My Dairy 467 --- As Go Consumers; Further Cuts Are Possible; How Cheap are Equities; The Forces behind USD
November 2, 2008
Happy Halloween, Mr. Market and Mr. Bernanke! --- The spiral of deleveraging, forced liquidations, redemptions and etc. have accelerated further in almost unthinkable ways over the week. After I watched all the ghost-type of movements, the market closed out the worst October in 21 years (Since 1987) but one of the best weeks ever (Since 1974). In fact, 79 years ago on 29 October, 1929, this day marked -- Black Tuesday, when a 13% plunge in the Dow marked the beginning of the Great Depression…but this is not a replay of 1929!…Looking back, over the past 18 months we first saw the sub-prime collapse, then credit, then commodity bubble burst, then equities and now HY currencies and EMs this past week. Global investors, including myself, have finally realized that there are few risk assets now unaffected by the savage de-leveraging/unwinding moves…Starting from the massive decline in equities that have brought most benchmark indices to new cycle lows. And in turn, it has resulted in the carry trade unwind, a dominant market force which creates a tidal wave of JPY and USD buying as the funding currencies of those equity market trades are re-purchased, and those currencies-particularly the JPY-have registered incredible gains. The closest analogy I can recall is the unwinding of the JPY carry trade in Oct 1998, when USD/JPY fell over 20 big figures over three days (from near 134 down to 111). Back then, the combined effects of the Russian debt crisis, the LTCM collapse and other stresses resulted in a destabilizing liquidation of financial assets, not dissimilar to the current crisis.
In addition, this was the week that central banks got shocked into action. This observation is well supported by a week of rate reductions that spanned the globe from
Having discussed all the above, let us go back to have a market check…Over the week, global equities finished +10% higher than last Friday. Despite this reversal, equities still collapsed 17% in October thanks to a dramatic drop during the first 3 weeks of the month. Regionally, stocks tumbled 24% in
After reading through the markets, I have to acknowledge that the most important thing that happened over the week for Asia is the Fed providing swap lines to
But still, I need a better explanation of the violent price action in FX, equities and rates I have seen over the week ---Why the market has become so excited with the price trends across many asset classes abruptly shifted during Thu/Fri? Is it due to the talk of possible coordinated rate cut before FOMC, or the short squeezes, or even the upcoming US presidential election on Nov 4th…None of them convinced me, but it appears that capitulations have happened - the Nikkei ended up 6.41% and ‘HSI reversed up a whopping 14.35%. In
All in all, based on what I have seen on Friday, there are tentative signs that global risk appetite is finding a floor. Spreads to Treasuries are narrowing, equity markets bounced sharply overnight and the VIX is well off its 89.53 high of 24 October at 59.89. Crucially, US rates are sharply lower and DXY index has also come off its highs of 87.88 on 28 October and is presently trading 2 85.63… Anyway, to fight against the Fed is one thing, but to fight against the global central banks is another thing…However, before markets get carried away with euphoria, I think we need to refocus on the fundamentals. Based on the collapsed US consumer confidence (38 vs. cons. 52), the ever-dropping home prices (-16.6% yoy) and the higher jobless claims (479K), I am concerned that the crisis has already badly hurt the finances and psyche of consumers and companies as well as that output will collapse in the final months of this year. In fact, that's what happened in the 2Q1980, when the economy shrank at 7.8% yoy after then- President Jimmy Carter instituted credit controls and urged Americans to cut their credit cards in half. The turmoil of the past six weeks has the potential to lead to the type of decline in lending that we had back in 1980.
Looking forward, I think nothing happens in a straight line, especially these days, and there will almost surely be further disruptions or stresses that will likely cause another wave of pains. I am hard pressed to find many market participants who believe that yesterday's stock market gains represent the beginning of a new upward bias. Instead, nearly everyone is viewing it as a bear market rally. The new conventional wisdom is that stresses in financial markets persist, redemptions at investment funds (leveraged and unleveraged) will continue-resulting in more forced liquidation of stocks, and the real economy in the US and much of the rest of the world is only at the beginning of what many are anticipating will be a deep and prolonged contraction. Against that backdrop, it is widely expected that there will be lots more demand to sell stocks going forward. Market position wise, there are still enormous hedge fund outright shorts, the layer upon layer of option protection shorts, but there's another category to consider - underweight cash - we see an absolute mad dash to get back in the market that will be well underway into November. The latter is in particular true as the next 30 days are lining up to be difficult for hedge funds, given that the results of September and October will soon be glaring sores on the upper lips of a number of funds looking for a date via the "capital raise" speed dating end-of-year event.
