My Diary 514 --- The Real Test to China; The Year of Credit

My Dairy 514 --- The Real Test to China; The Year of Credit; There Goes A-Shares; The Key to Metals

February 15, 2009

“Hope for the best, but prepare for the worst” ---- These were the words in my mind during the huge policy week in US when I was waiting for 1) Geithner's bailout announcement; 2) Bernanke's testimony and 3) Senator’s stimulus legislation. I think the week was the first chance for President Obama and his Treasury Geithner to shine, but it went badly with a US$2tn FSP. Investors are rightly focused on the details because they have watched for nearly 18 months as a series of government, regulatory and spending initiatives have not only failed to arrest the problems, but also not even been able to curtail their intensification. Such a ” wait and see” attitude has been reflected by market scorecards, as equities down 3.87%, bonds yields drop 5-9bps, USD roughly unchanged with EUR 1.29 and JPY 91.9. Gold rallied another $30 on continued safe haven bid, but other commodities lower (-5% CRB).

Economy wise, I remain concerned about consumer spending, even with BTE January retail sales in US, which may be due to a temporary +ve effect of recent energy-tax cut. I think it is way too early to celebrate a consumption upturn as retail sales continue to contract sharply on a yoy basis. Wealth losses from both financial portfolios and real estate, and sharply rising job insecurity are the key factors keeping consumers on the sidelines. The 4WMVG for initial claims increased 24K to 607.5K, the highest level since Nov1982. The period marks a peak for jobless claims when US was just pulling out of a sharp recession in the early 1980s. Policy support is coming, but it may be too late to prevent a renewed consumer weakness…Other things worth a note are that more bank bailout plans in Europe (Irish Bank capital injection & Russian $400bn floated bank debt), the upcoming G7 meetings on stimulus, banks and FX. In addition, judging by BDIY, gold, and other indicators, the markets continue to flash mixed signals on the underlying global economy. However, one thing for sure is that the rates seems to work on FX as SNB 100bps easing moved EUR higher, BOE comments on rates and QE moved GBP weaker and BOK’s rate decision sent KRW down 1.5% wow. Clearly central bankers are pushing for a weaker currency to help battle deflationary pressures.

On the policy front, many economists have expressed varying levels of concern that not enough of the $800bn-plus in spending will be directed towards near-term economic stimulus and job creation. Meanwhile, the bank rescue plans may reach 2trn dollars, which includes four main components: 1) a capital stress test for banks, 2) a “public-private” investment fund to buy troubled assets, 3) the expansion of Fed’s TALF, and 4) increased surveillance and reporting requirements. But I think there are three key shortcomings of the Geithner plan to bring its failure -- 1) it is not sizable enough for the buck to bang. The average cost of the 42 prior-recorded banking crises was 16% of GDP, according to IMF, but the original $700bn TARP equals just 5% of US GDP; 2) how will the government fund the plan, in particular, how to get private players involved? Moreover, further capital injections do not address the more fundamental problem -- the troubled assets still haunting banks’ B/S and reputations; 3) there was very little detail on dealing with troubled mortgages and the housing market more broadly, which remains central elements of this crisis chain.
According to Zilow.com, the US housing market lost $3.3trn in 2008 and almost one in six owners with mortgages is in –ve equity. FNM and FRE may need more than the $200bn in funding pledged by US govt, if housing market continues to deteriorate, while at the same time, foreclosure filings has exceeded 250K for the 10th straight month in January, RealtyTrac Inc. said. This is why US Regulator is urging thrifts to halt foreclosures. The Obama’s housing plan will use govt money to help reduce interest rates for struggling borrowers, while asking lawmakers to approve more ways to modify mortgages. But what I can still see is that nothing is concrete enough to prevent home prices from deflating further. This $23trn beast remains the backbone of US household B/S and the cornerstone of US banks’ collaterals, and based on IMF, World Bank and the BIS research reports, the real estate deflations always end up the same way - in a credit contraction, an economic recession, and a bear market in equities. Only the magnitude and severity of the collapse varied. For myself to see this chain of events reverse course, the key domino is that house prices begin to stabilize and the key indicator is the total housing inventory. As of 4Q08, the number has rose to its second highest level ever, in the 40-year history, to 2.23mn units. The pre-bubble normalized level was 1.2mn units.
It is time to review the weekly market performance. Over the week, global equity finished 3.0% lower than last Friday, with -4.7% in US, -3.6% in EU and -3.4% in Japan. YTD, equities have declined a cumulative 6.2%. Elsewhere, 2yr and 10yr UST yields slid 3bp and 10bp, respectively, this week. YTD, 2yr is up 20bp and 10yr is up 68bp. 1MWTI oil jumped $3.53 on Friday to $37.51/bbl, down $7 this year. USD rose 0.4% against YEN (91.5) but off 0.8% vs. EUR (1.290). YTD, TW USD has appreciated 3.7%.

