My how far have we come, in less than six months, a market that was firmly focused on inflation risk has swung sharply as growth has crumbled. Deflation is now more and more openly discussed and with the Fed funds rate approaching zero, talk of liquidity traps, unconventional measures and quantitative easing are all firmly on the agenda. With all this volatility and uncertainty one can’t help but ask, what happens next? The most obvious near-term steps involve both sizable fiscal stimulus and pre-commitments to keep rates at lower levels. Beyond that, more active plans to target longer-term securities are also likely to come into focus. But further action is also likely to be needed to try to reduce the spread of risky debt to risk-free securities. In the current episode, more than in 2002-03, it is less clear that influencing the Treasury curve alone would be enough to bring borrowing rates down sharply or deliver the easing in financial conditions that has so far been missing. For that reason, other measures including Fed purchases of risky assets could also be important. While these options are further away outside the US (and Japan), because there is still relatively more room for policy rates to fall, in principle many of the same options exist for policymakers in the other major economies too. In terms of the markets, these policy shifts have important implications. They make it highly unlikely that the market’s pricing of higher US rates next year will prove correct. Longer-term yields may also fall further, particularly if they become a target of policy, while mortgage spreads could compress from current levels as policy shifts more explicitly towards reducing the spread between risky borrowing and risk-free rates. For FX, the implications are less clear, but the risks are towards USD strength in the near term, but weakness further out. The good news – particularly with a Bernanke Fed – is that policymakers have a heightened awareness of the unusual risks posed by deflation and liquidity traps, and have plenty of tools left in the arsenal. But the biggest problem is likely to be that these policies will look radical and may require significant political capital to find support. Whether talking about the size of fiscal stimulus that could be needed or ‘unconventional’ monetary policy, we are moving towards territory where orthodox responses may not be enough. The key risk now is a lack of boldness on the policy front in the face of extraordinary pressures. Hence the title of this piece, we need radical action by the government before Obama is inaugurated on Jan 20, 2009, simply put, we need President Bush to save Christmas (or other similar winter holidays)!
With riskless short-term interest rates now close to zero, conventional monetary policy is becoming ineffective. So what other measures do US policymakers have up their sleeves? There are three options with a relatively high likelihood of near-term implementation: (1) a large-scale fiscal stimulus program, (2) more proactive use of Fannie Mae and Freddie Mac for purchasing and securitizing mortgages, and (3) a pre-commitment by Fed officials to keep the federal funds rate low for a considerable period (probably following a final 50- basis-point cut at the December 16 FOMC meeting). Options (1) and (2) are likely to be quite effective, while (3) would probably provide a more modest boost. If these policies fail to result in an economic pickup, Fed and Treasury officials would likely reach deeper into the unconventional policy toolkit. In particular, Fed officials might (4) purchase long-term Treasury and Agency securities in a more aggressive bid to lower rates further out on the yield curve, perhaps in order to finance another round of fiscal easing. Finally, the Treasury might (5) decide to purchase risky assets outright, and this could again be financed by Fed money creation. Both of these policies would probably be quite effective, although they are more radical and not imminent.
While it would be nice if the government would take such bold actions, risking any capital on that assumption is sheer lunacy. Now is the time to focus purely on individual securities experiencing aberrational price movements, one fantastic example of this is Citigroup. Over the past week we have seen Citigroup’s market value fall by more than half. This is the largest bank in the U.S. on a deposit basis. Currently the NPV for the investment bank is so negative that it is dragging down the value of the relatively good commercial bank. Although I think Citigroup will raise additional capital, further diluting shareholders, I would be surprised to see it fall any further. The following programs backstop Citigroup’s liabilities: a) its deposits are FDIC insured; b) the company is working out a program to insure some of its debt with the FDIC; c) the Federal Reserve discount window is always open to the company; d) it can sell commercial paper to the Fed; e) it can use the primary dealer debt facility; f) its deposits, which equal $780 billion, are primarily sourced overseas (64%) giving the bank greater diversity in capturing funds; g) it has access to bank protection programs in multiple countries around the world; h) it has $393 billion in long-term debt; i) it has net free cash flows; j) it has paid down $94 billion in long-term debt this year and $42 billion in short-term debt; and k) it is reducing the size of its balance sheet faster than any other company in the banking industry. The company’s estimated Tier One ratio by year end is 10.45%. This is very high relative to the past. Its stockholder equity is estimated to be $150 billion assuming the TARP contribution. Although I don’t technically have a hard line valuation number on the stock, I think its value is well above $4 which it closed under on Friday. At $4 they are valued at .4x tangible book value which is quite ridiculous. Although my investing career is not as long as others I think .4x tangible book value represents an interesting risk/reward trade-off. That being said this is a rather speculative wager, as we have seen in this market fundamentals matter far less than sentiment. I will keep you posted on Citigroup as I research this situation more.
