A Random Walk Down Main Street

The index of leading indicators turned positive with a +0.3% in December, but housing, consumer confidence and jobs continue to struggle. Meanwhile, the US government is pulling out all the stops to provide liquidity by injecting a tremendous amount of cash into the financial system. The increase in money supply was the largest on record, even surpassing the previous record when the government rushed to provide cash in the wake of September 11 attacks in 2001.

And now, President Obama and the Democrat-controlled Congress are on a multi-trillion dollar spending spree to keep our economy from slowing even further. Whether all that spending will revive our economy is yet to be seen. However, one thing is very clear — the recession is spreading across the Pacific Ocean to the booming Asian economies.

On top of that, China is also facing pressure from President Obama to allow the yuan to rise in value. Timothy Geithner, Obama's pick for Treasury Secretary, said that "China is manipulating its currency." the last thing China can afford is to allow its currency to rise and make its exports more expensive. So I foresee that the currency-valuation issue will probably turn into some sort of political battle down the road, threatening to make things worse for both the U.S. and China.
And over the Chinese New Year break, I have been deep into discussion with some of my fund investors – and one of the key worries is that there is a strong likelihood that Bank of America and Citigroup could fail despite the most radical government rescues of all time.

These two megabanks are on life support, receiving massive transfusions of government capital. But they're still hemorrhaging, and no one in Washington has found a cure. Already, they have received capital injections of $90 billion ($45 billion each) and this bailout is larger than the total combined capital of PNC Bank, Suntrust Bank and State Street Bank — all among America's ten largest. Please note that Bank of America Corp. and Citigroup, Inc. have combined assets of $3.9 trillion, or 43 times the size of the Treasury bailout funds they've received to date. Bank of America and Citigroup are the nation's second and third largest high-rollers in the derivatives market, with a combined total of $78 trillion in these bets outstanding. That's over ten times the derivatives that Lehman Brothers had on its books when it failed last year.

According to the OCC, JPMorgan Chase is actually the most heavily leveraged, with over 400% of its capital already exposed to the risk of default by trading partners. Bank of America's and Citigroup's exposure (177.6% and 259.5%, respectively) is also wild, but JPMorgan Chase's exposure is obviously far greater.

I am very sure that the economic picture will get uglier. But the best time to buy is when nobody wants to! And don't forget that stock markets historically bottom 6-12 months before the economy does.

Obama's Billions Game

If the new president is right, America will soon have more employed than unemployed workers. There is ample evidence that infrastructure spending can help, but it can even backfire, if pork-barrel spending and pet projects aren’t meticulously monitored.

During the Great Depression, Roosevelt’s New Deal put 7 million people back to work between 1933 and 1937, building highways, dams and bridges. The US President Obama is proposing at least $150bn to be committed to the infrastructure in the country.

Top of the spending list is physical infrastructure. According to the US Department of Transportation, an estimated 56% of the nation’s roads are in need of serious updates. 26.7% of the country’s bridges are structurally deficient and 13.6% are functionally obsolete. Meanwhile, the US railroad is requiring nearly $200billion in investment over the next 20 years. Likewise, with the US public transit system, which needs even more money and mass transit investments would need to increase by $3.2billion a year just to keep pace with existing needs. In 11 short years, 80% of the locks on the nation’s waterways will be functionally obsolete as well, according to the Army Corps of Engineers. Clearly, the $90billion that has been earmarked for this infrastructure category is just a drop in the bucket compared to what’s needed.

Also, call it ‘the invisible infrastructure’ if you will. The digital highways of today are critical to the economy – so critical that President Obama will appoint the nation’s first-ever ‘chief technology officer’. Between 1995 and 2002, IT was responsible for two-thirds of the growth in the US labour productivity – a huge boost to the country’s GDP. However, it still lags well behind countries like Japan, Singapore, South Korea and 3G cellular networks, even behind China and digital traffic in the US is expected to increase 500% by the year 2020 as demand for multimedia applications increases. The budgeted amount of at least $6billion is just a start.

