My Diary 474 --- Where Are We? How Much Longer? Where Goes
November 10, 2008
Election, Employment, Economy, Earnings, Equity, Where are we! --- History was surely made last week as we saw the biggest election-day rally since 1984 turned into the biggest post-election collapse ever. Once a time, the markets expect that perhaps President-elect Obama can put an end to this rout in equities by clarifying his positions on taxes & regulations, but traders swiftly reverted to the fear factor as negative economic indicators, especially employment and bad corporate earning, remerged. Speaking of the market, I think the rally we saw is more likely the case that the massive liquidity injections, the credit and funding facilities, the easier monetary policy, the TARP--and similar actions in major economies around the world--are gradually beginning to ease stresses in financial markets, which in turn inspire risk appetite, instead of the outcome of the election. In order to discuss each of the factors that could have an impact on the market movement over the week, I choose to preset each of them one by one as below:
Ø Election and Fiscal Spending --- President-elect Obama in his first press conference said that any stimulus package would combat unemployment,”…because the hemorrhaging of jobs has an impact on consumer confidence and the ability of people to purchase goods and services…” I think he catches the point, but another key issue for investors is the identity of the new Treasury Secretary, who obviously will hold a position of significant power over
Ø Employment and Economy --- After seeing the Sep-revision of 284K plunge in payrolls, followed by a 240K slide in Oct, I think it is hardly an overstatement that
Ø Central Banks Actions – Given IMF’s prediction of global recession (2.2% growth in 2009), global central banks continue to adjust to the new economic reality and are aggressively cutting interest rates in light of the downside risks to growth and the dramatic reversal of inflation pressures. I think the most impressive move was BOE shocked the market by cutting 150bp to 3.0%, but ECB stubbornly refused to acknowledge the worst financial panic in at least 60+ years by only dropping 50bps!? …It is interesting to think that the raft of global rate cuts is a game plan rehearsal for the upcoming Breton Woods II meeting scheduled on 15Nov, or a coordination mission to destroy speculators caught up in the Yen carry trade. But, I do think even though these worldwide policy actions have probably managed to drag the global economy from its deathbed, it is still very much in ICU.
Ø Asset Classes Performance --- Over the week, all the old correlations are coming back, witnessed by FX (JPYAUD), commodity and cyclical stocks. The key driver is that growth expectations falling (again), especially out of
After discussing the “5E” factors, we then take a look of market performance over the past week. Global equity markets tumbled 1.88% this week, though still up +8% from 27Oct low. Regionally, stocks declined 4.95% wow in
Looking ahead, it is a consensus now that we are in a severe world financial and economic crisis and the focus has shifted to how deep and how long the crisis will be. I think the financial crisis is in no doubt the worst since 1930s, but the depth of the economic crisis is harder to measure…One thing worth to point out here is that though MMK rate showed the signs of thawing in past week, with 3M LIBOR fell 74bps to 2.29% and TED spread down 58bps to 200bps, there are not many transactions in the interbank markets beyond 1M tenure. In addition, LIBOR-OIS spread, (used by Alan Greenspan to access money markets), closed down 63bp to 175bp remained at elevated level, if compared with 87bp on the last day before LEH collapse and an avg 11BP in the five years before the crisis started…In the near term, I think there are few risk factors to be repriced or priced by the global markets:
Ø The Solvency/Liquidity Risk of Big 3 --- if the saying "As goes GM, so goes
Ø US/China Growth Potentials --- with respect to the economy growth,
Ø When will stock market surrender, if the above mentioned scenarios turn out to be true? I have two observations here – 1) based on current market valuation, the stock market is priced for a recession, but the bond market is priced for a depression. This is explainable as even though bank risk has been reduced, global growth is slowing so sharply that risk for corporates (i.e. bankruptcies, unexpected losses and slowing profits) remains high. This is why, while TED spread and EM Sovereign CDS falling down, corporate bond spreads have barely budged; 2) To my view is that if the damage from the Sep financial market crash is done, then how much relief can we expect in this rally before the suffocation hits real activity?
