Eurozone – Coming to a Halt!

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

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

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

Negative Feedback Loop in 2009!

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

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

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

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

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

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

Palm Oil – Our Last Bastion of Hope!

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

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

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

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

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

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

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

BNM Did The Right Thing!

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

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

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

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

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

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

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

My Choice - High Yielders!

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Commodities – The Chokepoint?

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

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

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

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

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

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