My Diary 488 --- No Light in the Tunnel; Don’t Fight the Fed;

My Diary 488 --- No Light in the Tunnel; Don’t Fight the Fed; Lest Have Some +Ves; Deflation Dollar Inflation Gold

November 30, 2008

“Monk & PM, Hiking & Investing, Wise & Fool” --- Having had a few interesting conversations with friends over the weekend, I think these deep and inspiring comments are the no-better starting points of today’s diary ---1) Can a Monk be a good PM? Likely, as both have to ignore the market noises while stick into something they believe in; 2) Hiking is similar to investing as only after being able to control your breath and pace, one can go/last longer; 3) Elvis Presley, the king of Pop, has a great song for the current stock market…"Wise men say, only fools rush in, but I can't help falling in love with you"…Ha, enough entertainment and let us look at whaz going on out there…Over the week, global equity rose 11%. Regional wise, stocks gained 12.8% in US, 12.1% in EU, 7.6% in Japan and 10% in EMs. But, on the monthly basis, global stock prices contracted 6.3% in Nov, compared to a 17% plunge in Oct and 11% drop in Sep. Elsewhere, 1MWTI oil ended relatively flat at $54.43/bbl after falling precipitously through Oct and early Nov. UST yields declined this week to historic lows, with 2yr dipped 12bp to 0.98%, and 10yr slumped 28bp to just 2.92%. Currency wise, USD lost 1.8% on TW basis, weakening 0.9% against EUR to $1.269 and 0.5% vs. YEN to 95.53.

Having said so, most of the driving factors behind the weekly market movements are attributed to the China and US policy initiatives…After China cutting rates by 108bps (1st triple digit cut since 97, 3 wks after RMB4trn stimulus package), spurring speculation around the market that such measures will pull the global economy out of recession and boost demand, Asian stocks had their 2nd-best week this year with HSCEI added 12% and HSI gained 10%. However, it is interesting to observe that SHCOMP went down by 5% wow and SZCOMP down by 2%. Obviously, mainland investors disagreed with foreign investors, as the former focuses more on the real effect of govt fiscal and monetary stimulus, while the latter is looking at the headlines. In my own view, I agree with A-shares as the Chinese economy is deteriorating more quickly as many people initially thoughts, underscoring the need for “forceful” measures to support growth, according to Zhang Ping, chairman of NDRC. Certainly, the RMB23.31bn unlocking Da-Xiao-Fei in the coming month may be another good excuse for domestic investors to take profit.

In addition, BBG this week ran a story saying US is to provide $7.76trn (50% GDP07) to fix financial markets, and the Fed’s recent commitment to buying $800bn more of junk securities is only a portion of the multi-trillion-dollar plan. But from what I have seen over the past weeks, the Fed and US Treasury have effectively turned themselves into the world's largest hedge fund, financing at near-to-zero cost and buying everything with or without a ticker…Another good news for HFs is that US authorities don't enact a short selling ban on the ailing bank stocks receiving the TARP infusions. Such a policy leeway may have created a great trade for speculator who want to bet on banks to be guaranteed-govt-induced dilution, by which investors can buy CDS protection on the banks, buy out of the money puts, and then nail the stock with shorts…It simply looks like US govt keeps writing check for hedge funds…On the other hand, I think by directly granting liquidity to non-financial entities, Fed has officially crossed its bottom-line, signaling the current situation is quite severe and unconventional methods must be adopted to stop the credit crunch from intensifying. In reality, all these extreme actions will involve some long-term inflationary cost, but I think the risk-return is good as our central bankers are good at fighting inflation than deflation. Last note on the action taken by US govt is to the Citi bailout, which I do not believe the “$306bn guarantee + 20bn injection” marks as a solution to the broader stresses in the financial markets but rather to a specific remedy to a critical financial intermediary. For a bank with $2trn of on-B/S and $1.23trn in off-B/S assets (including $667bn Mtg securities), the $306bn is clearly not the end of the problem, if we include credit card and auto-related loans…Yeah, more is less…

