My Diary 498 --- The Race to Bottom; The Availability is Key;

My Diary 498 --- The Race to Bottom; The Availability is Key; How Much Priced in? The Year of Relative Value Play

January 11, 2009

“2008 Scorecard & 2009 Unknowable, Deflation & Inflation” --- The past year was earmarked by 38.5% loss in S&P, the most since the 38.6% plunge in 1937. Stocks rose and fell 5% in a single day 18X during the year. Rates in US were slashed to zero and global rates appear to be heading in that direction. VIX posted a 78% gain to 40 in 2008. Its close of 80.9 on 20Nov was the highest in its 19yr history. WM and McDonald’s were the only 2 companies in Dow to have a positive 2008…Junk food does have a redeeming feature after all...Stepping into 2009, the current consensus is that stocks bottomed on Nov 20th-21st, economy will recovery in 2H09, corporate credits are a buy, stocks are cheap and the stock market is now discounting all the bad news…Surely, it means the worst is likely behind us…Really? I think the key question is what has changed, as there are much unknowable beneath the water surface, including deflation/inflation, saving/spending, deleveraging/debasement and equities rally/economy slump.

Underpinned by the two powerful forces, the fall out effects from the world's greatest ever credit expansion and the largest fiscal and monetary efforts in history, the most important risk factor for 2009 is could inflation come back quicker than we anticipated, given the Fed is pumping significant amounts of reserves into the system and targeting liquidity towards mortgages and consumer credit, while US government is about to embark on middle-class tax cuts and infrastructure spending aimed to create jobs. I think any reflation will take significant time, something that is based on four observations. Firstly, policy makers are less experienced in dealing with deflation. Over the past two year, authorities made deadly judgment errors. They fought inflation when deflation was actually the main threat; they thought that the Subprime issue would be contained at a time when the crisis was metastasizing through the entire global financial system; and they dealt a fatal blow to already very fragile investor confidence by allowing LEH to fail. After that, they have waken up and made it clear that they will do whatever it takes to halt the downward spiral in financial asset prices and economic activity, regardless of the sums involved.

Secondly, the macro data over the past few quarters was clear that global economy continues to be in a significant slump. Judged by the Dec FOMC minutes, Fed reaction to economy is dominated by fear of a deeper slowdown, making them happy to promise longer term low rates as a solution. Some FOMC members were "uncertain over the extend to which inflation would fall", but some saw significant risks that inflation could decline and persist at "uncomfortably low levels". Even though, inflation expectations at longer horizons appeared well anchored, some survey evidence suggested firms expected prices to keep falling. Thirdly, the broad-based contraction in payrolls and income insecurity will continue to keep consumers from spending, and the already deflationary retailing environment will continue to worsen.

Historically, UST yields sustainably rebound only once the annual growth in payrolls turns up significantly. Thus, over the next few months, deflation and a contracting economy will be the primary drivers of USTs. Indeed, the key counter argument is based on oversupply. This sounds very intuitive, but in reality it only focuses on public sector dissaving, while ignoring the powerful and rapid surge in private-sector savings. As said by the CLSA strategist, Chris Wood, just as the monetarists underestimated the stimulatory role securitization and derivatives played in fuelling the credit bubble, so they now underestimate the power of the forces of contraction. My view point is that the LT impact of large public-sector borrowing could be either inflationary or deflationary. It will be inflationary only if spending is financed through monetization by central bank. However, if it is financed by debt issuance, higher taxes, or some combination of the two, the net result could be quite deflationary. The Japanese example is a classic one. Since the collapse in the Japanese asset bubble in 1989, the ever-rising budgetary deficit never triggered an outbreak of inflation in 1990’s Japan. Instead, deflation prevailed as the surge in private-sector savings far outpaced the government sector’s dissaving and spending. A similar phenomenon may occur in US, given the fact that the US household sector may have finally entered the “age of thrift”.

Having said so, it is relatively easy to see the performance of each asset classes over the week. Global equity prices declined 1.5%, with -4% in US, -1% in EM, while equities were about flat in JP and rose +1% in EU. Elsewhere, 2yr UST yield decreased to 0.75%, down 7bp this week, and 10yr weakened 5bp to 2.39%, up 2bp this week but higher more than 30bp from its low on 30Dec. 1MWTI oil slipped to $40.83/bb, down $8 from Monday. Gold dipped nearly 3%, while industrial metals and agriculture products ended a bit higher wow. US Dollar was mixed, +1.5% against EUR to $1.348, but down 1% against YEN to 90.4.