I think all these Qs are glued with one disclaimer --- the fundamental outlook argues for continued growth shocks ahead to pound stocks lower. Having discussed so, timing the market remains the harder part --- Is it due on Nov data, or 4Q08 preannouncements, or Q4 earnings or Jan data? At least, technically, S&P broke through the .618 retracement level in the latest trading session and I believe this will encourage many investors to look for a full re-test of the 28Oct low. In addition, the biggest risk in my mind headed into year end remains the risk of further redemption pressure not only from leveraged funds but also from non-leveraged real money accounts as we are just seeing the beginning of a deep recession and the deleveraging process at best is half-way through…Why? Go to next and next sections.
Where are we in the crisis?
I feel strongly that the worst of the financial crisis has passed, but that we have not seen the worst of the economic crisis yet. Just be reminded that we are still in bear market and most serious financial crisis since 1929, thus we should expect the market will swing around at the current level for a while and trend down again amid poor corporate earnings and economic data, even through historically bear market rally on average is about 50%.
But that does not mean we can use the comparisons based on historical averages, as each of recessions is different from each other for their causes, means and consequences. For example, the '70s and '80s were subject to serious levels of inflation, while the recession at the beginning of this decade saw fears of deflation. The current recession is the result of serious bubbles in the housing and credit markets imploding, but not the result of excess inventory or capacity. As I discussed before, it took nearly 2 decades to build up the over-indebtness and will take at least 2-3 years to correct. We are only 15 months into the correction process, even though numerically, global losses for houses, stocks and bonds are ~$23.4trn (60% of global GDP). The reality is that losses in wealth and violent de-leveraging in the financial world is boomeranging back to the real economy. So we need an assessment on where are we in the cycles of real economy, monetary policy and corporate earnings.
Ø Real Economy --- The recent ISM index shows that
Across the Atlantic Ocean, there were more weak data out of
Ø Monetary Policy --- Including the recent cuts by BOE, ECB and BOJ, central banks across the globe have been acting in concert to slash interest rates over the past few weeks. But the problem remains as banks may not pass all of the benefits of lower interest rates on to consumers, when loam officers re-evaluating risk premium and while raising the cost of loans. This phenomenon is well supported by the quarterly Fed SLOS, about 95% of US banks raised the costs on credit lines to large firms, and “nearly all banks” increased the spread on borrowing rates over the cost of funds on loans to firms from July. In the other hand, despite what policy makers do in coming quarters, the pace of recovery in the
However, the avg 30yr fixed rate mortgage is presently 6.03%, roughly equal to the peak in fixed rate mortgages since 2002. The 5/1 ARM rate is also sitting on an 8 year high at 5.95%. These mortgage rates need to fall significantly if equity markets are to get any sense of meaningful economic recovery into 2009. This implies that US bond yields need to fall further and given the massive UST issuance next year, Fed also needs a low LIBOR funding rate and a weaker dollar to stimulate reserve accumulation. Thus, I would expect FFTR to be lower than 1% and Fed will keep ST rates low for an extended period. In addition, I do think the long end of the US curve is going to become an increasing policy focus for both the Fed and the new US Administration. The same situation is also existed in many other countries as bank lending rates are going to become increasingly political. In EU, with policy rates still relatively high, it should be little surprising that ECB will cut another 50bp next month. But question is will these rate-cutting stop further falls in the real economy? Certainly not, but it will help bring forward the moment of stabilization.
