My Diary 518 --- The Negative Economy Theme; The Eastbloc Debt

My Diary 518 --- The Negative Economy Theme; The Eastbloc Debt Burden; A-Shares lost Steam; Buy American =Buy USD

February 22, 2009

“Drunk Financial Minister vs. Skeptical Economy Policy” --- The ugly week started with the drunk Japanese Finance Minister, Shoichi Nakagawa, who resigned citing health problems (good excuses!), and then dou bts over that govt stimulus and bank bailout programs could stop the global economic freefall dragged Dow below its Oct low (7552). Later on, depression fears continued to mount on the back of abysmal economic data, and both President Osama’s mortgage plan and Chairman Bernanke failed to lift the market confidence. One of my observations over the week is that the economic reality and political hope do not mix well together, as investors are still left with the same brutal reality -- housing prices are still too high, unemployment rate will move higher and capacity utilization is coming down. The conclusion is simple that US economy can’t move forward until housing market has bottomed in terms of both price and activity, and it cannot move forward until the inventory overhang is cleared.

Economy wise, data are nasty. US Jan IP fell 1.8% (cons -1.5%) with motor vehicle output fell 23.4%, the biggest monthly decline on record. Annualized auto production in Jan was just 3.9mn, compared with 10.2mn a year ago. Capacity use fell to a 26 year low of 72%, which will further concerns of steep disinflation. Labor market also shows no sign of improvement -- initial jobless claims remained at 627k while nearly 5mn workers are currently getting benefits. I think there is no surprise to market if US 4Q GDP is probably revised down to 5.1% yoy, from 3.8% initially reported. Thus I seriously doubt any speculation over the restocking story in DMs. Recent feedbacks from Chinese ports echoed this judgment as inventory/sales ratio has hit a ceiling and is showing no signs of softening. Meanwhile, Chinese Deputy Commerce Minister Zhong Shan indicated that the 8% growth target may be reviewed next month…

Mr. Zhong is not the only person painted a grim picture of growth, so does Fed. The Jan minutes show that Fed cuts its inflation and growth forecasts and hike its expectation of unemployment. For 2009, the Fed expects GDP at between -1.3 to -0.5% and UNE may top at 8.5%. LT inflation target is set at 2%. Growth is expected at 2.5-3.3% for 2010 and 3.8-5.0% for 2011, which would be a relatively good outcome for US if they were right. In addition, Chairman Bernanke re-iterated that the Fed’s credit easing policy will not be inflationary in the long run, as long as its B/S returns to a normal size in a timely manner as the economy revives, though many investors are rightly skeptical that the Fed can easily do so. Meanwhile the Fed decided to backtrack on its initial plan to buy longer-term USTs as a more effective way to employ it B/S to support credit flows to households and businesses.

What bothers me is that FOMC members saw no indication that housing sector was beginning to stabilise, worried that commercial real estate would deteriorate sharply in months ahead…I think they are right on it as both starts and permits have fallen for 7 straight months, with permits falling 54% over this period. Housing starts continued to decline steeply, falling 17% in Jan to a new all-time low (back to 1959) of 466k (cons 529k). In spite of this reduced activity, the month's supply of new homes for sale rose to an all-time high of 12.9 months as of Dec. This overhang is likely to keep new construction quite low until home sales recover. Furthermore, it seems that mortgage rate cuts and term extensions won’t stem the rise in delinquencies because many contract restructurings also require a reduction in home equity, which borrowers and bankers are resisting. The Subprime delinquency rate has risen to 39%, from 35%, even though MBA 30yr benchmark rate has declined to 5.19% from 6.47% on Oct. 31. Against this desperate data flow, we had detail of a further US$275bn in stimulus from the Obama’s mortgage relief plan. This includes US$75bn slated for mortgage relief and up to a further $200bn of capital for the GSE’s to enable them to purchase new mortgages.

Now, let us take a close look of the past week’s market performance. Global equities tumbled 6.8% wow and it is ~1% above Nov low. Regionally, stocks moved down +7% this week in US and EU, and 5% in Japan. Elsewhere, USTs yield curve flatten with 2yr down 2bp to 0.94%, and 10yr closed 10bp lower to 2.79%. 1MWTI oil went up $1.43 to $38.94/bbl, with trading below $40/bbl for 2 full weeks. USD was flat vs. EUR at 1.283 but up 1.5% against YEN to 93.4 and up 2.6% against EM currencies.

