My Diary 406 --- The Unlabelled Recession; I Would Say Wider;

My Diary 406 --- The Unlabelled Recession; I Would Say Wider; The Chickens to Roost; The Capped USD but Not Oil

June 21, 2008

I am no where a technical guru, but given the current irrational and uncertain market environment, TA may help tell something which could not be explained by the fundamentals. Here comes one -- ytd, Fridays have proven to be the worst performance day as S&P 500 declined avg 0.6% and 14 times out of the past 24 Fridays vs. -0.2% on Wednesday & 0.1-0.2% gain on n Mondays, Tuesdays and Thursdays…Maybe, there are things that probably won't happen in other weekdays, but could happen in Friday… Here I have a proof…Even though Chinese govt seems like Henry Paulson quite a lot and help bring down crude price $5/bbl by raising domestic fuel prices, Israel’s military rehearsal helped push crude oil to $135.36/bbl or +2.08% on Friday…

Having said so, global equities slumped 1.6% on Friday with US and EU markets down about 1.75%, Nikkei lost 1.3%. In fact, global stocks sank 2.6% this week after decreasing 1.7% last week. Elsewhere, USTs gained this week with 2yr and 10yr yields dipped 14bp and 9bp, respectively. Accordingly, USD lost 1.5% vs. EUR (1.561) and 0.8% vs. YEN (107.3). Agriculture prices were about flat on the week, although they still held onto last week’s sizable gains.

Over the week, negative news on current credit crisis and global economic downturns ratcheted up to a new level leading to a synergistic market collapse. Depressing stories which weigh on the risk assets, including HBOS’ $2bn write down, rumors on Lehman’s Insiders selling, Thornburg‘s delay on 2Q F/S and Paulson’s statement on only 1/3 through the write downs. In addition, GS and LEH forecasted more write downs for UBS & DB and more 2Q lose for Fannie and Freddie. Plus ML said bank stocks are in capitulation mode…Enough negatives, but the key is still on Oils. Indeed, o ver the next couple of months, I expect the SP500 to go +20% higher if oil price collapse to near 100$/bbl. The equation is simple as lower oil = lower inflation = less rate hikes= less policy mistakes = stock markets move-up. My other contrarian thought is based on a ML survey which reports the underweighted equity investors jump to 27% from 5% in May -- a decade high, and FT magazine showed that investor pessimism towards equities is the highest in decade…Decade high+ Decade low, that should mean something …

The Unlabelled Recession

Following a few weeks of hawkish comments aimed at containing inflation expectations, central bankers have toned down their stance in the past week, probably in order to contain rate hike expectations. Such a change should not surprise investors as US data continued to point to a familiar combination of lackluster growth and high inflation. Looking at detail, May housing starts and IP contracted and single-family starts and permits declined. In addition, the first two US June Fed manufacturing surveys ( New York and Philadelphia) point to a decline in the ISM manufacturing index, which posted a surprise increase in May. The implication is that manufacturing activity is not yet poised to recover.

In the other hand, US PPI soared at all stages of production in May, reflecting the surge in commodity prices and likely some downstream pass-through. Moreover, the latest Manpower survey confirmed the ongoing divergence in job markets, with housing/retail/financial sectors are in a deepening recession, whereas the rest of the economy (67% total payrolls) has held up fairly well, especially compared to previous economic slowdowns…An important observation is to compare the sluggishness of US growth with the continued boom in China. China’s May activity indicators were uniformly strong, including exports, IP, retail sales and FAI. With Chinese govt well-positioned to make up for any shortfall in export growth, and the reluctance to clamp down on domestic growth, the Chinese economy should continue to grow at +10% in 2H08.

Given all the recent macro indicators, one should expect that the current economy downturn in will eventually be labeled by NBER as recession, primarily based on payrolls, real incomes, IP and final sales ... Why I am able to say so, because these components are similar to the ingredients of Coincident Indicators produced by the Conference Board. The Coincident Index peaked in Oct2007 and has fallen since then… I think the worries behind the Fed’s mind is that, if the economy picks up too quickly, they will be left with an inflation rate still too high and a policy rate much too low…Would we see a quick recovery, I doubt as 1) housing bear markets usually last 4-5 years; 2) banks are still substantially undercapitalized; and 3) $4-per-gallon gasoline is acting as consumption tax …

Wider, I Would Say

Bond markets are waiting for another key decision made by FOMC and futures see a 90% chance the Fed will leave its 2% FFTR rate unchanged on June 25, up from 78% a week ago. The probability it will lift rates at its August meeting has slipped to 34%t from 53% one week ago. At the mean time, the BE inflation measured by 10yr TIPS and UST notes narrowed to 2.50% from 2.52% over the past week. However, the decade long inflation expectation did climbed from 2.28% at the end of April.