Ø Corporate Earnings --- So far, 341 of S&P500 have reported and in aggregate profits have fallen 9% yoy. However, if excluding financials, profits are up ~14%. Clearly the full impact of the recession has yet to be felt in corporate profit. But I think things should get worse before getting better as over the week, investors have received a series of profit warnings and negative guidance across different industries, including monolines (MBIA, Ambac, losses wider than estimated), insurance broker (Marsh & McLennan, world's 2nd-biggest insurance broker, 78% profit dropped in Q3), Beverage (Carlsberg, cutting FY08 outlook), Tech equipment (CISCO, 9% yoy order decline in Oct), Steel (ArcelorMittal, Q3 profit missed consensus and cut global output +30%). We also saw Sara Lee down 14% because of lower full-year profit guidance and Toyota cut its profit forecast 56%. Thus I would not expect this corporate earning down cycle end before Mac's and Wal-Mart report 10% yoy decline in profits.
Going back to Asia, according to Citi’s research, regional ROE will need to fall to the 8% trough seen in the past two earnings recessions of 1992-93 and 2001-02. But this is just at best a hope as the current fall of ROE could be steeper merely because we start with a record-breaking 16%, and if the IMF thesis is right (see below), there is every chance this recession will be more severe than the other two.
How much longer will the crisis be?
Where are we standing in the deleveraging cycle? Banks seemed close to finished as governments have put equity into banks, but this is not able to stop banks from shrinking their loan books. Corporates on average had low leverage, but will likely turn more cautious on spending. Households have started to delever, by raising savings rates, but I do not believe they are halfway in this process yet. Thus for the rest of this section, I want to put some inks on the on-going deleveraging process, which will continue to influence the outlook of economy, financial markets and even the policy responses.
Ø Household Deleveraging --- Overall, I think part of the deleveraging of the financial sector will occur via the reduction of household indebtedness. Since much of the credit created in recent years in US was used by households to fund house purchases, which in turn pushed house prices up, the question is how far do house prices need to fall to restore a “normal” relation with income, and – even if there is no overshoot – how long might this process take? And how much debt reduction would this imply? To answer this question, we have to bear in mind that many asset classes have mean-reverting characteristics. In the case of housing it can reasonably be argued that house prices should maintain a roughly stable ratio to nominal incomes over time. In the other hand, US household debt, including mtg, skyrocketed from 47% of personal income in 1959 to 117% in 4Q07, and from 25% of GDP in the 1Q1952 to 98% 4Q07. At the same time, other forms of consumer debts (i.e. credit cards, auto loans, bank loans) have also risen to $2.6trn over the last 20 years.
So if the US housing bubble is reckoned to have begun in 2000 and the total value of the housing stock steadily reverts to the same multiple of income as in 2000 by 2012, and we assume just 3% yoy nominal GDP and PDI growth for 2008-12, then losses amount to about $1.5trn over the period. Alternatively, the US household debt service ratio increased from 10.8% of income in 1993 to 14.4% by Nov2006. Assuming this ratio needs to fall to 10-11% again, then either household debt levels must fall (or at least remain stable) while income rises, or nominal incomes must rise sharply relative to debt (which is implausible). Either way, the restoration of sustainable debt service ratios will take several years.
Ø Financials Deleveraging --- Over the past three months, one of the brutal facts is that hedge funds are being forced to de-lever. While for most styles of hedge funds, leverage was not all that high (avg 1.4X Equity), large redemptions, especially by FoFs, are forcing sales of all types of assets, but in particular stocks. As an aside, this selling is not over because if during the 2001-03 stock market crash, hedge funds did produce positive returns, thereafter pitching themselves as the best protection in a bear market. The likely >20% loss YTD on HFs shattered this myth, inducing dissatisfaction among investors. Thus we are seeing several massively differing estimates of Q4 redemptions circulating around the market.
Beyond this leveraged money, mutual funds are also seeing large withdrawals and are selling. Large banks are being forced to reduce credit lines in order to shore up capital, as they must deal with subprime debt and other Mtg-related problems. Smaller banks are just now starting to deal with losses on commercial loans due to the economic downturn. This is happening all over the world, even including country like Italy, whose sovereign debt is around 110% GDP, while Iceland has blew up.