Obama’s commitment to energy sector is equally large. Not one single refinery or nuclear reactor has been built in the US since 1970s. The electricity demand has increased by about 25% since 1990, construction of transmission facilities has fallen by about 30%. Right now, the 20th century electrical grid is already struggling to keep pace with demand – many US regions see generation shortages on the 10-year horizon. Obama’s proposed $54billion in spending for this category, including for alternative energy, can really be a challenge, if that to be the case to transform the US economy, but nevertheless, it is still a vision for all to move forward.

Let Us Pray for Obama!

I join all Americans in the hope and prayer that Barack Obama can help lead America out of danger, and ultimately I believe, he can and will.

But it is not going to be a smooth sailing, as he inherited the greatest financial catastrophe any US president has had to deal with in at least 76 years. Bank of America’s $2.4 billion loss, Citigroup’s $8.3 billion loss, and the probability that both banks will sink deeper despite government bailouts cannot be ignored. The problem is no longer domesticated in soil of America, but it has gone global – with a vengeance. The Royal Bank of Scotland (RBS) has announced that its losses for 2008 to be a staggering 28 billion pounds – the largest ever loss posted by a British corporate in history.

Beyond financial and economic problems, he has not one, but two, medium-sized wars – in Iraq and in Afghanistan – to deal with, of which neither look easy to end with a fully satisfactory outcome. The possibility of these wars turning into a Vietnam-war alike is real and is straining every possible resource needed at home.

He has an ally, Israel, with has been threatening with annihilation by its sworn-enemy, Iran and at the same time, Israel-Palestinian debacle is far from resolved. Beyond that, he has another rogue nuclear power, North Korea, which rationally would remain quiescent but is its leadership rational?

The US and the world are in essence currently undergoing the inevitable aftermath of a decade of excessive money creation that must be wound down – an agonizingly painful process.

During the election campaign, Obama and his supporters had great fun assigning blame for these troubles, but it is now Obama’s job to come up with solutions.

What I really know is that there is a clear conflict between minimizing the current pain of recession and minimizing its duration. Actions that provide short-term relief may create new problems that both delay the ultimate exit from the downturn and may cause a deeper economic pain before recovery actually takes place. Back in December 1929, the US Treasury Secretary Andrew Mellon argued that the appropriate response to a downturn was liquidation of bad assets that will establish a solid base for recovery quickly, that was quickly ignored by US Presidents Herbert Hoover and Franklin Roosevelt, and this had resulted the 12-year Great Depression!

Nevertheless, one thing that I can say about Obama is that he appears to be much deeper and more long-term thinker than ex-President Bush. He is also surrounded by economic advisors who all are committed to a free market rather than a government-directed economy, and who in Volker’s case at least, had demonstrated its commitment before in 1981-82.

EU – The Late Comer to the Game

The corporate sector is noticeably more leveraged in the Eurozone than in the US. This, I believe, that the recession that we see in the Eurozone is not a primary function in response to the headwinds blowing from the US. Its internal imbalances clearly need to be addressed as its corporate de-leveraging will trigger a sharp decline in non-residential investment and hiring. At this stage, I am jolly well know that the ECB is still in denial in acknowledging the uniqueness of the current situation as well as its response, albeit much-much later than the Fed.

In the short-term, the resistance of the Eurozone central bankers to aggressively easing monetary policy will continue to provide the EUR with broad-based supports, but with deteriorating economic conditions, this is a classic recipe for the EUR position to be very much over-valued and that may induce heavy short-selling in times to come.

I think it is very likely that the ECB will continue to cut its refi rate below the historical low of 2% as early as March as can be seen with the somewhat rising polarization of views among the ECB council members. The ECB is struggling to catch up with reality as the Trichet virtually ruled out a rate cut at the February meeting in three-weeks’ time.

The economic outlook is seemingly to suggest a much deeper downturn than it expected in December 2008 and I believe the economic data will be once again be worse than the ECB is now factoring in, tilting the balance firmly towards a new cut in March.

The rebound in ZEW index in December 2008 had failed to ease tensions on financial markets and the signs of a steep contraction in business activity in Germany are accumulating. French consumer spending will take a hit as unemployment is rising at an alarming rate, thus offsetting the boost in purchasing power triggered by the fall in energy costs. The run-up to Christmas was characterized by increasingly desperate retailers offering larger and larger discounts to tempt shoppers into stores. Price reductions up to 70% were not uncommon.

