Gold – Alternative Investment during the Bad Time?

I often ask if GOLD is a good hedge for a bad time? It is true that gold always goes up in recessions and depressions?

The best way to answer that is to look at the data. Data never lies unless we decidedly to torture it hard enough!

To give a fair and balance representation, we track the data as far back as the end of World War II, when most people think that ‘modern finance’ began at that time. So our study fits the norm that most economists use.

Recession Period	Length of Months	Total Return	Total Return with 2008 Transaction Costs
Feb 1945-Oct 1945	8	0.0%	-4.0%
Nov 1948-Oct 1949	11	0.0%	-4.0%
Jul 1953–May 1954	10	0.0%	-4.0%
Aug 1957–Apr 1958	8	0.0%	-4.0%
Apr1960-Feb1961	10	0.0%	-4.0%
Dec1969-Nov1970	11	7.36%	3.36%
Nov1973-Mar1975	16	94.81%	90.81%
Jan1980—Jul1980	6	-9.43%	-13.43%
Jul1981-Nov1982	16	-2.18%	-6.18%
Jul1990-Mar1991	8	0.66%	-3.34%
Mar2001-Nov2001	8	5.63%	1.63%
	Average:-	8.80%	4.80%
	Median:-	0.00%	-4.00%

Table above shows the performance of gold during the 11 officially recognized recessions begin in 1945.

The results speak for themselves. Even though it is acceptable throughout most of the gold-bug community that gold rises in bad economic times, our findings show that such is not the case. The average return with 2008 transaction costs since Feb 1945 was 4.8%, of which result was skewed by the returns seen in November 1973-March 1975 period. If that being adjusted, the returns look far less appetizing.

The idea that gold reliably rises during recessions and depressions is wrong; in fact, like most such passionately accepted lore, it’s backwards.

After Fed, Now the ECB!

Fed did the expected and rate unchanged at 2%, albeit signaling rising worries about inflation risks. US dollar came under pressure, lost to euro, pushing the EUR/USD rate about 100 pips higher towards the closing. Amidst the credit industry’s cries for help via lower rates on one side, and the sky is falling under the weight of inflation, doomsayers on the other, it doesn’t seem like there is a solution.

Fear will grow when investors realize that no matter what the outside forces may perceive to be acting upon prices, the market trends are endogenous.

Well, with the Fed’s decision out of the way, all eyes are now on the European Central Bank (ECB) that meets next week, already hinting they may not sit on their hands like the Fed did on June 25.

However, one should take a closer look at the Europe’s real estate situation, which some already expect the housing mania in Europe is reaching its end and could make the US housing mania pale in comparison. Some studies that we have access to suggest that what the US has been going through is merely a ‘mild prelude of what could happen in Europe’ given the stronger dependence on debt financing for real estate than the US. If that is the case, the bubbles bursting in the US and Europe carry more deflationary potential than Japan’s did, because far more extensive credit leverage fueled today’s historic mania. With US and British consumers loaded with record level of debts, their economic stress may be worse than Japan’s was.

FIs – Please Think Out of the Box!

If there were any doubts that equities are in a bear market, last week’s 465 points Dow decline should end the debate. The USD index weakened as the market reduced expectations for monetary tightening in the United States and we look for the greenback to continue its slide. Housing continuing its decline in May with single family starts off for a 13^th consecutive month. Amid soaring costs, businesses are trimming production and attempting to control inventories.

It seems to me that several markets need to reverse course to get equities back on their feets; oil and inflation need to fall and the US dollar needs to make a sustained rally. The only way this could happen is, if Fed started a new policy by raising interest rates. Does anyone really think that is likely to happen? I don’t. We agree that the Fed will express a hard-line stance on inflation but they will not go so far as to raise interest rates after a series of rate cuts.

Under that operating environment, dwindling trading volumes and tumbling stock prices can be a big pain for financial institutions.

But we are seeing opportunity for financial firms to convert this bearish market into an opportunity by focusing on products such as ‘promoter funding’. Promoter funding, a part of the wholesale financing business for these firms, involves offering loans to company promoters who are keen to capitalize on rock-bottom stock prices, to shore up their stakes in companies.

Typically, promoters access these loans to buy stock through the ‘creeping’ acquisition route, convert outstanding warrants into equity shares or to buy-out other investors, which seek an exit from the company. Many new entrants have entered this business, where loans are offered at interest rates between 14 per cent and 18 per cent, with shares or property taken as collateral.

In today’s scenario, the promoters have become proactive because of market dynamics. Some lenders reserve the right to sell off the shares pledged, if the market value of the offered security erodes substantially. Share buyback proposals by corporates are on the rise, both at domestic and at global levels, as market valuations rule lower than the last year.

Follow the trend, not the so-called experts.

What is Your Best Bet?

Unless the market is falling fast enough then possibly we will still see some meat towards year-end. Else, you can effectively kiss good-bye to local equity. The present equity market conditions are the worst in 10 years. It won’t be long till average trading value hits below the RM1bn mark.