Ø IMF Thesis --- In a study covering 17 DMs over 30 years, IMF came up with three findings of particular relevance: 1) recessions preceded by a financial crisis tend to be deeper and longer than others; 2) they tend to be worse again if the crisis is in banking, rather than in securities markets or FX exchange; and 3) the countries hardest hit are those with so-called arm's length financial systems, such as US or UK, of which banks are free to innovate and tend to build up more pro-cyclical leverage. In practical terms, IMF found that recessions linked to banking crises lasted twice as long on average as those not linked to any financial crisis, and the cumulative loss of output was about 4X as great. Unfortunately, the present recession, plainly, ticks all the boxes.
I do believe all the above analysis are showing the deleveraging and recession will continue to live with us for at least a few more quarters, if not years. As a result, we will continue t see fund outflows from our regional markets. According to EPFR, over the week, there were half-a-billion Dollar redemptions from offshore Asian funds amid the biggest ever market rally. YTD net outflows from AxJ totaled $20.2b, or 37% of new money taken in during 03-07. Historically, during 1997-98 financial crises, a total $2.4b was redeemed by investors, or 37.6% of the amount taken in between Jan 92-Jun 97. If current outflows are no worse than the one in 1997/98, we should see redemptions close to an end… Wait, is that comparable? Remember, during 1997-98, there is no liquidity/credit crunch in the DMs, or their B/S is healthy. This is not the case anymore.
Where Goes China?
Based on the newly economic data, the slowdown in Chinese economy is now broad-based, and pronounced. Over the week, one of the most dramatic tone changes is China economists are falling over themselves to lower their 2009 GDP forecasts. The lowest so far is 5.5%. I think they have come too late to update us the sea change happened in the both macro and micro levels of China economy. One of my favorite gauges is commodity price. YTD, industrial raw materials measured by the Journal of Commerce fell as much as 56% yoy the most since 1949 and worse than the declines before every recession since then. Crude oil, copper and wheat tumbled +50% from records this year. Unlike equity markets, commodity markets are not forward looking. They reveal what is happening now.
Given that commodity prices typically will not turn until the global economy, including China, hits its nadir and they will not turn up until the global economy is back to trend and global growth is accelerating.Thus, I expect deep cyclicals -- steel, spot coal, non-ferrous, shipping and even cement - will not out-perform on a sustainable basis. In addition, if China slowdown below 7%, I may have to O/W Telecom and U/W Banks.
Ø Economy Growth and Three Components – Let us break down the economy into piece-by-piece and take a close health check. First of all, exports accounted for 36.8% of GDP in 07 (18.2% in 1998) and the share of SMEs in gross IP was ~65% in 07 (58.7% in 1998). Nobody now thinks export will likely grow as it was over the past 10 years at avg 25% yoy, because Chinese exporters and many SMEs are facing rapidly deteriorating external demand as well as significant depreciation of many other Asian currencies relative to USD. As a result, financial markets have been increasingly concerned about the risk of a major reversal in CNY, with NDF looking for 1.4% depreciation in 12M… Remember just 6M ago you have to pay 5-6% premium to go long RMB!
Secondly, investment, at 40% of GDP, is likely to remain a bulwark of China’s growth and driver of the internal momentum of the Chinese economy. Recently, given the past successful experience of aggressive fiscal policy adopted by China during 1996-97 and 2000-01, the markets single-minded focuses on China’s fiscal policy, with the hope at 8% growth in 2009. Indeed, over the week, I have kept hearing about something like RMB 2trn in Railway, RMB5trn in toll roads and ports, and this morning a RMB4trn comprehensive stimulus package. To be honest, I feel bored on these figures as clearly nobody can reconcile these RMB2-5trn investments. According to MOR, the 2trn is old money, and this money seems accounting for ~60% of the latest comprehensive package.