In general, I think the recent equity gain as a dead cat bounce as 1) systematically, banks are not allowed to fail, but what happens when industrials that hires tens of thousands of  workers go under; 2) credit side, bond spreads are still at historic highs with NA HY spreads still around 1400; 3) technically, S&P has yet to complete the wave down and Asia still looks set to test Oct lows;4) historically, when Japan announced QE on 19Mar2001, NKY bounced 20% over the next six weeks. But it proved to be just another bear rally…Indeed, at this stage, given that most equity markets have now run up to test some kind of resistance level - either trend line resistance or a 50D MAVG, the key question is whether we can start to break through the “ceilings” or whether this is the end of another bear rally?

Looking forward, I think we should watch for three gauges in order to detect the headwinds --- 1) Market Confidence. Just like Premier Wen said, confidence is just about everything in the financial world these days. Unfortunately, it has been cruelly frostbitten by the aftereffects of the seminal collapse of Bear Stearns & LEH, and the bailouts of AIG, FRE &FNM and most recently Citigroup. I do think we can not rule out the possibility of another black swan emerging in the coming future, but it seems that US administration and the Fed will do whatever it takes to prevent another major bank failure; 2) Liquidity Flows: with one month left into 2009, many investors must decide how to play their money over the next 12 months and beyond. A key indicator is certainly the US Dollar, and a weaker USD should be good news for EMs, as which means that Fed’s lax policy can be transmitted globally as EM central banks fail to sterilize their local currencies against Dollar. If that is the case, then in a year’s time, most markets will be awash with liquidity, and the question became --where that liquidity will end up with? No doubt, I think a big chuck will be parked in Chinese investable stocks and even domestic real estate, instead of commodities due to the economic lag (at least a year). This money flows seemed a more likely case as over the week, I saw China continues to look good in the EM and BRICS space with the terrible events in Mumbai and the negative news regarding Brazil (Petrobras) and Russia. In addition, I think investor have to pay a lose attention to the redemption of HFs (~$200bn more, according to Sanford C. Bernstein & Co.) and to the reallocation of SWFs in Kuwait, Qatar, Dubai and Abu Dhabi. Recently, the KIA has shifted $4bn from DMs into its own bourse and the Abu Dhabi Investment Authority ($700bn) is rumored to retreating to local markets; 3) Another trend to bear in mind is that market emphasis is transitioning from the macro to micro as stocks are reacting less and less to macro data, but reacting violently to earnings guidance. What this says to me is all macro bad news as well expected, but I do not think the gloomy outlook has necessarily been factor into analysts' models with respect to 1Q09 company forecasts. Here I have a few examples – Deere lost 13% after it lowered Q1 estimates to EPS 65c vs. street 82c, and Campbell dropped 7.6% after warning FY09 Rev & NP may be down by 5%. This looks odd as if we look a at the relationship between PMI and IP, it seems like a bad outlook for cyclicals stock in 1Q09 should be priced in, But IT IS NOT.

No Light in the Tunnel

There is hardly good news for a world economy that for decades has been geared towards feeding and servicing American consumer spending. Most strategists and forecasters believe the US economy will contract throughout 2009, and that a recovery will only be possible toward the end of next year or in early 2010. This is the consensus view today.  Having said so, ECRI leading indicator has hit a record low for the fifth month in a row - down to -29.2 as of Nov21 vs. -28.2 a week before. This is now getting much further away from the prior all-time low of -19.8 in the mid-1970s. That period defined the worst recession of the post-WWII era and saw a six-quarter consumer recession coincide with a 45% peak-to-trough decline in the stock market. Also note that the CEO Magazine Confidence Index absolutely plunged to 58.2 in Oct from 100.5 in Sep. Regular data prints wise, Oct consumer spending (-1%) fell the most since 2001, while Durable Orders plunged 6.2%, the third decline in a row and twice the consensus estimate. Nov Chicago PMI fell to a new low of 33.8 (vs. cons 37), the lowest since 1982, and the decline over the last two months mainly reflect the impact of falling new orders (to 27.2 from 32.5), production (to 34.3 from 30.9), and employment (33.4 from 41.5). Moreover, housing market is also far from recovery, even though 30yr fixed rate fell to 5.5% from 6.4% after $600bn Mtg debt purchasing plan. Oct new home sales fall to 433K (vs. cons 441K), down 5.3% from a revised 457K in Sep08. The cumulative 69% decline since Sep05 has taken sales to the lowest since Jan91. The supply of new homes is down ~33% from the peak, to the lowest since Feb04. As a result, the inventory remains elevated at 11.1 months, keeping downward pressure on prices (-7% yoy median price).