In fact, standing at this point of current cycle, it is quite remarkable to recall that a year ago how many people were saying that we were already near the end of the financial crisis. Indeed, even Fed chairman once was used to cite the resilience of the US economy as an excuse for its capability to withstand a succession of shocks. Now the fragile state of the US and of large parts of the world economy leaves it vulnerable. What makes the outlook more challenging is that we have both known/unknown unknowns. The known unknowns are things that we know could go wrong but we do not know if/when they will, and unknown unknowns are things that we do not know about that could hit us. Such shocks can hit us at anytime, whether they are political, economic, financial or environmental problems. We may not experience any shocks, but if we do, the world economy will be far less resilient to immediate economic and financial outlook, just like a sick person to take another hit.

Having said so, in the near term, US and China markets will continue to be policy driven as nations have their own problems. In US, fundamental problems have been delayed and not being resolved properly in my views, and that they now realize any solution will cost money, involve risk, and take time. In China, the very preliminary signs of economy recovery may hold back the government to deliver another stimulus plan, while the economy is undergoing a real challenge which has not seen in 20 years. With such a big picture in mind, it is understandable why gold-bullion sales just made a record as it suggests investors have lost faith in the global financial system. Events today share similarities with the 1930s and the bursting of France’s Mississippi stock-bubble in 1720. While markets doubt that the monetary and fiscal stimulus will eventually lead to inflation in a weak economy with an impaired banking system, the Zimbabwean experience shows that it is certainly possible. Inflation or deflation, whichever you choose, the message remains the same over the week -- markets are skittish, risk horizons are short, headline risk remains high, and positioning is more important than ever.

The Real Test to China

Recession is the key theme underlying the US trade numbers, as both nominal values and real volumes of exports (-6% mom) and imports (-1.5% mom) fell noticeably. Since Dec figures were substantially WTE, the revised 4QGDP could be –ve 4-5%. Moreover, less export means that US consumers have to save more to offset less foreign buying of US debt going forward. In Europe, the GDP decline continued with Germany (-2.1%) and France (-1.2%) contracted by the most in +20 years in 4Q08, intensifying EU recession (-1.5%) and adding to the case for more ECB rate cuts. In Japan, core machinery order, a proxy for domestic capex, fell again in Dec (-16.7% QoQ), indicating the further downward adjustment of business demand and a weaker employment outlook.

In China, the big news over the week was Jan CPI (+1% yoy), which was a 30 month low. Judging by PPI at -3.3% (-1.1% yoy in Dec), China is headed in to deflation in the next 2-3 months. In addition, the underlying trend of export declines is likely accelerating, as the 43% import collapse would eventually show up in weaker re-exports. The continued falloff in imports also taints the recent rebound in optimism, suggesting that even with stimulus programs in full swing the domestic demand is not coming back. Furthermore, destination breakdown also suggests further weakness in regional shipments ahead. In December, shipments to US were down 10%, those to Japan down 9%, and those to the EU dropping 17%. However, the plunge in shipments to neighboring producers was much more acute: exports to ASEAN fell 22% (-11% in Dec), while shipments to Korea dropped 29% (-13% in Dec), and shipments to HK even plunged 35%...Finally, China felt the full-scale of chill resulted from the sharp slow-down both in DMs and now EMs. I think the trend of Chinese exports is a very important signal to watch as it has been following the global winds in recent years. Thus, the next couple of months are going to be very interesting -- will all these fiscal money pouring out of the banks start to significantly prop up import demand or not? As far as the rest of the world goes, this will be one of the tests of whether China’s fiscal package is successful or not.