Currencies – Fundamentals Are Back

Many people say that last year was an unusual year for currencies, but to me, it was fairly standard given that there was tremendous volatility and being driven by a combination of sharp interest rate changes, volatile capital flows and brief outright USD scarcity. In my opinion, it was a very straightforward year of risk aversion. The three strongest currencies were the JPY, CHF and the USD that benefited from the closing of carry-trade positions, especially in the second half of the year.

Into this year, with the convergence of global growth (recession) and low global interest rate levels, this implies a return to normalcy especially in the second half of this year. Fundamental forces are expected to regain control, hence it would not be surprising if those low yielding currencies to be under-performing further, particularly if plagued by large external financing needs.

While the USD and GBP have already given back a substantial percentage of its gains during the risk-reduction period of September-November, further setbacks appear likely in months ahead. Further increases in USD supply on the back of extension of quantitative easing and likelihood of the Fed to hold rate near zero into early 2010 will put downward pressure on the currency.

Monetary policies are converging, but fiscal policies will take on increasing fundamental importance during this period. Currencies of countries with fiscal flexibility are likely to perform well. China has announced fiscal stimulus plans amounting to about 11% of GDP and that will enable the RMB to regain its uptrend versus the USD, in contrast with the 12-month NDF that suggests a 2.6% depreciation. On the other hand, countries like South Korea, Malaysia, Thailand and Indonesia which appear to have low debt ratios would open to potential larger fiscal initiatives. In Asia, KRW was meaningfully underperforming regional currencies in recent weeks to months – losing some 26% versus the USD and possibly we may see opportunity in long-short potential trades.

I always like commodity currencies, especially ones with stable domestic fundamentals. Key point to note is that I am in favour for it during the final three quarters of the year as the collapse of commodity prices in the 2H08 and the onset of a globally coincident inventory correction has driven manufacturing activity to unsustainably low levels. My top pick remains the AUD.

Banking Losses Telling!

Bank of America posts massive $1.79 billion loss in last three months of 2008, slashes dividends and accepts $138 billion emergency lifeline. This was its first loss in 17 years. Citigroup reports total losses of $18.7 billion in 2008 and 44% of the losses ($8.29 billion) attributed to the fourth quarter alone. This was its fifth straight multi-billion dollar quarterly loss.

In short, new phase of bank crisis is beginning to show with soaring unemployment, plunging stocks, cancelled dividends and sinking investment income ahead. This essentially suggests that the worst of the carnage in the US banking system is yet over despite the US$$350 billion in TARP funds Washington already spent to save the big banks. After all, Obama's advisers are getting their forecasts right and they have been freely admitted that they see an increasingly grave banking crisis beginning to unfold.

The stock market had a nervous breakdown — with stocks plunging as much as 1,000 points in a single trading session and the Dow crashing by nearly a third in less than 30 days.

I am always fascinated with black holes. The idea that you could have an area of space so massive, so dense that it could suck in and absorb anything that got too close — even light — seemed ludicrous. They're real…and they keep popping up throughout the financial sector.

Another possible bomb-shell could possibly come from the Federal Home Loan Banks (FHLBs) – the second biggest borrower after the federal government. Unless you follow the banking industry closely, you probably haven't heard of the Federal Home Loan Banks. FHLBs are vitally important as a source of funding for U.S. banks both large and small. FHLBs sell debt into the capital markets to raise money, using their AAA ratings to borrow cheaply. They use that money to make advances to banks that are members of the system and take collateral in exchange — often mortgages or mortgage-backed securities. The FHLBs own billions and billions of dollars worth of mortgage backed securities. Those securities have plunged in value. So just like their banking customers, FHLBs are facing potentially huge write-downs on their portfolios.

And that's what is stressing the system. Moody's recently warned that eight out of the 12 FHLBs could ultimately face capital problems. They collectively have roughly $1.25 trillion — with a "T" — in debt outstanding. Now, we're looking into the maw of yet another gigantic black hole!