Sunday, November 23, 2008
Sunday, November 16, 2008
Quick thoughts:
With the US election now behind us, markets are back to the more mundane task of focusing on the economic landscape (aka “bad news”). As should be quite obvious at this point world growth has lost momentum over the past few months and many leading indicators suggest a further slowing in growth in the coming months. I have seen no data that suggests a turning point in the economic cycle, the environment for riskier assets is likely to remain challenging in the near term. Given all this negativity I am inclined to believe we are more likely to face a severe overshoot to the downside which would result in a more V-shaped recession, I think this will actually be good as it will allow us to reach a true bottom and not stay in purgatory like the Japanese markets have for the past 20 years. The bottom line is that the signs of weakness in the US have spread.
The key issue now for markets is whether global policymakers will be successful in stopping the economic rot. Alongside further monetary easing, the re-emergence in policy deliberations of (expansionary) fiscal policy as an instrument of macroeconomic policy is a very encouraging development. Signs of a trough in the global IP cycle would be an important sign that policymakers are winning the tug-of war and in turn would be catalyst in changing some recent near-term trends, both in the world economy and risky markets. The weakness in the industrial growth cycle, particularly outside the US, has been an important contributor to recent market concerns about the growth outlook. Better signs here would normally be consistent both with firmness in global equity markets and some underperformance in bonds. It is personally my opinion that the US will have to offer substantially higher rates on the longer-term bonds that need to be offered to fund current budget deficits; this will inevitably further benefit those who are smart enough to be engaged in bullish steepeners. Steepeners are used to bet that the yield curve will be steepening (hence the name). Simply put, I believe the yield curve will steepen as the government will pursue numerous expansionary policies further driving our country into debt which will force the government to offer higher yields as in the long-run (i.e. many years from now) our currency will surely drop to a level that is more commensurate with the inherent risk associated with a deeply indebted country.
This actually brings me to one of the points I wanted to make today. On an absolute basis, both equities and credit look inexpensive. P/E ratios are at their lowest levels since the early 1980s and credit spreads are at historical wides. While current valuations have been driven by a bleak fundamental outlook, including the potential for declining earnings and rising defaults, risk aversion and liquidity have also played a major role. Both credit and equity look good relative to government bonds (this goes back to my steepener thesis). Limited liquidity has been an important driver of cash credit spreads, due to mark-to-market losses, lack of available funding, tighter risk budgets, and redemptions. Other asset classes, also affected by severe liquidity problems, also appear to offer very attractive valuations. While equities have also been challenged in this respect, liquidity problems have been less severe, however there are special situations, i.e. stocks with mass hedge fund concentration. Credit spreads may move even wider as default rates rise. Similarly, equities are unlikely to stage a sustainable rally until closer to an inflection point in economic activity. Moreover, as credit markets have been at the center of the financial turmoil, it is unlikely that equities can stage a meaningful recovery before credit markets, which in turn requires liquidity conditions to improve. Equities have de-rated against bonds. European equities are down close to 50% since their peak, erasing most of the gains since 2003 (or 1997, for that matter). Equities have not only performed badly in absolute terms, they have also underperformed bonds for most of the last 15 years. Equities usually lag the credit markets and as the credit markets have yet to improve I would be surprised if equity could improve. I would therefore recommend that investors seriously look at investing some capital in high quality credit and the reserve a portion to play in the equities market this way they could benefit from both turns.
Now I would like to take a moment to speak about that cowboy market that is energy. Oil prices and returns continued to decline sharply in October as negative macro sentiment accelerated and as the severe slowdown in economic activity resulting from the credit crisis – evidenced by plummeting manufacturing surveys around the world – has substantially weakened physical oil fundamentals and prices. In particular, substantial weakness in the Asian petrochemicals sector has prompted a collapse in petrochemical margins, which has weighed on refining margins, likely motivating a reduction in refinery utilization in Asia.
