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My Diary 424 --- The Unknowns of Bailout; The Unsolved Fragility; The Toxic Alt-A; The Only Bull left; The Catch Up of USD Cold
September 14, 2008
“Chinese Moon vs. Oversea Moon” --- Today is the Moon Festival, the traditional family gathering day. About 15-20 years ago, a famous slogan described the phenomenon of Chinese people who are keen to immigrate to the overseas is that --- The oversea moon is rounder than
Having had a bite on the delicious moon cake, let us go back to the markets. This past week will be marked by a heavy note in the history book, given the UST/GSE Bail-out. However, despite the dramatic move by US authorities, EM equities have lost “a decade” of performance with MSCI AxJ below 400, a level seen in 11 years ago. In general, investors were dumping commodity-related shares aggressively alongside financials & everything in between, and the trend seems to become a wicked spiral, with no one wanting to be left holding the bag, and with volumes so thin that moves are exaggerated.
There are 2 undercurrents driving the accelerating sell off - 1) massive liquidation by LOs; 2) concerns over the next casualty in the
Before we move for a relative long diary today, we take a review first… Global stock market closed the week 0.9% higher, with +2.6% in EU, +0.6% in US and flat in
Looking ahead, the quasi-nationalization of F&F should be somewhat +ve to the mortgage-finance market, but house prices are still falling and unemployment is still rising. Overall, I think a sustained recovery of risk appetite in DMs seems unlikely and central banks will continue to fight inflation, rather than supporting growth. That said, the Fed looks likely to keep its benchmark rate unchanged at 2% into next year. Moreover, I would not expect EM equity turn around in the near term, although capitulation and liquidation more often than not produce undershoots and ultimately create good buying opportunities. However, the duration and magnitude of any liquidation phase is difficult to forecast. In the energy space, given the overall bearish macro and EM sentiment and the current cycle of selling any rally (including those hurricane induced), I can't see oil getting back to the $110 resistance…Well, starting from now, investors should keep an eye on Alt-A Mortgages, which could be next Subprime…In China, I kept hearing foreign investors are going to bottom-fish the A-shares, but at the meantime, I continue to see property sales down, auto sales down (1st time in 3 years), industrial activities down, SMEs closing down, export slow down, and consumption not really accelerating…So I think we need God help A-shares and God save Americans, then the market can back to normal…Last note, next week is big --- broker earnings and FOMC Meeting …Stay Alert!
The Unknowns of Bailout
Doing a search on my outlook for the abbreviation "GSE", I find +2 pages of messages, so I feel pretty humble about my ability to add new value, while providing some of my observations and thoughts here…The initial market response to the government’s GSE rescue plan has been positive. One objective of the plan is to insulate the financial system from the damage that would have occurred had the GSE failed. The plan also is intended to support the housing market by improving the availability and terms of mortgage financing. While the plan to do something is not new news, two features that seemed to catch the market by (bullish) surprise -- 1) greater than planned expansion of GSE balance sheet and temporary plan to buy new MBS originated by the GSE. However, the positive reactions does not imply market consensus over the medium-term implications.
On the positive side, the bailout not only alleviates uncertainty about the fate of F&F and importantly the $5.3tn GSE bonds and their ABS, but work to improve home affordability and help prices finds a floor. In fact, US mortgage rates are down almost 50bp over the past week and are rapidly approaching their 1H08 average. If so (a large if), MBS and other ABS debt could eventually find a floor and that would be positive for financial institutions globally. On the negative side, the obvious issue is the assumption of additional US federal debt and the moral hazard stemming from government intervention (again), which could come back to haunt the USD at some time down the road.
In terms of the unknowns, it is not clear that the bailout has generated a "credit event" that would allow the holders of GSE CDS (>$1.4tn) to exercise their right to seek compensation. Although 13 major dealers agreed “unanimously'' that the rescue constitutes a credit trigger according to ISDA, this is a big deal and I believe that the credit market has not experienced any settlement of a credit event for a name of this size. One caveat to that is that there was no court involved (the govt simply implemented the new structure). If no court was involved in the appointment of a conservator, then counterparties may argue that a credit Event did not occur. Anther question in my mind is -- will GSE spreads narrow further? It seems many traders are skeptical that the GSE nationalization will cure the ABS market more broadly and see spreads move back to pre-crisis levels (5yr GSEs from 93bp to normal 30-40bp).