With complete absence of positive domestic market leads, rising likelihood of prolonged negative real consumption growth from second round prospective fuel price hikes, and fear of global stagflation, what is your best bet to find decent returns for your hard-earned money?

The KLCI fell more than 15% year-to-date, and significantly underperforming regional benchmark MSCI Far East ex-Japan. Now, it is a no-brainer for all houses to revise up their inflation projections. It’s a fair question to ask whether inflation is close to peaking as a number of emerging market yield curves are pricing for more rates tightening than central banks would be willing to deliver.

Possibly, by investing in high yielding foreign currencies deposit, like AUD, NZD and CAD may offer a better alternative compared to a pathetic 3.5% rate that local banks are offering. The upside, even if we take into account of possible rate hikes by Bank Negara in the next 12 months, remains insignificant compared to the mounting inflationary pressures.

The million dollar question for the months ahead is whether dollar strength and carry trade will persist much longer given how much re-pricing has already occurred in US rates market. I believe that the US money market had priced in unrealistic Fed tightening by year-end. Read PIMCO Paul McCulley’s ‘A Kind Word for Inflation’, which essentially argued that negative real short-term interest rates are here to stay for a considerable period!

I suspect the dollar’s bounce will give way to range and that the carry trade will succumb to fatigue. For choice, I avoid EUR/USD, GBP/USD and USD/JPY as the stagnating of these economies will drive their currencies not far in either direction.

And in the case of bonds, the only opportunity lies with a spread widening and carry position. As regional central banks are likely to deliver less than expectation and weak returns on bonds (developed government bonds returns are now 1% below cash) and the likely rise in supply in government papers by relying heavily on leveraged short-dated funding, Malaysian government included, I am long swap spreads. Overall spreads have come in mostly in fixed income and less in credit. For one, to get a decent return from spread widening at the long end, one should use leverage with long-dated funding. Inflation linkers have outperformed in most markets and I stay overweight.

As for commodities, I’ll go for momentum strategy, riding on volatility with a shortened duration. China cut oil subsidy, oil futures dropped and OPEC may raise production quotas, but I still firm with the long energy positions, but am reducing the overweight in the long-only version. This is because active investors are short of options and they still have to look for alpha to meet the decent returns on their hard-earned money after all.

Government-Linked Banks Make A Bet

When we make a bet, we want to win! But can be said about the track record of government of Malaysia. More often than not, they always pay higher than market rate, firstly of being a late mover, and secondly of being too simplistic in forming the expectations, and worst still, if some deals are quite suspicious in nature.

Being a late mover is not a sin, but paying a hefty premium is a death penalty in the heydays of Comrade Stalin and Chairman Mao Zedong.

Feedback from my analyst friends in Thailand is that the 2.9x book-value (BV) or 59% premium to last traded prices of BankThai price of Bt1.32 of BankThai paid by Bumiputra-Commerce is indeed, every expensive premium. The three latest M&As were done in the range of 1.2-1.6x BV. The only different between the case of BankThai and the other three M&As is for management control and potential 100% stake. But one should also be aware that further capital injection of RM500-600mn is needed into the new acquisition to bring the RWCR from 7.5% to a target of 13-15%. We are still not too sure about the need of provision despite its huge exposure to CDOs investment, even though management of Bumi-Commerce made the assurance.

Likewise, with the purchase of a 20% stake in Pakistan’s MCB (previously known as Muslim Commercial Bank) by Maybank. The agreed price is an 11% premium to MCB’s most recently traded price and 5.1 times trailing book value. Also, I also take note of the purchase of Bank Internasional Indonesia (BII) for US$2.7 billion -- an expensive 4.6x BV, compared with fast-growing Chinese banks trading at between 3.3 and 5.4x book value. The share price of Maybank fell 9% in the deal's wake. As the head of research of CLSA, Nick Cashmore succinctly puts it that Indonesia wants control and a strategic buyer is not going to spend for a 30 percent stake that they cannot control.

All these purchases are made in justification of hopes and RHB Capital Bhd has also stated its intentions to go regional. It may look very glamorous but ultimately it could turn out to be an expensive exercise laden with risks. The fittest survives!

A Shocking Revelation of Our Terms of Trade

Economists and governments are in their nature always good at confusing people. We are given the impression that we are trade-surplus nation, net oil exporters, beneficiary of rising commodity prices, and that means Malaysians are having a positive terms of trade. So, no worry because Malaysians are better off than rest of the world. To government, we as the ordinary citizens can still take pains from their nonsense.

For those not familiar with the term, a nation’s terms of trade is the ratio of what it must give up to get what it imports. The easiest way to understand this, at least for me, is to think of the number of hours of work necessary that you and I to have in order to buy anything of the desire, and in this case, I refer to a barrel of oil.

