My Diary 410 --- The Pattern is Depressing; Judgment Day is Yet

My Diary 410 ---- The Pattern is Depressing; Judgment Day is Yet to Come; Flow Trend is Intact; Buy Gold, Short Copper and Hold Crude

July 20, 2008

The old rule on Wall Street is when financials do well, market ends well. It did not work on Friday, a close with a relatively quiet end to an incredibly dramatic week. While SP500 Financials Index added 1.1% after BTE results from Citi, JPM and Wells Fargo, SP500 IT Index slumped 1.5% outside of the big declines in Google (-9.8%), MSFT (-6%) and AMD (-12%). Overall, I do not see the return of confidence to financial stocks as Barclays’ shareholders only bought < 1/5 news shares (($9bn) and investors do not listen to ML CEO John Thain’s pitch on cheap broker stocks. In addition, I observed that confidence is becoming more of a factor for USD as recently the market seemed voting against the Paulson plan and the question in my mind is that how many fires can FOMC, FDIC and UST fight? Furthermore, oil prices took a 3-day nose dive, offering a ray of hope on inflation and consumer spending due to a faster decline of demand in DMs and a slower growth of demand in the EMS. However, I think this would not necessarily dictate lower crude price going forward.

Looking back, 1MWTI finished the week with a $16 dip to $128.88/bbl. Oil price is at its lowest price since June 5. That said, oil price is still above the 2QAVG=$124/bbl and if oil prices were flat the rest of 3Q at today’s close, oil would still post a healthy gain of nearly 6% QoQ…As expected, equity markets embraced the big oil move, rising for the 1st time in 7 weeks, finishing 1% above last Friday. Regional wise, EU climbed 3%; US added 1.6% while Nikkei lost ~2%. So far, among the 23 DMs in MSCI World Index, only Canada has averted a bear-market decline of 20% and combined loss of global equities is about $13.5tn. Elsewhere, USTs dropped as 2yr yield popped 14bp to 2.63% and 10yr moved up 9bp to 4.08%, both now at their highest yield since the end of June. Accordingly, USD rose 0.6% WOW against both EUR (1.585) and YEN (107).

Surviving in current markets should be the top priority to hedge funds as one can see how quickly things have changed! Barely one month ago, was media comment that the worst was behind us. Now, a la Bernanke, the US is confronting "numerous difficulties' regarding growth and inflation. Looking ahead, investors are likely holding their pocket tight due to the prospect of recession, stagflation and a systemic collapse in the US banking system…Other banks failures are likely after IndyMac “bank run” and 90 regional banks are on the Fed and FDIC’s watch list… It's too early to say we've seen the worst --- fatigued, confused, exhausted and thinking about summer vacations is how the market feels right now. Having said so, everyone asking if last 3-days’ rally is sustainable. I think technical indicators say Yes --- 1) VIX was down 3.5ppts or 15% from 28.54. In the past 2 years, such a magnitude of VIX dip suggests we will have 75% of chance to see a 1-2 week rally in SPX, and 2) Market Breadth Index has collapsed to 2002-03 lows, indicating everyone seems to have thrown in the towel. The contrarian’s view says this usually signals a turning point. But I think even though the near-term fear and uncertainty of FIs is going bust after recent 2Q results, stocks cannot really rally unless oil collapses. The recent spike of US stock indices (+2-3%) is largely prompted by a $16/bbl fall in oil price as well short-covering prompted by SEC’s move to crackdown on naked shorts of financial stocks…Running into economy first…

The Pattern is Depressing

The outlook of world economy is not pretty. Chairman Bernanke summarized his view in the semiannual testimony --- there are “significant downside risks to the outlook for growth'' and “upside risks to the inflation outlook have intensified”. Data wise, US housing starts look better (+ 9%, 1066K) in June, but solely due to a change of NYC construction code. Jobless claims (366k) continues to expand and Philly Fed (-16.3) has ranged in soft territory between -16 and -24 all year long. Moreover, existing home inventories have continued to climb (+10 months), as the cost and availability of capital remain serious headwinds, along with rising unemployment. For instance, Jumbo mortgage rates (7.42% vs 7.19% a week ago) have risen significantly even after 325bp base rate cut by Fed. Overall, my feel to the US economy is that policy rates are already very low, yet economic and financial problems are getting worse, not better. The pace of US.growth is set to slow markedly as the impact of tax rebates fades, and the latest problems with the GSEs warn that the financial shock-waves from the burst housing bubble will reverberate for a long time.

Meanwhile, inflation data is still 'surprising' on the upside in many markets. The latest price data confirms that global inflation set a new high of 4.7% yoy in June, up 0.5% from May and the highest rate since January 1997. Regional wise, EU and US core inflation has moved up to 1.8% and 2.4%, respectively, and ECB president Trichet said ---“we must stop second round inflation effects…we will ensure that price inflation is below 2% in the medium term”…Headline CPIs are also worsening due to food and fuel costs. EM inflation climbed to an estimated 8.1% yoy last month, with DM inflation reaching an estimated 3.9%, according to JPMorgan. Last week’s reports confirmed that EU inflation climbed to 4% in June and US price climbed to 5% (1.1% mom), the biggest increase since 1982.

