My Diary 451 --- Recession is Everywhere! Even Underwear Getting

My Diary 451 --- Recession is Everywhere! Even Underwear Getting Cut! Where is the Market Bottom?

October 19, 2008

Good Buys and Good Byes --- We are experiencing one of the most exciting moments in the human history… How many times have you seen two trading days in the same week that were ranked one of the biggest gains (+936pts on 13Oct)  and losses (-733pts on 15Oct) on Dow Index? How many times have you seen VIX traded above 70? Under such an unprecedented market environment, there are lots of good buys emerging here, including the sale of ₤3.5 for Iceland on EBay (Not a joke, Business Weeks lists another 13 potential unlucky nations that could follow Iceland’s foot print, Check them out!)…Question is Do I want to buy a piece of “land with Ice only” when my HK MPF account is expected to lost +21% in the first 9Ms of this year. That said, I am not surprisingly to see a note from a trader friend,“… Goodbye to my house, Goodbye to my car, Goodbye to my trophy wife..."

Over the week, the unlimited USD funding for term announced by US and other major central banks is the biggest thing ever heard so far. However, the major problem with all the bailout packages is that they’ve failed to significantly reduce LIBOR rates across the markets, with limited achievement beyond the ON markets, so far. Libor-OIS spread stayed @329bp vs 24bp in Jan08 and 11bp of 10yr avg before Aug07. It seems that mistrust remains and almost any form of leverage is too expensive. It’s also getting difficult to gauge how far the deleveraging process has come so far. Having said so, I think there is a much deeper issue involved in the recent relentless volatility/sell-offs. The issue is not just about deleveraging and liquidity. It is about what will happen in the future. Investors do feel concerned about recession, but I believe they have started to worry about the substantial uncertainty, boosted by the massive government interventions into markets, related to the future structure of financial and economic systems. Historically, rates of return on capital suffer during periods of increasing and heavy regulation. 

The other unintended side-effect emerged from the aggressive intervention by the world's respective governments is capital market dislocation. For example, recently announced government guarantees of bank debt may have made agency debt seem less attractive on the margin. This is understandable as agency funding costs have to rise when their guarantee seems much less unique now, plus more supplies are coming. In a market which few investors have the B/S to respond to arbitrage opportunities, 2yr agency spreads over USTs surged by +20bp to historic highs around 155bp, while 5yr FME spread was 124bp, compared with 102bp a week ago, according to BBG. In addition, Mtg rates recently have been moving sharply higher with 30yr rates widened out by about 50bp @6.29% over the last two weeks, according to Bankrate. With housing already under severe pressure, the widening of agency spreads/Mtg rates will make a difficult situation even worse. This will not help with what UST Secretary Paulson claims is the "fundamental" problem…Oops, it seems highly likely that before Henry Paulson says good bye to his Treasury office, the common quote to American will remain --- good bye, my house! … Certainly, I do think higher Mtg rates are on the Fed's radar screen now. But if your are Mr. Paulson or Bernanke, compared the market of agency debts with that of bank debts, which one do you think is more important? I would bet the latter as now that the prevention of a systemic crisis is paramount and it's hard to imagine anything being more important than the liquidity of banking system. …Well, it looks like a perfect dilemma case for Nash, too.

[Note: let us look at this issue from a different angle -- the sovereign vs. bank spreads. Over the week, the Korean government spreads were traded way above Korean banks (KDB/Korea@110/160; Koomin/Korea@ 130/170; Woori/Korea @ 175/225; Shinhan/Korea@145/195). In the market terms, the ratio of bank-vs.-sovereign spreads for a given country is a function partly of the banking system's ability to pose a threat to sovereign solvency and partly the sovereign's ability to provide support. The markets appear to be saying that Asian sovereigns are able to provide that support but it will be costly for the governments…My question is Korea is not Iceland, but exactly how different? Both listed on the BW 13 nations!]

Before moving ahead, we take a look back of market performance. Over the week, global equity markets rebounded 4.44% after declining 20% in the prior 7 days. Regionally, US and EU were up 4.6%, while Nikkei was down 5.1% and AxJ lost 3.5%. Elsewhere, UST 2/10 spread has widened significantly since the end of Aug, from 144bp to 242bp, mostly due to the 76bp decline in 2yr yield. On Friday, 2yr UST closed at 1.61% and 10yr @ 3.93%.  However, USD was unchanged this week on TW basis, with EUR/USD finished at 1.34, while YEN/USD slipped nearly 1% to 101.6. With respect to commodities, 1MWTI oil closed at $71.85/bbl, down nearly $6 this week and lower $29 in Oct. Metals and agriculture prices have also broadly declined 10-20% this month. The key watch this week is US conventional 30-year FRM rates continued to trend upward. Rates on conforming and jumbo mortgages have run up about 40bp this month to 6.35% and 7.62%, according to Bankrate.