Misery is as misery does. We are now working more hours for the same barrel of oil. Talk to taxi drivers, middle income group earning less than RM3,000 per month, and pensioners to get a good feel what it means by negative real terms of trade shocks. Put differently, you are less rich, and if not worse still, you are poorer than you before oil prices took off.

Be warn - this time, don’t expect that there is escaping collateral adjustments of temporarily higher inflation and temporarily lower growth and employment.

Next – you should ask how this pain should be apportioned as the misery index rising to be translated into lower real wages and profits. That simple, and that painful. Logically, it also means negative short term interest rates – the rate of return on your money.

But you may retort – what if Bank Negara comes to rescue and that would one be essentially argues that we are operating in a world of perfectly indexed prices and wages. Are we?

The biggest surprise, if you are still not be awaken yet, is that we are likely to experience more nasty asset price deflation rather than the fat tail of acceleration of inflation, unless we are allowing greater adjustment to our wages. Otherwise, Bank Negara may have to tolerate higher headline inflation in the wake of a negative term of trade shock. If it decided to be a ‘hero’, it will create an even bigger mess, and I think Bank Negara understands these exigencies. It doesn’t means that Bank Negara won’t or shouldn’t rhetorically sound tough at times.

Bottom line – this means, my friends, that low, even negative real short-term interest rates are here to stay for a considerable period. Yes, I know that may believe that it is somehow sinful or immoral to hold nominal short rates so low. Sorry guys, CASH IS NOT KING!

Pak Lah – Waiting for Bottoming?

Even if he wins to turnaround current adversity, you and me still have to pay a heavy price for it – something that we are definitely cannot afford to have. If this political uncertainty continues past September, effectively we can say ‘God Bless Us’ at least until 1Q09. The scale has tipped, in favour of Pakatan Rakyat while the core of ruling party, UMNO still doing much needed soul-searching at expense of every one.

Even if Pakatan Rakyat fails to entice the required number of cross-over, the Sabah and Perlis saga are more than enough for UMNO to chew off. The upcoming UMNO branch meeting, 17 July to 24 August and Division meeting of 9 October to 9 November, and the planned 1 million protesters on the road on 15 July and Anwar Ibrahim going to the Federal Court to get his September 1998 sacking declared illegal are not events to be taken lightly, both politically and socio-economically.

If that is not enough to screw you, let us take a review what happened when interest rates up in 2006. Mind you – when a 20% fuel price hike in March 2006, of which resultant in a 80 basis points rise in overnight policy rate then, the private consumption clowed down from 9.1% in 2005 to just 6.5% in 2006. I doubt this time to be much different, even though some smart brains think that cash rebates and rising commodity prices could make a different – Dream on! Remember this – our household debt to GDP ratio now stands at almost 60% - one of the most highly leveraged in the region.

The price to be paid is already reflected in our stock market. Blind man can even testify that. Someone advises me to position myself for a ‘traditional’ year-end uptrend now, but I think as situation pans-out, I still do not want to be the one who is catching a falling knife. Instead of collecting the year-bonus, the bull might be slaughtered for offering.

Bottomline – I don’t know if Pak Lah resigns, would that help to reverse our fortune or not but now I pretty sure that the current situation is pretty much like the case in Thailand then.

It is could be anyone, but definitely not Pak Lah.

The Road to Revulsion for KLCI

Over the last two weeks of reading stockbroker reports round the world, one common theme among these bright brains is that the worst is behind us.

My question is that why should anyone should listen to these people? They didn’t see it coming, and yet somehow they are qualified to tell us it is allright!

As Karl Marx said – history repeats itself, the first time as tragedy, the second time as farce.

Perhaps, I am just unduly skeptical, but this reeks of a conspiracy of optimism. My view – the recession has barely started, let alone reached its nadir. Far from being behind us, the worst may well still be ahead! The slowdown in the US is barely starting. The demand and supply of credit are evaporating. The effective shutdown of both sides of the market should be serious concern for all, as it is one of the hallmarks of a liquidity trap situation. The underlying asset adjustment is likely to have much further to run as well.

To my mind, it is much worse that possibly the burst of Japanese bubble in land prices or the S&L crisis as securitization was part of the solution to the S&L problem, whereas it has been part of the problem in the build-up in this current bubble.

One of the key lessons from the Japanese experience is that the banks were second round losers and they didn’t really begin to under-perform the rest of the market until the second Japanese recession of its debubbling process. They really started to suffer when the consumers started to struggle.

Going by this backdrop, I think we are still a bunch of optimistic and the risk of underestimating the earnings risk of Malaysian companies remains real. Cut in fuel subsidies, rising inflationary expectation, policy flip-flop and uncharted territory in political scene – all of these suggest that P/E rating for KLCI could hit below 10x, or effectively we are seeing a potential drop of KLCI index below 1,100, if not more, sooner than later. The curse of Vietnam, the extent of oil tax, policy drift and shock to disposable income could further setbacks to why the consensus equity overweight remains a MISTAKE, at least over the next 6 months.