Eurozone – Coming to a Halt!

The ECB, who had ‘gung-ho’ with the July rate hikes, and now want to prevent any extra rate increase. The strong euro and a slight rebound in oil prices added fuel to the rout. The PMI index fell to below 47 in July for manufacturing and 48.3 for services suggests that purchasing managers in the Eurozone have become much more pessimistic. Technically speaking, every reading below 50 means that the PMI respondents are seeing a contraction. Consumers in the Euro-zone, like their counter-parts in the U.S. are expressing their lowest level of confidence in years.

German, the biggest economy in the Eurozone, is showing signs of weakness as businesses scaled back their expectations for the next 6 months. The Ifo business confidence index fell sharply to 97.5 in July from 101.2 in June – the biggest monthly decline since the recession in 2001, suggesting that businesses are highly likely to slash their investment and hiring plans accordingly. This is not unique to German. France’s business confidence inxed also fell to 98 in July from 101 in the previous month. Similar observation is made for Italy. If this trend continues, I expect the ECB to once again revise its growth outlook in September, and that will raise the risk of semi-stagflation instead. The risks of one or two quarters of negative GDP growth are rising and I see a 45% probability of a recession in the Eurozone. Such an outcome would be very significant for the monetary policy debate within the ECB Governing Council.

Fiscal policy will only marginally cushion the negative shock on purchasing power as the industry is particularly sensitive to the strong Euro. Unfortunately for the Eurozone economies, the most obvious source of hope is something over which it has no control whatsoever – the oil market. If oil prices continue to correct at the same pace as they have done these last days, consumers could find some breathing space.

Negative Feedback Loop in 2009!

Financial market conditions have remained tough because of inflation and diminished growth expectations globally. The access to capital markets is becoming costly with access limited, but the highest quality issuers. In turn, growth in private investment, business confidence will moderate to varying degrees across the region.

On average, the economic growth will be weaker in 2009 than in 2008! If this year, Malaysia is going to record above 5% GDP growth, then next year, I am not surprise to see a softer than 5% then. Exports, which didnʼt fall off as sharply thus far, in turn will hold off much of the adjustment from the recessionary impact from the US economy. The global economy, including those of the Japanese and the European economies, is weakening fast and that pretty much confirmed by leading indicators. That means the export slowdown seems to be spilled into 1H09. Even the intra-Asian trade will not be spared.

And in responding to the inflation problem, central banks, including Bank Negara, as many are expecting to see interest rate hikes, in turn, will severely affecting the discretionary spending. It could be far more severe if food and energy prices do not come down to match it.

In a nut shell, I expect the loss of economic momentum will be larger than the consensus expects. In his own words, Bill Gross of PIMCO points out that an asset deflation in turn becomes a debt deflation, and finally prime mortgages surrender to the seemingly inevitable tides. The ever worst thing that one can imagine in 2009 is that the world may fall into what I called as ʽnegative feedback loopʼ effects.

Make no mistakes, the current conundrum, if failed to be resolved, this will be a perfect recipe for dysfunction financial institutions.

Up to this point, efforts are limited to maintain the stability of major financial institutions, recapitalizing their balance sheets and lowering the cost of mortgage credit. As the discount rate is higher than the expectations for home prices, one could safely assume that Fed funds may have to be lowered to 2% to lower the discounted present value of an existing home to at least slow down the current descent, otherwise, this could prove to be the beginning of the long journey back to normalcy. One complicating factor has been the recent up-tick in mortgage rates, and is still about a percentage point higher than it was at the start of the year.

Palm Oil – Our Last Bastion of Hope!

CPO prices have eroded by about 27% from its all time high of about RM4,486 per tonne in March 2008. Of course, it dragged down the plantation stocks as well. Concerned are on Malaysia’s palm oil stock of about 2.1 million tones in June08 – the highest in 25 years (since 1983), which definitely do not bode well for CPO prices. On top of that, international news-flows are not supportive with the EU has come under heavy criticism as its biofuel target has been blamed for rising global inflation.

Question – is that the beginning of an end of commodity bull in Malaysia? Is China abandoning its long held policy in locking in supplies of critical commodities? None of China company has bought a significant stake in any palm oil company. Or could there be the case that these sovereign wealth funds, US pension and endowments, which have partly been blamed for the rising commodity prices, are backing off to reflect the heats?

Compared to other vegetable oils, palm oil is still relatively cheap and it is one of the critical elements to manufacture other essential products like cosmetics, detergents, chemicals (paints, grease) and food products like cakes, chips, mayo, margarine etc.

Perhaps, the current selling is a buying opportunity and the resumption of bullish trend is a matter of time, especially US dollar weakness is likely to stay for quite a while.

