Timing the Bottom of Deflation

Stock prices will remain depress as long as deflationary threats linger. Oil prices fell from peak of US$140/barrel in mid 2008 to a recent low of US$36/barrel. If deflation lingers, it means falling corporate cashflow, falling wages, delay in consumption and debt default.

One way to track this is looking at behaviour of treasury inflation protected securities (TIPS). If we look at the yield differences between Treasuries and TIPS as an indicator, we note the implied deflation rates quite strongly in a year ahead, but it gradually eases off as we move ahead in times and ultimately the inflationary forces will start to kick on in year 2015. Any material change in this view of deflation would reduce the risk of holding equities and produce a significant rally. We would notice that when TIPS were rising, the S&P rebounded quite strongly in October 2002, suggesting that the subsidizing threat of deflation is a key driver for any rally in an equity bear market.

Another indicator to watch is the copper prices, which I find quite useful in confirming the bottom for equities in the two near deflationary recession of 1982 and 2002. This relationship can be traced back since at least 1921. The copper prices bottomed in October 2001 and this coincided with the bottom of the business cycle as proclaimed by the National Bureau of Economic Research (NBER). In an almost instantaneous reaction, the stock market leaded the economic recovery and even the earnings recovery.

With greater commitment to quantitative easing, I find it rather difficult to expect more debt deflation going forward. Also, I would argue that deposit insurance will reduce the risk of losing faith in the banking system. Unlike the collapse of the US banking system in 1929-32, depositors withdrew funds and this time around, I don’t see that being the feature of the 2008 crisis. The combination of the liquidity loop and the explicit guarantee of money market funds along with the existing deposit insurance guarantees, this has significantly reduce the prospect of banks run today compared to 1929-32.

There is evidence that more unorthodox approach is being deployed and the rapid expansion in the Fed’s balance sheet since the third week of September 2008, will provide a good base for current crisis.

To those investors that subscribing to this views, you may want to prepare to buy equities today, given that deflation is much less likely that markets believe. Recent stability seen in prices of TIPS, and copper is an encouraging sign that it may be turning positive in the near future, perhaps.

RMB - On a Secular Appreciation Path

Over the last five weeks, I have been constantly bombarded with questions on China’s currency. About a year ago, I wrote a piece on Renminbi (RMB) outlook for one government agency and I argued that the currency is on a secular strengthening mode, pretty much like Japanese Yen after the Plaza Accord. However, with the recent global volatility, equity burst, contraction in property market in China and more importantly rising dependency on exports, some of my loyal clients to a great extent, have been persuaded not to subscribe to my earlier view.

For once and all, I still maintain my view that RMB is on a secular appreciation path, and the recent sell-down in the currency is not only a trading, but a great opportunity to build for a long term position in China.

Let us be very clear here – Firstly, what we are seeing today in China is a recession in demand and not peer competition that is creating a pressure on exports. Secondly, China is very unlikely to go into recession and my worst case projects above 6% for 2009. Thirdly, I put my bigger bet on the effectiveness of China’s fiscal policy in cushioning the global shock compared to a lot of economies that I monitored. China enjoys plenty of fiscal flexibility as both government and households maintain a high saving rate. Fourthly, RMB is not fundamentally overvalued even if I assumed the trade surplus to ease by 20% from current level in 2009.

Devaluing RMB will be a no-no for assets and market confidence. Risk of domestic capital flight can materialize, hence complicating monetary expansion, which has been partially a reflection on expectation of RMB appreciation. The competitive devaluation will invite trade retaliation from the US and EU as well as major emerging economies, which in turn will intensify pains to already shrinking global market. It also defeats and nullifies all efforts by the Chinese government in the last decade in areas of financial, economic and diplomacy coordination.

The latest CCCP annual economic meeting on 10 December has reiterated that the view to ‘keep RMB basic stable at fundamentally justified equilibrium level, improve balance of payment’ and on 14 December, the state council’s financial statement called for ‘proceeding in proactive, incremental and controlled mode; further improve RMB exchange rate regime, increase flexibility ..’

The government set 15-17% yoy M2 growth, RMB4 trillion new lending for 2009 and a stable exchange rate to reflect government’s strong commitment of clear re-flationary intent.

10 Uneasy Questions about Asia

Here are 10 questions for Asia that seem critical to the future of the most dynamic retion in the world:-

Q1. India and China are rising fast, but what are the big ideas they stand for? China has given up communism and India has given up its cold-war dalliance and is between now market and socialism.

Q2. Can India be used by the United States to contain China? This is fashionable belief but one cannot ignore the fact that America has an overwhelming military cooperation with India, but we cannot also ignore the fact that China is now India’s second-largest trading partner behind the US. Pragmatism can overwhelm ideology.

Q3. If India is not the answer to China, how about Japan? Japan now resembles Britain, an island off the coast of a continent, viewed as closer to Washington than to its neighbors. Japan, however is paying a heavy diplomatic price, worsening Chinese-Japanese relations.

Q4. What about Japanese past? We have seen riots erupted in China, South Korea and Taiwan fueled by fury at Japanese attempts to gloss over the savagery that marked Japanese’s occupations of the countries. Japan has not achieved Germany’s reconciliation with its neighbors.

Q5. Can China keep the lid on things? Pressure is growing on the system – from the widening gap between rich and poor, from the poison in the air spread by uncontrolled industries and from the friction of a quasi-free economic system meeting a closed political system bent on control. The Beijing Olympics 2008 and the Shanghai Expo of 2010 provide huge incentives for stability.

Q6. Will China deliver on North Korea? Chinese is committed to a successful outcome, but they don’t like American arms sales to Taiwan, American lectures on democracy and American threats of trade sanctions.

Q7. Are China’s choices of a market economy and the presence of US forces enough to keep the peace in Asia? The Chinese market economy spreads prosperity, multiplies ties and creates huge peace incentives. The American troops offset regional rivalries but Asia needs to become more of a community and less a mere accumulation of booming states.

Q8. Can China and the US deepen their ties? Current signs are not encouraging, but the need is over-whelming.

Q9. Can Indonesia be Asia’s Turkey – an example to the world of a democratic Muslim country where Islamic radicalism is marginalized? Yes, if US heavy-handedness is avoided and the inevitable emergence of moderate Islamic parties is encouraged. America must coax rather than lecture.

Q10. Are Australia and New Zealand part of Asia? Inclusiveness is in Asia’s interest. As Europe has realized, when we create broad institutions, the possibilities for absorbing nationalist tensions multiply.

FX Forecast - A Beauty and The Beast

I like Yen and fear about the sustainability of the EUR. So far, the US is doing the right things to combat deflation whereas European policy remain active – not cutting rates enough and not easing fiscal policy aggressively.

I think the Euro as a concept will come under tremendous pressure in 2009. Economic growth and productivity misalignment among members will becoming more visible and there are estimates that countries like Spain and Ireland may need 20-30% fall in wages relative to elsewhere in Europe, owing to an overvalued real exchange rate. There is considerable excess leverage differences among member countries and now will these countries be willing to deflate to restore competitiveness, hence an equilibrium in their external accounts with the potential of a severe recession. It is very likely that this will not be the preferred option and most likely they will choose to spend their way out of this.
On the other hand, Germany is likely to fare worse than the Eurozone in 2009 due to its higher exposure to cyclical industrial export demand compared to its peers. Support of German internal demand via fiscal stimulus is only possible solution in the medium term. Plunging business surveys paint a bleak picture going forward.