Looking forward, a big unknown is the outcome of this credit/banking crisis, which depends on fundamentals, the policy response and confidence. I think fundamentals are still fragile given that US housing markets, which have been at the centre of the current crisis, are likely to correct further and the unwinding of various derivative markets continues. The policy response from DM was initially slow but now a consensus appears to have been reached among policymakers to do whatever necessary to stabilize financial markets and support economic growth. As a partial policy toolkit, US and other major economies are talking of tax relief for savers as deposit rates have been slashed. This makes some risky assets with higher yield, like corporate bonds, income funds, and Asian equity, more interesting in 2009.

However, I think, a responsible investor should not take on excessive risk in a deflationary period. A well-diversified portfolio should be adopted with weights in risky assets such as stocks, credit and sovereigns, depending on various macro variables and cyclical forces, but it should always include gold and government bonds. In the meantime, PM must be nimble, willing to shuffle their portfolios around more often than ever before. In terms of equity, the risk is that we may get even more earnings disappointments in 1Q09 and warnings for 2Q09. Historically, earnings disappointments are the catalyst for protracted bear markets. But the wild card is the coming economic stimulus package. We have never been in a situation like this. With respect to credits, spreads may or may not tighten further as there will be a wave of issuance at every level - government, corporate, municipalities and EMs, etc. Regarding to USD, the big difference between now and 1929-32 is that US government is borrowing on a large scale from abroad – specifically from China. Thus, the key is whether or not this Chinese and other foreign government support for US government borrowing can continue. That said, the ultimate problem the US faces is not deflation, but rather the debasement of its currency.

The Race to Bottom

The term "race to the bottom" is certainly getting more sense to describe global economic developments. This is readily evident in the monthly business surveys and in global IP data, both of which posted staggering declines in 4Q08. Job cutbacks also are gaining speed, although the process is much less uniform across countries. The dominant theme over the week was the severe contraction in global IP and international trade. This was seen in the sharp falls in Germany’s factory orders, Germany’s exports, Norway’s IP, Hungary’s IP, Turkey’s IP, South Africa’s IP, the Czech Republic’s exports, Australia’s exports, and Brazil’s auto output.

In US, although there was no immediate reaction in equity futures in the face of a 524K plunge in Dec NFP, the fact that the Birth-Death model is still somewhere in fantasy-land as it added 70K jobs to the total. Just imagine what happens to these payroll numbers when the Birth-Death model, which guesstimates employment from new business creation, begins to swing in the other direction! In addition, we heard that WM, Macy’s and Gap lowered their earnings forecasts as the worst holiday-shopping season in 40yrs squeezed retail profit margins... You know we're in trouble when lingerie sales start missing expectations... In EU, Britain faces the worst economic outlook since the early 1980s;,with GDP fell 1.5% in 4Q08, after -0.6% in 3Q08. In German, labour market data released today was disappointing, with unemployment rising 18K, weaker than the 10K decline expected. The unemployment rate was unchanged at 7.6% but the Nov level was revised up from 7.5%. On the back of worsening manufacturing and labour market outlook, the global GDP growth has been shaved ~2% just in the past month. The sustained downward momentum in IP also casts doubt on whether there will be much improvement in the economy in the current quarter. I would expect more to come.

On the economy side, the Fed staff forecast was revised down sharply for 2009, with full year 2009 GDP was expected to be negative. Other entity like CBO, also projected the US economy will shrink 2.2% in 2009, the deepest for any calendar year since an 11% decline in 1946, before growing a modest 1.5% in 2010. The slide in global economic activity has been matched by an equally impressive fall in consumer inflation. Over the week, EU area inflation rate declined an additional 0.5% to 1.6% in Dec. Global inflation is expected to have eased to about 2% yoy last month, down from a peak of 5.2% July08. I will look for a continued decline to near zero by 1H09.

Cross the ocean, the question to China is whether the government has ability to spur the domestic growth when all of the world’s economic engines sputter... Yes, all of them…I keep a doubt here as given the weak US consumption, Chinas needs a longer time to digest the excess capacities which have been building aggressively in the past 5 years. I am not sure how this will play-out but a key element should be that the weakness of the US economy will force China to increasingly push for consumer-led growth. But so far, as with Japan in 1970-80s, exports will still be a driver and the savings rate will remain high due to rapidly ageing demographics.