According to ML, even we take the Rmb5trn as the base case to spend over 3-5 years, implying Rmb1.2-1.7trn a year, roughly 8-11% of 2007 FAI (13.7trn), given that capital formation accounted for 42% of GDP in 2007, this spending is equivalent to roughly 3.3-4.6% of 2007GDP…Ok, More money is better than no money, but we have to ask --- 1) where does the money come from? In 2007, Chinese government’s overall fiscal revenue was Rmb5.3trn. Thus, these incremental fiscal spending will largely and likely come from local govt deficit, bank loans, insurance and corporates investments, including foreign investors. But it seems that Premier Wen has a tight belt as the numerous natural disasters in the first 9M08 and the sharp deterioration of macro economy and cooperate earnings have left not much room for maneuver. One can find that for the Rmb400bn to spend in 4Q08, central govt is only to take RMB100bn. I think the only valuable argument is that China has low debt ratio; 2) even though we “Assume” that there are investors or money to be invested in toll roads in inland areas (guided by central govt as roads and ports in coastal China are already under-utilized), there is another question on whether this spending in infrastructure can offset slowdown in other areas as FAI in property is about 2X bigger, FAI in manufacturing capacity expansion roughly 3X, FAI in electricity about 0.67X, and even mining capex along was over 40% of that. All these fixed investments, excep for electricity transmission spending, may slow down sharply going forward (Note: most of the data come form ML Research).
Furthermore, the biggest surprise taken away from the GS China Conference in Beijing was probably in China retail, where sales guidance weakened significantly since the Golden Week holiday in early Oct. This includes high-end dept stores, women's shoes and sportswear. According to the latest channel checks on PRC dept stores by JPM and Cazenove, Tier 1 cities have seem biggest fall in SSS to single digit in Oct, while Tier 2 cities remain strong. This trend is confirmed by the management of Parkson& NWDS, indicating that coastal cities are facing more pressure whilst inland stores performed much better. YTD, Parson’s flagship store SSS growth slowed to mid-single digit.
Ø Micro Deterioration – After going through top-down factors, let me switch to bottom-up. In general, we are seeing a fast deterioration at the micro level, As a rule of thumb, corporate China needs 8-9% GDP growth to achieve positive EPS growth -- every 1% GDP growth deceleration will wipe out ~10% EPS growth for A-share and MSCI China. Based on the negative trend of earnings growth for CSI300d in 3Q08 (1st time since 1Q06), -17% CFOs of non-financial firms and +433bps increase (to 33.1%) in gearing level, it is not unreasonable to think 9% cons. growth in 2008 is still too aggressive because we will have to grow at 40% in 4Q08? Reality checks based on sector level also echoed my observation --- 1) nationwide, the 3Q results of leading listed developers showed that their inventory is at 2-3X of 2007 sales; 2) spot iron ore and coking coal prices have fallen >50% in the past few months; 3) Bao Steel lowered steel prices 3 times in the past 2 months. For its CRC products, Nov price is 800RMB/ton lower than Oct, and Dec is 900RMB/ton lower than Nov; 4) chemical products are seeing weak demand due to the slowdown in the auto, toy, textile and packaging industries.
Now, are these negatives priced in? Based on 10.2X09PE and 15-19% 09EPS forecast, if we assume zero growth, current 09PE will rise from 13-15X, 30% higher than historical trough (10X).
Ø Fiscal Spending and Rate Cuts --- Having discussed all the above, I am neutral on the recent stimulus package, as it is not big enough to fill the gap in FAI caused by other sectors. Hence, I do not think this kind of package is able to spur economic growth in 2009, even though we may avoid the complete hard landing. Having said so, from the historical data, we can find the stock market gives +ve reaction after fiscal stimulus plan during economic downturn in 1998. The whole market rebounded by 14% and 18% respectively in the following one week and one month after plan issued. Sector wise, industrials, energies and infrastructures are among the best performances which rebound by >30% in the following month.