In Europe, the overall economy is weakening rapidly, with several states are experiencing US-like bursting housing/credit bubbles, suggests that EU will soon be in a deep recession. Higher unemployment (7.7% in Oct from 7.5%) and gloomy economic outlook have caused consumer confidence (-25) to plunge to its lowest level in 15yr and retail sales to contract in most regional economies. Thursday CPI report showed a sharp drop in Nov to 2.1% (from 3.2%), and it seemed the trend will allow allowing policy makers to cut rates towards 1%. But concerns remained as EU area faces a liquidity trap and lower IR alone will not be sufficient, given that region's bank lending standards suggests things are getting worse…In my own view, it is difficult to foretell  the cancellation of the 11th Sino-EU Summit due to the planned meeting by President Sarkozy with Dalai Lama…To both side, given EU now is China's largest export destination (to absorb the overcapacity) and China is the largest importer of capital goods from EU (like Air bus) , there is no winner from economic perspective.

With respect to Japan, the macro metrics for Japan entering into recession is WTE. Data released over the week revealed acute weakness in IP (-7.1% yoy), a slackening labor market (3.7% jobless), stifled retail sales (-4.3%) and a disinflation like CPI (TKY Core 0.2%) …Will Japan return to deflation again in 1H09? …Not Unlikely, as monetary policy is largely ineffective since rates are already approaching zero, while announced fiscal measures appear too little and too late to offset the adverse impact of weakening exports and corporate spending…I think Japan will suffer more from this worldwide credit crisis as it too much depends on export “big ticket” items to the US consumers, who were financed by credits. While neighborhood countries like China and Vietnam that export lower value added items (typically financed by disposable income) will suffer less. Regionally, Taiwan, which is a bellwether, high-beta manufacturer, reported staggering declines in Oct factory output (-11% 3M) and export orders (-12% 3M) from July, and a surge in 3Q08 inventories, suggesting that the recent output decline has been magnified by a stock adjustment…Three is no light in the end of tunnel yet…

Don’t Fight against the Fed

Over the week, the Fed announced its QE No. 2 (QE No1 was the doubling of the Fed's B/S via all of the liquidity programs funding banks/dealers) through which it will buy up to $500bn of GSE debt (mainly MBS), $100bn of agency debts; and another $200bln (TALF) on ABS. According to Paulson, the $200bn program was just the “starting point” of the Fed’s plans to lower the cost of consumer and small business loans and TALF is expected to commence in Feb09…In numerical terms, I have to acknowledge that the amounts are massive as in the case of the MBS/GSE purchases, they equal the total net issuance in each category - for an entire year. The security purchases will add to the asset side of the Fed's B/S with the mirror increase in bank reserves appearing on the liability side of as excess reserves - which previous to this announcement have been running around $600bn (vs. avg $10bn a year ago). Practically, Fed is trying to engineer a middle path which strives to partially offset deleveraging and deflationary pressure with money printing measures that will eventually inflate the rest of the problem away. Why? I think US Treasury and the Fed are keenly aware of the fact that banks/hedge funds are desperate to further shrink B/S and thus secondary MBS supply hangs over the market (MBS were at all time wides). The GSEs were to be the buyer of the overhang but just could not accomplish the task. At the same time, however, this action will not automatically result in increase lending by the banks, unless associated with some form of Fed or govt guarantee. Note, credit standards and collateral requirements have already been raised by banks so only the best quality borrower is likely to get a loan. Finally, the household sector will likely continue to de-leverage to repair a significant impaired balance sheet, especially with job losses on the horizon and no real income growth in the foreseeable future. As a result, the Fed must follow this path to limit the downside risk to the real economy