If this is not handled properly, crisis could easily be spread across insurance industry as surplus cushions are eroding fast as well as pension funds. The consulting firm Mercer recently estimated that the pension funds of big U.S. companies are under-funded to the tune of $409 billion! At the end of 2007, they were running a $60 billion surplus. That huge swing could drive up corporate borrowing costs and drive down corporate earnings.

Constructing a Bond Portfolio?

By now, you must have identified me as a equity-bull and I continue to believe they’re the best income investment around for this year. However, to those pessimists out there, I propose a bond portfolio to diversify income and risk. The problem right now is that interest rates are pitifully low, particularly on the long end of the yield curve and risk involved with many of the higher-yielding bond categories is still very high. The 3-year MGS benchmark is currently hovering below 2.7% and it seems that market consensus is even expecting a 75 basis point cut!

This leaves us with not much options and I suggest you to largely steer clear of longer term government securities as well as high risk corporate right now. Someday in the near future, however, I think we are going to see longer term government papers yields to rocket higher, as pressure on US deficit and Treasury financing can be deadly inflationary. And then, it is not too late a time to consider starting to snap them up. Corporate bond activities continued to be sparse as liquidity thinned in early part of this year and investors continue to lap up high-grade credits, especially those with some form of government backing.

At this point in time, let us consider laddering the bond portfolio with a heavy bias towards the shorter rungs. Laddering is a good technique to hedge your bond portfolio against any sudden change in interest rates. Investing in bonds with various maturities and as they mature, re-invest the proceeds into new bonds at the highest rung of the latter. This allows some free-cash flows to work at current rates while protecting other portions of the portfolio. So, if the rates are falling, you will have some of your long-dated bonds would be in-money.

Of course this method will not allow you to get big return for the risk and another option is eschewing bond altogether and using mutual funds or exchange traded funds instead. This method will take out the benefits of laddering, but it gives a good diversification both in length and types of bonds held.

The idea is simply to keep the money spread out so that a move in rates doesn’t leave you high and dry and make sure that you are more weighted towards the short-end of the maturity range.

Oil as a Weapon?

I have no doubt the hottest media topic today is the Israeli-Palestinian conflict in Gaza. It is not my intention here to get into a debate about the rights and wrongs of either side, but if you are investor, you may have to make some decisions about how this conflict could potentially drive oil prices.

Besides rhetoric of some countries with verbal threats, demonstrations, boycotts, etc Iran is calling oil-producing states to launch an embargo in protest of Israel’s current military operations in Gaza. Similarly, we have seen of similar calls from lawmakers in Bahrain, a country whose political landscape is dominated by its Shiite majority – kind of associated with Iran.

Of immediate I see a possible significant in relation to Yom Kippur war, which was fought from October 6 to October 26, 1973. As one of the consequences, the members of OPEC (consisting of the Arab members of OPEC plus Egypt and Syria) proclaimed an oil embargo "in response to the U.S. decision to re-supply the Israeli military during the Yom Kippur war. OPEC declared it would no longer ship oil to the United States and other countries if they supported Israel in the conflict. Independently, OPEC members agreed to use their leverage over the world price-setting mechanism for oil in order to stabilize their real incomes by raising world oil prices. This action followed several years of steep income declines after the end of Bretton Woods, The 1973 "oil price shock", along with the 1973–1974 stock market crash, have been regarded as the first event since the Great Depression to have a persistent economic effect.

This time around, I believe, the probability of 1973 recur is low, but rather I see as an attempt by Iran itself to score political points by emphasizing publicly that Tehran is the only player in the region that stands up in supporting the Palestinians in this trying times. The primary goal is to make its Arab rivals look bad, especially Saudi Arabia and the GCC allies.

The truth is that Tehran is not in position to come to the aid of the Palestinians and only big oil players like Saudi Arabia and other smaller Persian Gulf states would be able to make such threats, but unfortunately they are far more concerned about their bottom-lines. Even Saudi Arabia, the main mover and shaker in OPEC is already facing difficulty in getting other cartel members to abide by recently announced production cuts, especially as oil prices has fallen by some 70% from the record high of July 2008.

