view it as yet another indication of the broad-based nature of the USD's weakness. In addition, the pullback in the VIX index is primarily a function of the recent consolidation pattern in US equities…… Looking forward, I would expect the VIX to spike again, if S&P comes under renewed downward pressure and in that case, not only would the VIX and YEN be more in synch, but it would presumably further increase the risk for further USDJPY declines from here.

Good night, my dear friends!