My Diary 536 --- The Inventory Adjustment Loop; The Upcoming Los

My Diary 356 --- The Inventory Adjustment Loop; The Upcoming Loss Waves; The Difficult but Possible Goal; The Exist Strategy of USD

March 22, 2009

“All in, Kitchen Sink, Shock and Awe, Rambo, Bazooka” – All these words are widely employed after Fed surprised the markets with a massive move further into QE. In fact, most of asset markets did respond well to the Fed’s calls. Over the week, global stock markets climbed 2.7% with +1.6% in US, +2.4% in EU, +4.9% in Japan and +3.0% in EMs. USTs were given a sudden boost on Wed but retreated a bit later, with 2yr lower 9bp to 0.87% and 10yr dropped 26bp to 2.63%. USD fell 2.9% wow on TW basis, slumped 5.1% to EUR 1.358 and declined 2.1% to YEN95.9. 1MWTI oil closed at $51.06/bbl, running up about $17 since mid-Feb09.  That being said, I think whether we are in a bull or bear over the near term horizon – the FED action is a game changer because it puts the US back into a comparative advantage for future growth.

With S&P500 risen 13% and AxJ +11% since 09Mar, I think such strong rallies are a typical characteristic of bear markets and I have seen four of 10% or more in Asia during this down cycle. I think there is a risk that the recent rally may not be sustainable and that equities may endure a near-term correction. However, the market seems to believe that the outlook over the next six months has improved markedly. My observations are echoed by several pieces of market surveys. First of all, driven by China & US growth prospect, investors surveyed by ML are more optimistic about economic growth over next 12 months than they have been since Dec2005. But the uncertainty over the US banking crisis is preventing them from putting their cash into equities. In my own view, I am not quite confident on the growth yet as global trade remains fragile, witnessed by the 24.93% drop of BDIY index since 11 March…Does this sound counter-positive to the rally of stocks?

In addition, it is hard to judge that whether much of the bad economic news may already be priced in, simply based on the signs that economic expectations have recently moved in line with the actual data releases, following months of significant downward revisions. It is also the case for any new policy initiatives. I have to say that the series of initiatives that policy makers have undertaken since the crisis began have failed to sustainably "right the ship." There have been occasional bouts of euphoria and increased risk appetite associated with some of those actions, but none has been sustained. Thus, one should not exclude the clear risk of a similar sequence this time around…Furthermore, one should remember that the past 18 months have proved that equity returns are highly correlated with credit conditions. Not only the Fed’s SLOS suggests most of the loan officers are still tightening credit conditions for C&I loans, both NA IG (257bp vs. 100bp last March) and HY (1794bp vs. 600bp last March) spreads remained very elevated. There is for sure that only if the central bank and government policies eventually succeed in easing credit conditions, one could see a more sustainable equity recovery as opposed to a bear market rally.

Talking about the central bank policies, the Swiss central bank recently followed a similar decision by the BoE to adopt QE. Until the British and the Swiss turned to QE, BoJ had been the only practitioner. But now, the QE team has the US Fed joined with a dramatic expansion of its QE agenda. In details, the Fed will purchase up to $300bn in USTs over the next 6 months. It will also effectively double its support to the housing market, committing to purchases of up to $1.25trn (prev. $500bn) of agency MBS, and $200bn (prev. $100bn) of agency debt. These purchases would amount to almost 10% of outstanding marketable USTs (notes and TIPS) in the 2-10yr maturity and 25% of outstanding agency MBS. In addition, the $1.45trn of agency debt purchases (MBS and straight debt) shows where the Fed believes the most crucial work is to be done and promoting a liquid mortgage market at low rates is a top priority at the Fed. Thus, we should see a corresponding plunge in conforming mortgage rates in coming days. In fact, as a stand-alone event, this QE v.2 is worth a 75-100bp of interest rate reduction. The announcement did trigger a plunge in UST yields – 2yrs dropped 22bp to 0.81% and 10yr plunged 47bp to 2.53%. Lastly, without committing to a size, the Fed stated that TALF would likely be expanded to include other assets with speculation of credit ratings below AAA. Already the TALF program is to be expanded from $200B to $1.0 trillion to include commercial and private-label mortgages.  