From now on, most of us would acknowledge that a recession is on the way, but debate is on the depth of the coming downturn. Market wise, I will continue to monitor developments in the equity market and look for currencies to respond accordingly. JPY and yen crosses remain an active barometer of the pain. I think there are several things to think about --- 1) given the world has stepped into another rate cut cycle, will this make a turnaround of stock market? Last time the cooperative cuts by 6 central banks only helped the stock market by 1-2 days. This time the market has already rallied 3 days with 30% rise. After some correction of oversold situations in short term, I believe market will get back to concern on real economy and ugly macro data still to unfold. Of course, we have to be watch for further government response from fiscal and monetary fronts; 2) given what the central banks have done, will this make a turnaround of credit market? I do notice TED spread has down 10bps to 265bps and the Libor-OIS spread fell 24bps to 239bps since 27Oct. I am still a little concerned that both spreads are too sticky at such high levels. Maybe, it is true that the effectiveness of policy interest rates has been diminished somewhat by the current stresses in the money markets, but it is the case that rate cuts now will indeed work to support economic growth in 2009, and future economic growth has become a key concern for financial markets. In addition, as Janet Yellen commented that "we have a long way to go before the credit crunch shows significant healing" and that "we are in the grip of an adverse feedback loop" in which tighter credit conditions are exacerbating economic weakness; 3) If we are looking for the last remaining shoe to completely drop, it's probably property markets around the world. If property markets were liquid assets, then they could easily be down 40-60% this year given that it's generally a high leverage asset. However, it often takes a third to a half of a generation for enough property to trade (especially in a downturn) to get the appropriate "natural" price for the asset. Thus, it wouldn't surprise us to see it fall 50% peak to trough over the next 1-2 years.
Based on all such observation, it seems that credits are getting to their bottom in this deleveraging world, while equity markets are well on the way to "getting" it. Thus to our investors, buying corporate bonds may be the way forward, while equities may be a better bet in 2009, if and when they overshoot properly. On a relative value basis property gets more expensive every day at the moment. However, from an longer term point of view, I do think, once the focus shifts away from the weakening DM economies, investors would find that Asia looks incredibly attractive in the new world. There is a whole lot of cheap money floating around now because of global central bank actions and eventually some of those monies will find their way back to risk assets and
As Go Consumers, So Goes Economy
Starting with banker’s talk again, The FOMC statement accompanying the 50 bps reduction to 1% was perhaps as dovish as ever - even when compared to the 25 bps cut to 1% in June 2003. What jumps out the most to us is the language describing weakening economic activity "in many foreign economies" as well as "coordinated interest rate cuts by central banks". Another sign of the dove was the "Committee expects inflation to moderate in coming quarters to levels consistent with price stability" and "Nevertheless, downside risks to growth remain" - both are indications that the super low level of rates will be sustained. Other notable news that may have been missed just before the FOMC event was "recent events in financial markets will likely reduce lending further to both households and firms in the near term”, as UK MPC Blanchflower said .This is a key factor underpinning my thought that we will see an even looser monetary policy globally, "With hindsight, monetary policy has not been sufficiently forward looking.
Evidence of a recession piled ever higher Friday, with new figures showing Americans are spending less and gloomy about the economy.
As go consumers, so goes the economy. There are more signals of global slowdown. Over the week, global manufacturing indicators continue to slide, with
The bearish outlook is echoed by the latest China PMI, which fell to 44.6 (sa.) last month from 51.2 in September, according to the China Federation of Logistics and Purchasing. Based on my record, this is not the first warning signal from government agencies. Early this week, NDRC called for attention to the Q308 slow down in IP growth as was up 15.2% yoy vs. 9M07 18.5%, while Sept output growth (11.4% vs. Aug =12.8% & July=14.7%) was down to record low since Apr 2002. Export front, MOC said last Thursday that
Further Cuts Are Possible
As discussed above, the global economy is sharply cooling down. To global central banks, their recent dramatic responses are better summarized as -- if the economy cools, then rates have to come down rapidly, so I do not risk falling behind the curve. Indeed, we not only saw Fed cuts 50bp and signal an easing bias with a dour statement on the economy, but also Taiwan (-25bp), PBoC (-27bp) and even BOJ (-20bp) for the first time in 7 years. The list has become longer as central banks in
Having said so, the yield curve in the US has widened to 240bp this week, the most in almost five years, as 2yr UST had the biggest monthly gain (+1.1%) since February after Fed cut twice to spur a contracting economy. In fact, today the yield curve in the
Looking forward, I think the key to watch is whether there is a more broad-based thaw in the credit freeze. So far, the signs are still not encouraging on this front with many key credit spreads at or close to their peaks, beside LIBOR shorter than 1 month. To this front, cutting the FFTR has limited ability to influence these rates lower as they would in normal times. As a result, the Fed is attacking high market rates through buying Commercial Paper, a new program begun this week. I would look next for the Fed/Treasury to begin purchasing mortgage securities. In addition, the Fed and the Treasury are cooperating to substitute or enhance lending from financial institutions. But I think, at present, the Fed and Treasury need to assure financial institutions on their access to funding on a long-term basis, or at least beyond the O/N financing.