This weakness in petrochemical demand is also occurring in Europe, exacerbating downward pressure on the Atlantic Basin gasoline market as naphtha (a colorless distillation product) that is not being consumed to make plastics is being re-directed into the gasoline pool. On net, the recent weakness in petrochemical activity is further weighing on the US gasoline market, which is already plagued by a combination of weakening motor gasoline demand and increasing ethanol production. This gasoline weakness is hindering the recovery of US refinery runs after the hurricane season, further reducing the demand for crude oil. Going forward, expect low demand for crude oil by refineries will likely continue to exert downward pressure on crude oil prices. While the announced 1.5 million barrels OPEC cut could counter weak refinery runs providing support to prices, the full implementation of the cut is not likely within the next couple of months, underscoring the downside risk to crude oil prices in the very near term. That being said I think the long-term price of oil will settle at the marginal cost of production which last time I checked is in the $60s now and is expected to go to around $75 by 2010. The reason for this increase is all the easy wells are already drilled. This forces E&Ps to move to more difficult locales, like tar sands or deep offshore drilling, these are expensive places to drill land as such require oil prices to be higher. Although oil is a waning resource it will be kept in check by developments in alternative fuels (which last time I checked are realistically 20+ years away from mass implementation). It should be noted that I am not recommending buying E&Ps but I think there are some real values in the pipeline MLPs which can be found to yield in the high single to low double digit dividends and have locked in business for years to come. This is where I would be focusing my attention.
In summary I recommend people take a look at steepener swaps (or other comparable ways to play a steepening yield curve), and be ready to pounce on values in both credit and equity markets, paying particular attention to MLPs with locked in business. On an aside, I want to apologize for the brief post, work has been quite all encompassing as of late and I have barely had time to go grocery shopping let alone craft a veritable in-depth investment thesis worthy of posting for public consumption, hopefully over the upcoming Thanksgiving holiday I will be able to devote some more time to this.
The key issue now for markets is whether global policymakers will be successful in stopping the economic rot. Alongside further monetary easing, the re-emergence in policy deliberations of (expansionary) fiscal policy as an instrument of macroeconomic policy is a very encouraging development. Signs of a trough in the global IP cycle would be an important sign that policymakers are winning the tug-of war and in turn would be catalyst in changing some recent near-term trends, both in the world economy and risky markets. The weakness in the industrial growth cycle, particularly outside the US, has been an important contributor to recent market concerns about the growth outlook. Better signs here would normally be consistent both with firmness in global equity markets and some underperformance in bonds. It is personally my opinion that the US will have to offer substantially higher rates on the longer-term bonds that need to be offered to fund current budget deficits; this will inevitably further benefit those who are smart enough to be engaged in bullish steepeners. Steepeners are used to bet that the yield curve will be steepening (hence the name). Simply put, I believe the yield curve will steepen as the government will pursue numerous expansionary policies further driving our country into debt which will force the government to offer higher yields as in the long-run (i.e. many years from now) our currency will surely drop to a level that is more commensurate with the inherent risk associated with a deeply indebted country.
This actually brings me to one of the points I wanted to make today. On an absolute basis, both equities and credit look inexpensive. P/E ratios are at their lowest levels since the early 1980s and credit spreads are at historical wides. While current valuations have been driven by a bleak fundamental outlook, including the potential for declining earnings and rising defaults, risk aversion and liquidity have also played a major role. Both credit and equity look good relative to government bonds (this goes back to my steepener thesis). Limited liquidity has been an important driver of cash credit spreads, due to mark-to-market losses, lack of available funding, tighter risk budgets, and redemptions. Other asset classes, also affected by severe liquidity problems, also appear to offer very attractive valuations. While equities have also been challenged in this respect, liquidity problems have been less severe, however there are special situations, i.e. stocks with mass hedge fund concentration. Credit spreads may move even wider as default rates rise. Similarly, equities are unlikely to stage a sustainable rally until closer to an inflection point in economic activity. Moreover, as credit markets have been at the center of the financial turmoil, it is unlikely that equities can stage a meaningful recovery before credit markets, which in turn requires liquidity conditions to improve. Equities have de-rated against bonds. European equities are down close to 50% since their peak, erasing most of the gains since 2003 (or 1997, for that matter). Equities have not only performed badly in absolute terms, they have also underperformed bonds for most of the last 15 years. Equities usually lag the credit markets and as the credit markets have yet to improve I would be surprised if equity could improve. I would therefore recommend that investors seriously look at investing some capital in high quality credit and the reserve a portion to play in the equities market this way they could benefit from both turns.