Looking ahead, there are several issues/ questions to be watched and to be answered --- 1) Given that governments are committed to solve for the liability side of the crisis through two critical items --- taxpayer-backed recapitalization and broad guarantees, the focus now is how the asset side will perform, given all the damages have done and will do to real economy, in particular what happens to unemployment? 2) The outlook for broad risky assets is more complicated as financial risk relief may be balanced by intensifying cyclical risk. Yes, investors are seeing longer-term value in equities, but two catalysts are missing --- strong economy fundamentals and easy financial conditions. Moreover, the consensus is market has not hit the bottom yet as suggested by the latest ML fund manager survey. [Note: the survey shows extreme pessimism- Asset allocation bears: 56% OW Cash 17% OW Bonds and 45% UW Equity - record levels since 1998.] It seems that the risk/reward tradeoff does not yet warrant aggressive accumulation of risky assets, given that many investors are looking for a bounce to lighten positions, redemption orders continue to mount, and a prolonged recession lies ahead. Even if equities are nearing a bottom, there should be several good opportunities to add exposure in the months ahead. 3) The most frequent question being asked now is what will be the next? Well, I am not sure whether it's because I only saw what I want to see, but it seems that signs of slowdown everywhere in China/HK, based on my recent company visits and the latest macro data…Thus, my preliminary observation is a board-based consumption slow-down is unavoidable.

Recession is Everywhere!

Having touched the topic of US consumer recession in my last diary, there are more and more evidence to support my observations. Over the week, the market saw another big sell off in the US following dismal retail sales figures and downbeat comments from the Fed which turned investor focus back to the R word…I think Bernanke is eventually getting the picture right, given the dark outlook of US retailers. Macro wise, the Sep US retail sales shows the largest drop (-1.2%) since August 2005. Auto sales are down, virtually in freefall, with many auto company sales down more than 30% (Volvo is down 50%). And it may get worse as the 3Q08 earnings guidance for key retailers such as Kohls, JC Penny, Abercrombie & Fitch and Macy's have all recently has been lowered. Even Wal-Mart could no longer bulk the trend and recorded a 1.2% drop in sales last month (note that 50% of sales is from non-discretionary items). The Wal-Mart data make sense to me as according to the Yiwu Toy Association, the orders of Christmas trees dropped about 30% yoy this year. This never happened in the past 10 years.

There is no doubt that the recent global financial turmoil has clearly done nothing to ease uncertainties for an already stretched consumer. While the threat posed by rocketing oil prices has eased, the impact of recent events on consumer confidence is unlikely to be erased overnight, particularly as the focus will now be shifting to the state of the jobs.  Talking about employment is because the two primary drivers of consumer spending are income and wealth. Standing in the current status of this cycle, I do expect income will contract sharply over the next several quarters. Historically, wages and overall income growth move with the employment cycle and according to the previous four recessions, for every 1% rise in unemployment rate, real wage growth declines, on average, by 1.5%. During this cycle the unemployment rate bottomed at 4.4%. So if the unemployment rate will rise to over 7% early next year, then real wage growth could drop by 3% in 2009 which will force consumers into a significant retrenchment, especially given the deterioration in wealth positions. In fact, based on B/S data of the US household sector, the now +40% fall in the S&P500 since Oct2007 has eliminated about $6.4tn in household wealth. All else equal, a traditional PCE model suggests that this fall in equity wealthy alone should reduce consumer spending by 2.2% (1.6% of GDP). According to JPMorgan, the total real PCE growth in 3Q is now tracking -3.2% (q/q, saar), the largest decline since the 2Q80 credit control debacle. Moreover, the extremely weak trajectory into the current quarter puts downside risk to our current call for PCE to contract at a 2.5% pace in 4Q.