The twentieth century saw three long commodities bulls – 1906-1923, 1933-1953 and 1968-1982 with each lasting an average of a more than 17 years. The recent commodity bear market ended in 1998 or 1999, when prices were approaching 20-year lows. Going by that count, this millennium of commodity bull is likely not to last before 2016.

So, at today’s price, when I factor in inflation, there is still plenty of room for most commodities to go even higher. My guesstimate is excluding the possibility of ware, political chaos and terrorism, which is a sufficient not necessary condition for prices to test a new high.

Remember this! No bull market in any asset has ever gone straight up; periodic corrections will always occur. A consolidation is caused by a glitch in the supply-and-demand relationship and I strongly believe commodities are tangible assets that offer different characteristics and no credit risk.

BNM Did The Right Thing!

The decision of not raising overnight policy rate (OPR) was a right one!

While the latest CPI inflation of 7.7% yoy seemingly alarming, the impact of rising costs on general prices is definitely not something that Bank Negara is capable of solving it. Interest rate is not the answer to all problems relating to inflation. In my previous posting, I made it clear that there is also the risk of slower growth. Consideration needs to be given to the deflationary impact of fuel price increases on consumption and debt servicing ability. In economies experiencing overheating and strong demand, there is a need for monetary policy to rein in demand, but that is not the current operating environment.

At times, the non-interest rate measure can be more effective. So far, the government has made the following supply-side announcement to deal with inflationary pressures:-

• Banned exports of 10 essential items – sugar, wheat flour, cooking oil, chicken, cements and clinker (except with permits), mild steel bars, petrol, all grades of spirits and gasoline for motors, diesel and LPG.
• RM 4bn for food security policy
• Additional RM500mn for agriculture and agro-based industries
• Higher monthly quota for extra-subsidized diesel to school bus operators and taxis
• Streamlined LPG prices between Sabah-Sarawak with Peninsular
• Abolition of 5% service tax on restaurants (outside hotels)
• One-off cash for vehicle owners plus road-tax cuts
• RM100mn micro-credit scheme for urban low income group

And certainly, there are more supply-side measures that can be adopted to fight rising inflationary pressures in the coming Budget, including adding more products to the list of controlled items, additional allocation for agriculture and agro-based industries, improving public transport services, cut in import duties and cut in personal income tax or greater tax relief/rebates plus cut in EPF contributions.

In the own word from the latest Monetary Policy Committee (MPC) of 25 July 2008, ‘…In the next twelve months, while both the risks to higher inflation and the risks to slower growth have increased, the immediate concern is to avoid a fundamental economic slowdown that would involve higher unemployment. Slowing growth itself will contribute to containing the potential for second round effects on inflation, thereby containing further increases in prices in the second-half of 2009’, I interpret that economic growth has take greater precedence over inflation as key determinant for future direction of interest rates.

The additional enhancement to the latest monetary statement compared to MPC statement in 26 May 2008 is the view that slowing economic in turn will propagate the potential for second-round effects on inflation. Arguably that if the economy to be spared from the second round inflationary impact, slow down in economic momentum must be avoided at all cost, at least not from triggering hike in interest rates. I see as one of the many great ways for authority in explaining why rates hike to be avoided for the foreseeable future.

My Choice - High Yielders!

I have seen rising retail investors are back buying foreign currencies. In particular, there are strong shift towards high yielders, despite that predicting the end of the high-yield heyday has become one of currency analysts' favorite tricks after the bull run of high-yielding currencies in 2005. A Japanese friend of mine shared with me last Sunday that Japanese retail investors are buying large quantities of AUD and NZD, and the outstanding position now exceeded the peak that was seen before the outbreak of sub-prime loan problem August 2007.

Retail investors in Malaysia and Singapore that I talked to over the last two months are showing similar behaviour. They don’t really care much about the slowdown in these two countries as long as the large yield gap remains against their own countries. They believe that despite monetary easing in Australia and New Zealand that I think is likely next year, the large yield gaps versus Malaysia and Singapore will be maintained for the foreseeable future. Besides these two currencies, I also take note of rising interest of South African Rand (ZAR) and Brazilian real (BRL) purchases among investors in Taiwan, Korea and Japan.

Signs of a real unwinding of the so-called carry trade have gained strength in recent days and weeks, hinting that the currency markets could be on the verge of something big. I continue to find carry trades attractive despite recent volatility. One should take note that the high yielding currencies, like the Australian and New Zealand dollars and many of the emerging market currencies may also be played under momentum strategies, not just a carry strategy. For the most part, it seems as if the recent price action in the currency market can be better explained by the momentum strategies than carry trades.

The RBA left the door open for more interest rate rises from the current 11-year high of 7 percent to cool the country's inflation pressures, with the market expecting another hike soon. The Aussie's rise helped pull the New Zealand dollar up to a seven-month high of $0.7987 , drawing investors to its high yield on expectations interest rates will be kept steady.