The market theme after the QE announcement since Wednesday has quickly swung from USTs towards USD and Dollar hedges, and the prime beneficiaries were the industrial metals as growth expectation resumes. The CRB index surged 5.3%, Oil +7.8%, Copper added +5% and Gold surged 8%.  However, G10 FX has been desperate to find a trend as it appears the weaker USD has captured everyone's imagination…As always, surprise end up with worries. When listened to the BBG and CNBC interviews, some market analysts have questioned ---1) what does Bernanke know that the market doesn’t or why else would the Fed move to such extraordinary measures, if he cheer-leads the recovery of the economy on the TV? 2) What is the outlook of USD and the government’s policy stand? Obviously, the QE program and the stimulus package have sparked concerns on the Dollar, and witnessed by the DXY chart, the downside risk of USD is big. 3) When the Inflation returns? I think this worry seems years away but traders like PIMCO will watch for it and trade accordingly as the risk stems from the Fed being ahead of deflation and therefore well behind risk of inflation.

However, it seems nobody thinks about what if QE fails to revive the credit markets? That is a likely scenario based on the Japanese case. In fact, the problems faced by BoJ in its QE plan a decade ago closely mirror the problems confronting the UK and US central banks today. Back to then, the problem appears to have been that Japanese companies and households were heavily indebted and therefore did not wish to borrow from the banks. In fact, BOJ data shows they were consistently de-leveraging their B/S, and as a consequence bank lending declined and the broad money supply (M2+CDs) did not pick up. The difference today is only that instead of non-financial companies and households wanting to deleverage, the debt in UK and US is now principally owed by households and financial institutions – both banks and non-banks. It is therefore highly likely that although central bank will find it easy to expand its B/S and the monetary base (M0) just as BoJ did, there is much more room for doubt about whether there will be any growth of bank credit, and hence a corresponding increase in the broad money supply. In short, As long as households and financial institutions are still de-gearing, it seems unlikely that spending will recover to normal levels. But the availability of additional funds should at least speed up the process of paying down debt. QE may help the private sector to repair their balance sheets, but it is only after balance sheets have been repaired that we can expect a sustainable recovery in spending and production.

Looking forward, at some point, the cycle of weakness in asset prices will turn, and that turn will probably initially be greeted with skepticism, probably in the face of the fundamental news flow of the time. The current improvement in asset markets fits perfectly --- global data pulse has remained weak, while policymakers continue to drip-feed policy responses that do not appear to be market-focused. I think we have not seen the turning point yet. One of my judgments is that the –VE feedback loop between impaired bank B/S and economic fundamentals remains very much in play. BBG cites the total capital losses worldwide at USD1.02trn. Even if FIs have received capital injections of somewhat more than this that implies little net improvement in financial sector leverage. The net result is that financing to growth and economy recovery is not there yet…Yes, Fed has stepped into this area, but unfortunately the reaction in the credit markets to last week’s positive news and the equity rally was unimpressive. The cost of insuring banks in the CDS market has fallen, but bank bond spreads have not narrowed materially and remain well above the previous peak in late 2008. The narrowing in LIBOR spreads (8bp) was equally disappointing. The bank credit spreads continues to plague as there have been increasing calls within Congress that bondholders should “share in the pain”. This political risk is reportedly preventing some investors from allocating funds into the corporate bond market. The street believe, and rightly so, that there is no sustainable upside for risky assets until the financial sector woes are sorted out.

WTD, it seems not many people have participated in the recent stock market rally and opinion is divided as to whether we are definitively moving away from a deflationary environment. But one thing for sure is that for the longer term – the fear of a weaker USD, weaker fiat currencies in general and potential global inflation – all point to commodity gains and support for commodity currencies. Thus, commodities and the related stocks and currencies will remain in focus. My own order of preference is agriculturals and precious metals followed by base metals. In addition, I think the latest QE announcement is forcing a reassessment of overly cautious portfolios. Although this bear rally must come to an end sooner or later, in the mean time PM must go with the trend. As studied by ML’s Rosenberg, the average of last 6 bear market rallies lasted 26-70 days. We are only 8-10 days into the squeeze before seeing any big pull backs…So enjoy the rally while it lasts…

The Inventory Adjustment Loop

The debate over deflation vs. inflation comes back recently with the estimated global CPI rose 0.2% mom in Feb. For example, US CPI subsequently increased 0.3% in Jan and 0.4% in Feb, and core CPI increase rebounded to 0.2%/month. I do agree that the upturn in sequential inflation is important, but I think the pickup in sequential inflation largely reflects the stabilization of commodity prices.