As a result, bond spreads will rise on the back of fiscal reflation, in turn could have a very large contraction in domestic demand and potentially to the sustainability of the common currency.

By default, the Yen looks to be the strongest currency. Consumers, corporates and banks have de-leveraged for nearly a decade and with its high gross saving of 27% of GDP, it makes Yen not that expensive relative to its norm.

In short, market will eventually realize that Europe cannot live with Euro strength and the divergence of strengths in favour of UK may force the Euro possibly to parity level, if not slightly above the parity in late 2009.

A Brief Outline for FEER Framework

When I was at Osaka three weeks, I was asked by couple of fund managers and academic about my evaluation of the equilibrium value of the various Asian currencies.

Here I wish to share the brief outline of the framework behind my Fundamental Equilibrium Real Exchange Rate (FEER), defined as the rate consistent with the economy operating at potential output while at the same time registering a sustainable current account balance. In essence, the underlying current account balance is arrived when the determinant variables are calibrated to values congruent with internal balance. My framework is very much based on the direct estimation method of Clark and McDonald (1998) but calibrated in the conventional FEER manner as in Williamson (1985).

In short, the final reduced form equation is as follow:

FEER = f (yd/yf, TOT, TNT, RIR, NFAR)

where:

yd/yf : relative domestic to foreign output ratio
TOT : terms of trade
TNT : relative ratio of tradable to non-tradable prices
RIR : real interest rate differential between asian-USD assets
NFAR : net foreign asset to nominal GDP

I include a real interest rate differential in order to assess the effects of a shorter-term fundamental determinant to exchange rates and a dummy variable for the effects of exchange controls imposed. Co-integration methods were used to estimate the final model with inclusion for the Phillips-Hansen Fully Modified estimation that allows estimates and standard errors to be derived free from the distortion due to nuisance parameters through a semi-parametric adjustment for serial correlation of innovations and endogeneity of the variables, which is suitable for the relatively small sample size.

Table 1 shows the final model estimation results with relevant diagnostic and it is interesting to note the significant findings on the relative productivity differential and terms of trade variables, which suggest the information contribution of these variables above what is contained in relative output levels. It is shown that exchange control dummy variable was significant and having an opposite sign to relative real interest rates indicating the effects of the capital restrictions in muting the response of capital flows to interest rate differentials after the imposition of the controls.

Table 1: Summary of Results
Variable Coefficient Standard-Error
Constant 2.908 0.892
yd/yf -0.301 0.066
TOT 0.614 0.003
TNT -0.201 0.004
RIR 0.158 0.003
NFAR -0.153 0.005
Capital Control
Dummy -0.201 0.054
Overall F-Test 290.8 9c.v. = 2.5@99% significance level

The Great Depression Headlines

When you read the quotes below you will notice something eerily similar to today. I wonder how today's group of meddlers are repeating history, both in policy and outrageous statements.


September 1929 - "There is no cause to worry. The high tide of prosperity will continue."- Andrew W. Mellon, Secretary of the Treasury.

October 14, 1929 - "Secretary Lamont and officials of the Commerce Department today denied rumors that a severe depression in business and industrial activity was impending, which had been based on a mistaken interpretation of a review of industrial and credit conditions issued earlier in the day by the Federal Reserve Board."- New York Times

December 5, 1929 - "The Government's business is in sound condition."- Andrew W. Mellon, Secretary of the Treasury

December 28, 1929 - "Maintenance of a general high level of business in the United States during December was reviewed today by Robert P. Lamont, Secretary of Commerce, as an indication that American industry had reached a point where a break in New York stock prices does not necessarily mean a national depression."- Associated Press dispatch.

January 13, 1930 - "Reports to the Department of Commerce indicate that business is in a satisfactory condition, Secretary Lamont said today."- News item.

January 21, 1930 - "Definite signs that business and industry have turned the corner from the temporary period of emergency that followed deflation of the speculative market were seen today by President Hoover. The President said the reports to the Cabinet showed the tide of employment had changed in the right direction."- News dispatch from Washington.

March 8, 1930 - "President Hoover predicted today that the worst effect of the crash upon unemployment will have been passed during the next sixty days."- Washington dispatch.

May 1, 1930 - "While the crash only took place six months ago, I am convinced we have now passed the worst and with continued unity of effort we shall rapidly recover. There is one certainty of the future of a people of the resources, intelligence and character of the people of the United States - that is, prosperity."- President Hoover

June 29, 1930 - "The worst is over without a doubt."- James J. Davis, Secretary of Labor.

September 12, 1930 - "We have hit bottom and are on the upswing."- James J. Davis, Secretary of Labor.

October 21, 1930 - "President Hoover has summoned Colonel Arthur Woods to help place 2,500,000 persons back to work this winter."- Washington dispatch.

November 1930 - "I see no reason why 1931 should not be an extremely good year."- Alfred P. Sloan, Jr., General Motors Co.

June 9, 1931 - "The depression has ended."- Dr. Julius Klein, Assistant Secretary of Commerce.

August 12, 1931 - "Henry Ford has shut down his Detroit automobile factories almost completely. At least 75,000 men have been thrown out of work."- The Nation.

July 21, 1932 - "I believe July 8, 1932 was the end of the great bear market."- Dow Theorist, Robert Rhea.

Quantitative Easing

Quantitative easing is becoming a common term from now onwards, especially markets begin to realize the limitation of central banks in lowering interest rates. This is very much seen as unconventional policy measures, which rather than encouraging but forcing changes in market prices and volume.

In short, quantitative easing can be seen either in terms of supplying an even greater ‘quantity’ of money that would be required to keep the overnight rate at o% or in terms of targeting interest rates further out the maturity spectrum. Beyond that we already see the widening collateral eligibility, unlimited US dollar funding and ways in which liquidity is injected. In fact, Bank of England went beyond this by establishing the Special Liquidity Scheme, which allows banks to swap MBS for US Treasury bills, renewable for up to three years.

In 2001-05 experience, Japan had a specific target for the quantity of excess bank reserves as part of its attempt to convince market players that it would hold short rates at zero for as long as necessary to bring the economy out of deflation. The main instrument to inject liquidity was the purchase of commercial bills on repo basis, rather than outright purchase of long-term JGBs. Of the 48 trillion yen increase in monetary base between Mar01 to end 2005, the commercial bill repo accounted for almost 71%.

In recent experience, we have seen much more variance of quantitative easing, including a sharp expansion of the central banks’ balance sheet as private sector financing mechanism are replaced, possibly that with a non-standard approach to the financing of the government debt and an exchange of assets such as the quality of the central banks’ balance sheet deteriorates. At some point, the distinction between fiscal and monetary policies can become blurred.

Under this circumstance, the government’s intervention may become a stronger influence on the shape of the yield curve than private sector flows and that potentially will break the curve from its normal relationship with the level of short rates. Recognizing that the same effect will force a change in duration and convexity hedging strategies as traditional relationships break down.