I should caution readers that the risk with high yielding notes are the 'hidden' potential for currency devaluation. Both Australia and New Zealand ran a current account deficit even larger than US! Unless they can continue to maintain their GDP growth rate, any slow down will just widen the deficit, cutting rates will just be a matter of time. Having said that most of the fixed deposits are short term – 1 mth or 3mth. So depositors are implicitly betting against devaluation within these periods.

In a nut shell, the higher-yielding currencies once again began to find buyers. Sort of like a scene from Wayne's World… Game On!

Will the global financial losses hit beyond US$2 trillion?

According to Bridgewater Associates one of the top analytical firms in the world, the estimates for losses in the international banking system are beyond the US$1.6 trillion mark, more than enough to pose a grave risk to the global financial system. This time last summer, the losses were estimated around US$400 billion.

It seems the credit crisis is going to get worse and the issue now is whether financial institutions will be able to obtain enough new capital to cover the losses. According to some estimates, lenders would have to curtail loans by roughly 10-to-1 to preserve their capital ratios, suggesting a cut back of credit by up to US$12 trillion.

One thing to note is that these losses are not all sub-prime. More than half of it is coming from corporate liabilities, estimated around US$800 billion. Of the US$800 billion, some US$500 billion of the corporate losses have yet to be written off. According to Bridgewater Associates, there are losses lurking from the prime and Alt-A loan portfolios that could be much bigger than the sub-prime problems, as those loans are more than six times the size of sub-prime. Going by that estimates, there are about US$1.1 trillion of losses that will have to be written off, including very large potential write-offs from insurance companies.

Another US$400 billion may also be needed by banks and investment institutions worldwide for capital infusions. In short, those sovereign wealth funds or large investors, who have put money will have to watch their investment taking large losses in a very short time, meaning that this could be very dilutive terms to current shareholders.

Bear Stearns is not a one-off deal and the constituency may perhaps go beyond US and it is a life-threatening for more than one major institution in Europe.

The trend towards lower lending is highly plausible and that could be a major headwind for the global economy that is already struggling.

What this means is that there will be a major global bailout. Treasury Secretary Paulson said that no bank is too big to fail, but that is for public consumption. In 1980, when every major US banks had large amounts of Latin American bonds in their portfolio, they were allowed to keep the bad bonds on their books at face value, otherwise, they were technically bankrupt as the exposure was at a size far larger than their capitalization. It took them more than 6 years of profits and capital raising to get to where they could deal with the problems without imploding themselves and the world at the same time.

Goldman Sach published a report recently in which they suggest the most probable scenario for the next 12 months is GDP between -0.25% and 0.25%, or basically zero. Earning estimates are being cut with each passing month, meaning that more pain for the stock market. Check this out - http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS?GXHC_gx_session_id_=5350992f205e73e4&.

Commodities – The Chokepoint?

Food and energy are important components of people’s budget and it is natural to be concerned with what people are concerned with. The story that we heard so far, is frightening as if it is about to crash through the floor, leaving the masses with no food to spare. Commodity prices across the spectrum have been on the rising since 2001 after two decades of underinvestment bought these to their inflexion point. From base metals, precious metals and energy, now price craze spreads to soft commodities including food.

Bad news is that if nominal prices are adjusted to real terms, the long term patterns of commodities suggest that we are some 75% of the way through this cycle, and probably have an average 2-4 years of higher prices ahead. Food demand still firm and as much of these demands are from outside the OECD countries, the prices will continue to rise into 2009-11. The CRB index has rebounded by 68% from its 2001 low but is still well below the 112% rebound from 1970 to 1982. The average rise of all commodities is 223% since 2001 but still again well below the 296% from 1970-1982 respectively.

The biggest single force for change is urbanization. In China, approximately 10 million people a year move into towns from rural areas and another 10 million live in areas whose designation is changed from rural to urban. Over the 2006-2010, forecasts made that China will see about 100 million people become urban and in the following decade, more than 200 million people should become urbanized. In the process, changing diet will drive the rapid growth in China’s food demand. The share of cereals falls while that of meat and fruit increases.

Good news is that higher prices will be the incentives to produce more. As the late Milton Friedman said `the cure for high prices is higher prices’ and this is already happening in mining with a close to a 55% increase in 2006-07 for non-ferrous exploration budgets. There appears to be plenty of land worldwide that could be bought into cultivation to meet the growing demand for food. The key suppliers of new land are likely to be Latin America – Brazil and Argentina and the former Soviet Union – Russia and Ukraine. Thus far, only 11.5% of the world’s surface is used for arable and permanent crops.