The Year of Credit

Morgan Stanley published a good research on credit market last week, citing that 2009 is the year of credit. Indeed, Asian companies are betting that credit will offer the best returns in 2009 as I saw 9Dragons last week bought back $300mn bond due in 2013, while other Asian borrowers retired ~$2bn in 2008. So far, given BBB spreads are at their highest levels in +100 years, HY credits are paying equity-like returns for credit-like risks, which make such bets very attractive. According to MS, BBB corporate bonds are now paying real yields of >9%, Compared with LT real returns of just 6.8% on stocks or 1.2% on govt bonds. In fact, even under the optimistic forecasts, US equities in 2009 are expected to have a maximum 8% rise.

However, money is not easily to be made as every bet involves risk. According to Moody's, the default rate on HY debt issued by companies worldwide will peak at 16.4% in Nov09 as the economy worsens. In addition, sovereign credit risks are picking up their pace. The AAA credit ratings of both US and UK are being tested by the strains in the global economy, while countries like Germany, France and Canada are proving more resistant, according to Moody’s research. As a result, 5yr CDS on US sovereign risk has been ticking up exponentially wider from levels of flat to LIBOR before the credit crisis emerged, to +15bps Sep/+30bps in Oct to current levels of +80bps according to Markit. But one interesting point in my mind is that since the US government controls the printing presses, and USD is a non-convertible currency, there is no risk that US will default on its debt in the conventional sense as a corporate borrower would. Thus, the only option to get rid of its debt seems like inflation.

That said, since Dec2008, yields on 10yr UST notes have increased 68bps, which to some degree it’s challenging the Fed effort on lowering private sector borrowing costs. Historically, the last time investors drove yields up from such low levels was 2003, when policy makers also commented on buying Treasuries as a way to cap borrowing costs…So does the market imply that Fed has eventually to do what it has to do? However, I think a continued exposure to the US TIPs is recommended as inflation is generally expected to continue the declining trend, reflecting the weakness of the global economy. Since Oct2008, total returns for a portfolio of global inflation-links has outperformed conventional equivalents by 16% and 12% over the last one and two months respectively, according to BBG.

There Goes A-shares

YTD, BRICs have been leading the way with China, Brazil and Russia all up more than 8%, while India is the only part of BRICs that is down until recently its up only by a small 1.9%. But I think the most important dynamics remains on China. Recently, China reported RMB1.62trn incremental loans for Jan09, a 100% yoy growth, beyond market cons, at 1.2-1.4trn. M2 growth also accelerated to 18.8% yoy in Jan which is significantly above the 17% annual target. In addition, deposit growth accelerated to 23% yoy, and inter-bank rates continued to fell, all suggesting that abundant liquidity is available in the system. These macro indicators look to suggest a recovery of QoQ GDP growth in 1H09. However, a negative sign should be keep on radar is that M1 sharply slowed down to +6.7%, -2.38% than Dec08, mainly due to worsening corporate earnings and investment environment.

In my own view, despite signs of life in Chinese economic data (particularly, bank loans and PMI), sustainability of the rebound is still uncertain. Yes, there are signs that severity of de-stocking may be coming off in China, alongside fiscal stimulus underway, but I do think the 2nd round of effects of employment loss on consumption filtering into the region is intensifying. According to a MHRSS survey, there are 64.5% of companies plan to hire after CNY vs. 84.5% in 2007 and the No. of openings is -10% yoy. In Guangdong, it is expected an inflow of 9.7mn migrant workers, while the demand is only 1.9mn in 1Q109, including those fresh college graduates.

Earning wise, one of the most capital and labor intensive industries, China Shipbuilding Industry is forecasting the whole industry new order may down 48-65% yoy according to CSIA. Thus, it is remarkable to observe that A-shares advanced 7.2% this week, with CSI300 at 2399, +32% ytd. In contrast, H-shares lost 1.7% mainly on earning concerns with HSCEI at 7568, -4.1% ytd. Valuation wise, MSCI China is now traded at 10.9XPE09 and 1.1% EPSG, CSI 300 at 17XPE09 and 4.5%EPSG, and H-shares at 10.5XPE09 and -1.2%EPSG, while regional market is traded at 12.5XPE09 and -7.5% EPSG…I think the current equity market bounce and earnings recovery forecasts seem to ignore the underlying economic data and look vulnerable to a correction. The strong gains and outperformance of A-shares vs. H-shares and MSCI China ytd reflect different liquidity, political and fundamental situations onshore and offshore. But to A shares, if the rally just goes on like this way, the market would most likely have a big crash by the time of the NPC conference…This does not make sense in China due to the embassy of losing face on the background of such an important political event. In addition, as domestic market turnover ($33.8bn) has been going up sharply (+3-4% daily) in the past two weeks, implying the annualized ratio up to 600% (based on 200DMVG), outpaced the 2007 average…there is no doubt that it wont be sustainable and it may decline in any second for any reason..

