Stock prices will remain depress as long as deflationary threats linger. Oil prices fell from peak of US$140/barrel in mid 2008 to a recent low of US$36/barrel. If deflation lingers, it means falling corporate cashflow, falling wages, delay in consumption and debt default.
One way to track this is looking at behaviour of treasury inflation protected securities (TIPS). If we look at the yield differences between Treasuries and TIPS as an indicator, we note the implied deflation rates quite strongly in a year ahead, but it gradually eases off as we move ahead in times and ultimately the inflationary forces will start to kick on in year 2015. Any material change in this view of deflation would reduce the risk of holding equities and produce a significant rally. We would notice that when TIPS were rising, the S&P rebounded quite strongly in October 2002, suggesting that the subsidizing threat of deflation is a key driver for any rally in an equity bear market.
Another indicator to watch is the copper prices, which I find quite useful in confirming the bottom for equities in the two near deflationary recession of 1982 and 2002. This relationship can be traced back since at least 1921. The copper prices bottomed in October 2001 and this coincided with the bottom of the business cycle as proclaimed by the National Bureau of Economic Research (NBER). In an almost instantaneous reaction, the stock market leaded the economic recovery and even the earnings recovery.
With greater commitment to quantitative easing, I find it rather difficult to expect more debt deflation going forward. Also, I would argue that deposit insurance will reduce the risk of losing faith in the banking system. Unlike the collapse of the US banking system in 1929-32, depositors withdrew funds and this time around, I don’t see that being the feature of the 2008 crisis. The combination of the liquidity loop and the explicit guarantee of money market funds along with the existing deposit insurance guarantees, this has significantly reduce the prospect of banks run today compared to 1929-32.
There is evidence that more unorthodox approach is being deployed and the rapid expansion in the Fed’s balance sheet since the third week of September 2008, will provide a good base for current crisis.
To those investors that subscribing to this views, you may want to prepare to buy equities today, given that deflation is much less likely that markets believe. Recent stability seen in prices of TIPS, and copper is an encouraging sign that it may be turning positive in the near future, perhaps.
Wednesday, December 31, 2008
Monday, December 29, 2008
RMB - On a Secular Appreciation Path
Over the last five weeks, I have been constantly bombarded with questions on China’s currency. About a year ago, I wrote a piece on Renminbi (RMB) outlook for one government agency and I argued that the currency is on a secular strengthening mode, pretty much like Japanese Yen after the Plaza Accord. However, with the recent global volatility, equity burst, contraction in property market in China and more importantly rising dependency on exports, some of my loyal clients to a great extent, have been persuaded not to subscribe to my earlier view.
For once and all, I still maintain my view that RMB is on a secular appreciation path, and the recent sell-down in the currency is not only a trading, but a great opportunity to build for a long term position in China.
Let us be very clear here – Firstly, what we are seeing today in China is a recession in demand and not peer competition that is creating a pressure on exports. Secondly, China is very unlikely to go into recession and my worst case projects above 6% for 2009. Thirdly, I put my bigger bet on the effectiveness of China’s fiscal policy in cushioning the global shock compared to a lot of economies that I monitored. China enjoys plenty of fiscal flexibility as both government and households maintain a high saving rate. Fourthly, RMB is not fundamentally overvalued even if I assumed the trade surplus to ease by 20% from current level in 2009.
Devaluing RMB will be a no-no for assets and market confidence. Risk of domestic capital flight can materialize, hence complicating monetary expansion, which has been partially a reflection on expectation of RMB appreciation. The competitive devaluation will invite trade retaliation from the US and EU as well as major emerging economies, which in turn will intensify pains to already shrinking global market. It also defeats and nullifies all efforts by the Chinese government in the last decade in areas of financial, economic and diplomacy coordination.
The latest CCCP annual economic meeting on 10 December has reiterated that the view to ‘keep RMB basic stable at fundamentally justified equilibrium level, improve balance of payment’ and on 14 December, the state council’s financial statement called for ‘proceeding in proactive, incremental and controlled mode; further improve RMB exchange rate regime, increase flexibility ..’
The government set 15-17% yoy M2 growth, RMB4 trillion new lending for 2009 and a stable exchange rate to reflect government’s strong commitment of clear re-flationary intent.
For once and all, I still maintain my view that RMB is on a secular appreciation path, and the recent sell-down in the currency is not only a trading, but a great opportunity to build for a long term position in China.
Let us be very clear here – Firstly, what we are seeing today in China is a recession in demand and not peer competition that is creating a pressure on exports. Secondly, China is very unlikely to go into recession and my worst case projects above 6% for 2009. Thirdly, I put my bigger bet on the effectiveness of China’s fiscal policy in cushioning the global shock compared to a lot of economies that I monitored. China enjoys plenty of fiscal flexibility as both government and households maintain a high saving rate. Fourthly, RMB is not fundamentally overvalued even if I assumed the trade surplus to ease by 20% from current level in 2009.
Devaluing RMB will be a no-no for assets and market confidence. Risk of domestic capital flight can materialize, hence complicating monetary expansion, which has been partially a reflection on expectation of RMB appreciation. The competitive devaluation will invite trade retaliation from the US and EU as well as major emerging economies, which in turn will intensify pains to already shrinking global market. It also defeats and nullifies all efforts by the Chinese government in the last decade in areas of financial, economic and diplomacy coordination.
The latest CCCP annual economic meeting on 10 December has reiterated that the view to ‘keep RMB basic stable at fundamentally justified equilibrium level, improve balance of payment’ and on 14 December, the state council’s financial statement called for ‘proceeding in proactive, incremental and controlled mode; further improve RMB exchange rate regime, increase flexibility ..’