From 1961-99, more than 78% of output increase came from improving yields with another 7% coming from better crop intensity, leaving just 15% to come from land expansion. The FAO estimates that this may rise to a bit to 20% coming from new land over the next 30 years but still 70% should come from yield enhancement.

Trade pattern will see significant change in the next 10 years or more. Gone are the days when bulk cargoes dominated the food trade and the fastest growing category is processed food such as meat, beverages and chocolates. The conclusion of greater Free Trade Agreements (FTA) will also give greater comfort for many countries about the tightly guarded concern of about the need for a total food security. That in turn will create great opportunity for domestic producers to consolidate and in the process to build stronger brands. It would not be a surprise to see the growth of global multinational food companies comes from Asia. Food processors clearly have significant long term growth as currently only 30% of food processed and there is plenty of scope for growth considering that developed economies have around 80% of food processed.

Central Banks Are Rushing to Raise Rates – Malaysia next?

Recently, central bankers and investors elevated inflation to the top of the ‘worry’ list. Of not to be blamed in reacting too slowly, many regional central banks are rushing to raise the key benchmark rate arguably to fight inflation. So far, Philippines’, Indonesia’s and Thailand’s central banks have tightened monetary policy, in the context of each central bank’s inflation target. In fact, some claimed that the Bangko Sentral ng Pilipinas (BSP)’s greater than expected policy rate hike should be seen that the authority is serious about bringing inflation back to target in the medium term.

Grounding on that, together with inflationary threat, punters are expecting a 25bps hike in overnight policy rate (OPR) by Bank Negara this week – 25 July 2008. On 23 July 2008, market will get report on the June CPI, which more likely than not, will show inflation to accelerate beyond historical average rate on the fuel subsidy adjustment.

I doubt that BNM will deliver the expected hike, as the BNM once said that it has no immediate plan to raise policy rate if there is no evidence of the second round effects. It will be too premature to act.

Question – Is rate hike will be the solution that we are desperately searching for or there be other viable alternatives?

Under a cost-push scenario, interest rates hike will only worse the macro situation, and if not handle well, it exposes the economy to risk of stagflation. Debt servicing ability and business sentiment will be badly affected. Malaysia has one of the highest household debts to GDP ratio in this part of the world. Inflation expectation is unlikely to ease because price pressure is supply-side driven. Raising interest rates, at this point of time, is akin to rubbing salt to the wound!

If the objective is to ensure neutral or slight positive real interest rates, then the 25 or even 50 bps hike will not do the tricks. A rule of thumb is that for every 100 bps hike in interest rates, consumer spending will ease by 0.5-0.8 percentage points in the first year and 0.4-0.6 percentage points in the second year respectively.

Perhaps, there are more effective tricks that relying on interest rate management. Fiscal tools like reducing business costs and raising disposable income may be better options to current dilemma.

By allowing Ringgit to appreciate is another viable option, especially when the US dollar is on the depreciation path. It reduces imported inflation and strengthens purchasing power, hence promoting low and stable inflation expectations (see Mishkin Frederic, Monetary Policy Strategy, 2007, p 4). Impact to exports is likely to be minimal when the global demand remains weak.

As inflation heads higher, credibility to handle inflation is becoming more vital, and if the authority is not making the right use of right policy tools, we are likely to see greater impact of capital outflows and diminishing of wealth.

KLCI - More dislikes than likes

I met a group of seasoned semi-retired analysts, fund managers and potential investors over the last Sunday. Over our ‘the-tarik’ discussion, we are sort of in common agreement that Malaysian equities are marginalized, and there are no significant efforts to dig ourselves out of bottom pit since the 1997/98 crisis.

The Government-linked companies (GLC) restructuring story is no longer the buzzword of the day. Other than focusing on initial phase of business re-engineering, including cost rationalization and working capital management, efforts to improve their core competencies are seemingly no longer part of the mantra. This is evident from the declining foreign shareholding in top GLC companies and we sense the demand for more transparency and accountability from Khazanah’s investee companies apparently fizzles out as they entering into Phase 3 Transformation Program. About 35% of KLCI’s market capitalization is linked to GLC and you must realize by now that these companies operate in an environment where government regulation is heavy. So you really have to wonder how strong their balance sheets and income statements really are.

What left proudly visible in the transformation journey is not more than series of coloured books, well-archived deep in our well-trusted libraries, perhaps one day it may be just to be as a good source of reference for MBA and graduate students in times to come.