Iran is just another hopeful that its threat will kill two birds with one stone, pushing prices up even if there is no embargo. Despite its long slide, oil prices have jumped some 25% in the last 10 days since the Israeli operation began. Is it that markets are spooked or are they will be spooked further by the threat of an embargo? Or perhaps, Saudi Arabia and its allies are hoping that the assault will cut Hamas down to more manageable proportions and thwart Iran’s attempts to use the Israeli-Palestinian conflict to its own advantage.

Obamanomic's Dilemma and Market

Obama in his weekend radio address says this recession could linger for years and the unemployment rate could reach double digit. In the past month alone, the economy has lost more than half a million jobs – a total of nearly 2.6 million in the year 2008. Another 3.4 million Americans, who want and need full-time work have had to settle for part-time jobs. Families across America are feeling the pinch as they watch debts mount, bills pile up and savings disappear.

I agree, but that’s not the half of it. The government has released one of the most shocking federal budget reports of all time. The 2009 federal deficit will be US$1.186 trillion! In sheer dollars, the 2009 fiscal deficit will shatter every record deficit of every nation in history, representing 8.6% of GDP, more than four times the average under Bush, nearly seven times the average under Clinton and 1.4 times the post World-War II record of 6% under Reagan.

And please be reminded that numbers have not included fiscal expansion of Obamanomics. If that is being included, federal spending could reach as high as 25% of GDP – the highest level in American history outside of World War II. During the WW II, most of the money was spent on war-related production, creating entire new industries and keeping millions of American in uniforms or on the job. In contrast, most of the 2009 deficit spending will be for corporate bailouts, unemployment benefits, social security and Medicare.

Investors will be tested in the coming weeks as earnings season approaches and corporations share their ‘gloom & doom’ of the past quarter. So far, stocks are giving back those gains form the first trading day as investors were over-analyzed economic data. However, bond investors appear more willing to accept risk as US$750mn flowed into high-yield funds during the last two weeks of 2008.

As usual, for every bull out there calling for a new rally, you will find a bear calling for another leg down. But I have just read one of my favourite fund managers – Barton Biggs that he says ‘sometime around the middle of the year, there is going to be pretty conclusive evidence that the economy has stabilized. That’s what the stock market is now looking forward and seeing, and that’s why I think this rally carries furhter’.

Who’s know? And I wouldn’t be surprised to see the unearthing of further frauds, too. Think about all the good times before that, when everything was going up – that’s when the scamsters would have been sewing their bad seeds. Still, after the impressive rally that we’ve seen since 21 November, I certainly would not rule out the possibility that the we’ve seen the bottom of the market.

Cratering US Labour Market and FX Market

December’s US payroll jobs collapsed by more than half a million for the second straight month. More revealing is that the revisions to the prior two months suggested even deeper declines in October and November as unemployment surging at an alarming rate.

We are now seeing the full semblance of financial crisis being full reflected in real economy. The intensity of the labour market downturn matches the severe downfalls of the mid-1970s and early 1980s that it has forced income into negative territory for the first time since 1982. It possibly would have to take a massive tax relief under Obamanomics to replace the shortfall in incomes as the labour market meltdown persists.

The average peak-to-trough percentage decline for payroll job recession since 1960 is -2.1%. Twelve months already from the peak, payroll jobs are down -1.9% in the current episode and there are indications that the current downturn could be longer than the average 14 months. Even those still employed, the work-week shrank to 33.3 hours and that translated into a big hit in the size of paychecks. The rate of decline in temp employment is accelerating – down 83K per month on average over the last two months compared to 32K on average during the first ten months of the year. Full time job opportunities are getting scarcer. Roughly 1.75 million more people in December were working part-time for economic reasons than in September.

Translating this to FX market, I note that exchange rate markets are still very much US-centric, especially to movement in US equities. That in my opinion, is definitely not sustainable for US dollar but market will stay hopeful for stimulus spending after the inauguration of Obama as US president next week (January 20, 2009). Until then, I expect the EUR to remain under pressure from rate cut expectations when its governing council meets on January 15, while on the other hand, Yen seems to be unable to shake off its role as a gauge for risk aversion.