The government set 15-17% yoy M2 growth, RMB4 trillion new lending for 2009 and a stable exchange rate to reflect government’s strong commitment of clear re-flationary intent.
Friday, December 26, 2008
10 Uneasy Questions about Asia
Here are 10 questions for Asia that seem critical to the future of the most dynamic retion in the world:-
Q1. India and China are rising fast, but what are the big ideas they stand for? China has given up communism and India has given up its cold-war dalliance and is between now market and socialism.
Q2. Can India be used by the United States to contain China? This is fashionable belief but one cannot ignore the fact that America has an overwhelming military cooperation with India, but we cannot also ignore the fact that China is now India’s second-largest trading partner behind the US. Pragmatism can overwhelm ideology.
Q3. If India is not the answer to China, how about Japan? Japan now resembles Britain, an island off the coast of a continent, viewed as closer to Washington than to its neighbors. Japan, however is paying a heavy diplomatic price, worsening Chinese-Japanese relations.
Q4. What about Japanese past? We have seen riots erupted in China, South Korea and Taiwan fueled by fury at Japanese attempts to gloss over the savagery that marked Japanese’s occupations of the countries. Japan has not achieved Germany’s reconciliation with its neighbors.
Q5. Can China keep the lid on things? Pressure is growing on the system – from the widening gap between rich and poor, from the poison in the air spread by uncontrolled industries and from the friction of a quasi-free economic system meeting a closed political system bent on control. The Beijing Olympics 2008 and the Shanghai Expo of 2010 provide huge incentives for stability.
Q6. Will China deliver on North Korea? Chinese is committed to a successful outcome, but they don’t like American arms sales to Taiwan, American lectures on democracy and American threats of trade sanctions.
Q7. Are China’s choices of a market economy and the presence of US forces enough to keep the peace in Asia? The Chinese market economy spreads prosperity, multiplies ties and creates huge peace incentives. The American troops offset regional rivalries but Asia needs to become more of a community and less a mere accumulation of booming states.
Q8. Can China and the US deepen their ties? Current signs are not encouraging, but the need is over-whelming.
Q9. Can Indonesia be Asia’s Turkey – an example to the world of a democratic Muslim country where Islamic radicalism is marginalized? Yes, if US heavy-handedness is avoided and the inevitable emergence of moderate Islamic parties is encouraged. America must coax rather than lecture.
Q10. Are Australia and New Zealand part of Asia? Inclusiveness is in Asia’s interest. As Europe has realized, when we create broad institutions, the possibilities for absorbing nationalist tensions multiply.
Q1. India and China are rising fast, but what are the big ideas they stand for? China has given up communism and India has given up its cold-war dalliance and is between now market and socialism.
Q2. Can India be used by the United States to contain China? This is fashionable belief but one cannot ignore the fact that America has an overwhelming military cooperation with India, but we cannot also ignore the fact that China is now India’s second-largest trading partner behind the US. Pragmatism can overwhelm ideology.
Q3. If India is not the answer to China, how about Japan? Japan now resembles Britain, an island off the coast of a continent, viewed as closer to Washington than to its neighbors. Japan, however is paying a heavy diplomatic price, worsening Chinese-Japanese relations.
Q4. What about Japanese past? We have seen riots erupted in China, South Korea and Taiwan fueled by fury at Japanese attempts to gloss over the savagery that marked Japanese’s occupations of the countries. Japan has not achieved Germany’s reconciliation with its neighbors.
Q5. Can China keep the lid on things? Pressure is growing on the system – from the widening gap between rich and poor, from the poison in the air spread by uncontrolled industries and from the friction of a quasi-free economic system meeting a closed political system bent on control. The Beijing Olympics 2008 and the Shanghai Expo of 2010 provide huge incentives for stability.
Q6. Will China deliver on North Korea? Chinese is committed to a successful outcome, but they don’t like American arms sales to Taiwan, American lectures on democracy and American threats of trade sanctions.
Q7. Are China’s choices of a market economy and the presence of US forces enough to keep the peace in Asia? The Chinese market economy spreads prosperity, multiplies ties and creates huge peace incentives. The American troops offset regional rivalries but Asia needs to become more of a community and less a mere accumulation of booming states.
Q8. Can China and the US deepen their ties? Current signs are not encouraging, but the need is over-whelming.
Q9. Can Indonesia be Asia’s Turkey – an example to the world of a democratic Muslim country where Islamic radicalism is marginalized? Yes, if US heavy-handedness is avoided and the inevitable emergence of moderate Islamic parties is encouraged. America must coax rather than lecture.
Q10. Are Australia and New Zealand part of Asia? Inclusiveness is in Asia’s interest. As Europe has realized, when we create broad institutions, the possibilities for absorbing nationalist tensions multiply.
Thursday, December 25, 2008
FX Forecast - A Beauty and The Beast
I like Yen and fear about the sustainability of the EUR. So far, the US is doing the right things to combat deflation whereas European policy remain active – not cutting rates enough and not easing fiscal policy aggressively.
I think the Euro as a concept will come under tremendous pressure in 2009. Economic growth and productivity misalignment among members will becoming more visible and there are estimates that countries like Spain and Ireland may need 20-30% fall in wages relative to elsewhere in Europe, owing to an overvalued real exchange rate. There is considerable excess leverage differences among member countries and now will these countries be willing to deflate to restore competitiveness, hence an equilibrium in their external accounts with the potential of a severe recession. It is very likely that this will not be the preferred option and most likely they will choose to spend their way out of this.