The Underlying Fragility is Unsolved
Globally, the fact that several central banks outside of the US quickly praised the US move, including those of China, Japan and EU, proves the point that it was extremely necessary to shore up confidence in the US financial system. But the underlying issues that still leave the US economy fragility remain unresolved, and the US bailout could end up widening the disparity in perception between weak US growth offsetting by proactive policy vs. an increasingly fragile ROW still coming to terms with the rising risk of domestic recession.
Having said so, several Fed Officials expect a rate increase, not a cut as though commodity prices have fallen, core inflation could continue to drift higher. And after the GSE bail out, the immediate reaction from US IR markets was to increase expectations for FFTR hikes from 35bps to 55bps over the next 12 months. Since then, this has moderated to around +42bps currently. Rightly or wrongly, the market remains consistent in anticipating the next Fed move as being a hike. However, I believe that housing remains at the center of the Fed's concerns about growth and financial stability. With the financial system faces continued strains, a bottom in home prices is still not in sight, especially when the number of people receiving unemployment benefits jumped to 3.53mn, the highest level since 2003. Moreover, Given the inability of US consumers to borrow against their homes, and with rising unemployment, there is no wonder that Aug retail sales dropping 0.3% for the second month in a row (-0.5% in July). Also weighing against a shift in policy is the inflation backdrop, which has eased considerably 05Aug. Falling commodity prices haven take steam out of food and energy inflation, while a rising jobless rate has produced slack in the labor market. A stronger dollar has also taken pressure off import prices. And a slower global economy means less global demand. Furthermore, it's not clear that more rate cuts would help the economy, given that a year of cuts hasn't significantly reduced rates on mortgages and other loans.
Looking outside the US, markets are also deteriorating. The EU economy shrank for the first time in almost a decade last quarter, and EU Commissioner Joaquin Almunia said this week that the outlook is “unusually uncertain.'' In Asia, Japan economy contracted more than initially estimated, with GDP shrank 3% annually in 2Q08 (-2.4% in 1Q). In the EM markets, China data showed that the growth of exports (slowing 26.9% to 21.1%) and FAI (27.4%) remained OK in August. But it is fairly to say that the correlation between China’s exports and global GDP is not that strong. Moreover, two other EM heavyweights reported strong activity numbers, although these are more backward-looking. Brazil and Russia GDP advanced at 6.5% and 7.3% in 2Q08, respectively. So far, the overall EM GDP growth is in a 6-6.5% range for the third consecutive quarter…
The Toxic Alt-A & European Downgrades
We all know how bad the Subprime was. But it is time to get ready for Alt-A mortgages, a form of loan made to borrowers with better credit scores than Subprime borrowers, but who could not or decided not to document their income. One estimate is that 70% of Alt-A borrowers may have exaggerated their incomes and +50% exaggerated by 50% or more, according to Mortgage Asset Research Institute…So one should ask how big is the sick Alt-A market? Around 3mn US borrowers have Alt-A mortgages totaling $1tn, compared with $855bn of Subprime. With $400bn sold in 2006, ~16% of securitized Alt-A loans issued since Jan06 are at least 60 days late. Many of these loans (around $270bn) were IOs or with a low teaser rate and the resets were at 3yr and 5yr lengths. These are called Option ARMs. That means starting next year, the market will see a wave of mortgages resetting to new rates. And it is no modest increase. Rates can jump 4-8% or more from teaser rates. Some Option ARMs are resetting at 12.25%....Double Payment, ZZZZZ! …This is the reason why the prices of big seller of Alt-A loans, like Wachovia and Washington Mutual (2Q Book Value of $122bn and $53bn), are under pressure. And the upfront price that credit-default swap sellers demanded to protect WMU bonds from default for five years rose 9% to 41%, according to broker Phoenix Partners Group. WMU's CDS are trading at a level that would imply an 80% chance the company will default in the next five years, assuming bondholders recover 30c/dollar in the case of a default, according to a JPMorgan.