The argument that Malaysia is the top pick, especially in times of uncertainty, due to its defensive quality and low beta market is getting less irrelevant. Bursa’s market velocity is amongst the lowest in Asia ex-Japan and is still relatively under-owned by foreign investors. Rising political tension, which is not likely to ease in the foreseeable future, has raised the beta of this market, and even solid blue chips with low betas are following the market south. Only one of the two largest sectors on the KLCI namely plantation is quite immune (not really immune after all) from this uncertainty. The top 10 stocks account for 50% of the KLCI. Sometimes you just have to wonder how much choices that investors in the perceived defensive Malaysian market really has to offer.

These are latest additions to long series of common grouses of portfolio investors about Malaysian equities. Top of the grouses are (i) relatively small markets, in terms of market capitalization, (ii) relatively illiquid and/or low free float, (iii) few listed world class companies, (iv) misconstrued existence of capital controls, (v) cumbersome administrative rules, (vi) expensive PE valuations relative to other markets etc.

What is really left to be appreciated, else possibly the last retention tool of why someone may want to have an exposure to this market is the increasingly higher dividend yields. Dividend yields in the Malaysian equity market are attractive and supported by good dividend payouts. The estimated dividend yield for Bursa Securities is estimated at 4.25% as at 31 March 2008, above the long-term average yield of 2.59%, thumping its peers by 50-100 percentage points. Its current yield is also not too far from its historical high and also beats the current fixed deposit rates of around 3.5%.

Watch out for the consumer, tolling, gaming, plantation, and telecommunication to raise their dividends in the coming years. This will, apparently, come from a combination of improved earnings and higher payout ratios.

Fannie Mae & Freddie Mac – a bigger role for Treasury?

Fed’s semiannual monetary policy testimony to the Senate Banking Committee concluded that the economy still faces difficulties in the form of financial strains, declining home prices, a softening labour market and high and rising commodity prices. The Fed also knows the negative real Fed fund rate is inconsistent with its long-run low inflation objective, but weak economic conditions and credit stresses prevent it from hiking rates anytime soon. The Japanese economy so far is probably not in recession, but is getting closer to one. Business investment growth is slowing on deteriorating profitability and sentiment. As a result, trading thinned out by vacations and volatility driven by rumours and aggressive chatter from analysts and commentators.

To bolster confidence, the Fed Reserve and US Treasury Department announced that it will allow the Fannie Mae and Feddie Mac to borrow from the discount window at the primary credit rate ‘should such lending prove necessary’. Borrowing would be collateralized by US government and federal agency securities.

The Fed noted that the move is intended to supplement the Treasury’s existing lending authority. For once, market concluded that is the bondholders, not shareholders, who will be supported and sparked a flight from equities into bonds. Many still think that the two Government-sponsored Enterprises (GSEs) will have to be nationalized, hence increases the fiscal burden on the federal government and hurt the US dollar. Freddie Mac is also reported scheduled to sell US$3 billion in short term notes today.

The problems with the GSEs are pretty straightforward. Both GSEs need more capital and perhaps far more than their current market capitalization. Combined, they have about US$95 billion capital and hold over US$5 trillion in mortgages. Former St Louis Fed Reserve President William Poole asserted that these institutions are essentially on a short path to insolvency. And make no mistake. The problems with them have to be resolved as they are doing 80% of the mortgages in the US. Without them, the housing market would grind to a halt quickly and housing prices would drop even beyond Gary Shilling’s pessimistic views. Not to mention that the world has assumed the implicit backing of the government in buying the paper of Freddie and Fannie.

If the access to the Fed’s discount window failed to resolve the issue, then the Treasury appears to be laying the ground work to take a temporary equity stake in the two enterprises. Higher mortgage rates are the last thing the housing market and the broader economy need today, which ultimately make these problems all that much more difficult to solve. They are too tightly wound into the core and fiber of the US economy. Otherwise, the authorities are slowly losing control.

Why Should You Be Scared of Inflation!

Inflation means different things to different people. In financial world, it is a much greater driver of financial market than changes in economic activity.

• A rise in inflation usually increases volatility of economic growth, which in turns reduces P/Es and the willingness of the private sector to take risks.

• Inflation typically takes a much meaner bite out of margins than a recession does. It is inflation, not growth, which wreaks havoc on profit margins.

• A surge in inflation typically means interest rates will be rising in the near future. That means investors get to lose money on both bonds and equities. For example, from 1966 to 1980 – the last inflation surge period – US bonds shed 2% per annum and US equities fell 4.9% per year.

Fear is understandable because growth almost everywhere around the world is slowing while inflation is still accelerating.

There is little doubt that the weakness in the USD, often associated with the spike in commodity prices, is the key parameter to the whole equation. This is more so in the emerging economies, where food and energy represent a much bigger slice of the average family’s spending than in most OCED countries.

Of course, USD is part of the problem. Like the saying of the late Milton Friedman that ‘inflation is always and everywhere a monetary phenomenon’, the excess liquidity creation is, however not the work of central banks, and it will not be a valid criticism to them. The narrow money growth, M1 has not seen much of a rise in recent years suggesting that the pace of monetary creation has by and large been tame.