On the other hand, Germany is likely to fare worse than the Eurozone in 2009 due to its higher exposure to cyclical industrial export demand compared to its peers. Support of German internal demand via fiscal stimulus is only possible solution in the medium term. Plunging business surveys paint a bleak picture going forward.
As a result, bond spreads will rise on the back of fiscal reflation, in turn could have a very large contraction in domestic demand and potentially to the sustainability of the common currency.
By default, the Yen looks to be the strongest currency. Consumers, corporates and banks have de-leveraged for nearly a decade and with its high gross saving of 27% of GDP, it makes Yen not that expensive relative to its norm.
In short, market will eventually realize that Europe cannot live with Euro strength and the divergence of strengths in favour of UK may force the Euro possibly to parity level, if not slightly above the parity in late 2009.
I think the Euro as a concept will come under tremendous pressure in 2009. Economic growth and productivity misalignment among members will becoming more visible and there are estimates that countries like Spain and Ireland may need 20-30% fall in wages relative to elsewhere in Europe, owing to an overvalued real exchange rate. There is considerable excess leverage differences among member countries and now will these countries be willing to deflate to restore competitiveness, hence an equilibrium in their external accounts with the potential of a severe recession. It is very likely that this will not be the preferred option and most likely they will choose to spend their way out of this.
On the other hand, Germany is likely to fare worse than the Eurozone in 2009 due to its higher exposure to cyclical industrial export demand compared to its peers. Support of German internal demand via fiscal stimulus is only possible solution in the medium term. Plunging business surveys paint a bleak picture going forward.
As a result, bond spreads will rise on the back of fiscal reflation, in turn could have a very large contraction in domestic demand and potentially to the sustainability of the common currency.
By default, the Yen looks to be the strongest currency. Consumers, corporates and banks have de-leveraged for nearly a decade and with its high gross saving of 27% of GDP, it makes Yen not that expensive relative to its norm.
In short, market will eventually realize that Europe cannot live with Euro strength and the divergence of strengths in favour of UK may force the Euro possibly to parity level, if not slightly above the parity in late 2009.
Tuesday, December 23, 2008
A Brief Outline for FEER Framework
When I was at Osaka three weeks, I was asked by couple of fund managers and academic about my evaluation of the equilibrium value of the various Asian currencies.
Here I wish to share the brief outline of the framework behind my Fundamental Equilibrium Real Exchange Rate (FEER), defined as the rate consistent with the economy operating at potential output while at the same time registering a sustainable current account balance. In essence, the underlying current account balance is arrived when the determinant variables are calibrated to values congruent with internal balance. My framework is very much based on the direct estimation method of Clark and McDonald (1998) but calibrated in the conventional FEER manner as in Williamson (1985).
In short, the final reduced form equation is as follow:
FEER = f (yd/yf, TOT, TNT, RIR, NFAR)
where:
yd/yf : relative domestic to foreign output ratio
TOT : terms of trade
TNT : relative ratio of tradable to non-tradable prices
RIR : real interest rate differential between asian-USD assets
NFAR : net foreign asset to nominal GDP
I include a real interest rate differential in order to assess the effects of a shorter-term fundamental determinant to exchange rates and a dummy variable for the effects of exchange controls imposed. Co-integration methods were used to estimate the final model with inclusion for the Phillips-Hansen Fully Modified estimation that allows estimates and standard errors to be derived free from the distortion due to nuisance parameters through a semi-parametric adjustment for serial correlation of innovations and endogeneity of the variables, which is suitable for the relatively small sample size.
Table 1 shows the final model estimation results with relevant diagnostic and it is interesting to note the significant findings on the relative productivity differential and terms of trade variables, which suggest the information contribution of these variables above what is contained in relative output levels. It is shown that exchange control dummy variable was significant and having an opposite sign to relative real interest rates indicating the effects of the capital restrictions in muting the response of capital flows to interest rate differentials after the imposition of the controls.
Table 1: Summary of Results
Variable Coefficient Standard-Error
Constant 2.908 0.892
yd/yf -0.301 0.066
TOT 0.614 0.003
TNT -0.201 0.004
RIR 0.158 0.003
NFAR -0.153 0.005
Capital Control
Dummy -0.201 0.054
Overall F-Test 290.8 9c.v. = 2.5@99% significance level
Here I wish to share the brief outline of the framework behind my Fundamental Equilibrium Real Exchange Rate (FEER), defined as the rate consistent with the economy operating at potential output while at the same time registering a sustainable current account balance. In essence, the underlying current account balance is arrived when the determinant variables are calibrated to values congruent with internal balance. My framework is very much based on the direct estimation method of Clark and McDonald (1998) but calibrated in the conventional FEER manner as in Williamson (1985).
In short, the final reduced form equation is as follow:
FEER = f (yd/yf, TOT, TNT, RIR, NFAR)
where:
yd/yf : relative domestic to foreign output ratio
TOT : terms of trade
TNT : relative ratio of tradable to non-tradable prices
RIR : real interest rate differential between asian-USD assets
NFAR : net foreign asset to nominal GDP
I include a real interest rate differential in order to assess the effects of a shorter-term fundamental determinant to exchange rates and a dummy variable for the effects of exchange controls imposed. Co-integration methods were used to estimate the final model with inclusion for the Phillips-Hansen Fully Modified estimation that allows estimates and standard errors to be derived free from the distortion due to nuisance parameters through a semi-parametric adjustment for serial correlation of innovations and endogeneity of the variables, which is suitable for the relatively small sample size.