That said, I think the outlook into 2010 will be BTE due to: 1) mild re-stocking once inventories reach acceptable levels; 2) some recovery in demand as bank intermediation continues to normalize; 3) very strong monetary and fiscal stimulus; and 4) simple base effects from the extreme economic weakness seen in 2009.

The Availability is Key

Measured by TED spread (133bps) and Libor-OIS spread (122bps), it is suffice to say that credit indicators have improved greatly over the past month. However, on the ground, credit availability for corporates and individuals is still very tight. In US, since Aug08, consumers have repaid $10.5bn of their auto, credit card and student loans. To be sure, the contraction in consumer borrowing has been driven by both S&D factors. Fundamentally, negative wealth effects and deteriorating employment prospects should have weakened demand. However, even with these poor fundamentals, the demand collapse may not have been as severe without the credit freeze. The ABS market is the biggest culprit behind the consumer credit freeze. Since Sep08, the market has been virtually shut down with spreads historically wide. The inability to securitize and sell consumer loans means that more debt ends up on banks B/S and finance companies who themselves are credit constrained. This has triggered a significant tightening in credit standards and a sharp reduction in lending.

Therefore, the key to reviving demand and stabilizing consumption is improving the availability of credit. As a result, Fed will launch TALF (Term ABS Liquidity Facility), and begin extending liquidity to investors who purchase ABS paper. Taking these steps, the Fed is trying to by-pass the broken intermediation channels and to provide credit more directly to the consumer. Thus, I would look for some improvement in real consumption on the back of gradual restoration of credit flows.

Indeed, I still think that private sector borrowing rates must fall from current levels because credit costs for households and businesses haven’t followed yields on government debt lower. 15yr fixed-rate mortgages were at 5.06% last week, 259bp above 10yr UST. The spread averaged 88bp in 2003, when the Fed slashed rates to 1%. This is why Fed is now focused on driving down the spreads between UST yields and consumer and corporate loans, after cutting the main interest rate to almost zero failed to revive lending. That being discussed, I would not expect UST yield curves to shift up at a faster pace than spreads narrow on a sustained basis until there is concrete evidence that the global economy has turned the corner . However, still the problem is US remains stuck in a “liquidity trap”, where the banks are flooded with liquidity and the effective funding cost has fallen towards zero, but they are still not willing to lend. The logical solution to this is to boost fiscal spending to pull the economy out of the financial quagmire. Another way is for the Fed to by-pass the banking system to lend to the corporates directly. This will all be done.

Back to home market, over the week, HY credit continued to outperform equity. The attractive pricing levels of credit are seeing interest from different investor groups - distressed, retail, special sits apart from the normal ones. The benchmark iTraxx AxJ IG and HY indices closed in a tight range, at 300bp and 1200bp, respectively. However, fundamental outlook remains cautious as a heavy forward bond supply calendar, rising corporate defaults, and more de-leveraging at both HFs and banks remain ahead of the market.

How Much Priced in?

Based on the above discussion, it is difficult to see how equities can sustain an advance until the monetary transmission mechanism begins to function more normally. In addition, the poor earnings outlook will be a persistent headwind for stocks throughout 2009 and analysts are likely to be disappointed in their overly optimistic profit forecasts. Historically, the downsizing of private risk positions replaced by govt credit usually result in reduced profit margins and a slower rate of earnings growth after the bottom is reached. Given the macro is really far away from the bottom, the corporate earnings have still big downgrading room from the current level. I think the worse scenario is that earnings could fall by as much as 25 to 30% as revenue growth slows and margins contract.

Talking about earnings, according to BBG, earnings at S&P 500 will probably fall in 1H08, marking eight straight Qs of declines. In Europe and Asia, the outlook may be even worse as the recession curbs demand for retail goods and exports. According to ML strategist, the downward trend in AP earnings expectations continues in Dec08 with 3M ERR falling from 0.36 to 0.30. Downgrades outnumber upgrades in all countries. In China, 128 A-share companies have warned they may post wider losses. Looking forward, worst time has not come yet, and I think earnings probably won’t rebound until the end of 2009 and the sequence is the market recovers, then the economy recovers, then finally the earnings recover.