For the next week, the credit market will have something to digest as MBIA and Ambac, the world's two biggest debt guarantors, lost their top Aaa rankings. After Fitch and S&P, Moody's lowered the rating on MBIA on Friday to A2 and that of Ambac to Aa3. As a result, rates on short-term municipal securities guaranteed by MBIA and Ambac, i.e. California’s Housing Finance, rose to 9% from 4.5%. Such a magnitude of soaring borrowing costs is threatening to provoke a new turmoil in the $2.6tn muni market, a traditional safe haven, and it may start to rattle the MMFs again, as which are required to hold ST debt rated at least AA …T he financial sector is still very much under water and it seem unreasonable for the Fed is going to raise rates next week…

In response to Moody’s action, our regional CDS also rose with iTraxx Asia IG advanced 2bp to 135, according to BNP Paribas SA. In addition, due to the lack of conviction, liquidity and continued negative headlines, iTraxx Asia HY has moved wider for the 3rd day and traded at 527 on Friday based on Lehman’s closing price. In fact, the index was traded as tight as 484 on Tuesday…Now guess where will the spread go from here…Wider, I would say, and anybody interested in the credit strategist’s call on equity index …

The Chickens to Roost

RBS credit strategist, Bob Janjuah (well known due to his very accurate call on credit crisis) said last week that "A very nasty period is soon to be upon us - be prepared…and the S&P would hit 1050 by September as all the chickens come home to roost “… Hey, Sir, do you imply we investors are chickens…Forget eggs & Chicks and I have some figures on the valuation of S&P… Compared with the year of 1990 when PE ratio was around 15X, which then S&P entered into an bull market till 1999 when PE surged to 35X, the index P/E ratio is now 21.8X. As earnings are dropping as US economy is working through a very tough period with 1-2% GDP growth likely in the next two years, Bob’s forecasting is sounded like a rooster hooting in dawn.

Having talked about Bob’s talk, we take a look at local markets – by Friday, HSCEI dropped 23.5% ytd, while CSI300 fell 46.6% and ‘Hangseng down 18.3%. It seemed that the markets are ignoring all important fundamentals and run their own courses. Although history or technicals don't necessarily reflect future performance, but there are people out there who trade on charts based on historical or technical data…Why not, if the market is losing its mind, and let us looking back the various "bear markets" in the past 12 years … Here the chart shows me that each time the HSI has dropped +50% to form a bottom (-60% in 1997, bottoming out in 98, rallied 63% subsequently; -54% in 2000 , hitting bottom in 02 and then rallied 266%)… what do I learn? 1) each time bear markets will drop more than 50%; 2) bull markets usually last longer than bear markets; 3) the crisis in bear markets were the "best buying opportunity" as rally would be 2-5X in size.

It shows that. HSI will have 15% more to the south, implying 20,000 the bottom … But I am not that bearish as A-shares seemed to have reached its 50% bottom and the authority is rolling out new policies to save the market for the shinning Olympic Games…But I have to say, I don’t really have the crystal ball, who has it? The time machine and the history ... Indeed, the domestic A-share indices have recently send +5-7% intraday swings for several times due to he usual proliferation of rumors and to call A-share next move is nothing more than to predict a random walk…I even saw a broker friend called SH Composite Index as SH compacted Index…Valuations perspective, MSCI CN ended 14.5X08PE vs. 22.7% 08EPSG, CSI 300 at 16.5X08PE vs. 26.7% 08EPSG and H shares at 14X 08PE vs. 23% 08EPSG. The MSCI AxJ is averaged at 13.2X 08EPE vs. 14% 08EPSG. The region continued to see large outflow of USD2.4bn with shrinking trading volumes…Seemed like chickens are going home…

The Capped USD but Not Oil

China announced price increases of 16%-17% on gasoline and diesel. Regarding the economy, I think the direct impacts on CPI are likely to be small as only 0.5% weight of refined oil in CPI basket. More visible impact is on PPI and corporate profitability of downstream industries will likely to decline. In addition, I guess these increases should curb the growth rate of domestic energy consumption, but the impact on demand is ambiguous as such an increase in retail prices should spur refiners’ demand to crude. In reality the govt is still subsidizing as domestic fuel price is now 30% below international level. A research note done by Morgan Stanley also showed that a negative statistical relationship does not exist between consumption and domestic prices. These results suggest that the demand destruction impact of a fuel price increase in China would likely be rather small.

That is to say that as long as EM consumers continue to be shielded from the full force of the increase in global commodity prices, we are not likely to see a straight decline of energy price. Recent data showed that EMs contributed almost all oil demand growth since 2000 and was over 50% of total demand as of 2007, while DMs’ demand has responded sharply to rising oil prices, contracting in 2006 and 2007. Moreover, IEA estimates that world oil use this year will climb 800K bbl/d or 1% as EMs demand increase. Stagnating production from Russia and the North Sea are also contributing to higher prices.

USD headed for a weekly decline against EUR on speculation the Fed will hold off from raising interest rates next week to support the US economy. USD also headed for a weekly loss vs. YEN after a contraction in US manufacturing. Over the week, t here was a general agreement that the USD is stuck in a range trade against the majors as now the relative interest rate prospects are the major drivers. It seems certain that ECB will hike rates at least once this year, meanwhile US rate expectations continue to decline from +143bps a week ago, to +119bps over the next 12 months. Looking ahead, I do think such expectations are likely to be further reduced as more US economic data come in on the weak side. In short, USD will be limited by prospects for rate hikes elsewhere and reduced US rate hike prospects… The upside to USD is capped...

Good night, my dear friends!