Within FX itself, it could undermine carry and real interest rate spreads are becoming more important. It forces players to focus on relative changes of base money as well as the sustainability of financing flows. As we are experiencing greater quantitative easing, currencies with a record of protecting against inflation as well as those with a low level of combined public/private debt will be the preferred ones.

2009 Macro and Market Outlook

This past year was rough on most investment portfolios. Many are worth a lot less on paper than they were in 2007. But there are always ways to turn those lemons into lemonade in 2009.

Just in third quarter alone, US households lost US$647 billion in real estate, US$922 billion in stocks, US$523 billion in mutual funds, US$653 billion in life insurance and pension fund reserves, plus US$128 billion in private business interests. Total destruction of household wealth in the review quarter – US$2.8 trillion – the worst in recorded history. This compared to the government’s entire US$700 billion bailout package (TARP).

Now I sense that the USD index has probably peaked for the year. The temporary support provided by the global de-leveraging process appears to be fading, and the onset of quantitative easing in the United States should prove to be inconsistent with a strengthening currency. I note that the recent advance of the USD rests on a weak foundation. As sources of support – shortage of USD liquidity abroad and a bid created by the de-leveraging process appear to be fading.

With credit markets showing signs of improvement and some stability developing in equity market, risk appetite appears unlikely to deteriorate in the near future. However, the upcoming GDP releases will likely highlight how the global slowdown is clearly seeping into reduced output with a varying degree on the depth of the slide and timing of various recoveries.

I believe that US Fed Reserve is committed to lower fed funds rate for a significant durations and has strong intention to engage in quantitative easing to keep the Fed balance sheet at a high level. Credit market and economic improvement, currently clogged, are likely to be necessary conditions for an end to quantitative easing. Growing fiscal deficits will lead to an increase in government debt and at some stage, it will make harder for monetary policymakers to contain inflation. It remains a challenge for the US to attract external financing for its domestic spending with all the accompanying risks this may hold for the long term value of the US dollar.

On the Eurozone, my view is that there is no end to the bad news and expect the ECB to cut rates further. The bad news will not be appropriated across the zone given the major discrepancies in economic health among the members. One potential conflict is the direction of unit labour costs, which have taken very different paths within Eurozone countries in recent years. Germany increased its competitiveness by reducing unit labour costs, while at the other extreme Italy has lost much competitive ground.

Malaysia-specific, choppy waters for financial market will continue and I recommend a cautiously optimistic investment stance. Commodities, which reversed course since July 2008, have fallen more than 30% in USD terms and this trend is likely to continue into first 4-5 months of the year with a likelihood of a pick-up thereafter. Inventories are likely to be cleared with support from USD depreciation. Supply cutbacks will be meaningful then and enough to slow the build up in inventories. It would not be a surprise to me if the crude oil prices to again re-test the USD$85/barrel toward the end of 2009 with the marginal production cost of unconventional crude oil hover around US$70-75/barrel along with production cut by OPEC.

I am a firm believer in stocks for the long run – but only if purchased at the right price. One of my favourite valuation methods – ‘Q’ ratio that measure relativity of the value of the stock market to the replacement cost of net assets. If the ‘Q’ ratio is above 1.0, then the market is valuing a company at more that it costs to reproduce it – then stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap as they can be bought in the open market.

Today’s KLCI ‘Q’ ratio is almost never been lower and certainly not since 1997/98 financial crisis, implying quite a degree of undervaluation. My calculation suggests a value of 0.86 as at November 2008 compared to 1.34 a year ago, implying a decline of almost 56% year-to-date.

Another long-term standard of valuation comes from P/E ratio, which shows the same relatively undervaluation. It shows that KLCI is trading at two standard deviation band of last 20 years.

One, however, should be careful in interpreting these results because the underlying assumptions are that the market is mean reverting and as long as capitalism is a going concern. The famous J.M. Keynes pointed out that John Maynard Keynes famously warned that ‘the market can remain irrational longer than you can remain solvent’. In times such as these, and as markets are still cycling between greed and fear following a long and costly plunge, there is no question that tough challenges are ahead even I take a quite optimistic view on political situation in the country.
Sector wise I like banks, plantations, oil & gas, gaming, property, utilities and to some extent, media and consumer. I am cautious with export-oriented manufacturing, automotive, REITs, timber, conglomerates, technology and non-bank financial institutions.

Spells in Banglore

My view is that the deadly terrorist attacks at Mumbai’s financial district are not the main cause for the struggling Indian economy. Even before it, the economy was already struggling when the real GDP was expanding at 7.6% in the 3Q – the slowest pace in four years and was well below the 9% growth average for the last three years.

The Reserve Bank of India has been aggressively cutting rates to keep its economy on track and much like our politicians, the government is embarking on a stimulus-seeking spending spree, suggesting that India shares our same slowdown worries.

Mumbai may be India’s financial centre, but the lucrative high technology centre is in Bangalore. It has become the Silicon Valley of India being the back office of the world, handling customer service calls, process payments and writing the code that runs much of global corporate’s software. The global slowdown has already being reflected in reducing hiring, freezing salaries, postponing new investments and laying off thousands of programmers and call centre operators.

Infosys – India’s second largest software services exporters gets two-thirds of its business from the US. One-half of that is from financial corporates like Citigroup and Bank of America. It is recently scaled back its earnings projections for the year and that’s way below the 30% growth of recent years. Satyam Computer – India's fourth largest exporter is cutting its 2009 recruitment plans from 15,000 to 10,000 and has suspended travel for all but the most critical needs.

Interestingly to note also because of changes in the IT world, the arranged marriage trend also changed accordingly. According to a matchmaker friend of mine in Bangalore, bridges’ families are not accepting grooms from this background because there are no job guarantees for IT people. This happens for the last six months.

Comparing Last Two US Recessions

Key Statistics for the Last Two Recessions

Leading into the 2001 recession, the US dollar was very strong. Commodity prices had suffered a multi-year deflation and CPI inflation was falling to very low levels. Is this helps to refresh some recent memories?

In sharp contrast, the 1990-914 recession came preceded by a relatively weak US dollar and rising inflation.

In terms of government policies, the two recessions were almost opposites. The government cut tax rates during and following the 2001 recession, whereas it raised rates substantially in 1990, partly can be explained that the recession started just two months after the presidential term began and ended 36 months before the next presidential election. The Fed only cut rate in January 2001, months before the official beginning of the recession.

In contrast, the 1990-91 recession occurred in the second-half of the presidential term and ended 20 months before the November 1992 election.

Weakness in business investment spending was clearly the prominent factor behind the 2001 recession, while weak consumption spending and residential investment played their usual important roles in the 1990-91 recession.

It would not be too surprising if I think that the 2001 recession will be a less important factor than the 1990-91 recession in the context of our current predicaments.

Key Statistics for the Last Two Recessions

Moral Hazard & Systemic Risk

Either it is intended or unintended consequence, as early as the intervention in Bear Stearns, now it has created an expectation as market participants are expecting a government bailout as it fails under current market forces. Lehman Brothers was able to maintain short-term borrowings, and the series of bail-out including Citigroup, hence the over-concentration of these borrowings in the Reserve Fund has led to its ‘breaking the buck’ and that may once again prompt unnecessary systemic panic in money markets.

