My Diary 397 --- At least 2Qs Recession; A Slow Deleveraging in

My Diary 397 --- At least 2Qs Recession; A Slow Deleveraging in Banks; 
A Rescue for A-shares; A Fall of EURUSD?

April 20, 2008

This week ended with an irony photograph capturing a naked male Chinese investor standing in the front door of CSRC. Well, for a market measured by SHCOMP, which has fallen 13.5% wow, 41.2% ytd and almost 50% since its peak in last October, there should have many retail investors with barely anything left, if they are still hanging on……In the US, stocks rallied (S&P500 +4.3%) and UST dropped as investors reacted to earnings results from Citigroup to Google and Caterpillar that topped analysts' estimates and pared their anticipation of Fed action.

Over the week, DM stocks ran up 3.5% vs ~1% in the EMs, but both groups are down about 7.5% ytd.  US Treasuries yield curve flattened a bit with 3M yield climbed 7bp and 2ye firmed 7bp (2.17%), while 10yr inched down 2bp (3.71%). In fact, after adding a cumulative 39bp, the 2yr yield is at its highest point since January.  Elsewhere, Oil rose nearly $2 on Friday to another new high at $116.69/bbl on news that a militant group sabotaged a major oil pipeline in Nigeria. Oil prices jumped more than $6 this week and are up more than $15 in April. Meanwhile, industrial and precious metals and agriculture prices declined, each commodity group flat to slightly down on the week… Well, feel better as I don’t drive, but I do eat…

In general, I believe stock markets are somewhat optimistic after seeing some better-than-expected earning results and figures of asset write-downs. The issue is large banks now have the risk of undercapitalized after taking such mega size losses. For instance, although shareholders were cheered by a small-than-estimated ($5.1bn) 1Q08 loss, Citigroup’s T1 CAR fell to 7.7% at the end of March. S&P is reviewing its credit rating for a possible downgrade, while Fitch has lowered its rating AA- from AA, with a negative outlook…Certainly, I do agree that the worse part of banking crisis may have passed after Fed rescued Bear Sterns.  Now, the biggest problem for equity markets is the rising energy prices, which have introduced huge uncertainties into the world economy. And from now on, the severity and duration of the global business cycle downturn will inevitably be impacted by the evolution of energy…… Let us start with something slightly positive --LEIs

Why: At least 2Qs Recession?

US leading indicator did not continue to erode, but still staying one STD below its long-term trend, implying a weak economy for another 6-9 months. As a result, I still think further interest rate cuts are probable, especially the credit sector problems have not been resolved and inter-bank spreads have failed to narrow and mortgage rates remain stubbornly high…I will explain later in this diary…

The justification for more rate cuts coming from a thinking that this recession is fundamentally a consumer recession, brought by a bursting of the housing bubble and a credit crisis. Now, we all know that US consumer spending is under pressure from several main areas, despite a still low unemployment rate --- 1) there is a fall in housing related spending, including construction, furniture, mortgages, etc. The problem is that the resulting fall in housing prices produces a negative wealth effect. The American either can't or won't borrow as much as they did in a few years ago, which will make them start saving more… Good for individuals, but bad for overall consumer spending; 2) even though core inflation is tame, headline inflation is high and rising, which is directly linked to the daily life of average American. Remember, the rising energy bills are acted like a tax bill to US consumers and there is less money left over to buy discretionary things; 3) the rising unemployment ( from 4.8% to 5.1%) is clearly bearish of consumer spending. All of these factors suggest a recession of at least 2Qs, if not three…Why is at least 2Qs?

Of course, the lower Fed funds rates and the efforts by Congress to stimulate lower mortgage rates will help eventually, but it will not be an immediate solution as the cause for the current recession is the bursting of the twin bubbles, housing and credit. It will take years to clean the 3.5mn excess homes (with 2mn vacant) in the US, not matter that the Fed does to FFRs and opening the discount window to I-banks. Moreover, about 60%  of the debt market value has gone due to the implosion of CDOs, SIVs, CLOs, etc…Is there anybody believe that the freshly-burned buyers will come back soon …No way, as we spent 15 years creating the markets, it will take a few years at least to build their replacements. Plus, we have inflation threats now as over the week, Fed Governor Kevin Warsh, San Francisco Fed President Janet Yellen and three other district-bank presidents voiced concerns about rising prices. In addition, Harvard University economist Martin Feldstein, who has the responsibility to name when is the recession, called for an end to Fed rate cuts. As a result, the downward momentum of FFR may be nearing a pause after the fastest reductions in two decades as the Fed’s policy makers has sensed both renewed inflation dangers and a possible economic boost from government rebate checks.

How: A Slow Deleveraging in Banks?

In the US and Europe, commercial banks remain under stress, as evidenced by abnormally high inter-bank spreads (Libor spreads), a measure of both counterparty default risk and liquidity factors. Measured by LIBOR-3M spread, it still hangs above 150bps vs. 30-40 bps in 1H07. In addition, the LIBOR/OIS spread also has continued to edge higher in the US and Europe. Notably, the short maturity inter-bank spreads have dropped back below recent highs, but spreads at the longer maturities continue to march steadily wider. The implication is that banks will remain unwilling to lend to each other for an extended period, with potentially damaging effect on economic growth. The reasons for this could be quite complicated and not completely understood. Perhaps banks still do not trust each other, or maybe they are hoarding cash in an attempt to shore up their capital bases. Whatever the reason, the threat of a credit crunch and financial disintermediation is still lingering.