Table 1 shows the final model estimation results with relevant diagnostic and it is interesting to note the significant findings on the relative productivity differential and terms of trade variables, which suggest the information contribution of these variables above what is contained in relative output levels. It is shown that exchange control dummy variable was significant and having an opposite sign to relative real interest rates indicating the effects of the capital restrictions in muting the response of capital flows to interest rate differentials after the imposition of the controls.
Table 1: Summary of Results
Variable Coefficient Standard-Error
Constant 2.908 0.892
yd/yf -0.301 0.066
TOT 0.614 0.003
TNT -0.201 0.004
RIR 0.158 0.003
NFAR -0.153 0.005
Capital Control
Dummy -0.201 0.054
Overall F-Test 290.8 9c.v. = 2.5@99% significance level
Monday, December 22, 2008
The Great Depression Headlines
When you read the quotes below you will notice something eerily similar to today. I wonder how today's group of meddlers are repeating history, both in policy and outrageous statements.
September 1929 - "There is no cause to worry. The high tide of prosperity will continue."- Andrew W. Mellon, Secretary of the Treasury.
October 14, 1929 - "Secretary Lamont and officials of the Commerce Department today denied rumors that a severe depression in business and industrial activity was impending, which had been based on a mistaken interpretation of a review of industrial and credit conditions issued earlier in the day by the Federal Reserve Board."- New York Times
December 5, 1929 - "The Government's business is in sound condition."- Andrew W. Mellon, Secretary of the Treasury
December 28, 1929 - "Maintenance of a general high level of business in the United States during December was reviewed today by Robert P. Lamont, Secretary of Commerce, as an indication that American industry had reached a point where a break in New York stock prices does not necessarily mean a national depression."- Associated Press dispatch.
January 13, 1930 - "Reports to the Department of Commerce indicate that business is in a satisfactory condition, Secretary Lamont said today."- News item.
January 21, 1930 - "Definite signs that business and industry have turned the corner from the temporary period of emergency that followed deflation of the speculative market were seen today by President Hoover. The President said the reports to the Cabinet showed the tide of employment had changed in the right direction."- News dispatch from Washington.
March 8, 1930 - "President Hoover predicted today that the worst effect of the crash upon unemployment will have been passed during the next sixty days."- Washington dispatch.
May 1, 1930 - "While the crash only took place six months ago, I am convinced we have now passed the worst and with continued unity of effort we shall rapidly recover. There is one certainty of the future of a people of the resources, intelligence and character of the people of the United States - that is, prosperity."- President Hoover
June 29, 1930 - "The worst is over without a doubt."- James J. Davis, Secretary of Labor.
September 12, 1930 - "We have hit bottom and are on the upswing."- James J. Davis, Secretary of Labor.
October 21, 1930 - "President Hoover has summoned Colonel Arthur Woods to help place 2,500,000 persons back to work this winter."- Washington dispatch.
November 1930 - "I see no reason why 1931 should not be an extremely good year."- Alfred P. Sloan, Jr., General Motors Co.
June 9, 1931 - "The depression has ended."- Dr. Julius Klein, Assistant Secretary of Commerce.
August 12, 1931 - "Henry Ford has shut down his Detroit automobile factories almost completely. At least 75,000 men have been thrown out of work."- The Nation.
July 21, 1932 - "I believe July 8, 1932 was the end of the great bear market."- Dow Theorist, Robert Rhea.
September 1929 - "There is no cause to worry. The high tide of prosperity will continue."- Andrew W. Mellon, Secretary of the Treasury.
October 14, 1929 - "Secretary Lamont and officials of the Commerce Department today denied rumors that a severe depression in business and industrial activity was impending, which had been based on a mistaken interpretation of a review of industrial and credit conditions issued earlier in the day by the Federal Reserve Board."- New York Times
December 5, 1929 - "The Government's business is in sound condition."- Andrew W. Mellon, Secretary of the Treasury
December 28, 1929 - "Maintenance of a general high level of business in the United States during December was reviewed today by Robert P. Lamont, Secretary of Commerce, as an indication that American industry had reached a point where a break in New York stock prices does not necessarily mean a national depression."- Associated Press dispatch.
January 13, 1930 - "Reports to the Department of Commerce indicate that business is in a satisfactory condition, Secretary Lamont said today."- News item.
January 21, 1930 - "Definite signs that business and industry have turned the corner from the temporary period of emergency that followed deflation of the speculative market were seen today by President Hoover. The President said the reports to the Cabinet showed the tide of employment had changed in the right direction."- News dispatch from Washington.
March 8, 1930 - "President Hoover predicted today that the worst effect of the crash upon unemployment will have been passed during the next sixty days."- Washington dispatch.
May 1, 1930 - "While the crash only took place six months ago, I am convinced we have now passed the worst and with continued unity of effort we shall rapidly recover. There is one certainty of the future of a people of the resources, intelligence and character of the people of the United States - that is, prosperity."- President Hoover
June 29, 1930 - "The worst is over without a doubt."- James J. Davis, Secretary of Labor.
September 12, 1930 - "We have hit bottom and are on the upswing."- James J. Davis, Secretary of Labor.
October 21, 1930 - "President Hoover has summoned Colonel Arthur Woods to help place 2,500,000 persons back to work this winter."- Washington dispatch.
November 1930 - "I see no reason why 1931 should not be an extremely good year."- Alfred P. Sloan, Jr., General Motors Co.
June 9, 1931 - "The depression has ended."- Dr. Julius Klein, Assistant Secretary of Commerce.
August 12, 1931 - "Henry Ford has shut down his Detroit automobile factories almost completely. At least 75,000 men have been thrown out of work."- The Nation.