Where I differ from market expectations is that the near-term period of mild deflation will probably linger for longer than has been discounted, despite aggressive Fed stimulus. One of my arguments is based on the intensifying global labor markets. Over the week, US initial jobless claims stayed above 600K and continuing claims rose to 5.47mn, the highest since records began in 1967. In the rest of world, job markets are also deterating as well as I saw UK UNE rate rose to 6.5%, Korea’s seasonally adjusted UNE rate climbed 0.2% to 3.5% and HK Feb unemployment rose to 5% from 4.6% in Jan. In addition, global manufacturing remains in a severe slide despite the recent firming in consumer spending. In the US, Feb IP dropped another 1.4% mom (vs. -1.9% in Jan), the 4th straight monthly decline and the 6th fall in 7 months. The CapU rate fell from 71.9% to 70.9%, matching the all-time record low set in Dec1982. This gap between the growth of production and sales is evidence of an inventory adjustment that is focused in the consumer sector, especially autos.

Furthermore, since employment always lags demand, the only way for any economy to emerge out of recession is via a drop in savings. Typically the drop in savings is engineered via lower interest rates and cheap credit. This has been a more difficult task in the current downturn given the credit crunch conditions. Thus, given that global economy is likely to contract this quarter at a pace similar to last quarter’s -6.7% QoQ, I think the earliest signal that the rate of decline in global industry is diminishing will come from manufacturing PMI, in particular the new orders and inventory component. Some key indices to be watched include ISM-composite in US, Tankan survey in Japan and PMI in EU.

The Upcoming Loss Waves

The Fed's shocked that market with Wednesday's QE v.2 announcement. Looking back, when QE v.1 was launched in late Nov08, UST10yr, without looking back, ran higher for a full four weeks to the tune of well over a 100 bps. QE v.2, which is near doubled -- $1.15trn vs. $600bn -- had UST10yr running higher for less than a day and for perhaps 40 bps. All that suggest that UST may have further room to run…Meanwhile I saw BoJ also decided on Mar17 to begin offering subordinated loans to 14 major banks (JPY 1trn), subject to international capital standards. I think BoJ may have concerns over the unprecedented widening of Japan's deflation gap and the mid-to-long term pressure to deleverage B/s in EU and US may result in a decline in banks' CARs, bringing about a credit squeeze.

In comparison, ECB said it has more room to cut rates but is not in a rush to embark on alternative measures, such as quantitative or credit easing. The rational is that "the Euro zone is in a different situation" from than the US and UK. In EU, banks are the main transmission channel for monetary policy while in the U.S. and the UK, government bonds and commercial paper play a more dominant role…That argument seems strongly held beneath the ECB members, but I think the markets should not ignore the uncertainty facing the banking sector --- the magnitude of the upcoming wave of corporate defaults and its impact on credit losses. So far, corporate sector is only beginning to experience a rise in defaults. In Feb09, global HY default rate rose to 5.2% vs. 4% in 2008 and 0.9% in 2007. Moody's now projects that ~15% of global HY issuers will default by the end of 2009, implying the worst post-war credit cycle. Regionally, US default rates are expected close to the global average, while in Europe the projected default rate is close to 19%. Since 1920, the global HY default rate has averaged at 2.7%. The worst year was 1933 when HY default rate peaked at 15.4%. I think corporate debt markets are already priced for the scenario foreseen by Moody's, so it may not be a huge shock for the bond market. The bigger concern is the impact on the loan and CDO portfolios of financial institutions. In fact, those "X" credit indices such as ABX and CMBX have fallen 19% on average in 1Q09, which is almost as bad as 4Q08, with almost half of the change coming in March.