In Short, I think further cuts are possible, given that 1) the Fed formally dropped the upside inflation risk, and reaffirmed the downside growth risk, despite the long list of aggressive and unprecedented policy measures put in place over the past year; 2) although Fed returned the policy rate to 1%, the level reached in the wake of the burst Tec bubble, the economy is in much worse shape today than it was back then; 3) financial markets remain very strained. I think as unemployment soars over the next few months and quarters, the Fed has to do more by the middle of next year. But a legitimate concern about further cutting would be further dislocation in the capital markets.
How Cheap are Equities?
There is no question that the equities have become deeply oversold, based on market sentiment, rate of change measures and breadth indicators, which have all hit new cyclical (if not historical) lows. In addition, valuations look attractive with global authorities continue to work aggressively to provide support to the financial assets. That said, I still think it is unlikely that a sustainable equity advance will develop anytime soon given recession appears to be gaining momentum and the profit outlook will remain highly uncertain for some time. In addition, volatility remains extremely high, which will discourage many investors from adding equity exposure…Who knows what would be bought to us when November starts on Monday.
Having said so, over the week I saw people were throwing valuations out the window, but seems that they're suddenly all using dirt cheap valuations and massive oversold as an excuse to buy the market now…Guess if/when you want to buy, you can find many reasons to justify…Yes, dirt cheap valuations we have as HK trading at all time low PE of around 6.5X and US trading at 10.7X which is a 23 year low…Yes, extreme oversold as HSI -65% from high and -45% in 1 month…But in such an volatile environment, we need to ask ourselves --- how cheap is the HK equity? How long will we bottom out? Here I try to find out the answer by doing an empirical comparison based on top down approach, with factor including, economic recession, investors confidence, length of bear market and market valuation and earning growth.
1) Economic recession
In the post-war history, the average
The last two recessions – 1990/91 and 2001 – were different. The downturns have been turning shallower, and more importantly, recoveries are more and more L-shaped. In the last two recessions, the economy contracted by an average 0.7%/ quarter. It then grew by ‘only’ 2.7% in the first quarter following the recession and 2.1% in the second quarter. These post-recession growth rates were below-trend, which means that the unemployment rate continued to rise well into the recovery, creating the so-called “jobless recoveries”.
The nature of the current economic slump, driven by wealth destruction and credit crunch, means that consumption and residential investment – the normal drivers of economic recoveries – are unlikely to contribute to a strong recovery next year. In other words, we will look for a long, flat L-shaped recovery like in 1992-93 and 2002-03.
2) Investor confidence
In the 2000-2002 equity market plunges, US households lost about $5.4trn of wealth, or about 70% of annual income. For the current episode, based on data till 2Q08, the estimates put the cumulative loss at about $7.5trn. That’s also about 70% of current annual income. While today’s loss is about the same relative to the size of the economy, the major difference is timing. In 2000-2002, it took households 10 Qs to accumulate $5.4trn of losses; in the current episode, it took only 5 Qs to accumulate $7.5trn!
The rapid deterioration in wealth positions combined with highly uncertain employment outlook will surely lead to psychological damage that hurts investors’ confidence. Same phenomenon happened in HK, not only an earlier UBS forecast saying that HK home prices may plunge 30% from now to the middle of 2009 because of a threatening recession but also, this time it took only 12 months for HSI to drop 66%. Without counting the 70s, this is by far the biggest drop in magnitude in the shortest period of time.
3) Length of Bear Market
One of the most accurate indicators to predict the bottom-out process of equity price is to look at the policy rate cycle, i.e. S&P and FFTR, as they tend to go hand-in-hand. As said above, the
Moreover, past regional real estate bear markets and banking sector crises suggest that it will take much longer than the market is currently expecting for the
4) Market Valuation and Earning Growth
Lastly, it is the speed and size of market deratings sets the current crisis apart. During the Asian financial crisis in 1997, the market didn't bottom out until analysts downgraded rating and EPS for 80-90% of companies under their coverage. From this angle, we are perhaps getting close to the tipping point – As of last Friday, around 75% of companies have been downgraded.