The intervention may reduce the CDS spread, and it is not surprising given the role of the government in reducing risks faced by the creditors as well as equity holders, but the risks now are assumed by the government and the potential blow-out in government finances can be long term and systemic.

Short-term, the news may spark a rally in financials and the sustainability of this rally will depend on expectations that Fed policy will be easier for longer. Risk is that Fed is rapidly expanding its balance sheet in a form of quantitative easing without a good match from traditional Keynesian stimulus, which essentially will reduce the effectiveness in turning around the economy.

Without that part of the equation, the amount of excess reserves at the Fed will continue to rise and that will neutralize faster-than-expected earlier works to jump start the economy. Under normal circumstances, the amount of excess reserves at the Fed is roughly US$5-10bn, but last week the excess reserves were US$634bn and it would not be surprised if it hits above US$1.5trn and removal of these excesses could potentially take more than 5 months.

The massive amount of quantitative easing, while is not a major concern now, it is likely create periodic waves of concern over inflation in the market and would force players to take shelter at shorter duration for Treasury hedges. It may defeat the purpose in driving business investment intent towards longer tenure of Treasury and commercial papers. The underlying issues have not changed. So far, we are only seeing Fed err on the side of caution, add slightly to many reserves and merely renting its balance sheet space to other financial institutions while it continues to lose money (subsidizing) in a negative carry trade.
Fed should not assume that it has unlimited access to financing and capital raising ability.

Gold – The Next Fever

I was with Mickey, Goofy, Mervin the magician and an Arab at Hong Kong Disneyland last week. This new friend oil rich of the Middle East as we talked, was telling me that his friends are buying gold hand over fist, and it turns out they’re not the only ones.

You know what? I think the best is yet to come for gold because the WORST is yet to come for the US economy, and its ascendance was temporarily halted by US dollar risk aversion. And these economic forces could send investors charging even faster into gold just as fundamental forces also align for a move much higher.

Emerging markets are falling into a ditch, Europe’s economy is in the tank and the ECB will probably have to lower its benchmark interest rate further. And downward pressure on all currencies, US dollar in particular, would only add to an upward pressure on gold.

Massive buying is seen in the Middle East, as well as rising demand for gold in China in the first nine months of the year, and on the supply side, a downward trend in global gold mine production. Retail investment blasted off with strong bar and coin buying reported in Swiss, German and US markets. Gold inflows into ETFs surged to a record 150 tonnes while jewelry demand in India soared by 65% followed by the Middle East, China and Indonesia which gold demand rose by 40% in dollar terms. If there was a party pooper for gold, it was naturally the US and UK. In all, global consumer demand for gold rose 31% from a year earlier to 250 metric tones.

I would expect some overhead resistance of gold at US$900 an ounce and potentially could a rocket ride for the New Year, but the path will not be a straight line. Besides the yellow metal, I also like silver.

Asian and Commodity Currencies Update

AUD/USD and NZD/USD did not crash despite the significantly larger rate cuts by their central banks. The Reserve Bank of Australia cut its cash rate by 100bps to4.25% on dec 2, only to be outdone by the Reserve Bank of New Zealand’s 150bps cut to 5.00%.

After these experiences, the market will probably not be so gung ho about shorting EUR/USD if ECB also surprises with a cut larger than expected.

There is one explanation why rate cuts are not hurting currencies. There is discomfort about buying the USD, because its yield is now too low to be attractive. Certainly not with talks of Fed quantitative easing and a US budget deficit set to cross the trillion dollar mark in the next financial year. US officials are likely to keep up their bearish tone on the US economy as they work towards a large stimulus package. That said, the ECB press conference will be important to see if ECB intends to continue easing monetary policy into next year. Barring any surprises, exchange rates are likely to stay range-bound amidst bad news.

Despite the political crisis in Thailand, the THB has actually held up pretty well compared to its Southeast Asian peers. Ever since the USD bottomed in mid-July, the greenback has risen 6.1% against the THB. Not bad when compared to the IDR (30.3%), SGD (13.0%), MYR (12.8%), and PHP (8.5%). In fact, the ongoing crisis that started in 2006 did not really have a material impact on the USD/THB because it did not interfere in the way the central bank manages its exchange rate. That is, to keep it aligned with regional currencies with as little volatility as possible.

As long as USD looks consolidative, and as the USD/JPY remained above 90 level, Asian currencies should also be range-bound. The three currencies that are remained most vulnerable to risk aversion and a lower USD/JPY are KRW, INR and the IDR with rate cut expectations being priced in in-line with lower CPI readings. A lower CPI reading in these countries should also bolster calls for the country to start easing monetary policy. However, focus has shifted from the Mumbai bombings toward tensions between India and Pakistan.

US Recession Confirmed

At long last, the National Bureau of Economic Research (NBER) declared that the US economic recession started in December 2007. Since the end of Bretton Woods, the US economy experienced two long recessions lasting 17 months. The first major recession was triggered by the global oil shock and lasted from November 1973 to March 1975. The second major recession took place between July 1981 and November 1982 after the global commodity boom. In both episodes, the Dow Jones Industrial Average bottomed three months before the end of the official recession. If history repeats itself, the Dow should bottom in February 2009, in anticipation of the projected end of the recession in May 2009. If so, we may finally be able to see the beginning of the end of this long crisis that started last July.

In this regard, the same can probably be said for risk aversion and the unwinding of JPY carry trades. While some players still see more unwinding here, we find it difficult to ignore the policy risks that accompany this strategy. The USD faces downside risks from an ultra-accommodative monetary policy and expansive fiscal policy in the US. The JPY faces increasing risk from Japanese policymakers viewing, more and more, excessive JPY volatility as a threat to the Japanese economy. G7 nations are uncomfortable with the stress to emerging markets posed by the recovery in both USD and JPY. These are the issues that players must also consider in their currency strategies, which at this moment, risks being too naïve in discounting interest rate differentials. The market landscape will probably look different next week, after all the central bank meetings this week.

Worst of Credit Problem May Have Passed

The Reserve Bank of Australia (RBA) got the ball rolling. Since it started easing its policy in September, the RBA has so far cut by 300 bps. The Swedish Riksbank sliced 175 bps off its policy rate, which was 75 bps more than most investors had expected. The Bank of England followed last month’s 150 bps cut with another 100 bps and I expect the authority to follow up with another 50 bps cut in both Jan and Feb 2009, taking rates to a trough of 1.0%. On the other hand, the European Central Bank (ECB) reduced its policy rate by 75 bps – the largest rate cut the ECB had ever made. The ECB's new pragmatism also came through in Trichet’s answer to the question whether the ECB could engage in "quantitative easing" if need be, that is in simply flooding the banking system with liquidity once it has exhausted much or all of the scope for rate cuts. Trichet pointed out that, with its bold liquidity injections, the ECB has already tolerated a major expansion of its balance sheet.

I expect recession conditions for this quarter and the first half of 2009 will dictate the Fed to ease this month by another 50 bps and a further ease next year is possible. The two-year Treasury will remain below 2% for next year and historically the two year Treasury has served as a good benchmark for pricing private instruments. It will be a key challenge for most investors to search for the new risk/reward trade-off with less credit than what we experienced earlier this decade.