So if this is not the creation of central banks, then the natural choice of candidate will be the commercial banks. Banks have ridden the ‘financial revolution; as hard as they could possibly be, evidently from the rapid expansion in corporate paper outstanding in the period between 2003 and 2007. The challenge now is whether the velocity will remain as buoyant over the next two years, as it did in the 2003-2007 period, especially with bank balance sheets now under severe strain. As such, the willingness to take risk from private lenders would be very surprising.

Last but not least, the US current account deficit, which in essence, is providing the world with its working capital. When the US current account deficit improved, the US deflated other countries and vice versa. To-date, the US current account deficit still stands at a rather large 6% of GDP, and large of the reflating situation is much related to oil producing countries. The fact that the US is no longer reflating non-oil producing countries is a very important element to our economy, which resulting not only us, but a number of countries as well to save more than they earned!

There are countries that are today dealing with the largest inflation threats because of the need to reflation their economies, and the large US current account deficit propagates the belief that the USD could only fail, and thus encouraged large borrowings of USD outside of the US.

In short, inflation is proving to be massive headwinds for financial markets, and part of the fear is that if the central banks will have little choice but to tighten the policy in the coming months and the leadership of equity markets should go through a serious adjustment.

China – RMB at a 10% appreciation path!

We expect a 10% RMB appreciation this year, even though the non-deliverable forward (NDF) market has yet to respond in spot. The pace remains volatile, but the appreciation has accelerated after pausing at 7.0 throughout April and early May.

Capital flows surged in 1H08 and more importantly the onshore-offshore interest rate spreads remain in its favour. The latest data show that ‘hot money’ inflows may have accelerated, estimated in the region of US$300-400 billion.

As the US aggressively cut rates and China raised interest rates, the RMB quickened its appreciation. The Chinese economy is still expected to grow by 9-10% in 2008 and 2009, despite the global slowdown and a looming US recession.

While Chinese exporters are complaining about the effect of strong RMB and limited ability to pass through of production costs, but on the other hand, officials also keen to restructure the sector towards high value-added manufacturing. Exports bounced in Q2 against expectations as Chinese exporters are capturing market in Germany, Japan and the United Kingdom. Perhaps consumers are opting to buy cheaper consumer goods as fear on jobs security rises.

Amid rising concern about ‘hot money’ flows, China is adopting stricter existing foreign exchange controls, including checking for proper export documentation for FX sales. It is clear that the implied appreciation in the NDF market collapsed, but the underlying appreciation expectations have not been significantly affected thus far.

Shaking the Foundation!

The downturn in the global economy is now at least 9-months old, measured from the S&P high of last October. The housing and mortgage crisis is far from over.

The oil price crisis started in August 2007, when the oil price was only $70 per barrel, half what it now is. The prices of other commodities, particularly corn soybeans and wheat, have moved with the price of oil. Equity markets behaved as though they were immune from the building recession as they always do. But that charade lasted until last October when the S&P 500 peaked.

Everyone would like to know how long and how deep the 2008 recession is going to be. There are always commentators and analysts who think that the end of a recession is about six months away. In 2007 there were many so-called experts who expected a recovery in the second half of 2008; that expectation has now shifted back into 2009. Now, they believe the recovery will start in the second half of next year and persist through 2010. Will they be right this time?

One thing is clear that this is not going to be a short and mild recession like that of 2001. So, the time has come to ignore the talking heads who keep calling a "bottom" that could be years away. U.S. stock investors are nowhere near the "point of recognition" or the mid-point of the dominant trend when participants see that trend for what it is.

On July 1, a survey of Japanese manufacturers showed that companies expect earnings to decline for the first time since the 2001 recession. A survey in China showed that manufacturing in that country last month expanded at its slowest pace in three years. According to Moody’s, the global issuer-weighted speculative-grade default rate rose to 1.98% in June with much of the rise continues to originate from the US.

What does this means for the KLCI?

The KLCI is down 22% YTD and combined with the current political drama, more earnings downgrade are likely. The larger declines in other markets are by no means the result of any improvement in sentiment in Malaysia.

We think 2008/09 consensus earnings growth is more at risk. Importantly, domestic multiples remain at stretched levels, and we think a multiple de-rating is required to price in what are now substantial political risks. The Wall of Worry with which equity markets have had to contend for most of their upward journey continues to hold firm.

Pak Lah’s announcement that he will retire early and hand over power to his deputy by mid-2010, is not likely to ease, instead will intensify the political uncertainty gripping the country since March general elections. Muhyiddin who was tipped as a number-two to Najib after Abdullah’s departure, opined that if the duration is that long the situation will not become more convincing. UMNO veteran Razaleigh Hamzah, also questioned the premier’s right to hand over the party’s leadership to Najib. Worse still that Abdullah’s predecessor Mahathir Mohamad predicted that Najib will never become prime minister.