One of the possible reasons is related to the “asset-reversal”. Although banks would normally deal with a drop in asset prices by reducing leverage, in this cycle they were forced to do the opposite. The 2007 collapse in the ABCP market triggered backstop lines of credit and also forced many banks to take depreciating assets back onto their B/S. As a result, banks were forced to increase the asset side of their B/S at the same time when investors flied to quality. The dislocation is demonstrated by the acceleration in Commercial & Industrial (C&I) loan growth…In addition, as pointed out by David Roche, the current deleveraging in bank is slow as 80% of lending to leverage investors is subject to legal agreements. It will take times to end the contracts. Further more, lenders continue to believe that their normally high (up to 90%) collaterals ratio was a sufficient guarantee against loss in case of default. Certainly, with the falling of a broader range of asset prices, this attitude is gradually changing.

Having said so, we are fortunate that the bond market seems to know there is no inflation, and as such is acting on its own to regulate the economy. So far, bond prices have been positively correlated with oil prices. If not, both businesses and consumers would be facing severe squeezes from high energy costs, rising interest rates and slowing income growth. Having said so, liquidity remained thin on Asian credits and the market see no end to the painful dilemma --- a sound regional credit fundamentals vs. a risk of  further deterioration in the global credit environment. Asian spreads have not managed to decouple from US and European market performance (not in the near future as well). Spread wise, iTraxx Asia IG was at 117bp and HY reached 522bp……Personally, I don’t have the crystal ball to know how these market variables will eventually play out. Everything seems to be interrelated and it is hard to figure out how the circle is closed.

Whether: A Rescue for A-shares?

As I discussed with several friend, the biggest barrier now for equity markets to rally further is no longer the credit crisis in the US, but the soaring oil prices, acting as an even bigger threat to growth. Historically, stocks are almost always negatively correlated with energy prices during periods of weak growth or economic contraction…This makes perfect sense and answers my first point regarding the US consumption-led recession. During the period of recession, income growth is seriously restrained, and therefore any additional increase in oil prices, a form of growth tax, will take away at the spending power of consumers and businesses and hence damages equity prices. However, during periods of good economic growth, income gains are the dominant factor, offsetting the negative impact from rising oil prices.

Having talked about stock prices, the 84-year old, legendary author of the Dow Theory Letters, Richard Russell believes that stocks were not at great value in the classic sense at October 2002 and January 2008. The moment is coming with the dollar losing its reserve currency status, while Blue-chip stocks selling in the single digit PE ratios with dividend yield =7-8%. Maybe echoing his great life-time insights to the stock markets, H-shares receded 3.1% on US recession fears, while my homeland A-shares fell 13.5% last week due to concerns on further tightening measures and deteriorating earnings prospects. A-H price premium has shrunk to 43%, with turnover contracted sharply. Valuation wise, MSCI China is now traded at 15XPE08 and 24.7% EPSG, vs. CSI 300 at 19.4PE08 and 27.3%EPSG, while regional market is traded at 14.2XPE08 and 13.7% EPSG.

In the near term, the market sentiment to A-shares should remain weak witnessed by that domestic mutual fund subscriptions have slowed to a trickle. As a result, A-share markets may continue to drop despite 1) government’s gesture to help --- from CSRC approved over 30 new mutual funds since Feb and will approve more QFIIs (US$20bn quota), to SASAC said no worry about SOE share sell; 2) several government officials called on the government to save the market, including CBRC head……Maybe we do need to rescue the A-shares, other wise the CSRC will be blocked by more and more naked persons……

Having joked about the A-shares, Chinese economy is rolling over with 1Q08 GDP growth @ 10.6% yoy, stronger than expected, and CPI up 8.3% yoy in March, down slightly from 8.7% in Feb. The concern is PPI jumped to 8% (6.6% in Feb). As a result, PBOC made the 3rd RRR hike (50bp) this year. My observation is that US and EU slow-down have begun to impact the Chinese economy. Although overall export growth in 1Q08 was still at a healthy level of 21.4%, it has come down from 27.8% in 1Q07. The biggest hit came form the US (dropped from 20.4% to 5.4% yoy), while shipments to EU rose by 24.2% compared to 34.5% in 1Q07. More importantly, with important growth actually accelerating this year (28.6% vs. 18.2%yoy), the contribution of net exports to GDO is turns to negative……we need stronger Chinese consumer more than US now ……

When: A Fall of EURUSD?

I have an interesting, multiple choice question to the US policymakers regarding the US Dollar. That is, which one is better -- a stronger USD and lower energy prices or a weaker USD and even higher energy prices?  Personally, I do believe the think the USD will likely continue to slide, as you can not have a strong USD, when you are cutting rates aggressively! In reality, the decline in USD has been accompanied by falling bond yields and short-term rates and is therefore a “free lunch” as far as the US economy is concerned.

Market wise, over the last few weeks, US Dollar has lost ground again, especially EURUSD (1.5815). This is not a surprise as the economic weakness and the global credit crisis continue to take its centre stage in the US. In addition, recently several ECB members have ruled out any room for interest cuts near term given that EU’s headline CPI is currently at 3.6% y/y, way above the medium term inflation target at 2%. It is well-known NOW that the ECB does not care about the EUR strength, while the US government does not mind the USD weakness.

Thus, we may see EURUSD test higher through the 1.60 level in the coming future, as the key to watch for EURUSD cross is the trade weighted level fro each of the single currency, but not the rate differentials. From this perspective, it should be noted that, in trade weighted terms, the EUR is actually >7% below the highs of the 1970s. With this in mind, investors should be able to focus on the ongoing divergence between the worsening US data compared to that from the EU, which is expected to deteriorate until 3Q08…. That is the time I expect to see a fall of EURUSD and energy price maybe. It is the most important currency to watch as year to date about 60% of bond investors’ gains coming form currency…… Stay tune….

Good night, my dear friends!