Credit availability is coming back into the market, at least for inter-bank lending. The worst of the credit problem may have passed – at least at the short-end.

Save the US Government

US federal budget deficit jumped to US$4545bn or 3.2% in fiscal year 2008 (US$162billon, 1.2% of GDO in 2007) and this is expected to hit US$1 trillion or nearly 7% of GDP in 2009 – highest in the post War II period, exceeding the 1983 high of 6% respectively.

Deepening recession and falling corporate profits will weaken government revenues and topping with new fiscal stimulus program to be debated by Congress of US$300 billion will drive government’s debt-to-GDP ratio from 37% in 2007 to above 50% - the highest level since 1994.

The Congressional Budget Office (CBO) shows that in the past 6 recessions, the budget deficit widened by an average 1.6% of potential GDP but this time around, I am expecting an outsized impact on deficits. President-elect Obama advocates such a stimulus program, as does Federal Reserve Chairman Bernanke. In the ‘Economic Policy Agenda’ of Obama Nov 5 2008, the amount is expected to be at least US$300bn, or more than 2.2% of GDP, include some of the components of Obama’s economic platform – tax cuts for lower and middle income households, further subsidies for distressed homeowners, job creation program primarily geared towards infrastructure building etc, will occur in FY20098 and some of it are likely to spill into 2010 and later.

The soaring of debt and rising outstanding government debt will definitely lower the potential growth that would occur otherwise and eventually taxes will be increased. Presently, interest rates are low and the yield curve is steep, reflecting low or negative real interest rates associated with recession, but dynamic will be changed, which will eventually push up US bond yields.

The pool of excess global savings will shrink as the booming high savings emerging nations will decelerate markedly. These economies have to redirect a sizeable share of national income toward internal activities, hence significantly reduce the pool of funds available to purchase US dollar-denominated assets. Likewise, with the case of oil producing countries – OPEC and Russia that are succumbing to effects of falling crude oil prices.

In essence, this could be the turning point from a deflationary to inflationary concerns and neither the Fed or the Treasury have had any time to consider an appropriate ‘exit policy; to reverse their recent strategies, in line with rising pressure on interest rate front.

FX Focus – The Pinnacle of USD Rally

The USD index has experienced its largest quarterly rally in more than 15 years. One of the earliest sources of support for USD seems to come from rising tensions in the money markets, seen in the level posted by the three month USD LIBOR-OIS spread on the back of severe lack of USD liquidity. Now with global central banks continue to ease tensions in the money markets, this has largely removed this source of support for USD.

However, the expected USD retracement was largely prevented by repatriation bid created by the sharp declines in global equity markets. If the repatriation of foreign investments to the United States is slowing down, then this source of support may also be coming to an end. TrimTabs reports that American mutual funds that invest primarily in non-US equities returned nearly US$66bn in capital from late August to mid November, but these flows are easing with the two-week moving average is pointing south.

The sharper decline in the yields in non-US also contributed to this momentum as the long end 10-year Bund has plunged 93bps versus the 27bps drop in US 10-year Treasuries on the back of increased expectations for monetary easing in the Eurozone and a flight to quality bid.

Now, it seems that the ability of USD to post further gains appears to be limited. That, in turn, will make valuations in emerging markets are cheap and December could offer an interesting entry point due to pattern of seasonal weakness normally seen in year-end for USD. A meaningful rally for EM currencies is unlikely before year-end given the substantial deterioration in the international financial crisis could readily push the real effective exchange rate lower.

The Last Bail-Out

Debt liquidation and price deflation are the economy’s natural mechanism for cleaning itself – a process that if we do not manage proactively, then it can be insurmountable pains to all. Think ahead and connect the dots – more than three hundred million people, banking system in shambles, no jobs and no money. It is staring us in the face and so far, we have been too busy saving the big institutions and failed to anticipate the magnitude of the human tragedy ahead!

I cannot accept this defeatism and will never accept it and I want to lay down the foundation with a basic principle of choices of between (a) deflation and depression, or (b) hyperinflation and destruction of currency. So far, I hardly see any serious debate whatsoever as to which is the lesser of the evils.

The deflation road is extremely arduous but ultimately leads to recovery. The hyperinflation road can provide a temporary palliative, but ultimately leads to the destruction of our society and culture. A strong currency – the nation’s social and political anchor and a failed currency will be a nation’s albatross.

Key risk is the cancer of mistrust. First, it was mistrust in sub-prime mortgages, then spread to almost every private financial institution in the world. If we are not handling this matter carefully, the next stage – the fatal stage – is the mistrust in the US government itself. It happened in the 1980 under Carter presidency and the mistrust was so intense and so widespread that the government could not sell long term government bonds and the end result could be crashing bond markets.

This is the last government bail out, and it must be to save the government itself.

Postwar Era Global Recession

On Nov 6, the IMF released its ‘World Economic Outlook’ projects a 0.3% growth contraction for the developed economies in 2009 - the first instance of negative growth in the postwar era. US to shrink 0.7%, the Eurozone 0.5%, the UK 1.3% and Japan 0.2% respectively due to rapid transmission of the US-originated financial crisis.

Current downturn resembles global recession of early 1980s and such comparisons have also been rife in the media of late. The recession then lasted a postwar-record 36 months.

To date, GDP growth was in negative territory at the same time in the US, the UK and the Eurozone in 3Q2008. Capital expenditure is constrained because the seizure in the financial markets, which has triggered a dramatic tightening in credit markets. This compared to the 1980 as the need to end high inflation that sent real interest rates to record highs, drying up investment. Inflation expectations now anchor at a much lower level.

The US dollar continues to attract a repatriation bid as the process of global leveraging runs its course, especially against the core European currencies, which opens up short term trading opportunity for a rebound on the back of US dollar’s pattern of seasonal weakness in December, and if the repatriation bid fades.

The policy response by various governments has been intense with a high volume of government measures already being implemented with fall into four areas – support for banks, injection of liquidity into local money markets, intervention in equity markets and fiscal stimulus. In China, the authorities outline a RMB4 trillion fiscal stimulus packaged and that should help to limit downside risk to the economy.

We should give time allowance for patients to recover for credit-related illnesses, and also from related illnesses due to high dosage of antibiotics. In short, we are going to see a sustained period of ‘outrage list’ with more questionable practices, ridiculous statistics and it is getting long these days. So, you might need to pop a Valium before reading the headlines in the next couple of months.

The curative process is baked in the case, but teversing years and years of reckless overspending, over-borrowing and over-lending wouldn’t be as easy as just wave a magic wand!

Fear and Greed

Fear has the upper hand. Everyone I talked to had horror stories. Even the bears were making up for lost money.

Even if you are a long term investor, it doesn’t mean standing still when you know you’re in the middle of a railroad track. Fed went from inflation fighting to panic attacks and if any good news now will be the consensus that the whole global financial system is in peril and central banks are willing to do something about it.

While I am not looking for a dramatic turnaround in the global economy, but in the next 18 months or possibly less, I am looking for a turnaround in the global markets. And for picks, I like energy, infrastructure, materials and utilities companies. It generates cash and I would be worrying less about when the bear market will finally end.

Bond market had been totally throttled, and when market is going to heck in a handcraft, people get bullish then and I see great bargains galore in select corporate bonds.