Looking forward, on the back of global equities plummeting, credit spreads and sovereign CDS gapping wider, commodities falling but gold holding up, USTs rallying and VIX touching 50 again, the markets are entering into renewed concerns of economic crisis and x-board risk aversion. I think the larger unanswered question is whether a faster and more aggressive policy response makes a difference or whether the adjustment from a debt-fueled binge must lead to a “lost decade.” Based on recent data flows, I think there are material risks that global growth could show a negative number in 2009. Now, with all the markets in confirmed technical downtrends, pronounced earnings weakness and the threat of at least partial bank nationalization, there is a clear danger of a breakdown if policymakers cannot promptly articulate a well defined strategy for stabilizing the banking sector and restoring confidence in the economic outlook.

Another measure of market stresses is evident in sovereign credit markets, in particular Eastern Europe. Lately, Ireland CDS surged to 350-400bp late and Italy's latest CDS is 182bp. That compares CDS of Germany and France at 68 and 76 respectively. With governments increasing spending in an attempt to cushion the economic downturn and/or provide capital to their respective financial systems, and doing so amid an environment of declining tax receipts, concerns about their ability to service their debt have obviously increased. The notion of the-weakest-link may be the more important issue for EUR more broadly. For now, developments in CDS are important and need to be on the FX radar screen.

Lastly, there is an old friend who may come back to visit the market. According to FT, hedge funds are facing a 2^nd round of redemptions after several big investors hit by Madoff’s alleged $50bn fraud began liquidating portfolios, according to some of the world’s biggest HF managers. The scale of the redemptions is not as bad as the heavy withdrawals that hammered the industry in October and November, but is significant enough to create problems for managers still struggling with the hangover of last year’s withdrawal requests…Stay alerted and let us switch the macro book…

The Negative Economy Theme

Recent macro reports continue to highlight the intensity of the US corporate adjustment, with 627K initial jobless claims suggesting that payrolls could contract by another 600K. Big picture wise, Europe and Japan are now ahead of US in this down cycle, with EU growth -5.9% yoy (largest decline in 13 yrs), Japan -12.7% yoy (largest fall since 1974) and US -3.8% yoy (the worst has not yet to come).

In addition, after struggling nearly 20year in economic mud, things in Japan have turned into very ugly. As noted by Governor Shirakawa that “the deterioration of the Japanese economy has been very rapid and steep, and finances for corporations remain severe”. Already, the Japanese economy plunged by a -12.7% yoy in 4Q08, exports and IP (-20.8%) have fallen off a cliff, and nationwide dept store sales contracted in Jan by 9.1% yoy. Heading forward, Shirakawa expects the “GDP data for the 1Q and 2Q to be severe”…All these macro information paints a negative economy theme to me --- G3 wage growth is falling, unemployment rising and spending is slumping lead to a collapse in manufacturing activity, for Asian exporters G3 import demand collapsing, 2009 will be very difficult for Asian export -driven countries, including China. Thus I believe that the deepening recession in G3 and growing synchronization of business cycles will continue.

As result, East Asia seems to be suffering a double-whammy of export growth collapse, both on slumping G3 demand and de-stocking, plus substitution/crowding out effects as it is squeezed out of the production chain vis-à-vis China. The biggest losers are Taiwan and Japan, followed by Korea. Taiwan’s GDP fell at a 22.5% yoy in 4Q08, similar to Korea (-20.8%) and Singapore (-17.2%). In each case, one driving factor was a collapse in exports in a relatively export-intensive economy. In turn, the export collapses appear to reflect a knock-on effect from the disruption in global trade financing.

The East Bloc Debt Burden

After BoJ detailed its corporate debt buying plan (US$10.8bn), Bank of England’s latest minutes indicate that while the default choice for QE is purchases of govt securities, MPC will also consider buying private sector assets such as CP and corporate bonds. But, that may not be enough as George Soros has a bigger call, according to FT. He suggests that Euro zone needs a government bond market as EUR suffers from certain structural deficiencies -- it has a central bank but it does not have a central treasury and the supervision of the banking system is left to national authorities. These defects are increasingly making their influence felt, aggravating the financial crisis.

But the real headache remains on Eastern Europe as almost all East bloc debts are owed to West Europe, especially Austrian, Swedish, Greek, Italian, and Belgian banks. En plus, Europeans account for an astonishing 74% of the entire $4.9trn loans to emerging markets. They are 5X more exposed to this latest bust than American or Japanese banks, and they are 50% more leveraged based on IMF data. According to Stephen Jen at MS, Eastern Europe has borrowed $1.7trn abroad, much on ST debt. It must repay – or roll over – $400bn this year, equal to 1/3 of the region's GDP… Good luck as the credit window has slammed shut…Today, not even Russia can easily cover the US$500bn debts of its oligarchs while oil remains near $33 a barrel. Their budget is based on Urals crude at $95.