Not only we identify the next potential mortgage bomb, but the general corporate bond market is at its most illiquid since the collapse of LTCM a decade ago, prompting PMs to demand higher compensation to buy new bonds, driving up borrowing costs and reducing returns on existing securities. IG yields reached a record 3.22% above UST last week, according to ML US Corp Master Index. While in the Europe, companies may be living on borrowed time as the non-financial companies are burdened with EUR5.3tn ($7.6tn) of debt, equal to about 57% of the euro-zone economy. That's up from 48% before the 2001 slowdown and compares with 46% in the US, according to the Fed and ECB. So far this year, Moody's has cut long-term credit ratings on 216 European companies as the gap between profits and Capex rose to 4.5% of annual output last year, compared with 3.6% for their counterparts in the US, according to Citigroup….The size of the debt imbalances makes it very difficult to envisage a strong euro-zone economy over the next year or so, if it does not increase the risk of recession.
The only bull left in the world
According to the feedback of recent HSBC marketing tour, Indian investors must be the only bulls left in the world. Their bullishness is perhaps understandable as the Indian market has rallied in the past two months, outperforming MSCI AxJ by 25% when the rest of the region petered out. In addition, they enjoyed the luxury of net inflows this year with monthly average inflows of INR39bn, compared to INR20bn last year. In contrast, there seems no any bullish investor left in US, EU and around Asia (even in China and Korea) and there are several market indicators still point to the further downward adjustment -- 1) US mutual Fund holdings are up to 4.4% vs. 6.5% level of 2000; 2) total net outflows @ $708bn since the peak vs. $1.9tr outflow from 2000-2002; 3) buy rating from sell side analyst is @ 62% vs. 45% in past bear markets. The reason I mentioned the global funds or US funds is because, in terms of single countries, the US and Japan have been the largest diversifiers into offshore asset markets in the last decade, while foreigners have been heavy net sellers of Asian equities this year, but there may be more to come - perhaps a lot more. By AUM, US real money funds in total have around $17-18tn, compared with $8tn for all the central banks and SWFs in the world combined. Thus, an easy conclusion is that the real power in terms of asset allocation and diversification is with US and Japanese PMs rather than Asian or Middle Eastern central banks as even 10% allocations could equate to ~$2tn real money in foreign stocks, bonds, currency and other assets.
Talking about liquidity, we have seen daily T/O of RMB32.78bn, the lowest level in 21 months in the A-shares market. In addition, measured by both SH and SZ stock exchanges, Aug new added stock accounts is only 704.9k, the lowest level in past 20 months. Among all the accounts, only 40.18% have stock holdings…Does the low holdings imply investors to wait for bottom fishing? Furthermore, Aug saw bank deposits up 18.7% YoY (+19.7%), and time deposit accounts for 78.8% of new deposits…people are really hold back and with such thin liquidity plus 75% of XiaoFei shareholding still unsold, A-shares is not going anywhere but down. Valuation wise, A-shares now trade at only 10% premium with H-shares. HSCEI is trading at 11.9xPE and 17.6% EPSG, CSI300 at 12.8xPE and 20.6% EPSG, compared with regional market traded at 11.6XPE08 and 0.9% EPSG….Relatively cheaper, if you believe in the earnings…Having said so, Chinese economy is indeed slowing, but only gradually. To some extent, Aug IP reading (12.8%) reflects the temporary disruption of Olympic Games. More importantly, August exports slowed only modestly to 21.1%, while FAI has remained stable (27.4%) and retail sales are still growing at + 15% in real terms. In other words, all growth figures are still above 10% yoy in real terms. Thus, there is no hard landing risk and 2H GDP could stay around 9.5%, and there is no need to ease the monetary policy, as suggested by both PBOC and NDRC. However, with CPI (4.9%) moderated further and PPI remain at 10%, the corporate profit growth could further dampen in the period immediate ahead. In addition, given inflation is the reason behind the robust nominal growth of FAI, the prospect of a lackluster property market and further declining in export growth imply FAI has the potential to slip down.