With respect to growth, global manufacturing data were soft. US July Philly Fed survey was 45.4 on an ISM-equivalent basis. Japan’s Tankan survey dropped an additional 8 pts in July to the lowest level since April 2003. Consumptions side, US core retail sales rose 0.3% following gains of 0.7% in May and 0.9% in April, suggesting that the stimulus impact from tax rebate is behind us now…Apparently, going forward, US consumers have to look at their bills more carefully, as I recently read that US avg household makes $48K, of which 12K goes to food and energy, another 20K goes to tax, and the rest flows to Gap and Sony. In addition, the evidence continues to point to a slowdown across most EMs. The street is now forecasting worldwide real consumption at a 0.2% yoy in 2H08, reflecting an array of drags including higher inflation, softer labor income growth and falling household net worth.

I think such a pattern is depressing as the growth-inflation tradeoff has deteriorated and markets still need to adjust. On the one side, the EM central banks are mostly coming from behind the curve on the inflation threat in an environment of slow growth and the cut of fuel subsidies is releasing the pent-up inflation. If this wasn't enough to worry you, then we have the on-going credit crunch (witness FNM and FRE) and de-leveraging has further to run. Under such circumstances, equity markets are likely to be weighed down by a combination of weaker growth and tighter policy.

The Judgment Day is Yet to Come

It's true that Freddie’s recent bill auction drew solid demand, but to be fair to say, it is too early to judge the US govt's plan to stabilize/support/fund the GSE's will have on GSEs and on the broader financial system. I think the US Treasury is simply “buying time” as the reaction of financial market has showed another no confidence vote, reflecting by the vicious cycle of USD weakening back to the lows, oil back to the highs and stocks to new lows. Moreover, concerns have spread beyond the GSE's to private sector banks. I think as the judgment day comes, the only question left is -- at what cost and what manner that government will pay for taking GSEs over? The likely scenarios are 1) US taxpayer will be laying out the wallet; 2) or otherwise known as US Government debt; 3) maybe the recycled petrodollars/Asian export dollars… Problem is most of Petro/Asian Dollars are already earmarked to bail out/replenish US banks' capital.

Taking a quick look of USTs, 10yr notes had the biggest weekly drop in a month due to a few reasons –1) a sell hedge to the rising mortgage-bond rates. The 10yr yield has climbed 14bps to 4.08% wow while yields on 30yr mortgage bonds guaranteed by FNM touched 6.17%, the highest since 16Aug, 2007. The corresponding mortgage spread is 206bps more than 10yr notes, the biggest spread since March 11; 2) USTs fell also due to Citi LTE loss, easing concern about widening credit-market losses and cutting demand for the safety; 3) Treasuries fell amid speculation on ECB is considering another rate increase to combat inflation, after raising it on July 3 to 4.25%.

In the credit world, CDX NAIG fell 4.75bps to 136.75bp, according to Deutsche Bank and iTraxx EUIG index (125 companies) fell 1bp to 97.25, according to JPMorgan. On the week-to-week basis, the credit spread was largely flat. Same picture in our local markets and Asian credit market experienced a mixed week with directions driven by major firms' financial results. Asian CDS drifted wider post ML’s weak 2Q08 results and Moody's downgrades of MER and LEH. The iTraxx AxJ HY and IG indices returned to levels at the beginning of July to 593bp (flat) and 160.5bp (-2bp), respectively….It seems the bond investors are not yet clam down as well and I think at this moment, it is quite difficult to predict how the credit cycle and deleveraging process will progress in the coming months and years. There are highly complex interactions among energy costs, overall inflation, policy and business cycle dynamics.

The Flow Trend is Intact

I take a few weeks to scan through Fed’s speeches during 70s, 80s and 90s, through which I am interesting to keep a note that in all of these earlier times, an energy crisis was almost always accompanied by a banking crisis, such as Penn Central and Franklin National Bank (1970s), First Penn and Continental (1980s) and the S&L crisis (1990s) when over 2,000 regional banks and thrifts went under…These episodes look quite similar to nowadays as recent worry (in addition to FNM, FRE) has been US regional banks, especially after IndyMac's failure.