In effect, Treasury & Fed are putting on a huge curve flattener, buying duration and selling front end (Bills /ST maturity auctions), caused instant reaction in the financial markets, witnessed by the drop of 30yr conforming Mtg rate from 6.38% to as low as 5.76% this week according to Bankrate., as a combined result of rallying UST and the announcement that the Fed will start purchasing GSE debt and GSE-backed MBS. In the government bond markets, the duration trade also push benchmark10yr note down as low as 2.92%, surpassing the record set on 20Nov as UST of all maturities plummeted. It was the least since the Feds daily records on the note began in 1962 and since 1958 on a monthly basis. The 2-10 curve spread also narrowed to 188bp from 262bp on 13Nov, the widest in >5yrs…What we learned again is -- Don’t fight the Fed, and don’t fight the federal government… A flattening of the so-called yield curve indicates investors favor LT debt on speculation inflation will be subdued as the economy contracts. On the back of such massive Long duration trade, US govt debt returned 4.7% in Nov, heading for their biggest monthly gain since 1985, according to Merrill Lynch. YTD, UST returned 9.3% vs. 9.7% by German bunds and 1.8% by JGB. In terms of credits, corporate bonds in US and Europe also rose the most since 2003, luring investors with the highest yields on record relative to govt debt. US IGs returned 3.6% in Nov, after losing 7.4% last month, according to Merrill Lynch. European notes returned 1.7%, the most since May03. However even with Nov gains, corporate bond returns in US are down 12% for 2008 while European bonds declined 1.9% in Nov, both poised for the worst year ever, based on Merrill data.

Lest Have Some +Ves

With the markets betting on the world economy further slowing down, I try to think from a contrarian perspective, what are the +ve undercurrents beneath in cold fronts? Here I bring out “Magic Four” – 1) the direct purchasing of MBS by Fed. I think this is a bid deal as US central bank is NOW bypassing the credit system and directly tackling the issue of high cost of private credit. With the first move of lower 30yr Mtg rate, we need to closely watch refinancing activity as historically a pick up in refin activity would be the leading indicator of household sector stability and a rebound in consumer spending; 2) the QE implemented by Fed. Of course, one could interpret these actions as signs of a desperate attempt to preempt debt deflation or severe recession. However, it is also true that quantitative easing is absolutely necessary to fend off debt-deflationary risk, especially when banks are not lending and the financial system is in a liquidity trap. 3) The determined govt stimulus by all major economies in the world, suggested by the $500bn package proposed by Obama, $586bn of infrastructure spending in China and $258 billion stimulus plan in European Union; 4) The self-equilibrating mechanism of financial markets, as the sharp drop in the price of oil is freeing up disposable income for consumers and easing business cost burdens. Historically, a sharp drop in gasoline prices has always led to a rebound in consumer spending and corporate profits.

Even armed with the above Positive Four, recently the World Bank suggested that China should do more to rebalance its economy from investment, exports and industry to consumption and services, lowered its 2009 GDP for China from 9% in Jun08 to 7.5%, and expect half of the growth is driven by the govt…I think World Bank is doing the right match as in absolute numbers, Asian consumer has been always impressive but not quite where it mattered, namely, spending power and importance to GDP growth. Measured by relative numbers, Asian individual only spends, 1/2 of Europeans and 1/3 of Americans, while in aggregated term, Asia consumers account for 49% of AxJ GDP. In the two biggest markets, China and India, consumption as a share of GDP is lower today than it was in 1997. In the past year, the Asian consumer has been further diminished first by rising inflation which has eaten into discretionary spending and now by slowing nominal wage growth. As a result, consumer sentiment is deteriorating rapidly, despite falling interest rates and govt efforts to stimulate domestic economies.