Market used to favour small cap stocks, but now prefers large-cap stocks for a simple reason that with large-cap stocks trading at huge discounts to the prices, you don’t need to take on the risk of a small-cap stock if you can buy a large-cap stock at a low price–to-value. 2008 is the second-worst year for the market in 183 years, second only to 1931. So when you see hedge funds and well-respected investors doing badly this year, this could be a sign the carnage is almost over and I open to possibility that markets will improve in 2009.

Credit market is now trading as if the S&P is at 800, implying another haircut of 13% while as the government bailouts will keep coming and that could have profound effect on the economy. General Motors may be a dead man walking, but dead men can keep walking as Frankenstein.

A contrary investor as I could tell you all the bearishness I was hearing is a possible sign that need closer monitoring from now, of a market bottom. May be that is true but until then, be careful out there and there might be an even bigger bear lurking around the corner in the next couple of months.

Foreign Exchange Forecasts

I have been approached by traders, investors, fund managers and friends alike wanting to know my views (after all, I am still an active night trader, and my positions have been quite impressive over the last couple of years).

• US Dollar - NEUTRAL

It is benefiting from the funding crisis and the sudden deleveraging of European banks and this will persist for next couple of months. However, the recessionary conditions in the US, which will force the Fed to lower rates and stabilizing in the wholesale funding markets will stall the dollar’s trend.

• EURO – BEARISH

The rapid deterioration in Euro zone led markets to price risk of ECB easing, and the longer the ECB denying this, the Euro would have to take the depreciation heat longer. Expect it to hit 1.55 soon. Cross trade opportunity in Yen, AUD and Swiss.

• YEN – BULLISH

Trade on interest rates convergence and combined with higher volatility across markets, I think it will make it more difficult for Japan to recycle its current account surpluses. Watch for sell-down in commodity funds by Japanese household and the possible intervention of BoJ to keep Yen competitive from falling below 87.

• UK Sterling – Bearish

Rapid deterioration in UK data has reinforced my expectations that BoE will cut rate again, undermining the pound. The household’s debt position is much weaker than its peers and house price correction will continue for quite a while. May hit 1.856 next three months.

• AUD – Bullish

Strong case for AUD rebounds if signs are confirmed that Australia may escape recessionary threat in the next 6 months. RBA is reengineering its success seen in the 2001 and 1997/98 crisis. Sell down by Japanese investors is coming to the tail end.

• NZ Dollar – Bearish

Remain bearish (nothing personal) as market is pricing in a great deal of easing and carry trades having sold off aggressively. Tourist flows, new government, rate cuts and soft commodity exposures like diary products will keep one to be cautious on entering new long at current level.

• Renminbi – Bullish

Interest rate policy has turned dovish, and supported by traditional Keynesian stimulus, the currency will continue to appreciate, but it will be traded in a narrow range. Easing of oil prices will be another support for domestic demand-led growth.

Foreign Shareholdings in Malaysia

Rising redemption, rising recessionary threat, risk aversion in emerging economies and cloudy political environment are among common factors cited why the sell-down in the KLCI will continue for the foreseeable future.

Foreign shareholding falls to 18% from a high of almost 30% as at end 2007. A closer look at the foreign shareholding profile of companies is becoming latest tool to gauge potential selling pressure ahead. Stocks, which still have more than 30% foreign shareholdings are Alliance Financial Group, AMMB, Bumiputra-Commerce, Genting, IJM, Public Bank, SP Setia and Top Glove – and all these names are among the constituencies of the KLCI major.

On the other hand, the local shareholding, government and government-related in particular, is rising. EPF shareholdings in AirAsia, Alliance Financial Group, AMMB, Bumi-Commerce, Dialog, IJM, Media Prima, Sime Darby, TMI, YTL, is showing an uptrend sign. Shareholding of government-liked investment companies (GLICs) stands at an average 39% from 30% in early 2008. So far, the GLICs collectively owns more than 50% of KLCCP (67.8%), Maybank, MISC(80.9%), Proton(70.4%), Sime Darby(64%), TM, Tenaga(65.7%), TMI(65.8%) and UMW(74.1%). This could be one of the key reasons for its relative out-performance of these stocks, except for Protn and TMI.

Some 40-50% has been erased from the share prices of blue chips with high foreign shareholdings such as Gamuda Bhd, SP Setia Bhd and AirAsia (M) Bhd. The valuations of Genting Bhd and its subsidiary Resorts World Bhd have dropped to levels below the level it fell to when the SARS outbreak had hit the region. The list of worst performers includes sectors sensitive to the new political realities such as construction (Malaysian Resources Corporation Bhd, Gamuda and IJM Corporation Bhd), property (UM Land Bhd and SP Setia) and the stock market (Bursa Malaysia Bhd).

Many foreign investors that were heavily overweight on Malaysia earlier in the year due to the country's large exposure to commodities were caught by surprise by the quick turn of events post- general election on Mar 8. The sharp market plunge on the first trading day after the election when circuit breakers were triggered for the first time ever after the Kuala Lumpur Composite Index (KLCI) fell 10% did not allow for a quick exit by foreign investors.

It could take a lot longer for foreign investors to unwind fully their exposure in Malaysia. In the previous peak in 1996, it took four years before foreign shareholding in Malaysia bottomed out.

G20 Summit

November 15 will be another roadmap for global leaders to respond, perhaps in a coordinated way to the unfolding financial and economic crisis. The G-20 grouping accounts for 90% of the global economy, includes 10 major emerging economies – Brazil, China, India, Saudi Arabia and South Africa among others along with members of the G-8, Australia and the European Union.

Markets will be watching attentively to see what reforms might be on the cards. Among possible agenda includes:-

• Submit rating agencies to registration and surveillance, especially within the Basel II capital requirement framework
• Convergence of accounting standards
• No discrimination in terms of regulation and oversight
• Establish codes of conduct to avoid excessive risk-taking in the financial sector, including the renumeration of executives
• Give the IMF the necessary resources for recommending the measures to restore confidence and stability in the international financial system

There have also been calls for a global fiscal stimulus to offset the decline in private aggregate demand and cushion consumers and firms from the prolonged global slowdown. While surplus countries like China, Germany and the GCC states have enough fiscal room for this, deficit-laden nations might face the risk of higher future sovereign debt and nominal yields.

The expanded IMF agenda may call for new capital injection since its current available funds are just over US$200bn. Japan has suggested it might channel funds from its forex reserves through the IMF, if needed to support vulnerable emerging markets. China argues that the best way it can support the global economy is by maintaining Chinese growth through a series of monetary and fiscal stimuli through 2010. They are also beginning to need more capital at home as the sovereign wealth funds may have suffered significant losses in the last few months.

For now, it is very clear that the financial crisis seems to be contributing to an unwinding of some of these imbalances with the correction in oil and commodity prices and easing capital flows in surplus countries, but the economic outlook is worsening before it gets better.

I like AUD!

Following one of the largest, concentrated sell-offs in history, I think AUD has reached historically attractive levels. The collapse of AUD in recent months rivals the largest drop in the last 25 years – even larger in percentage terms than in the 2-3 years following the 1983 AUD float. The combination of events, including collapse of commodity prices, risk aversion, rewinding of long AUD speculative exposure, malfunction of global banking system etc – contributed to a drop of nearly 50% in about three months.