The Key to Metals

Last week, Nikkei press reported that Russian govt to moderate talks with foreign creditors on $400bn worth of outstanding loans. The report raised new concerns about financial stability in Eastern Europe and contributed to the notable pullback in EURUSD, as well the talk of EUM breakup. I think Euro breakup is not likely as it is not in the interest of stronger players like Germany. So far, not only exports dominate German economy, but intra-Europe trade is nearly 2X as large as external trade. Thus, if EUR zone fell apart, Germany’s replacement currency would appreciate significantly, while other former members underwent competitive devaluation.

That being discussed, however, this week the decline in GBP has been exceptional, with the currency falling ~3.4% vs. EUR, 4.6% vs. USD, and 6% vs. JPY. Some of the blame is being put on BOE inflation report and the downgrade of growth outlook and the prospect for a quicker move to QE, which have compounded the pressures on front-end yields (implied yields on Dec2009 future contacts are down 30bp) as well as GBP. But the interesting observation is that the decline in GBP actually started well before the inflation report.

To the commodity world, China still holds the key to save the global base metal complex. Chinese industrial production has been one major force driving base metal prices in the past 10 years. As China’s export-dependent economy has quickly lost its momentum, the government has realized the danger and accelerated its steps to stimulate the domestic market. But M1, which is a good indicator of Chinese economy, shows a preliminary divergence, and the recovery of tertiary industry simply reflects an increased infrastructural investment. Indeed, it is encouraging that Chinese copper and zinc consumption appears to have bottomed, but given that 1) G7 economy is still in a funk and there are no signs of improvement in most leading indicators, and that the inventories for most metals are still rising, I would remain U/W base metals.

[Appendix]

FT: Asian hedge fund assets plunge 36% -- Asian hedge-fund assets fell 36% in 2008, shrinking more than the global average, as the biggest market declines since the Great Depression prompted performance losses and investor redemptions, according to Hedge Fund Research, reports Bloomberg. Assets peaked at $111bn at the end of 2007 for hedge funds invested in Asia and stood at $71bn in the fourth quarter. The global hedge-fund industry peaked at $1,900bn in mid-2008. The hedge-fund industry worldwide shrank by more than 20% to $1,500bn at the end of last year, and averaged losses of about 19%, as measured by the HFRX Global Hedge Fund Index.

Japan in 1990: Take a look at Japan for inspiration --- Since 1990 there are only six stocks in the Topix with a market cap of more than US$10 billion which have generated an average annual return of more than 5%. These stocks are Honda (7267), Nintendo (7974), Canon (7739), Astellas Pharma (4503), Fanuc (6954), and Kao (4452). If you are looking for names which could do well in an extended depression, one could do worse than to look at the experience of these stocks. I would make three observations: First, none of these stocks were "value" stocks in 1990. They were trading on an average PE ratio of 26x, and an average P/B of 2.3x. They were all growth stocks. Second most of these stocks had very low RoE by 1990 but they all had one thing in common, they had fat gross margins. The average gross margin in 1990 was above 40%. Third, they all make stuff. I’ll leave you with that but my thought is that value is not what you want in this environment. You want solid defensive growth with fat gross margins.

Designations of China export breakdown --- In 2008, the US accounted for 20% of all exports, but only 8% of total export growth (down from 24% and 20% in 2005 and 2006, respectively). Europe, in contrast, accounted for 26% of China’s exports and 26% of its export growth in 2008. According to our numbers, China sold USD 322bn to Europe in 2008, compared to USD 264bn to the US. Emerging markets have become increasingly important for China, accounting for 17% of all exports in 2008 but 27% of export growth.

Good night, my dear friends!