July 21, 1932 - "I believe July 8, 1932 was the end of the great bear market."- Dow Theorist, Robert Rhea.
Sunday, December 21, 2008
Quantitative Easing
Quantitative easing is becoming a common term from now onwards, especially markets begin to realize the limitation of central banks in lowering interest rates. This is very much seen as unconventional policy measures, which rather than encouraging but forcing changes in market prices and volume.
In short, quantitative easing can be seen either in terms of supplying an even greater ‘quantity’ of money that would be required to keep the overnight rate at o% or in terms of targeting interest rates further out the maturity spectrum. Beyond that we already see the widening collateral eligibility, unlimited US dollar funding and ways in which liquidity is injected. In fact, Bank of England went beyond this by establishing the Special Liquidity Scheme, which allows banks to swap MBS for US Treasury bills, renewable for up to three years.
In 2001-05 experience, Japan had a specific target for the quantity of excess bank reserves as part of its attempt to convince market players that it would hold short rates at zero for as long as necessary to bring the economy out of deflation. The main instrument to inject liquidity was the purchase of commercial bills on repo basis, rather than outright purchase of long-term JGBs. Of the 48 trillion yen increase in monetary base between Mar01 to end 2005, the commercial bill repo accounted for almost 71%.
In recent experience, we have seen much more variance of quantitative easing, including a sharp expansion of the central banks’ balance sheet as private sector financing mechanism are replaced, possibly that with a non-standard approach to the financing of the government debt and an exchange of assets such as the quality of the central banks’ balance sheet deteriorates. At some point, the distinction between fiscal and monetary policies can become blurred.
Under this circumstance, the government’s intervention may become a stronger influence on the shape of the yield curve than private sector flows and that potentially will break the curve from its normal relationship with the level of short rates. Recognizing that the same effect will force a change in duration and convexity hedging strategies as traditional relationships break down.
Within FX itself, it could undermine carry and real interest rate spreads are becoming more important. It forces players to focus on relative changes of base money as well as the sustainability of financing flows. As we are experiencing greater quantitative easing, currencies with a record of protecting against inflation as well as those with a low level of combined public/private debt will be the preferred ones.
In short, quantitative easing can be seen either in terms of supplying an even greater ‘quantity’ of money that would be required to keep the overnight rate at o% or in terms of targeting interest rates further out the maturity spectrum. Beyond that we already see the widening collateral eligibility, unlimited US dollar funding and ways in which liquidity is injected. In fact, Bank of England went beyond this by establishing the Special Liquidity Scheme, which allows banks to swap MBS for US Treasury bills, renewable for up to three years.
In 2001-05 experience, Japan had a specific target for the quantity of excess bank reserves as part of its attempt to convince market players that it would hold short rates at zero for as long as necessary to bring the economy out of deflation. The main instrument to inject liquidity was the purchase of commercial bills on repo basis, rather than outright purchase of long-term JGBs. Of the 48 trillion yen increase in monetary base between Mar01 to end 2005, the commercial bill repo accounted for almost 71%.
In recent experience, we have seen much more variance of quantitative easing, including a sharp expansion of the central banks’ balance sheet as private sector financing mechanism are replaced, possibly that with a non-standard approach to the financing of the government debt and an exchange of assets such as the quality of the central banks’ balance sheet deteriorates. At some point, the distinction between fiscal and monetary policies can become blurred.
Under this circumstance, the government’s intervention may become a stronger influence on the shape of the yield curve than private sector flows and that potentially will break the curve from its normal relationship with the level of short rates. Recognizing that the same effect will force a change in duration and convexity hedging strategies as traditional relationships break down.
Within FX itself, it could undermine carry and real interest rate spreads are becoming more important. It forces players to focus on relative changes of base money as well as the sustainability of financing flows. As we are experiencing greater quantitative easing, currencies with a record of protecting against inflation as well as those with a low level of combined public/private debt will be the preferred ones.
Saturday, December 20, 2008
2009 Macro and Market Outlook
This past year was rough on most investment portfolios. Many are worth a lot less on paper than they were in 2007. But there are always ways to turn those lemons into lemonade in 2009.
Just in third quarter alone, US households lost US$647 billion in real estate, US$922 billion in stocks, US$523 billion in mutual funds, US$653 billion in life insurance and pension fund reserves, plus US$128 billion in private business interests. Total destruction of household wealth in the review quarter – US$2.8 trillion – the worst in recorded history. This compared to the government’s entire US$700 billion bailout package (TARP).
Now I sense that the USD index has probably peaked for the year. The temporary support provided by the global de-leveraging process appears to be fading, and the onset of quantitative easing in the United States should prove to be inconsistent with a strengthening currency. I note that the recent advance of the USD rests on a weak foundation. As sources of support – shortage of USD liquidity abroad and a bid created by the de-leveraging process appear to be fading.
With credit markets showing signs of improvement and some stability developing in equity market, risk appetite appears unlikely to deteriorate in the near future. However, the upcoming GDP releases will likely highlight how the global slowdown is clearly seeping into reduced output with a varying degree on the depth of the slide and timing of various recoveries.
I believe that US Fed Reserve is committed to lower fed funds rate for a significant durations and has strong intention to engage in quantitative easing to keep the Fed balance sheet at a high level. Credit market and economic improvement, currently clogged, are likely to be necessary conditions for an end to quantitative easing. Growing fiscal deficits will lead to an increase in government debt and at some stage, it will make harder for monetary policymakers to contain inflation. It remains a challenge for the US to attract external financing for its domestic spending with all the accompanying risks this may hold for the long term value of the US dollar.