Regarding to China’s outlook, NDRC Chairman Zhang Ping has unusually delivered a dire warnings on the state of the economy last week, highlighting the global financial crisis and its impact is deepening in China. Some domestic economic indicators could point to an accelerated slowdown in Nov, including Power Consumption, Export, as well as IP growth… It appears that 4Q08 GDP growth may below 7% …He also said the economic downturn has created an explicit impact on the job market and social unrest may rise if there's a wave of factory closures. In addition, fear of deflation is also enveloping in China as BoCom forecast Nov CPI may have reached 2.6%, down from 4% in Oct…However One thing clear now is the RMB 4trn stimulus does not represent a forceful factor as it only add about 1% to GDP over the next two years, while FAI growth will slow to 12.5% in 2009 from about 16.7% in 2008, according to Mr. Zhang. Meanwhile, as we discussed, the micro China keeps falling apart --- 1) SOEs saw profit drop for the 3rd month in a row (10M08 profit was -8.3% yoy vs. 9M08’s -2.9%); 2) Net exports (20% of GDP growth last year) are surely to decline further as 2/3 small toy exporters closed in the first 9M08, reported by the Customs Bureau.

As a result, it is not hard to understand that earnings expectations have fallen broadly in Asia with 1M ERR reaching an all-time low of 0.21 in Nov. Country wise, the earnings upgrades-to-downgrades has reached record lows in HK (0.09) and IND (0.17) this month and is falling fastest in Thailand, HK, and Korea, according to Merrill. On the back of this trend, it is hardly to believe that China's lisco ROE can stay at 14% in the coming 12 moths, after it peaked at 17% following the US. In comparison, ROE of S&P, which peaked one year ago from ~17%, has sharply tumbled to 9%, far below its avg 14% of the past 20 years, while China's ROE, but still, far above its average 10% in the past 10 years…Lastly, valuation wise, MSCI China is traded at 8.8XPE09 and 8.7% EPSG09, MSCI HK is traded at 11.3XPE09 and -7% EPSG, CSI300 are at 11.3XPE09 and 13.7% EPSG vs. regional market is traded at 9.6XPE09 and -6.2% EPSG.

Deflation Dollar, Inflation Gold

The driving force behind the recent USD rally was the further quantitative easing taken by Fed, including TALF lending facility and the GSE facility. It seemed that investors took the action as a signal of future growth potential as the FED has learned from Japan’s lost decade.  But for every fix today will lay the seed of USD weakness, underpinned by the fear of future inflation. Certainly, the risk seems far away from the present as the market is pricing in a global recession and got a -0.1% core CPI as evidence. What seems a larger risk for the USD is the ability to fund the future govt debt obligations, but again the recent UST 5Y auction shows the fallacy of this argument…In terms of BOP, the fate of the US debt rests with the choices of extending debt and spending or hoarding cash and saving – and right now it seems savings wins as savings rate reached 3% in 2Q08, pointing to the shifting psychology of the consumer, along with weak spending.

However, the commodities run over the week are based on the fact of Chinese rate cuts and the expectation of further cut. But I think the view of aggressive easing may not be well expressed via commodities, due to the dominant world concern for the next six months is deflation as suggested by the decline of 10yr UST yields and US 30yr swap spreads and 10yr BE inflation. These all tell me deflation is being factored as a major risk. I think given that macro traders usually drive the early phase of commodity rallies. They will not buy commodities when China’s economy is in free-fall and when bond markets are fearful of deflation.  If they have a bullish growth recovery view, they will express that view by shorting bonds, or going long interest rate swap spreads, not by buying commodities. I would wait for these to move before contemplating anything more than a ST trade in commodity names.