Valuation wise, the earning estimates of S&P started at $92 in early 2007 and are now down to $48 (02Jan09). On a 1YR trailing basis, that puts the PE at 18.5X as of Friday's close at 890, which does not make the market cheap. Such a valuation does not seem to price in all the bad news as if we look at the last recession, (2001 reported earnings= $24.67; 2002 operating earnings =$27.57). Now do we think the current recession will be milder/shorter than the last one? I think the reality is there is no established theory on how to value stocks in a deflationary environment. The traditional PE or PB metrics work well only in a stable growth environment. In such a deflationary circumstance, the best approach could be the basic “Equity cost” concept – what kind of excess returns investors need to compensate for risks embedded in equities, assuming a steady state of risk-free rates and profit growth. For instance, the ex-post risk premium for the US equity market has averaged 600 basis points for the last nine decades. Perhaps risk-free rates in a steady state should be around 2 - 3%, but in a macro sense, profit growth is roughly equal to the nominal rate of interest. Hence, equity multiples could simply be an inverse of the long-established risk premium. For the US market, this would suggest a fair value PE for stocks of around 16X. In fact, in some of the low nominal countries with zero or negative inflation such as Switzerland and Japan, equity multiples seem to converge to the 17-18X range. This once again means stocks at current levels are not expensive, but not very cheap either.

Lastly, valuation wise, MSCI China is now traded at 10.2XPE09 and 4.5% EPSG, CSI 300 at 13XPE09 and 7.3%EPSG, and H-shares at 9.8XPE09and 2.4%EPSG, while regional market is traded at 11.4XPE09 and -9.8% EPSG…One thing to be worth a note is that in current bear market, we are 14 months into a multiple-compression cycle that averages 21-23 months for AxJ. Moreover, in the recessions of the 1970s, and 1982 and Asian crises, PB for the region dipped below 1X. That hasn't happened yet, but it will.

The Year of Relative Value Play

One outstanding feature for currency markets is the elevated volatility. According to BBG, in Dec08, EURUSD traded between 1.2550 and 1.4719, a 17% range. To put this in context, the annual range for EUR-USD was 8.5% for the whole of 2004, 16.7% in 2005, 13.3% in 2006 and 16.3% in 2007. This extreme volatility is persisting. YTD, EURUSD has already moved in a 5.5% range. Near-term, I think that elevated volatility will continue as markets digest the deep economic recession in DMs, the global credit and banking crisis and the extraordinary policy responses.

Looking ahead, the long-term theme is the debasement of USD vs. the major currencies driven by Fed QE, which will eventually lead to a sustained increase in the supply of the greenback. With the exception of BoE and BoJ, other major central banks are less likely to move to QE. However, in the near term, positive factors such as global recession and de-leveraging will continue to provide fundamental support to USD. Thus, I would expect USD will start to fall when US (global) economic expectations bottom out in 2H09. In AxJ, the outlook is clear. Those small and high beta economy and currencies such as the SGD, THB and TWD will weaken further given the collapse in external demand, while KRW, INR and IDR will stabilize after global asset markets stabilize and due to relative strong domestic demand and fiscal and monetary stimulus. Thus, 2009 is a relative value play, while in 2008 all currencies except for CNY and HKD weakened against USD.

Oil starts off the New Year on a positive note, mainly due to the geopolitical tensions between Israel and Hamas, bringing prices closer to $50. Also aiding the crude complex was the strong rally in equities. The question now is if demand destruction will still weigh in on the market. Recently, a huge build in crude oil storage levels was revealed in DOE inventory report (for the week ended 02Jan) and led to a significant $6 sell- off in oil. Crude inventories rose 6.6mn bbls, well above expectations of 1mn bbls…

Good night, my dear friends!


W:  few points that i disagree. But i'm running out of office now. Here they are and maybe I'll formulate them better tmr:

1. USD going up longer than consensus thinks

2. stimulus package and talk-consumer-into-more-credits will prove useless and entirely de-ja-vu

3. we won't know how 2010 will be compared to 2009, but if u point a gun to my head, i'd bet the ship keeps sinking beyond 2010.

oh and one more thing, i think monitoring rates to gauge macro conditions will be more and more useless.

What quantitative easing achieves is to make financing conditions LOOK good nominally, but look good only.

With deleveraging and deflation forces gaining momentum as u said, LIBOR at 0 or whatever rate spread narrowing doesn't really have a lot of meaning.