Local markets, Hong Kong was trading within 21K to 22K for the week, following the regional downward swings due to further US banking concerns, a rally on Thursday after SEC changed the rules on short-selling, but inching lower later as WSJ says Freddie considers US$10b capital raising to avoid a government bailout…A-share wise, SHCOMP lost 2.7% wow but the market saw a strong rebound on chatter that top govt officials will meet this weekend to discus the issuance of new articles on 2H08 macro control policy. An interesting observation is that the high correlation has been seen between the local and outside markets in the past month and people now are saying -- it is H-shares driving A-shares nowadays…Having talk about China, there are a few headlines worth for inks – 1) RRR hikes could slow on CBRC’s concerned that more banks will fall below the minimum requirement for short-term financial strength and warned against further increases; 2) Economic mix is turning as June data showed 2Q GDP @10.1%, CPI @ 7.1% and PPI @ 8.8%. CPI showed a 3rd consecutive monthly decline, however PPI reached the highest level since Nov2004; 3) Government price caps have brought further down refineries (386HK, 1H08 NP - 50%) and IPPs with Huaneng, Huadian expecting to post losses for 1H08.

To read the local markets on a broader basis, Asia Pacific FWPE has corrected 33% since Oct2007 and is currently below its LT average (13.8X), according to ML quant strategist. Nevertheless, compared with its all-time low (10X), there still remains potential downside risk of 17% from the current level as their propitiatory profit indicators have consistently provided negative signals. In particular, the OECD leading indicator has fallen for ten consecutive months. Fund flow wise, I have heard that global equity funds witnessed their highest outflows in the last three months at $2.1bn. Global equity funds have gone from 31% O/W EMs to just 4% MoM (from May to June). Countrywide, India has had outflows for ten straight weeks and the index lost 29.4%. Korea has witnessed a YTD outflow of $22 billion which is 76% of 2007 outflows…How much do all these flows worth?...MSCI AxJ was down about 12% vs S&P (-9%) during June, while July MTD performance so far, including the rally this week, is MSCI AxJ down 5% vs S&P (-1.3%)… so the trend looks intact for now...Valuation wise, MSCI China is now traded at 14.1XPE08 and 21.8% EPSG, CSI 300 at 16.2XPE08 and 25.3%EPSG, and H-shares at 13.9XPE08 and 22.2%EPSG, while regional market is traded at 12.3XPE08 and 9.3% EPSG…Cheaper but lower growth…

Buy Gold, Short Copper, Hold Crude

As I discussed in the last diary, USD is more or less a confidence and credibility issue now. One critical element of the current panic in the market that should raise red flags is that within the massive increase in global central bank reserves this decade --- most of which is held in USD -- the holdings of US agency and other ABS has increased significantly. According to Fed Data, the foreign investors’ holdings of agency bonds went from under $100bn at the beginning of this decade to $974bn at present, nearly a 10-fold increase. Moreover, during that same period of time, the ratio of Agency-to-Treasury debt in the custody holdings series jumped from13% to 70%. For example, Bank of Korea released its 2007 annual report and it stated that 55.8% of its FX reserve portfolio is in agencies, non-agency ABS and corporate bonds.

Having said so, there had been a few significant changes across the planet in last week, given that USD’s downward bias increased ---1) Kuwait declared that it is not planning future investment in Agency Debt and plans to increase investment in Japan, China, India and Canada (CAD$6.09bn in May); 2) The FT carried a cover story declaring that "Sovereign funds cut exposure to the weak US dollar". Obviously, the FNM&FRE problems and subsequent government intervention/bailout is clearly unhelpful for the USD in terms of enticing foreign investors to increase or even hold their existing USD-denominated assets. But in the near term, we may not see the collapse of USD vs major currency, although the USD is weak across board, given that 1) US Treasury and the Fed have unambiguously signaled that they stand behind the GSEs’ solvency and liquidity; 2) there is a high degree of financial and cyclical convergence between the major currency areas (EU and JPY). YTD, S&P500 is down 14.17% whereas DAX and Nikkei indices have lost 22.26% and 15.81%, respectively. Meanwhile, the economic growth indicators out of the EU, UK and Japan are turning from bad to worse. Hence, the market may not see a break through of 1.60EUR/USD, in particular EUR has risen over 83% vs USD and 51% in TW terms, since its lows in late 2000.

Regarding the metals, gold recently is catching a flight-to-quality bid (Closed @955) as the yellow metal is one of the best options as a “crisis hedge'' than oil. Another yellow metal --- Copper tumbled the most in a week as 3M LME dropped to $8085/ton, due to the falling imports in China and a weakening outlook for the global economy. In fact, strategists at Merrill Lynch and Morgan Stanley have been calling investors to sell commodities stocks because a slowing global economy will cut demand for raw materials such as copper, nickel and corn. In the other color side, black gold -- oil tumbled below $130 a barrel for the first time in more than a month. The declines accelerated amid growing concerns that the weakening economy and creeping inflation are eroding demand for fossil fuels in US and other large energy-consuming nations. Oil is now more than 10%t cheaper per barrel than it was on Monday and natural gas prices are down more than 20% t just since the Fourth of July…But I am not convinced that prices have turned a corner as fundamentally, the worldwide oil inventories remain at very low level and S&D is still tight.

Good night, my dear friends!