Compounding the matter is that Najib and opposition figurehead Anwar Ibrahim are now gripped in a bitter political brawl, with both facing serious misconduct accusations. Bottom line – we do not foresee an early end to current political uncertainty that has hampered Malaysia’s financial markets.

Even if there is a change to current administration, what unites the opposition is a common wish to see the government of Prime Minister Abdullah Badawi end, but for widely differing reasons. What next – your guess is as a good as mine!

EUR – Running on Empty?

The trade-weighted EUR has risen to its strongest levels since the late 1970s, almost 40% above the trough reached in mid-2000. However, the underlying fundamentals are bringing into question of whether EUR may be overvalued.

While German economy remains relatively solid, trade deterioration in the remainder of the Euro zone is becoming more obvious. Weakness in the Irish and Spanish real estate markets has translated a two-tier Euro-zone economy, with the weaker sectors gaining momentum relative to the stronger. From exports, it spreads into domestic production with the German ISM holding above 50 while similar index readings hold below 50 for France, Ireland, Spain and Italy.

And that effectively will put the recent surge in the trade-weighted EUR to be increasingly at risk.

The EU Business Climate Index (BCI) peaked in April 2007 and has fallen steadily over the last year. With an average lead time of about 6 months to changes in the trade-weighted EUR, this suggests that the cyclical support for EUR is waning. With the residual tightening by the ECB to address inflation overshoot, which could be the near-term support for the EUR leads us to believe that EUR trade weighted index gains are increasingly at risk.

As at now, just as the USD was supported by high US rates in the first half of the 1980s, the EUR is supported by higher ECB rates and relatively weaker US fundamentals. The breakout to 1.6018 on April 22 was triggered by two aggressive US rate cuts totaling 125bps in January and that bought the Fed fund rate to below European counterpart for the first time since October 2004.

In the latest Merrill Lynch Fund Manager survey released on June 18, a net 71% of asset allocators believed that the EUR was overvalued, which was a key motivation for them to shift away from European equities.

In short term, it is very difficult to convince the market to dump the EUR today because the ECB’s refi rate is currently twice as high as the Fed fund rate with the ECB still considered to be relatively more hawkish than the Fed.

Beyond that we expect a gradual EUR weakening in 2009 with a move toward 1.45-1.50, resulting more from potential EUR weakening, albeit from very strong levels than USD strength. As the US economy and Fed policy normalization gain momentum in the later part of 2009, it will likely to push the EUR below 1.38 into early 2010.

Politic Bites!

The key index had violated the critical support of 1,157.47, essentially threatens to open the window for a prolong downtrend going forward. The Composite Index already in 54 weeks low. Market breadth was negative. Bursa Malaysia saw 561 losers versus 47 gainers with a volume of 469.58 million shares worth RM225.49 million. Is there a connection between angry public protests and stock market declines?

Businesses are finding it difficult to lure foreigners in and investors remain wary against the backdrop of such uncertainty. Foreigners have been gradually slashing their exposure to Malaysian equities since March.

Politic is becoming a dangerous game. Since 1957, ethnic issues have dominated Malaysian politics and with the weaker political base of Barisan Nasional (BN) as seen in the latest election, this sets the scene for future political turmoil. Failure to respond to the message from the electorate is proving to be disastrous for UMNO and the BN. Talk of potential defections to the opposition, particularly from the BN’s historically fickle component parties in Sabah and Sarawak can be taken lightly.

Political pluralism can spell economic disasters. It cannot be denied that the non-Malays (especially Indians and Chinese) have become increasingly aware of the negative effects they suffer as a result of the government’s discriminatory policies. The question that has been frequently raised is: How long can this continue without seriously disrupting inter-ethnic relations in Malaysia? There are growing unease about the direction of the country with a slowing economy, a slumping stock-market, and political uncertainty stoked by divisions among Malays, who form 58% of the population. If the current situation is not carefully managed, the economic slowdown may take its toll on inter-ethnic relations between ethnic Malays and ethnic non-Malays, especially from the lower income categories.

Another reality of post-2008 election politics is that UMNO cannot realistically hope to perpetuate its 54-year old Malay supremacy model if it no longer enjoys a monopoly of Malay support — which is now shared by PAS and keADILan. Maintaining Malay dominance on the strength of non-Malay support is a contradiction in terms that seriously undermines the ethnic framework of Malaysian politics.

The blood and fire of 1969 seem far away from the prosperity of modern Malaysia, but after all, it may not be too far away from us as now that deal has to be reshaped into something less unfair to the minorities. In short, Malaysia can do it the easy way, or the hard way. It may choose the hard way after all.