Back to our home market, it was also very weak, especially in Sovereign CDS as the KRW traded at its lowest level (1506) since the Asian Financial crisis of late 1997. Korean 5yr CDS traded at 455 and KOSPI is also down 3.1% on Friday over currency concerns, its weakest close in 2 months. Other CDS benchmarks are 10-25bps wider as well with ‘iTraxx HY closed 14bp wider at 1519. Broader credit market was dogged by the fact the Dow hit a 6 year low and that despite more & more govt initiatives, we can't seem to arrest the decline in equities.

A-Shares lost Steam

The macro drag on equities is now greater than at any time since the early 1980s. Excluding inflation, the drag is worse than any time since the Great Depression. Going forward, the biggest risks stem from the timing and magnitude of the economic recovery, the degree to which credit spreads will compress, and the direction of corporate profit margins…Having said so, of the approximately 400 companies in the SP500 that have reported 4Q earnings, the average contraction in earnings has been 33%. In Asia Pacific, the proportion of stocks in with forecast -ve earnings growth has reached 45%, which is already close to previous recession levels. As the macro environment continues to deteriorate, I think more stocks are likely to have -ve earnings growth this year. In addition, according to ML, DRR suggests there have been 62% more dividend D/Gs than U/Gs in recent months. Given current prices, dividends would have to fall 44%, on average, for the AP DY to return to 20-year average levels.

Last week, sentiment turned sour and the unstoppable rally in A-shares lost steam as BBG article does well to question real demand pushing the loan growth – “China Record Loans Diverted to Stocks”. CSI300 index ended its 4WK rally and was down 2.3% at 2,344. Policy front, China had quite a lot of announcements for several key sectors. To property sector, 2 pieces of news came out, including Beijing’s pilot program of “Rural land - Urban housing Swap” program, and Shanghai lifting a ban on using FX to pay for land auction deposits. But these policy initiatives are not enough to stop property price from dropping because of two overhangs – 1) 2-3 yrs of inventory; 2) supply could increase 35% yoy from desperate developers.

In addition, State Council approves 2 more industry stimulus plans for Light Manufacturing and Petrochemical. But results are slightly disappointing as there was NO mention of any duty cuts and NO specifics on which sector will get more export tax rebates, as well as NO mention of any changes of windfall taxes. Demand side, in tourism sector, Shanghai saw its hotel occupancy drop since Aug08, first time over the past 20 years, with 11M08 avg occupancy rate at 56.3% vs. 61.8% 11M07. Regarding Coa/IPP, QHD coal inventory closed near its capacity cap of 7.5mt, 2nd time since last year…Valuation wise, MSCI China is now traded at 10.3XPE09 and 1.2% EPSG, CSI 300 at 16.6XPE09 and 5.4%EPSG, and H-shares at 10XPE09 and -1.6%EPSG, while regional market is traded at 11.9XPE09 and -8.2% EPSG…

Buy American =Buy USD

From FX perspective, the "buy American" seem pretty straight forward and USD may yet see further gains in 1H09. USD has been supported since 3Q08 by de-leveraging and repatriation. At the mean time, USD remains the world’s reserve, invoicing and funding currency. For one thing, USD de-leveraging is not over. US bank credit/GDP was at record levels heading into this crisis. For another, repatriation of offshore investments may have further to go after 10 years of expansion abroad following the EM crises of 1997/1998. Moreover, we are seeing downside economic surprises outside of the US, notably in the Euro zone, UK, Japan, Australia and much of AXJ. In line with this, central banks around the world continue to cut policy interest rates towards levels seen currently in US and Japan. For now, it is not so much the level of interest rate spreads that is driving FX rates, but the direction – and that too favors the USD for now.

But to the rest of world, the strengthening USD is a more disturbing development than falling S&P, as a strong USD means that US economy will be forced to go through a process of real devaluation, which is very bearish for the world economy as a whole. As a result, it is quite reasonable to see gold rose to + $1000 an ounce for the first time in almost a year as investors, spooked by plunging stocks and a deepening recession, sought to protect their wealth. Recently, USD’s inverse relationship with gold reversed as the global recession deepened, increasing the appeal of the metal as a refuge and stoking bets central banks outside the US. will cut interest rates to near zero. The weekly correlation between their returns for the 5 years before the Fed cut borrowing costs to near zero on 16Dec was -0.56. The relationship turned positive with a daily correlation of 0.45 during the past month.

Good night, my dear friends!