The deterioration of the financial position of US households is also witnessed clearly by the rising delinquency rates of various types of consumer debt over the week. In particular, the delinquency rate on auto loans is 3.8%, up from 2.9% two years ago…Consumer finance? Up to a very high 8.3%... Credit card delinquencies are 4.8%, rising from 4%...Is anybody still wondering why banks are cutting credit lines and raising interest rates to try and stem the bleeding?... Mtg delinquencies have doubled from 2.5% to a current 5%. Consumer credit in general is up to 5% delinquent, more than two-thirds higher than two years ago. This is all illustrative of a consumer in trouble. More importantly, let's pay particular attention to the fall-off in applications for re-financing, down by almost 60%. This was the source of MEW, which fueled consumer-spending growth even in the face of the last recession. As pointed out by Steven Roach, the root of the problem of this crisis was America's audacious shift from income- to asset-based saving. The US consumer has been enjoyed the “easy-money” with trend growth in consumer demand hitting 3.5% yoy in real terms over 14 years, from 1994 to 2007, while real disposable income growth averaging just 3.2% over the same period…This is not the case any more…Say good bye to your overextended life style, American….

To the boarder US economy, this demand weakness is feeding back on production. US factory output skidded in Aug (-1.1%) and Sep (-2.8%), even after adjusting for the hurricanes and the Boeing strike. The severe weakness in the New York and Philadelphia Fed manufacturing surveys suggests that output declined sharply again in Oct (-37.5). Fresh demand weakness also is seen in the NAHB survey, which fell to a new low (14) in October. Initial jobless claims, which gave an early warning of trouble, have stayed high (469K) although their underlying level has stabilized in recent weeks…Recession is everywhere….

Even Underwear Getting Cut!

The drop in US consumer spending is common across the DMs as suggested by most of the monthly retail sales volume and personal consumption index, which are plunging at a pace not seen in a decade. Even in Japan, Sony is expected to undershoot its guidance (¥470bn) by+¥100bn, according to an article in the Nikkei, not mentioning all the indicators of Oct Tankan survey point to more negatives. To China, there is no question that a deep economic recession in the US and EU will have a significant adverse impact on Chinese growth, as the two economies combined account for >35% of China's overseas sales. As a result, China's cyclical outlook now depends on whether domestic sectors will be able to pick up the slack. And the question is that whether the Chinese growth engine is stuck? I think, Very Much likely. As the global factory, the difference of China’s growth outlook lies in the fact that China now bears much of the brunt of the global inventory adjustment. During my recent visits to Li & Fung (Bruce Rockowitz, President) and Calvin Klein (Joy Fong, Asia Sourcing Director), both firms have pictured me a significant slow-down in shipments and even the cancellation of full quarterly orders over the past few weeks…It looks like that the negative impact on the real economy down to the root is kicking in and even underwears getting cut!...

As warned by the Chief Executive Donald Tsang, the global credit crunch is worse than Asia's 1997 financial crisis and HK is still at an early stage of reeling the impact of the global financial crisis...Still in the early stage!!! Did he know that his judgment has turned into brutal reality over the past few weeks as we are seeing more bankruptcy/closing-downs in HK? The laundry list now includes toy and electronic manufacturers --- BEP Intl (2326 HK) & Smart Union (2700 HK); retail chain -- Tailin (a home appliance retailer like GOME) & Timeplus mall (a shopping centre in Causeway Bay), as well as the recent liquidation of U-right (627 HK), Tak Fat and Peacemark (340 HK). I think Tailin is so far the best example to indicate the severity of this credit crunch. As one of the major consumer electronics appliance chains in Hong Kong, Tailin was established in 1946 and has been operating in HK for 62 years, meaning it has survived previous downturns such as those in 1998 and 2003.

With respect to China, I can not help thinking about what is the "true" growth rate of Chinese economy now? …Below 8%, or above 9% or between…If based on what I have seen and what I have heard, the forward looking growth rate at below 8.0% yoy is not totally out of box as historically, after the Asia Crisis, growth was reported around 7-8%. Alternatively, we can take a look at power demand as an indicator of economy growth and any underlying structural shifts. So far, MoM figures are showing signs of slowing – July08 YTD 10.9%; Aug08 YTD 10.2% and Sep08 YTD 9.7%. This series of data is very significant because this would mark the first time since 2001 that demand growth has dipped below 10%. If based on the 1.6X correlation of power demand and output growth, China’s Sep demand growth would be ~5-6% yoy….5-6% in China, means Very Hard Landing (Last seen in 1998)!!! …In fact, the slow down of power demand growth is also echoed by the lower Sep utilization of CRP's plants (59%, -6ppts yoy) and that of Datang (67%, -4ppts yoy). Having said so, the Sep M1 yoy growth also dipped below 10% --- an alarm signal as 10% is threshold during the last 3 economic slowdown in 1998, 2001 & 2004… How bad the over picture is? We will know it one day ahead of schedule as NDRC will announce 3Q macro data tomorrow. The street is expected 3GDP growth@ ~9%; IP @ <12% and FAI Urban @ ~27%... Stay Tune!