And as long as EUR remains under downward pressure, I expect some Asian currencies, especially SGD, MYR and TWD to face upside pressures. Not surprisingly, the MYR has been taking its cut from its neighbour – the SGD since the USD bottomed last July. Of course, the biggest risk to this view is that the Chinese economy, especially exports data slide deeper into negative territory this week. In the same breath, the dismal Chinese economic data will undermine optimism for KRW and TWD as the market is struggling between recovery hopes and the reality of the US has yet to overcome its structural problems. In essence, I believe this calls for more than just range-trading but with a more pessimistic bias.

Financial Storm Recedes, Corporate Bankruptcy Rises

Let me reiterate that financial crisis is over and in this new year, we will see less turbulence in financial services than in 2008. The dangerous process of deleveraging becomes less dangerous as leverage itself is reduced and the capital injections from the Troubled Asset Relief Program (TARP) into the major US banks have hastened their recovery.

This year, however, we will see the transition of problems from financial to real economy with corporate bankruptcies to be a key concern for investment community. The resilient US consumer started to give up in the 3Q08 and with the personal consumption n making up over two-thirds of aggregate demand, this will be the centre of the dynamics that will play out in the real economy. The negative wealth effects from housing and equity market losses, the disappearance of home equity withdrawal from the second half of 2008, mounting job losses, tighter credit conditions and high debt servicing ratios will drive share of bankruptcies in retailing industry. The recession will inevitably push more retail chains over the edge with the highest casualty rate being among high-end and specialty retailers.

The real economy outlook to a large extent will depend on outlook on equity market. According to Tobin’Q, S&P 500 is still too expensive relative to the cost of replacing assets. After RTC was established in 1989, it took 1 year for the stock market to bottom, 2 years for the economy to bottom and 3 years for the housing market to bottom.

As defaults rise, the new rules governing Chapter 11 of America's bankruptcy code will face their first test. Long admired as the world's best system for allowing corporate liabilities to be restructured while giving firms a decent chance of staying in business, the rules were tightened in 2005 to deter firms from staying in Chapter 11 too long and to stop the managers of bankrupt firms from paying themselves too much. More companies that file for bankruptcy protection are shutting down, lawyers say, because they cannot obtain enough financing to operate while they reorganize. Part of the problem is that in recent years, large lenders to corporations have been hedge funds, private equity investors or other institutions.

The number of construction companies that failed in November 2008 rose more than 40% from a year earlier, increasing by a double-digit figure for the eleventh straight month for the first time in 15 years. The number of corporate bankruptcies rose last year to 28,322, but that is the second-lowest number of filings since 1980, according to the American Bankruptcy Institute.

The Fate of Paper Money

This piece is heavily extracted from work of Mike Hewitt, the editor of DollarDaze.org, and the reproduction is with his permission.

His key argument is that paper money that we are having in circulation now will come to an end, like all historical stories testified below:-

The first well documented widespread use of paper money was in China during the Tang (618-907 A.D) dynasty, then spread to the city of Tabriz, Persia in 1294 and to parts of India and Japan. However, its use was very short-lived in this region. In Persia, the merchants refused to recognize the new money, thus bringing trade to a stand-still. By 1455, after 600 years, the Chinese abandoned paper money due to numerous problems over issuance and hyperinflation.

And in the case of Europe, the first instance of paper money allegedly occurred in Spain in 1438 during a Moorish invasion, but no known notes have survived.

At present, there are 176 currencies in circulation in the world and the longest running currencies are (i) Pound Sterling (inception in 1694), US dollar (inception in 1792, Netherland Guilder (inception in 1814) and others, but of these currencies, we are seeing the declining value of the British Pound sterling and the US dollar – considered to be the most successful paper currencies of all time.

On the other hand, there were 599 currencies that are no longer in circulation that either ended through monetary reforms, acts of independence, acts of war or destroyed by hyperinflation. The Second World War saw at least 95 currencies vanished as nations were conquered and liberated.

Of recent times, we see strong expansions to the US monetary based. Up until August 2008, the monetary base growth was between 8-12% and in December 2008, that proportion had risen to 47%! – part by the unwillingness of the banks to lend recent ‘liquidity injections’ from the Federal Reserve.

Essentially, these massive expansions to the US monetary base increases the probability of a complete collapse in the confidence of the value of the US dollar as it could spark a hyperinflationary face to the world’s de facto reserve currency.