Having mentioned the FAI, the real estate sector now represents the greatest economic and financial risk to China markets, with significant implications for sentiment, economic activities, and financial health. Recently, we have see the tier-1 players offer 20-35% discount around the country, including Vanke, Hengda and Shimao. But, the price cut seems not enough, as the Caijing survey shows potential home buyers are adopting a wait and see attitude, implying another 20~40% down of property price in mainland before finding support ( Wang Shi on 06Sep: 15-20% near term correction is reasonable). At the mean time, inventory continues to build up in major cities, with out of the 16 cities see the level >= 12 months, based on annualized 7M08 transaction volume. More worrisome is that mortgage loan by SH banks only increased by RMB290mN in Aug vs. 1.4bn in May, 2.7bN in June & 2.8bn in July….Oops, banks usually take back the umbrella during rainy days… Put this together, the outlook of Chinese property sector could be uglier and the next one month would be important in terms of assessing whether the price cuts can stimulate demand. I believe the natural next move for developer is to cut prices to lock in sales and recoup cash as quickly as possible…This echos the 38.18% cut of its GFA sales target in 2009 by Agile…I also think the end of this cycle will be earmarked by one or a few high profile developer bankruptcy case…
Couple with the concerns over property related loans, the failed expectation of RRR cut, the delayed CMB and WLB deal and the concern over loan demand, given weak IP figure have caused a substantial off-loading of bank stocks by long fund managers. In fact, this is not a surprise, as the sector has outperformed the market about 20% since 2Q08 with 2.2XPB09 (HSCEI =1.9X), while it is a very crowded trade as a heavy weighted sector in the China related index ( 41% HSCEI, 20% MSCI China AND 4,1% MSCI AxJ). Thus, even though there will no dramatically change of monetary policy, a rising NPL and the lagged downgrade of consensus earnings with deteriorating sector fundamentals --economic slowdown, shift in deposit mix, falling property prices, loan slowdown, NIM peaked in 1H08, fee income decline --- enough to justify a turn away of real money accounts.
The Catch Up of USD Cold
During the coming days and weeks, assessments of the GSE bailout and the implications for the USD and broad financial markets will continue. But for now, it is apparent that the bailout plan has not derailed the recent trend of USD strength. The USD rally is taking place due to global de-leveraging, decelerating MS growth and regional economic rotation. Overall, I think USD has further to rally based on these key themes. In effect, the USD is being rewarded for the govt’s strong actions to support the US financial system, housing market and overall economy, in stark contrast to the policy paralysis in Europe and Asia. But, more may yet be needed as there is a risk that the US consumer may not respond favourably even to these measures and we may see "demand failure."
In the other hand, as the USD consolidates its most recent gains, the uncertainty and outright concern surrounding so many other issues is ongoing. Stresses in the US and global financial systems persist and are at risk of intensifying, financial market de-leveraging continues, global growth is slowing, commodity prices are falling with oil approaching $100 even as OPEC attempts to curb overproduction and another hurricane moves to the Gulf of Mexico, and geopolitical risks are intensifying rather than receding. So what does all of this mean for the USD? Stresses in the global financial system alongside ongoing de-leveraging have seen risk assets correct lower in incredible fashion. That is clearly evident in the bursting of the commodity bubble, the decline in global equity prices, the widening in credit spreads, and the accompanying demand for cash that has pushed front-end yields lower in many countries. But to FX markets, USD has been a huge beneficiary of de-leveraging, due in part to USD-funded positions being cut globally. This judgement has been reinforced from a fundamental perspective, as downgraded global growth has forwarded the notion that other currencies need to be marked down in a manner similar to the USD's mark down during the previous year. Thus, there is every chance that EM Asia currencies will continue to mark down vs. USD as the region catches up to the problems the US has struggled through for the past year.
Good night, my dear friends!