Beyond that, credit woes have now extended to real economy sectors as February master trust data further deteriorated. For now, the 1:1 relationship between card losses and unemployment continues to hold. This is painful as it means the average loss rate for master trusts increased 90bps mom to 8%. This is the biggest increase cycle to date.  Delinquencies were up 25bps mom to 5.7% and the rate of increase has been 20-35bps over the past few months. This is why I saw AMEx, BoA and Citi have underperformed cycle to date and this was true in February too. Moreover, US financials in 4Q08 began to take more aggressive charge-offs on their C&I portfolios, but still appear behind the curve given these Moody’s default projections. As of 4Q, the charge-off rates on C&I loans reached 1.35%, going up from 0.61% a year ago. This is still below the peaks of the last two credit cycles (2.23% in 2001 and 2.05% in 1991)

The Difficult but Possible Goal

History shows that bear markets end when monetary policy is eased aggressively and the banking system is sorted. Such examples include US in the 1930s, Sweden's 1992 banking crisis and Japan in the 1990s. Most clearly, when recession is caused by a financial crisis, stocks tend to bottom when the last troubled bank is rescued, even if the economy remains weak for some time after. That being said, I think the stock market rally over past two week is just the 7th bear rally instead of the nirvana start to a bull market. One major reason is that I saw the similar sector performance as the previous bear rallies. In fact, each one of these flashy bear rallies was led by financials, followed by consumer discretionary and then materials…It's been no different this time around, in the same order! 

In China, policy hope and economic fundamentals are still not mixed well. Although NPC concluded without further substantial stimulus measures, I found that overseas investors take a different view on Premier Wen's comments that China still has plan-B should the current measures fail. Economy wise, Chinese exports tumbled by 25.7% yoy in Feb, the sharpest decline on record, and this dramatic contraction in overseas sales also hampered IP, which gained a mere 3.8% yoy in 2M09, the lowest growth rate in almost 10 years. Good news is that domestic retail sales remained reasonably resilient, while some LEIs, such as electricity consumption, money supply, bank loan growth and PMI, have rebounded recently.  Put these together, I think although it is too early to conclude an imminent recovery, there is evidence that this command economy has been responding to the government campaign. As Wen told reporters on 13Mar, to achieve an 8% GDP target is “difficult but possible”.

In my own view, though China does see recovery signs in some areas, it faces tremendous challenge. This is why I think it is realistic for SIC to expect Chinese economy to remain weak in the next 6 months despite the govt spending. Sector wise, according to Centaline Leading Index, domestic property were down 20% from their peak in Mar08 and the agency believes property prices have another 25% downside till mid-2010. This bodes well with the nationwide land sales which drop 84% in acreage sold in 2M09, and Feb saw 40% of land sales failed due to reserved prices was not met. The weak demand from down stream sectors have traced back to the upstream ones. Over the week, both Angang and Baotou Steel cut prices significantly for Apr with HRC and CRC prices cut by RMB500/ton and RMB400/ton, about 10-15% respectively. Also, Shenhua said its Feb commercial coal sales volume went down 20.6% yoy and 22% mom to 15mn tones. Moreover, A-share market dynamic saw signs of fragile as last week I saw accounts with stock trading dropped to 13mn, a new low YTD and new accounts opened dropped 3 weeks in a row. Meanwhile, Daxiao Fei is aggressively sold unlocked shares in March. By 14 March, DXF sell volume has already exceeded that of full month February according to China Securities Journal.

Lastly, valuation also suggests some near-term correction as PetroChina in A-shares trades 2X vs. H-shares. The last time when the difference in multiples was this wide, Chinese share lost 19% in 30 days…Regional wise, MSCI China is now traded at 11.2XPE09 and -0.3% EPSG, CSI 300 at 17XPE09 and +10.5%EPSG, and H-shares at 11.1XPE09 and -3.4%EPSG, while regional market is traded at 13.5XPE09 and -7.9% EPSG.