Separately, I have to put down a note on gold, as investors have been disappointed with gold's inability to move vertically despite the worst financial crisis since the 1930s and increasing risks of debt-deflation. However, I think this suggests that the yellow metal is a leading barometer of excess liquidity. Therefore, it is not the crisis that benefits gold but rather evidence that policymakers are beginning to win the battle in favor of reflation. Looking ahead, while gold could face some near-term vulnerability until the Fed has fully ramped up its printing press and until a fiscal package is implemented, I would expect significant price gains in the years ahead.

[Note; US 30yr swap spreads is effectively a measure of US LT bank credit risk, trading 42bp through the 30yr UST yield. US banks aren’t exactly a solid credit, so this shows you that pension funds and insurers desperately want to receive – they are worried about deflation.]

[Appendix]

I. Bernanke: Deflation - making sure "it" doesn't happen here (21 Nov 2002). My two favorite quotes as a teaser: 1) The U.S. government has a technology, called a printing press"; 2) By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails."

Among the 8 steps/tool he laid out in the speech, 4 have now been deployed. The steps in short summary:

1. Use the discount window aggressively to lend to banks (done)

2. Cut rates early and fast when growth and inflation slow (done)

3. Push for fiscal stimulus (done, more to come)

4. Pre-commit to zero or close-to-zero rates for some time (likely in Dec)

5. Target the treasury yield curve and flatten it by buying longer-dated treasuries (GS forecast for 2009)

6. If credit doesn't expand, buy agency debt (*new* done today)

7. Start printing $ by having Treasury buy risky US assets (incl equity)

8. Start printing more $ by having Treasury buy foreign assets to get the $ value down and create export stimulus

II. Deleveraging

Lastly, on the macro to micro theme, we have a very interesting report out on "shadow banks": Non-Financial Financials: The impact of the credit crisis extends well beyond the banks. Summary:

1) New loan originations are down about 40% across categories, while corporate financing sources such as loans, bonds and CP are also down sharply.

2) We estimate a -2.5% hit to trend GDP from credit tightening. Applying a 6x multiplier to that number (based on other periods of stress, that has been the relationship), we see a -15% whack to US corporate profits (from declining sales volume due to lower vendor financed lending). 

3) Deleveraging is a theme that seems likely now to extend beyond financials;  if US leverage is measured as non-financial debt to GDP, there is a long way  to go.  Statistic: Non-fininancial Non-government Debt to GDP is 190%.  We  forecast expected loss severity to vary across industries (attached).

III. AxJ: US$ Strong = Asia Weak (Markus Rosen) 

1) During strong US$ => Asia fell by 35% on average during weak US$ => Asia rallied by 120% on average

2) Strong US$ hurt Asia in terms of export growth, export price, Roe, liquidity and valuations

3) Strong US$ => weak top-line growth & export px => lead to declining RoE => lower P/B multiples => fund leaves         

4) US$ printing => dollars can't stay strong for long 

5) Beginning of US$ weakness => signal end of the deflationary and shift towards reflation    

6) Our expectation: during 1H09', US$ begins to turn & global reflation is on the cards => recovery in Asian markets         

7) Near term: US$ remain strong, Asian flat at best, likely lower

IV. Japan IP and Negative Realization Ratio

Given that 35% of Japan's exports to the US are autos and auto components and that US auto sale have collapsed this autumn, as well as that production actually falling faster than manufacturers originally expected – a so called, negative realization ratio on manufacturers own forecasts, the correction of IP will also be worst than the -6.8%QoQ correction that occurred in Tech Bubble in 2001. The distinguishing feature of the 2001 production correction was how narrowly concentrated it was in the IT and ancillary industries. This current episode of production weakness is led by the auto and electronic manufacturers and has many broader linkages through the production chain. Japan’s positioning at the very top of the consumer goods pyramid, leaves little scope for export redirection or retooling of industry to meet other potential sources of demand.

Good night, my dear friends!