On the Eurozone, my view is that there is no end to the bad news and expect the ECB to cut rates further. The bad news will not be appropriated across the zone given the major discrepancies in economic health among the members. One potential conflict is the direction of unit labour costs, which have taken very different paths within Eurozone countries in recent years. Germany increased its competitiveness by reducing unit labour costs, while at the other extreme Italy has lost much competitive ground.
Malaysia-specific, choppy waters for financial market will continue and I recommend a cautiously optimistic investment stance. Commodities, which reversed course since July 2008, have fallen more than 30% in USD terms and this trend is likely to continue into first 4-5 months of the year with a likelihood of a pick-up thereafter. Inventories are likely to be cleared with support from USD depreciation. Supply cutbacks will be meaningful then and enough to slow the build up in inventories. It would not be a surprise to me if the crude oil prices to again re-test the USD$85/barrel toward the end of 2009 with the marginal production cost of unconventional crude oil hover around US$70-75/barrel along with production cut by OPEC.
I am a firm believer in stocks for the long run – but only if purchased at the right price. One of my favourite valuation methods – ‘Q’ ratio that measure relativity of the value of the stock market to the replacement cost of net assets. If the ‘Q’ ratio is above 1.0, then the market is valuing a company at more that it costs to reproduce it – then stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap as they can be bought in the open market.
Today’s KLCI ‘Q’ ratio is almost never been lower and certainly not since 1997/98 financial crisis, implying quite a degree of undervaluation. My calculation suggests a value of 0.86 as at November 2008 compared to 1.34 a year ago, implying a decline of almost 56% year-to-date.
Another long-term standard of valuation comes from P/E ratio, which shows the same relatively undervaluation. It shows that KLCI is trading at two standard deviation band of last 20 years.
One, however, should be careful in interpreting these results because the underlying assumptions are that the market is mean reverting and as long as capitalism is a going concern. The famous J.M. Keynes pointed out that John Maynard Keynes famously warned that ‘the market can remain irrational longer than you can remain solvent’. In times such as these, and as markets are still cycling between greed and fear following a long and costly plunge, there is no question that tough challenges are ahead even I take a quite optimistic view on political situation in the country.
Sector wise I like banks, plantations, oil & gas, gaming, property, utilities and to some extent, media and consumer. I am cautious with export-oriented manufacturing, automotive, REITs, timber, conglomerates, technology and non-bank financial institutions.
Just in third quarter alone, US households lost US$647 billion in real estate, US$922 billion in stocks, US$523 billion in mutual funds, US$653 billion in life insurance and pension fund reserves, plus US$128 billion in private business interests. Total destruction of household wealth in the review quarter – US$2.8 trillion – the worst in recorded history. This compared to the government’s entire US$700 billion bailout package (TARP).
Now I sense that the USD index has probably peaked for the year. The temporary support provided by the global de-leveraging process appears to be fading, and the onset of quantitative easing in the United States should prove to be inconsistent with a strengthening currency. I note that the recent advance of the USD rests on a weak foundation. As sources of support – shortage of USD liquidity abroad and a bid created by the de-leveraging process appear to be fading.
With credit markets showing signs of improvement and some stability developing in equity market, risk appetite appears unlikely to deteriorate in the near future. However, the upcoming GDP releases will likely highlight how the global slowdown is clearly seeping into reduced output with a varying degree on the depth of the slide and timing of various recoveries.
I believe that US Fed Reserve is committed to lower fed funds rate for a significant durations and has strong intention to engage in quantitative easing to keep the Fed balance sheet at a high level. Credit market and economic improvement, currently clogged, are likely to be necessary conditions for an end to quantitative easing. Growing fiscal deficits will lead to an increase in government debt and at some stage, it will make harder for monetary policymakers to contain inflation. It remains a challenge for the US to attract external financing for its domestic spending with all the accompanying risks this may hold for the long term value of the US dollar.
On the Eurozone, my view is that there is no end to the bad news and expect the ECB to cut rates further. The bad news will not be appropriated across the zone given the major discrepancies in economic health among the members. One potential conflict is the direction of unit labour costs, which have taken very different paths within Eurozone countries in recent years. Germany increased its competitiveness by reducing unit labour costs, while at the other extreme Italy has lost much competitive ground.
Malaysia-specific, choppy waters for financial market will continue and I recommend a cautiously optimistic investment stance. Commodities, which reversed course since July 2008, have fallen more than 30% in USD terms and this trend is likely to continue into first 4-5 months of the year with a likelihood of a pick-up thereafter. Inventories are likely to be cleared with support from USD depreciation. Supply cutbacks will be meaningful then and enough to slow the build up in inventories. It would not be a surprise to me if the crude oil prices to again re-test the USD$85/barrel toward the end of 2009 with the marginal production cost of unconventional crude oil hover around US$70-75/barrel along with production cut by OPEC.
I am a firm believer in stocks for the long run – but only if purchased at the right price. One of my favourite valuation methods – ‘Q’ ratio that measure relativity of the value of the stock market to the replacement cost of net assets. If the ‘Q’ ratio is above 1.0, then the market is valuing a company at more that it costs to reproduce it – then stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap as they can be bought in the open market.
Today’s KLCI ‘Q’ ratio is almost never been lower and certainly not since 1997/98 financial crisis, implying quite a degree of undervaluation. My calculation suggests a value of 0.86 as at November 2008 compared to 1.34 a year ago, implying a decline of almost 56% year-to-date.
Another long-term standard of valuation comes from P/E ratio, which shows the same relatively undervaluation. It shows that KLCI is trading at two standard deviation band of last 20 years.