In addition I do think the best way to counter current cycle is by using monetary tools. As discussed, if the US recovery mechanics are to work, the US needs a weaker currency. If so, then China needs to rely more on interest rates to stimulate and its interest rates need to come down to cut the cost of intervention. On average the market expect 120-150bps cutting going forward, but I guess we may see 200bps more to the level below 2002-2003 (1.98% 1yr DR and 5.3 1yr LR). If this is the case, and given market economists have altered their China GDP numbers aggressively but not moved their interest rate assumptions enough, I am thinking this is could be good news for China property.
Well, to have a full picture of China economy, this coming week is important as we will see a fleet of macro data being released --- PPI due today, CPI due Tue, Retail Sales due Wed, IP due Thur, FAI due Fri
[Appendix:]
1) Stock Recession, Bond Depression
Corporates rated Baa yield about 550 basis points (5.5 percentage points) more than comparable Treasuries, nearly half again the spread in the 2002 post-WorldCom-Enron debacle and twice the average of post-war recessions. You have to go back to the early 1930s, when Baa corporates yielded 700 basis points over Treasuries, to find a comparable situation. Meanwhile, the stock market hasn't fully priced in the likely decline in earnings ahead.
Ø Even based on conservatively estimated 2009 earnings on the S&P 500 of $68.50 -- about a quarter less the Wall Street consensus -- the S&P trades at a P/E of 12.4. That's an 8.06% earnings yield, 86% of the 9.39% Baa corporate yield.
Ø In 1982, the S&P bottomed at a 6.6 P/E, a 15% earnings yield, close to the 16.32% on Baa corporates.
Ø In 1974, the 7.9 P/E resulted in a 12.66% earnings yield, well over the 10.48% Baa yield.
Ø In 1932, the 5.6 P/E equated to 17.86% earnings yield, more than half again the 11% Baa yield.
2) How much MORE employment weakness?
In the last recession – including the so called “jobless recovery” that extended from 2002 to mid-2003 – the economy lost 2.7mln jobs. There were 5 months with job losses in excess of 200K per month. The recession of the early 1990s produced a similarly weak job market. From 1990 until early 1992, the economy lost 1.8mln jobs, or about 1.6% of total employment. During this time, the economy registered 3 months of job losses in excess of 200K per month.
So far, in the current economic downturn, the economy has lost nearly 1mln jobs, or 0.7% of total employment. In order to match the previous two downturns, we would have to see total job losses at least DOUBLE from current levels. If this recession proves as severe as 1982, job losses would have to QUADRUPLE relative to those realized so far.
3) Recent Corporate Bond Issuance
Corporate bond new issue calendar began to pick up with Verizon, Kimberly-Clark, and Estee Lauder closing debt deals. In high yield, MGM priced one of the few HY deals in October.
Ø Verizon A3/A priced $3.25bn of 10-yr and 30-yr debt at 8.75% and 8.95% coupons, respectively.
Ø Kimberly-Clark A2/A priced $500mm 10-yr debt at 7.5%
Ø Estee Lauder A2/A priced $300mm 5-yr debt at 7.75%
Ø MGM Ba1/BB priced $750mm 5-yr debt at 13% (discount of $93.13)
4) Downside risks to US C/A deficit?
Such a sharp rise in the private savings rate should lead to a significant compression in the US C/A deficit: a structural, not just cyclical, development. Downside risks to EM's C/A surpluses? The US external deficit has powered many of the EM economies. A permanent decline in demand for imports will hurt the export-oriented EM economies. Indirectly, this trend could also undermine the commodity cycle. Key trends in the last seven years may not be repeated in the next seven years. Extraordinary global growth, leverage, the US C/A deficits, the RoW's C/A surpluses, the sharp rise of EM and the weak dollar were the key trends in the last seven years. Since all of these factors are inter-linked, a reversal in the US credit cycle could undermine EM's structural growth.
Good night, my dear friends!