Where is the Market Bottom?

As I discussed above, the markets are likely to refocus in coming weeks on the economic outlook and how it has changed in light of recent events, given a 1930s-style depression looks less likely now, while major central banks are likely to cut rates further as the near-term outlook for inflation over the next 1-2 years has improved. On the back of this observation, I think the short-term bias is higher, but the medium-term bias is lower. Such reasoning comes from 5 perspectives of my analytics, including credit market, historical experience, growth reduction, valuation and technical indicators.

1.        LIBOR & Deleveraging

As pointed out, beyond the tenor of 2 week, money market curves (LIBOR >=1 Month) remain barely budged, indicating the lack of willingness for back to lend to the economy. I think bankers are not greedy and foolish at this stage as leverage cannot be solved by more leverage. So, if the consumer is leveraged, banks are unlikely to solve their problems by giving more loans. Thus, we will continue to face the -ve impact of falling asset prices, including equities, during the on-going deleveraging process.  According to a HSBC senior treasury manager this week -- we are only three months into a three year global de-leveraging.  That is to say, before banks get back to the business of market-making, we will not see the floor of collateral/asset price under which banks feel comfortable to lend. 

Investors should monitor measures of bank funding costs and related spreads for signs that the latest policy initiatives are working. These include LIBOR/OIS spreads, 2yr swap spreads, counterparty CDS spreads and the slope of the LIBOR /swap curve. Also watch financial over non-financial corporate bond spreads.

2.        Historical Experience in 1929 & 2000-03

The current financial crisis, although far from being over, is already the most costly in recent history in USD terms. But these costs could rise sharply if this crisis broadens into a global economic crisis. The depression of the 1930 that followed the stock market crash of 1929 led to more than a 30% plunge in US output and a jump in the unemployment rate to 25%. Could it get as bad as that this time around?

In addition, it is important to know that in all previous cases, the bear market has always ended in a series of cathartic drops, which were followed by sharp rebounds and then by chaotic retests of previous lows. In other words, big bear markets historically have ended either with a “double bottom” or a “triple bottom” (Check out SPX during 2000-2003). I suspect that we may have seen several retests ahead of us.

3.        Growth Reduction

Over the week, I think markets start behaving like a classic bear market, driven by redemptions and pricing in a deeper recession or growth reduction. I think such a growth reduction makes sense as data ranging from Japan Machine Orders to US Retail Sales have fallen off the meter. More importantly is that these data was sampled before the worst of the financial shock had a chance to hit the real economy. Market wise, sectors leading the growth reduction were falling from cliff, such as steels, industrial metals, energy, commodities, and cyclical manufacturers. Given such a backdrop, investors have to set a lower base to start forecasting the next level from of the episodes of the two weeks.

4.        Market Valuation

If only looking at the valuations, most of the stocks are cheap enough and quite attractive. However, the valuation is based on 2009 and 2010 earnings forecast and sell-side analysts are still in the process to downgrade their covered stocks. In addition, valuation is not the most important yardstick in stock picks as current economic crisis could easily wipe out a company if they could not seek funding or re-financing from banks.  (More appropriate valuation metrics should be some kinds of “Turning-Point” Indicators, such as ROA, ROE, ROIC or FCF per share, which are all declining now!)

Valuation wise, S&P 500 is valued at 18.5XPE, MSCI AxJ traded at 9.8XPE and MSCI World at 11.4X, near the lowest in more than a year. However, earnings estimates remain way too high. For example, earnings in Asia will grow 11.9% in the next 12 months, according to IBES estimates. In previous recessions, EPS growth has fallen 30-50%. Even measured by price-book ratio, MSCI AxJ is now at 1.3x PB, equal to THE 30 year average. However, given the outlook of economy and corporate earning, we could retest the 1982 or 1998 lows of 0.9X. Furthermore, timing wise, to date in this downcycle, 12-month forecasts have been cut for the past 2 months; historically, another 7 months have followed.