One, however, should be careful in interpreting these results because the underlying assumptions are that the market is mean reverting and as long as capitalism is a going concern. The famous J.M. Keynes pointed out that John Maynard Keynes famously warned that ‘the market can remain irrational longer than you can remain solvent’. In times such as these, and as markets are still cycling between greed and fear following a long and costly plunge, there is no question that tough challenges are ahead even I take a quite optimistic view on political situation in the country.
Sector wise I like banks, plantations, oil & gas, gaming, property, utilities and to some extent, media and consumer. I am cautious with export-oriented manufacturing, automotive, REITs, timber, conglomerates, technology and non-bank financial institutions.
Thursday, December 18, 2008
Spells in Banglore
My view is that the deadly terrorist attacks at Mumbai’s financial district are not the main cause for the struggling Indian economy. Even before it, the economy was already struggling when the real GDP was expanding at 7.6% in the 3Q – the slowest pace in four years and was well below the 9% growth average for the last three years.
The Reserve Bank of India has been aggressively cutting rates to keep its economy on track and much like our politicians, the government is embarking on a stimulus-seeking spending spree, suggesting that India shares our same slowdown worries.
Mumbai may be India’s financial centre, but the lucrative high technology centre is in Bangalore. It has become the Silicon Valley of India being the back office of the world, handling customer service calls, process payments and writing the code that runs much of global corporate’s software. The global slowdown has already being reflected in reducing hiring, freezing salaries, postponing new investments and laying off thousands of programmers and call centre operators.
Infosys – India’s second largest software services exporters gets two-thirds of its business from the US. One-half of that is from financial corporates like Citigroup and Bank of America. It is recently scaled back its earnings projections for the year and that’s way below the 30% growth of recent years. Satyam Computer – India's fourth largest exporter is cutting its 2009 recruitment plans from 15,000 to 10,000 and has suspended travel for all but the most critical needs.
Interestingly to note also because of changes in the IT world, the arranged marriage trend also changed accordingly. According to a matchmaker friend of mine in Bangalore, bridges’ families are not accepting grooms from this background because there are no job guarantees for IT people. This happens for the last six months.
The Reserve Bank of India has been aggressively cutting rates to keep its economy on track and much like our politicians, the government is embarking on a stimulus-seeking spending spree, suggesting that India shares our same slowdown worries.
Mumbai may be India’s financial centre, but the lucrative high technology centre is in Bangalore. It has become the Silicon Valley of India being the back office of the world, handling customer service calls, process payments and writing the code that runs much of global corporate’s software. The global slowdown has already being reflected in reducing hiring, freezing salaries, postponing new investments and laying off thousands of programmers and call centre operators.
Infosys – India’s second largest software services exporters gets two-thirds of its business from the US. One-half of that is from financial corporates like Citigroup and Bank of America. It is recently scaled back its earnings projections for the year and that’s way below the 30% growth of recent years. Satyam Computer – India's fourth largest exporter is cutting its 2009 recruitment plans from 15,000 to 10,000 and has suspended travel for all but the most critical needs.
Interestingly to note also because of changes in the IT world, the arranged marriage trend also changed accordingly. According to a matchmaker friend of mine in Bangalore, bridges’ families are not accepting grooms from this background because there are no job guarantees for IT people. This happens for the last six months.
Tuesday, December 16, 2008
Comparing Last Two US Recessions
Key Statistics for the Last Two Recessions
Leading into the 2001 recession, the US dollar was very strong. Commodity prices had suffered a multi-year deflation and CPI inflation was falling to very low levels. Is this helps to refresh some recent memories?
In sharp contrast, the 1990-914 recession came preceded by a relatively weak US dollar and rising inflation.
In terms of government policies, the two recessions were almost opposites. The government cut tax rates during and following the 2001 recession, whereas it raised rates substantially in 1990, partly can be explained that the recession started just two months after the presidential term began and ended 36 months before the next presidential election. The Fed only cut rate in January 2001, months before the official beginning of the recession.
In contrast, the 1990-91 recession occurred in the second-half of the presidential term and ended 20 months before the November 1992 election.
Weakness in business investment spending was clearly the prominent factor behind the 2001 recession, while weak consumption spending and residential investment played their usual important roles in the 1990-91 recession.
It would not be too surprising if I think that the 2001 recession will be a less important factor than the 1990-91 recession in the context of our current predicaments.
Key Statistics for the Last Two Recessions
Moral Hazard & Systemic Risk
Either it is intended or unintended consequence, as early as the intervention in Bear Stearns, now it has created an expectation as market participants are expecting a government bailout as it fails under current market forces. Lehman Brothers was able to maintain short-term borrowings, and the series of bail-out including Citigroup, hence the over-concentration of these borrowings in the Reserve Fund has led to its ‘breaking the buck’ and that may once again prompt unnecessary systemic panic in money markets.
The intervention may reduce the CDS spread, and it is not surprising given the role of the government in reducing risks faced by the creditors as well as equity holders, but the risks now are assumed by the government and the potential blow-out in government finances can be long term and systemic.
Short-term, the news may spark a rally in financials and the sustainability of this rally will depend on expectations that Fed policy will be easier for longer. Risk is that Fed is rapidly expanding its balance sheet in a form of quantitative easing without a good match from traditional Keynesian stimulus, which essentially will reduce the effectiveness in turning around the economy.