I am not a strong advocate of timing investment and timing an improvement in sentiment remains difficult.

Last week, I read statements from RBA that Australia may avoid recession this time around, like 2001 and 1997/98. That is very comforting as far as it provides floor support for the currency. In both cases, timely reduction in cash target of 275bps in 1996/97 and a 200bps cut in 200/01 and significant current depreciations were most helpful. The officials point out that if the RBA cuts rates ahead than expectations, while keeping AUD relatively weak and stable, it should help to minimize recessionary threat. The RBA has stunned financial markets by announcing a full-percentage point cut - double what analysts had tipped in early October 2008. Australia's official lending rate was lowered by the most since May 1992.

I sense the drop in AUD seemed to reflect some of the extreme pressure in bank funding markets as well. As global central banks continue to adopt aggressive monetary easing and fall in bank wholesale funding costs, particularly prime money market funds in the US will help to lower one major impediment to a stabilization of risk appetite for AUD.

One should take note that the AUD’s commodity export basket is about 165% higher than its rather stable average throughout 1997-2001, including a 67% gain in the past year alone. According to estimate by Bank of America, the gain in Australian foreign terms of trade gains are providing a 5% boost to real domestic fiscal stimulus and that will help to cushion domestic demand from the impact of the global credit crunch – another stand-out factor as currency supportive.

Funding My Future or Someone’s Else

Government is borrowing more, in trillion as Washington runs amuck with bailouts in the name of protecting people like you and me.

Reality – many Wall Street banks are using billions and billions of taxpayer dollars to pay fat cats’ bonuses, in case you not knowing it.

Goldman Sachs, which is getting US$10 billion from the bailout plan, is paying out US$6.85 billion in bonuses, according to media reports, despite a 47% drop in its profits and 53% drop in its share price.

Morgan Stanley, which is also getting the same bailout amount, is doling out US$6.44 billion in bonuses, even though its profits tumbled 41% and its shares are off by 69%.

Even the failures at Lehman Brothers are collectively getting its fair share of over US$1 billion in bonuses.

End result – we got hosed.

It is a high time to stop bailing out these bums…so let us hope that the next President Obama stops from bailing Wall Street fat cats, and uses it to feed Main Street skinny cats, otherwise, we could be headed for Depression.

Orgy of Debts

I have just seen the greatest borrowing binge of all time – an orgy of new debt offerings that can potentially kill bond markets, drive interest rates up and pound Wall Street and Main Street in combination to a pulp.

The record smashing amount to date is only the tip of the iceberg as Washington may need to borrow more than US$2 trillion, if it is to finance an US$850 billion fiscal deficit, US$500 million in bad asset and roll over maturing Treasury securities. This is not part of the already whopping US$2.7 trillion bills to cover the bailout loans, investments and commitment by the government so far.

Details – TARP – US$700 billion, Bear Stearns – US$29 billion, Detroit Big Three – US$25 billion, AIG – US$123 billion, Fannie and Freddie – US$200 billion, Mortgage-backed securities – US$144 billion, FHA Rescue Bill – US$300 billion, JPM for Lehman Brother – US$87 billion, Fed’s TAF program – US$200 billion, commercial papers – US$50 billion and Fed currency swaps program of US$740 billion – IN TOTAL – US$2.7 trillion.

This means a plunging bond prices and potentially I am staring down the barrel of one of the most devastating bond market crashes ever.

The real estate crash is still accelerating. One in very four homeowners is now under water. Construction spending has plunged three times in the last four months. US unemployment is exploding and consumer loan defaults are spiraling higher throughout the country.

Of course, you may have heard the chuckleheads on CNBC line up to say: ‘The government will ultimately end up making money on this bailout’? The idea is that as the housing market recovers, the government will sell its holdings – all that worthless mortgage papers from the banks and recoup its money.

SURE, WHEN PIGS FLY, AND ELEPHANTS CLIMB TREES!

Do you realize that over the past 8 years, Bush added approximately US$5 trillion to the national debt ceiling already.

US Dollar Disequilibria - Long Yen/Short EUR

I am struggling to get near term directional view on FX at the moment. My sense is that the US dollar could trade at the strong side of a trading range. Euro will see 1.33-1.46 while yen threatening to break 90 level. Liquidity to be thin, volatility to be high and risk-return to be meager for most trades.

Clarity only comes on stream if the US financial sector bails out bill passes and how markets trade post-quarter end. It really gives everyone a serious thought of how much of the recent price action is fundamental discounting and how much is sheer noises, especially when the Euro-dollar overnight FX swap implied yield for dollar surged to a high of 54% in late September.

As dollar is struggling to find its balance, the near term gravity is currently at trades of Euro/Yen with rising pressure for the ECB to cut rates sooner and deeper than before. Many central banks have gone from buyers to sellers of FX reserves. If the dollar benefits from rate convergence as ECB taking the baits, I expect the Yen to benefit even more, partly thanks to its current account surplus and partly inflows of Japanese investments overseas, given the extreme FX vol and higher default risk, which exacerbate the challenge for the Japanese of finding an overseas asset worthy of the risk.

One should also take note that markets are differentiating credit risk across Europe’s sovereigns, which my view is that it will rise sharply in coming months. For example, I don’t expect the Swiss National Bank (SNB) to cut rates as much as the Bank of England (BoE) and ultimately the ECB.

Anything beyond that I doubt this dollar rally can persist as pressure for aggressively reflationary policy in the US is rising. The deterioration in the US economy should continue and TARP financing will add pressure on the Fed to ease further, hence the underlying budget deficit and the Treasury’s other programs linked to this crisis. As a result, the front end US yields will see rising pressure, of which the market will have a right to fear monetization of this debt.

• My view remains staying short USD/JPY, but to be balanced with concern of elevated risk aversion and high FX volatility. Downward pressure on yields in the G10 will help diminish Japan’s yield disadvantage. This view could equally be expressed via short Euro/JPY.

• On the same count of surplus in current account and low yielder profile, I short EUR/CHF, but the currency is obviously more vulnerable to central bank easing policy. However, I doubt that the SNB will cut rates prior to the ECB and that the ECB will ultimately cut by more than the SNB.

• The sharply weaker data from UK and highly likely BoE to cut rate in October, if not in November leads me to sell sterling.

Mr President – Welcome with a Stimulus Program!

Who ever is the 44^th US president – be it Obama or McCain, the winner will face a daunting task. The recession in deepening, major parts of the financial market remain in intensive care while the government’s balance sheet is deteriorating by days.

The faster pace of economic contraction is certain and the extent to which the financial and economic crisis has damaged household attitudes was revealed in last week’s record-low consumer confidence and continued labour market deterioration.

While credit conditions backed by the extraordinarily aggressive efforts of leading governments and central banks are showing tentative signs of improvements, the still falling housing prices will likely limit the gains for now.

It wouldn’t surprise me if a second fiscal stimulus package will emerge soon after the election. Underlying the intensity of the current episodes, the Fed eased 50bps last week and signaled a willingness to cut further, citing declining consumer expenditures, weakening business equipment spending and industrial production.