5.        Technical Indicators

Based on the magnitude of price drop, the massive market volatility and a sluggish low trading volume, many technical analysts have pointed out that whenever an abnormally large bear-market decline occurred (a loss of more than 45%), a secular bear-market pattern followed. The weight of evidence indicates that Asian equities markets are likely to spend the next 12-24 months in a large trading range, based on historical data since 2000.  However an interim rally is certainly on the cards. This typically lasts just 3-13 weeks before the next stage of the bear market arrives and investors look at stocks with disgust. 

Appendix:

The FDIC estimate that there's 1.4trn of bank debt that could conceivably be issued under this program, and even if, say, 20% of that materializes, that's 380bn of HIGH QUALITY assets that will compete with agencies. Indeed, this is your textbook, classic "crowding out" effect we all learned about in economics 101.

Business Week lists the unlucky 13 nations that could follow Iceland into a melting collapse. In its nations at risk the list contains some of the usual suspects but a few surprises- Pakistan, Argentina, Serbia, Turkey, Indonesia, Philippines, Vietnam, Romania, Kazakhstan, Latvia, Hungary, South Korea, New Zealand.

Although less quickly than the markets would have liked, authorities in the US and Europe have now taken decisive initiatives to stop the financial meltdown. The measures are not uniform across countries, but they do nevertheless follow a common pattern. Key elements include:

ü  augmented guarantees of bank deposits and in Europe guarantees of a wider range of bank debt (the latter expected but not yet announced in the US);

ü  schemes for the re-capitalization of banks suffering from depleted equity buffers and in need of more capital to shore up investor confidence;

ü  facilities to buy illiquid assets from banks or to guarantee these assets or to swap them against liquid assets;

ü  commitment by central banks to provide all necessary liquidity to the banking sector, and in some cases (US) to provide unsecured term lending even to non-banks;

ü  cuts in policy interest rates to offset some of the tightening of credit conditions in private markets and to counter recessionary forces.

Central banks are throwing everything they can at the credit markets to get them working again,'' said Win Thin, an economist at Brown Brothers Harriman & Co.  UBS, Switzerland's biggest bank, will get a 6 billion Swiss franc ($5.2 billion) capital injection from the government to help it set up a fund for as much as $60 billion of toxic assets that will be supported by the central bank. The transaction will leave UBS with ``essentially zero'' risk related to U.S. subprime-mortgage-backed securities, Chief Executive Officer Marcel Rohner said.

Compared yields of Asia US$ bonds now with that during the Asian financial crisis. We highlight two stalwarts of the region's US$ bond market, the Philippines and Bangkok Bank. In the worst of the crisis in 1998, the RoP 2017 bond yielded around 23%, and Bangkok Bank 05 traded at around 30%. The yields of these notes tripled from trough to peak. So far, these issues' yields have only risen to around half of their previous peak yields.

What is similar? What is often overlooked is that the worst of the bond performance in 1997-98 was triggered not by Asia, but elsewhere. Sure, the problems in Asia had caused Asian US$ bonds to perform poorly from 1996 to mid 1998. But it was the default of Russia and the collapse of the major hedge fund, LTCM, that set off the most severe price falls. The fragile confidence that Asia was emerging from its financial collapse was easily shattered by a default in another emerging market, Russia. LTCM's failure in the US sparked fears of a rapid unwinding of leverage. Investors in emerging market credit then just wanted out and buyers were scarce. Sound familiar?

What is different? In 1998, emerging markets were hit the hardest. Other risk credit markets suffered too, albeit less and for shorter periods. This made fundamental sense, in particular for the US, due to its then robust economic condition. Now, we believe Asian credit fundamentals are generally sound. Asia's relative strength, though, has counted for little to date. For more details, please refer to our report, Asia's $ bonds: unfairly caught in the fire?, published 8 October 2008.

SHCOMP is at all-time high 1-yr ago today.  Stunning reversal…although it only took 11 months to climb the same distance (see attached).

                                          10/16/07              10/16/08

SHCOMP                           6092.06              1909.94

SZCNST                           19358.44              6166.56

A-share Total Mkt Cap      RMB 32 trillion     RMB 12 trillion

Avg A-share Price             RMB 20.1044      RMB 6.6448

Avg Daily Turnover            $27 bn                $9 bn

Good night, my dear friends!