But question remains -- is the valuation cheap enough? In US, BBG shows S&P500 is cheap now trading at 11.8Xforward PEx08. The data is misleading sine analysts haven't adjusted the earnings. If based on the 20.4x 07PE & 11.8X08 PE, it means in 4Q08 will make FY08 earning jump 100%...Imagine that… For
The Forces behind USD
The key problem in the FX market at present is that the movements in X-rates have only relatively little to do with FX. That is, the appreciation of the JPY (it rallied an astonishing 13 big figures or over 11% in less than 24 hours from Monday evening to Tuesday evening, ET) is mostly a byproduct of the massive liquidation of financial assets (primarily equities). Hence, a prerequisite for "calming" the FX markets would be halting the spiral of decline in financial assets. And that is something that a year-plus of policy initiatives from a host of countries has failed to engineer. There is lots of speculation that the IMF aids to EM countries may provide some relief to those markets. However, I am not convinced that will have any more success in stabilizing global financial markets than the host of other initiatives and programs has had.
Going back to USD, the driving forces behind USD strength are likely to continue near term –namely de-leveraging and global recession. One reflection of this de-leveraging is the decline in global MS growth. There is a strong and inverse correlation between global M2 growth and the DXY index - as the former rises, the latter falls, and vice versa. Fundamentally, this makes perfect sense as much of global money supply growth is again USD-denominated. Additionally, this global de-leveraging process is not immediately sensitive to the level of nominal interest rates, which is why Fed policy rate cuts and the decline in LIBOR rates have so far had no impact. Given the extraordinary levels of leverage in the system prior to the credit crisis, this suggests that global de-leveraging will remain a USD-positive factor well into 2009. Global recession or downturn is also usually USD-positive. Moderate growth or slowdown typically weighs on the USD as investors focus on nominal interest rate spreads.
However, global downturn usually causes a refocusing on reduction of "riskier" assets. While much has been made of the diversification in recent years by central banks and sovereign wealth funds, the real diversifiers in the last decade have been US and Japanese real money managers, notably into EM. Looking back, the Fed's stated policy of boosting the rate at which it inflated away the value of money was "successful" in that it resulted in a severe depreciation of the USD and an accompanying commodities boom. Investors then funneled massive amounts of capital into emerging market economies that benefited from that commodities boom. Eventually, the inflationary boom turned to bust after the Fed shifted its focus to fighting inflation and the USD made a major trend change from mid-year 2008.
There are interesting signs in commodity markets worth a note. First of all, the copper price bounced back to 4000, inspired by the surprise bounce in US new home sales. I always believe that the copper market will tell us more about the economic reality than the financial markets. If copper can stabilize here, it will tell us something about the nominal growth slowdown in
Appendix:
1. Rationales for Fed Swap:
Fed Chairman Ben S. Bernanke is trying to prevent the global credit crisis from upending the financial markets and economies of developing countries, where currencies have plunged and government bond premiums have soared.
2. The Fed CPFF
The Fed’s Commercial Paper Funding Facility, which targets three-month CP, was launched this week. In response, data through Wednesday show a huge surge in CP issuance at 80+ day maturity, from a daily average of near $7bn last week to $57bn this week. The pickup in issuance pushed the outstanding balance of CP up by $93bn to $1523bn in the week ending yesterday compared to the previous week. However, this rise in total outstanding CP follows 6 consecutive weeks of declines and the level remains well below its balance just two months ago.
3. EU will provide EUR 6.5bn to
This morning it has been confirmed that the EU will provide EUR 6.5 bn as part of the IMF mega-package, but it also clarified that it is not the Commission but the EU as a whole, i.e. de facto underwritten by the individual governments. In my view, this is extremely important because it is the first time that the long implied European halo has been turned into concrete action. Fundamentally, this tells you that an EU member who gets caught in this crisis and is ready to address it with policy tightening, as aligned by the IMF, will be rescued by its fellow EU members.
4. The biggest 5 day crash
Interestingly enough 3 of the biggest 5 day crash in HK all happened in October. (1987, 1997 and yesterday) And more interesting is that each of these big crashes is around 10-11 years apart from each other.
5. What sets the current crisis apart?
In many respects, the oil embargo was a very similar situation to what we have now - no oil or no credit, same -- pretty much equivalent problems in that they both threaten to bring the economy to a screeching halt. The speed and size of market deratings sets the current crisis apart.
6. How long it takes from peak to bottom in last few bear markets In HK.
1973: -91% from Mar73>Dec74: 21 months
1987: -50% from Oct87>Jun89: 20 months
1993: -45% from Jan94>Jan95: 12 months
1996: -61% from Aug97>Aug98: 12 months
2000: -50% from Jul00>May03: 34 months