Weak USD Clearer in 2H09

I have been quite pessimistic on USD for a long while and have been consistently arguing the case of weaker USD, as signs of deflation ending are clearer in the last three months. The flight of quality is becoming a less than issue.

In this article, I argue that the weak USD trend will become more apparent in 2H09 onwards. For most part of 1H09, I am looking at scenario where most currencies to consolidate in broad range. There will be a clear struggle for those currencies that are impacted structurally by the global crisis, and those currencies that are struggling on cyclical recovery, predicated that the stock markets are not testing a new low.

Holding up the candle will be expectations for US President-elect Obama to deliver a large scale of economic stimulus by early February after his inauguration on January 20. Already, we are seeing signs of further easing in yields and narrowing of interest spreads.

Specific about Asian currencies, those with high exposure to external sector and the need to rebuild foreign reserves would see quite a limit to the currency’s appreciation. Chinese government has been actively supporting exports by raising export tax rebates to help its industries stay competitive will see continued appreciation of RMB over the medium term. A 5% nominal appreciation or possibly more cannot be ruled out as we move into 2H09. The worst of Korean won, which has been consolidating in a large 1200-1500 range appears to be over. Having said that, we should be more concerned with the appreciation of Japanese Yen, especially Japan’s export sector is in recession. The Bank of Japan has joined the Ministry of Finance in discouraging further Yen appreciation and this helped to push USD/Yen above 90 again.

The act of rebalancing is about the get real nasty for export-model and oil exporting countries.

2009 – A Year to be Remembered

If 2008 is a year to forget, I guess 2009 will be a year to be remembered. 2008, indeed is a roller coaster year, swinging from a peak of 1524.7 points in mid January 2008 to a four year low of 801.3 on October 28, 2008.

To-date, the KLCI has plunged almost 41%, defensive in nature if we compared to our regional peers. China fell 62.3%, Hong Kong of 56.5%, Indonesia of 58.3%, Japan of 49.7%, Korea of 50%, Thailand of 54.3%, Singapore of 53.7% and Taiwan of 51.9% respectively. But on the other side of the coin, Malaysia’s standing as an out-performer during the recent sell-down, it renders Malaysia to be relatively expensive market – the third most expensive market after China and Japan. As at time of writing, Malaysia’s price to earnings (PE) ratio stands at 10.2, versus Hong Kong of 7.42x, Indonesia of 6.83x, Thailand of 6.3x and Singapore of 5.3x respectively.

Economic conditions may not be better, but market will lead the economy by a wide margin. The fiercest bear occurred back in 1937-1942 with the S&P index losing 60% of its value over 62 months, and that would be the most extreme case study for all of us. But on the other hand, if we exclude the extreme case, and traced back the bear markets since 1942 onwards, markets tend to drop by an average 34.1% for an average period of 16 months. As the numbers suggest there could be less pain ahead and it is always a good lesson that we buy when everyone else is fearful.

I am talking about what has happened during the average bull market – a whopping 164% return over 57 months. The historical lesson is clear – bears can be absolutely brutal, but the ensuring bull runs have always paid off handsomely for patient investors.

From another supporting angle, I note that NBER recession announcements tend to coincide with the end of recession, not the beginning nor even the middle. On December 1, the NBER officially announced that a recession started way back in December 2007.

Table 1. NBER Announcement and End of Recession

Recession Start Date	Recession End Date	NBER Official Announcement	Announcement Date Compared to Actual Recession End Date
Dec-2007	-	Dec-2008	-
Mar-2001	Nov-2001	Nov-2001	Same month as recession ended
July-1990	Mar-1991	Apr-1991	1-month after recession ended
July-1981	Nov-1982	Jan-1982	10 months before recession ended
Jan-1980	Jul-1980	Jun-1980	1-month before recession ended

Source: James Stack of InvesTech Research

So, judging by the NBER’s track record and its official recognition that December 2007 marked the beginning of a contraction, the current economic crisis is probably far closer to the end than the beginning.

