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.