G-3 Central Banks Turn Speechless!

The survey data took a turn to the worse in June. At the same time, global inflation is accelerating and many central banks appear to be on inflation-fight, at the expense of growth.

The US – A Record Breaking Country!

Private residential construction spending has now fallen for 27 consecutive months and the cumulative decline is almost 60%.Vehicle sales tumble to 15-year low on the back of sharp rise in gasoline prices. The last time vehicle sales were this low was 1993.

The US consumer has cut the spending on non-oil items by almost 40% in terms of GDP over the past two years, and the trend is clearly down every quarter. Banks are cutting leverage as aggressive as they once expanded their balance sheets. In a typical recession, the US stock market typically falls 30% or more, and we are now down almost 20%. No prize for guessing, if we are to see the markets to fall another 10%, at least from the perspective of history.

The Japan – Growing Pessimism

The equities have fallen almost steadily since early June and the downward trend in JGB yields since mid-June on receding rate hike expectations for the Japan appears to be moderating, if not stalling. Growing pessimism on the economy and corporate profit outlook, and higher inflation in coming months would constraint Bank of Japan (BoJ) policy. Preliminary June Tokyo data and companies’ price hike announcements – including electricity rate hikes and wholesale gasoline price hikes on July 1^st suggest a further pick-up in core inflation in coming months.

Core CPI inflation of 1.5% yoy in May already well above the 0.5% policy rate and close to the high end of the BoJ Policy Board’s medium term price stability concept of 0-2%. At the same time, the economy is slowing significantly on terms-of-trade losses and slower overseas demand growth. The June BoJ Tankan also confirmed a broad-based deterioration of business conditions with expectations of profit declines boding ill for capital spending and wage growth.

The European Union – Calibrating the Message

The ECB raised interest rates by 25bps to 4.25% and hinted that the move will be a one-off, even though the risk of one further rate hike to 4.5% later this year remains substantial, if the logic is to forestall rising headline inflation and inflation expectations from spilling over into wages. At one hand, the ECB continues to expect ‘on-going moderate growth’, but on the other hand, the ‘uncertainty surrounding this outlook…remains high, owing not least to the very high level of commodity prices, and downside risks prevail”.

A number of economic indicators such as the below-par purchasing managers’ indices or the contraction in real M1 money supply point to hardly any growth at all, with a risk of virtual stagnation or worse. In a nut shell – a genuine recession – although still unlikely – it cannot be fully ruled out anymore.

KLCI – In A Value Trap!

We are in un-chartered territory. It is very seldom that we see confluence of political uncertainty, policy flip flop and rising risk of stagflation come into play. Stock futures slid, putting benchmark indexes on the brink of a bear market, as an almost $3- a-barrel jump in oil dimmed the outlook for corporate profits and more analysts reduced earnings estimates for banks.

If the KLCI’s PE of 12x represents the 10-year-through, of which effectively keep KLCI year-end index at around 1,200 level, perhaps we may be little bit of too confident of ourselves in riding through this storm.

Billionaire investor Eli Broad said the U.S. economy is in the ``worst period'' of his adult life as a housing market recovery remains ``several years'' away. ``This is worse than any recession we've had since World War II,'' Broad, 75, said in an interview recently.

The problem is most people don’t believe prices have bottomed out as consumer confidence and home sales ebb. Redemption fears are mounting, as political newsflow momentum continue to be in the state of flux, on top of runaway inflation and knock-on impact on windfall taxes. At an average of RM1.1bn in the last two weeks, the market’s average trading volume is collapsing to a 5-year low. The rise of more than 100bps of the benchmark 10-year MGS in the past month has historically not been a favourable backdrop for the equity.

The mid-term review of 9^th Malaysia Plan also failed to provide much excitement to markets. Until March 2008, gross development spending of RM81.6bn represented 40.8% of the original RM200bn 9^th MP allocation.

The best strategy now is to ‘STAY INDOORS’. Hold cash, and lock-in with commodity-related foreign currency deposits. Potential bottom fishing opportunities only if the index is down below 1,050 and that only because the KLCI is supported by gross dividend yield of 5%. I like the cash-rich large caps with desire to raise the dividend payouts taking advantage of a single-tiered tax system, ideally backed by share buybacks. Forget about the small-mid caps as the valuations continue to be depressed at single-digit prospective PS multiples, even though the small-mid cap index has fallen almost 23% from its peak.

Sector wise, I stay overweight on no-brainer consumer, REITs, steel, oil & gas and plantation. At the same time, I begin to warm up on gaming, partly because of steep drop in the share prices and partly on hope that the coming budget will not raise duties on it.