And that there is going to be tons – literally tons – of money to be made in 2009. Malaysians tend to have short memories. If we look at the previous bear cycles in 1987/88, 1997/98 and 2000/01, the market took an average 18-22 months to recover. In 1987/88, it was 18 months before recovery between October 1987 and March 1989. In 1997/98 episode, it took 22 months and in 2000/01, it lasted for 20 months, and going by that simplistic count, KLCI could lag the global recovery by a quarter or two in this instance.

Consumer Upturn in UK Sooner than Expected

I don’t claim to know United Kingdom very well but I do know a little bit about economics and I write this piece to assuage worries of my friends.

We know jolly-well the fifth largest economy in the world, the second largest economy in the Europe after Germany has deteriorated dramatically in the past 4 months and is already in a recession. Consumer spending growth collapsed under the weight of higher inflation, rising debt servicing costs and a fall-off in housing equity withdrawal and the deterioration in consumer finances are likely to continue in the next one or two quarters, as experts have suggested.

The Ernst & Young Item Club says the economy will shrink by 1% next year, but I do see some bright spots that perhaps, could be the key to turn-around in consumption growth.

Firstly, the policy backdrop has changed in both monetary and fiscal terms and supported by tumbling energy prices. As inflation declining, it helps to kick-start consumption as it allows Bank of England to further slash interest rates, hence lowering debt-servicing costs. Essentially, I expect borrowing would no longer be a drag on activity, unlike in 2008. Coupled with lower taxes (VAT rate to 15% from 17.5%), improved social benefits from the fiscal side, this will contribute to improvement in real consumer disposable income.

Secondly, the collapse in wholesale food and energy prices is beginning to be passed to consumers – obviously as petrol prices have fallen by 25% from their peak.

Thirdly, the RICS survey of chartered surveyors already showed a pick-up in enquiries for purchasing a home.

Fourthly, on one hand, I do expect employment to decline through 2009, but on the other hand, I do expect higher social security benefits to mitigate to a large degree the negative impact on consumer firepower of falling employment. For example, the government will pay now mortgage interest for mortgages up to ₤200,000 for the newly unemployed.

In short, my calculation shows that the fiscal boost is equivalent to 5% of nominal GDP, and infrastructure spend will give rise to boost construction jobs. So, be watchful for the sudden turn of UK-related market prices!

Equities - Here I Come?

Based on my study, on average global investors’ returned only 6 months after stock markets bottomed, as seen in the 1997/98 Asian financial crisis, and in the sell-off in the US between 2001 and 2003. In the Asian financial crisis period, I noted that global investors waited until the equity prices recovered almost 50% before turning net buyers and that essentially gave further momentum to market.

So far, the short-term uncertainties have translated that any rally may prove hard to sustain and with little appetite for risk, we have seen greater capital allocation to cash at a faster pace and levels are now approaching highs not seen for a number of years. Some have made estimates the rising possibility that global earnings could plunge by as much as 40-50% before the cycle turns and global earnings are only 30% way through its earnings decline and there is more way to go from here and this fear is reflected across the globe including Bursa Malaysia.

Corporate earnings are likely to be bashed again by the time the 4Q results reporting season arrives – in February 2009 and that will put a cap on share prices. Corporate earnings results then will be showing impact of ballooning receivables and a strangled cash flow and followed by further earnings slash by analysts. Forward PER will be higher than what they are now, so logically for one to expect share prices will have to drop to justify those rates since earnings have fallen.

On the flip of coin, we know that markets will turn before we know the economic recovery is going on. Housing bubble in Sweden in early 1990s and in the 12 months that followed, its stock market soared 42%, even while the economy continued to recede. During the recessions of 1982 and 1991, the S&P began to climb four months and five months before the economy started to recover. The 45% loss in the DOW between 1973 and 1974, it rallied a whopping 53% from its 1974 low, as bad economic news poured for the next 18 months. The DOW bottomed in 1932 but bad economic news continued to stream out for another three years.

Based on my simplistic calculations, the earliest period for a possible rally will be in January or February 2009 given the speed of its tumble from last year’s peak and the time it took stocks to gain before recessions ended in 1975, 1982 and 1991. This seemingly will coincide with the Inauguration Day of President-elect Barack Obama.

However, if the recession is to be far serious than that of my optimistic case, then the rally could perhaps be delayed by another 6 months, somewhere around June or July 2009.