The Exist Strategy of USD

Risk appetite appears to be the dominating influence in FX markets recently. But I would have to say that USD still has its serious illness to be cured, namely a housing and credit bust, massive fiscal stimulus, large external deficit and rising savings rate. But going forward, a big concern is the risk that the vast Fed monetization of USD-denominated debt debases USD. In deed, from an S&D perspective, the massive increase in USD supply associated with the US fiscal expansion will boost outstanding UST debt several times over. But I think the key question is whether the world has the appetite, capacity and confidence to absorb that debt, without requiring much higher yields and/or a much cheaper dollar? For now, Fed is stepping into that arena and its buying efforts should create direct demand and attract private capital, presumably enabling the absorption of the extra securities and USD will little market disruption, at least initially. But down the road, the inflationary risks of such massive B/S expansion are clearly evident and, if realized, would represent a considerable risk to USD. I think the recent broad-based response of hard assets suggest that markets are already looking forward to the end-game or exit strategy from these actions.

As part of the consequence of Dollar weakness, Oil closed above US$50 for the first time since late November. I think this is side-evidence of Fed’s game-change action. Earlier this week, Oil took a dive as OPEC decided to keep quotas unchanged and IEA lowered its consumption outlook by 0.3% to 84.4mn, citing dreadful economic conditions. OPEC likewise reduced its 2009 oil-demand prediction by 520Kbbl to 84.6mn bbl/day. In addition, the DOE inventory data (13Mar ending Week) revealed a BTE 1.9mnbbl build, highlighted by the 368Kbbl increase at Cushing. Ordinarily a high level of crude inventory would suggest a subdued outlook for oil price but I am now suspecting that at least some of the crude inventory has been held as a USD dollar hedge ever since I saw the extreme contango a few more weeks ago. It still costs 20.3% to hold a barrel of oil for a year in the futures, much more than the physical holding cost, so there is no incentive for these positions to be unwound. This time however, a sizable inventory buildup has caused the forward curve to steepen, following a few weeks of declining stocks at the NYMEX delivery point. I think the steepening reflects the optimism that the Fed's action will spur the struggling economy and thus increase demand for oil and products.

[Appendix]

Reason for QE: Another major factor that intensifies the need for quantitative or credit easing in the current environment is the inability for major foreign exchange adjustments. Currency depreciation was useful during past debt crises because a significant portion of a nation’s assets became nonproductive. Currency depreciation aided in the economic adjustment because it cheapened domestic assets and boosted international competitiveness. A dramatic drop in the currency also serves in the interest of a crisis stricken economy by stimulating exports and providing a nominal anchor to fight price deflation…There are many examples of banking crises in postwar history: Latin America in the 1980s, the Nordic countries in the late 1980s and early 1990s, emerging markets in the late 1990s and Japan throughout the entire 1990s. With the exception of Japan, all of these previous banking crises involved major currency devaluations (ranging from 35% to 85%), providing needed support to these economies.

The major problem with the current economic and financial market crisis is that it is global in nature, which means that all major economies need a cheap currency. The irony is that with all policymakers facing a similar incentive to engage into competitive currency devaluation, no country ends up getting a weak exchange rate. The implication is that with exchange rates paralyzed by the globalized contraction, the burden of adjustment has fallen squarely on domestic policy.

ML Survey: On growth: driven by China & US growth prospect, investors surveyed by ML are more optimistic about economic growth over next 12 months than they have been since Dec2005. Just two months ago, a net 70% of the respondents thought China's economy would worsen in the year ahead. That figure fell to a mere 1% this month. Investors increased weightings in cyclical Emerging Markets, commodities and tech (to highest weighting in 15 months).

On risk: Investors are stubbornly unwilling to fully commit to pro-risk stance. A net 48% of asset allocators say they are underweight banks this month, up from a net 39% in February. asset allocators actually reduced global equities to second lowest weighting the past decade (net OW = -41%); raised bond allocations to record high (net OW = +26%); fund managers increased cash balances to 5.2% from 4.9%; HF's remain inactive (net exposure a low 17%).

What's impeding risk appetite? pessimism on global banks rose to an all-time high (only 8/100 investors are OW banks) . On global sectors: still defensively positioned; pharma (net OW +30%) still most popular sector but OW trimmed; big rotation into global tech (+28%); much less bearish materials (-10%); significant capitulation on global banks (-48% versus previous low of -41% in 3/08)

Good night, my dear friends!