Without that part of the equation, the amount of excess reserves at the Fed will continue to rise and that will neutralize faster-than-expected earlier works to jump start the economy. Under normal circumstances, the amount of excess reserves at the Fed is roughly US$5-10bn, but last week the excess reserves were US$634bn and it would not be surprised if it hits above US$1.5trn and removal of these excesses could potentially take more than 5 months.
The massive amount of quantitative easing, while is not a major concern now, it is likely create periodic waves of concern over inflation in the market and would force players to take shelter at shorter duration for Treasury hedges. It may defeat the purpose in driving business investment intent towards longer tenure of Treasury and commercial papers. The underlying issues have not changed. So far, we are only seeing Fed err on the side of caution, add slightly to many reserves and merely renting its balance sheet space to other financial institutions while it continues to lose money (subsidizing) in a negative carry trade.
Fed should not assume that it has unlimited access to financing and capital raising ability.
The intervention may reduce the CDS spread, and it is not surprising given the role of the government in reducing risks faced by the creditors as well as equity holders, but the risks now are assumed by the government and the potential blow-out in government finances can be long term and systemic.
Short-term, the news may spark a rally in financials and the sustainability of this rally will depend on expectations that Fed policy will be easier for longer. Risk is that Fed is rapidly expanding its balance sheet in a form of quantitative easing without a good match from traditional Keynesian stimulus, which essentially will reduce the effectiveness in turning around the economy.
Without that part of the equation, the amount of excess reserves at the Fed will continue to rise and that will neutralize faster-than-expected earlier works to jump start the economy. Under normal circumstances, the amount of excess reserves at the Fed is roughly US$5-10bn, but last week the excess reserves were US$634bn and it would not be surprised if it hits above US$1.5trn and removal of these excesses could potentially take more than 5 months.
The massive amount of quantitative easing, while is not a major concern now, it is likely create periodic waves of concern over inflation in the market and would force players to take shelter at shorter duration for Treasury hedges. It may defeat the purpose in driving business investment intent towards longer tenure of Treasury and commercial papers. The underlying issues have not changed. So far, we are only seeing Fed err on the side of caution, add slightly to many reserves and merely renting its balance sheet space to other financial institutions while it continues to lose money (subsidizing) in a negative carry trade.
Fed should not assume that it has unlimited access to financing and capital raising ability.
Sunday, December 14, 2008
Gold – The Next Fever
I was with Mickey, Goofy, Mervin the magician and an Arab at Hong Kong Disneyland last week. This new friend oil rich of the Middle East as we talked, was telling me that his friends are buying gold hand over fist, and it turns out they’re not the only ones.
You know what? I think the best is yet to come for gold because the WORST is yet to come for the
Emerging markets are falling into a ditch,
Massive buying is seen in the
I would expect some overhead resistance of gold at US$900 an ounce and potentially could a rocket ride for the New Year, but the path will not be a straight line. Besides the yellow metal, I also like silver.
Thursday, December 11, 2008
Asian and Commodity Currencies Update
AUD/USD and NZD/USD did not crash despite the significantly larger rate cuts by their central banks. The Reserve Bank of
After these experiences, the market will probably not be so gung ho about shorting EUR/USD if ECB also surprises with a cut larger than expected.
There is one explanation why rate cuts are not hurting currencies. There is discomfort about buying the USD, because its yield is now too low to be attractive. Certainly not with talks of Fed quantitative easing and a US budget deficit set to cross the trillion dollar mark in the next financial year. US officials are likely to keep up their bearish tone on the
Despite the political crisis in
As long as USD looks consolidative, and as the USD/JPY remained above 90 level, Asian currencies should also be range-bound. The three currencies that are remained most vulnerable to risk aversion and a lower USD/JPY are KRW, INR and the IDR with rate cut expectations being priced in in-line with lower CPI readings. A lower CPI reading in these countries should also bolster calls for the country to start easing monetary policy. However, focus has shifted from the Mumbai bombings toward tensions between
Tuesday, December 9, 2008
US Recession Confirmed
At long last, the National Bureau of Economic Research (NBER) declared that the
In this regard, the same can probably be said for risk aversion and the unwinding of JPY carry trades. While some players still see more unwinding here, we find it difficult to ignore the policy risks that accompany this strategy. The USD faces downside risks from an ultra-accommodative monetary policy and expansive fiscal policy in the
Monday, December 8, 2008
Worst of Credit Problem May Have Passed
The Reserve Bank of Australia (RBA) got the ball rolling. Since it started easing its policy in September, the RBA has so far cut by 300 bps. The Swedish Riksbank sliced 175 bps off its policy rate, which was 75 bps more than most investors had expected. The Bank of England followed last month’s 150 bps cut with another 100 bps and I expect the authority to follow up with another 50 bps cut in both Jan and Feb 2009, taking rates to a trough of 1.0%. On the other hand, the European Central Bank (ECB) reduced its policy rate by 75 bps – the largest rate cut the ECB had ever made. The ECB's new pragmatism also came through in Trichet’s answer to the question whether the ECB could engage in "quantitative easing" if need be, that is in simply flooding the banking system with liquidity once it has exhausted much or all of the scope for rate cuts. Trichet pointed out that, with its bold liquidity injections, the ECB has already tolerated a major expansion of its balance sheet.
I expect recession conditions for this quarter and the first half of 2009 will dictate the Fed to ease this month by another 50 bps and a further ease next year is possible. The two-year Treasury will remain below 2% for next year and historically the two year Treasury has served as a good benchmark for pricing private instruments. It will be a key challenge for most investors to search for the new risk/reward trade-off with less credit than what we experienced earlier this decade.
Credit availability is coming back into the market, at least for inter-bank lending. The worst of the credit problem may have passed – at least at the short-end.
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