Early this year, the US government has approved a US$168 billion economic stimulus plan, including taxpayer rebates and business tax breaks. This time around, the program could be larger than the previous amount, including several provisions to help the housing market, which would include bonds that would allow states to help homeowners facing foreclosure.

The chairman of the Federal Reserve, Ben Bernanke, said that he supported a second round of additional spending measures to help stimulate the economy. I am working with numbers of US$200-300bn package of spending. The drumbeat for lawmakers to do more to boost the economy is growing louder. And the chances have increased that Congress could pass a second stimulus package during its lame-duck session following the presidential election.

Recent Congressional, Treasury and Federal Reserve Intervention to Stem Financial Crisis

Who is ValueCap?

Finance Minister Datuk Seri Najib announced that the government is injecting an additional RM5 billion into ValueCap Sdn Bhd, arguably as a strong signal to investors that the market is severely under-valued. This was part of a wider package of economic stabilizing measures, the details of which will be revealed not too long from now on Nov 4.

It was established in October 2002 with a paid up capital of RM50 million. ValueCap was the brainchild of Second Finance Minister Tan Sri Nor Mohamed Yakcop with a sole purpose to invest in the Malaysian equities market. Its shareholders are Khazanah Nasional Bhd, Permodalan Nasional Bhd and the Pensions Trust Fund Council.

There is little public information on the stocks that ValueCap has invested in. Information on its investments is only known through annual reports of companies they have invested in. However, based on filings with the Companies Commission of Malaysia, ValueCap is very much in the black despite the bearish stock market.

As for returns to its shareholders, it has been reported that since its inception to September 2007, ValueCap had paid out a total of RM135 million in dividends. Nevertheless, based on industry information obtained, ValueCap is believed to have about RM4.9 billion worth of investments in 70 companies currently (Oct 2008). These companies are from a variety of segments and include the YTL Group, the IJM group, Malayan Banking Bhd, Hong Leong Bank Bhd, Public Bank Bhd, Tenaga Nasional Bhd, Malaysian Oxygen Bhd, Amway (M) Holdings Bhd and PLUS Expressways Bhd. The list also shows that Valuecap has interest in Real Estate Investment Trusts (REIT) such as Axis REIT and Quill Capital Trust REIT.

As of Dec 31, 2007 it had total assets worth RM7.56 billion and posted an after-tax profit of RM1.102 billion for the year against revenue of RM1.325 billion. It has retained earnings of some RM2.408 billion and had paid out dividends of RM50 million over that period.

The fund size has blossomed from RM5.1 billion to RM7.7 billion as at end 2007. It is generally regarded as a fund management company, but of course, it remains debatable if that label is indeed accurate.

Dow – Next Stop 7,200!

The Dow collapse is gaining momentum. The next stop is 7,200. And if that level is broken, almost anything is possible!

The government is throwing everything at the credit and mortgage markets. It has taken over Fannie Mae and Freddic Mac and has pledged to take hundreds of billions of dollars in crummy assets from the nation’s major financial firms.

Outcome – the rate of the 30-year fixed mortgage, which is America’s bread and butter loan are not going down – they are going up. The average 30-year rate jumped to more than 6.4% and just shy of the August high of 6.58%, the highest in more than a year. This is because bond investors are dumping the heck out of bonds as they learned that the budget deficit soared to US$454.8 billion in fiscal 2008 – more than double the US$161.5 billion deficit in 2007 and the highest in history of the country.

Thus far, the carnage on Wall Street is linked to forced liquidations by hedge funds that had taken on far too much risk. Over the past decade, the greatest excesses were in housing and finance. Volatility in financial markets this week appears to have been sparked by the growing realization among investors that a global recession is imminent. It has overshadowing the good news on the declining LIBOR rate.

The recession that we may be facing is likely to be along the lines of the 1973/75 downturn. That recession was relatively long and deep. Real GDP from peak to trough and the downturn lasted for 18 months. By contrast, the past two recessions were relatively short and real GDP declined at most 1.3 percent and the downturn lasting for nine months each.

My view is that in this round of recession, the weakest period for the economy is likely to be the fourth quarter of this year and the early part of 2009. The unemployment rate will likely rise through the next year and peak at around 7-8% in early 2010. In this environment, consumer spending will be particularly weak and it would not be surprise to see declines for multiple quarters, marking the first declines in consumption since 1990-91. The National Association of Realtors (NAR) noted that 35 to 40 percent of sales were foreclosure-linked. Distressed sales are pushing activity higher.

In short, the leaks are now turning into a gusher. For a recessionary economy like US, Dow is still trading at a relatively high valuation with PE in excess of 20x. This compared to an average PE of 10x for Asian markets.

It's Global

In case you had thought that the current credit problem was only affecting the US and Europe, think again. It is affecting almost every major country on Earth. Reality struck like a lightning bolt. The easy money is gone. The financial alchemists have been run out of town on a rail.

I found a good summary of recent events from RGE Monitor as follow:

• Iceland – it has been at the foremost of the global credit crisis as its banks heavily relied on wholesale funding to finance the aggressive expansion abroad. With the rapid depreciation of local currency and the seize-up of credit markets, refinancing of debt is almost impossible and some analysts predict Iceland GDP could shrink by 5-10% after almost 5% growth in 2007.

• Hungary – While it's not suffering a banking crisis a la Iceland, the global credit crisis has exposed long-simmering vulnerabilities – high level of foreign currency lending, slow growth, twin deficits and heavy reliance on non-deposit foreign funding. Given its woes, eyes are focusing on rest of Eastern Europe for signs of trouble.

• Turkey - a number of analysts have cited Turkey in particular is vulnerable due to its large current account deficit.

• Ukraine – its high reliance on external finance leads it to seek financial assistance from the IMF. With persistent inflation and a widening trade deficit and domestic and regional political uncertainty have contributed to deposit outflows, tighter money market rates and exchange rate volatility. The Ukrainian currency, hryvnia, sank by 20% so far in October and the equity market fell over 70% this year.

• South Africa – worries that a global recession would depress export demand especially metals, and investment inflows needed to finance its current account deficit. So far, the Rand has fell to its lowest level since 2003 while President Thabo Mbeki's resignation ushered in a period of political and economic uncertainty.

• UAE – It starts to feel the pinch of reversal of speculative capital that flowed in early this year to bet on currency revaluation. Long term project finance costs already tightened throughout the GCC and the freezing of global credit markets exposed UAE banks, which financed rapid credit growth with foreign not local borrowing. Worries about Dubai's property market are looming. Kuwait 's Central Bank stepped in Sunday to prop up one of the country's biggest banks.

• Venezuala – the main problem is that its sovereign wealth fund, known as Funden, holds about US$300mn in debt instruments that Lehman had agreed to cash. With Lehman's bankruptcy, Venezuela will have a hard time selling the debt. Moreover, the fund has a significant amount US$2bn allocation allocated in structured notes.

• China – Q3 marked the fifth consecutive slowing of Chinese real GDP growth, implies fewer commodity imports but government sponsored infrastructure projects may pick up some slack – clouding the outlook for countries like Brazil, Chile and Australia among others.

Now, we see the problem is global. As the US continues to sneeze, it's probably safer to say that the rest of the world gets walking pneumonia.