Now I would like to take a moment to speak about that cowboy market that is energy. Oil prices and returns continued to decline sharply in October as negative macro sentiment accelerated and as the severe slowdown in economic activity resulting from the credit crisis – evidenced by plummeting manufacturing surveys around the world – has substantially weakened physical oil fundamentals and prices. In particular, substantial weakness in the Asian petrochemicals sector has prompted a collapse in petrochemical margins, which has weighed on refining margins, likely motivating a reduction in refinery utilization in Asia.
This weakness in petrochemical demand is also occurring in Europe, exacerbating downward pressure on the Atlantic Basin gasoline market as naphtha (a colorless distillation product) that is not being consumed to make plastics is being re-directed into the gasoline pool. On net, the recent weakness in petrochemical activity is further weighing on the US gasoline market, which is already plagued by a combination of weakening motor gasoline demand and increasing ethanol production. This gasoline weakness is hindering the recovery of US refinery runs after the hurricane season, further reducing the demand for crude oil. Going forward, expect low demand for crude oil by refineries will likely continue to exert downward pressure on crude oil prices. While the announced 1.5 million barrels OPEC cut could counter weak refinery runs providing support to prices, the full implementation of the cut is not likely within the next couple of months, underscoring the downside risk to crude oil prices in the very near term. That being said I think the long-term price of oil will settle at the marginal cost of production which last time I checked is in the $60s now and is expected to go to around $75 by 2010. The reason for this increase is all the easy wells are already drilled. This forces E&Ps to move to more difficult locales, like tar sands or deep offshore drilling, these are expensive places to drill land as such require oil prices to be higher. Although oil is a waning resource it will be kept in check by developments in alternative fuels (which last time I checked are realistically 20+ years away from mass implementation). It should be noted that I am not recommending buying E&Ps but I think there are some real values in the pipeline MLPs which can be found to yield in the high single to low double digit dividends and have locked in business for years to come. This is where I would be focusing my attention.
In summary I recommend people take a look at steepener swaps (or other comparable ways to play a steepening yield curve), and be ready to pounce on values in both credit and equity markets, paying particular attention to MLPs with locked in business. On an aside, I want to apologize for the brief post, work has been quite all encompassing as of late and I have barely had time to go grocery shopping let alone craft a veritable in-depth investment thesis worthy of posting for public consumption, hopefully over the upcoming Thanksgiving holiday I will be able to devote some more time to this.
Sunday, November 9, 2008
Interesting economics analysis
I wanted to write a post about how I thought the Fed was running out of options and we were most likely headed for a longer recession than the government would like, but then I found this paper which quite frankly is much better than anything I could have written, so please read and enjoy....
Economics Getting to the End of the Rate Cut Road Hatzius 2008-10-31[1]
Economics Getting to the End of the Rate Cut Road Hatzius 2008-10-31[1]
Get your own at Scribd or explore others:
Saturday, November 1, 2008
Emerging Thoughts
Before getting into this week’s post I just want to comment on this past week. Last week I spoke about the temporarily insane valuation of VW and how it was easy money to short it at 90 like it was temporarily during the past week. Well have I got good news for you, on Tuesday Volkswagen surpassed ExxonMobil to become the world's biggest company by market cap after Porsche announced plans to raise its stake in the German carmaker to 75% from 42.6%, triggering a short squeeze. As of Oct. 23, almost 13% of Volkswagen's shares were on loan, mostly to short sellers who were forced to swallow massive losses and exit their positions. The ADR traded as high as 225 on Tuesday which is a full 400% from last Friday’s (10/24) close of 53. They traded down the rest of the week to end at 122. Let me preface this by saying shorting is very risky and by nature has an unfavorable risk/return slope. That being said if you are a fundamental value investor, it is not very hard to see that the current price on VW is absolutely insane. Anyone who knows there financial history can see that this is a modern day corner and that fundamentals have been thrown out the window. For those with a strong stomach join SAC and Greenlight and try to ride VW back down to where it should be in the 30s.
In other economic news real GDP fell -0.3% in Q3, better than economists' -0.5% consensus, according to advanced estimates. Last quarter it grew 2.8%. The largest contributors to the downturn were lower prices for nondurable goods and a deceleration in exports. While the GDP shrinkage was more modest than expected, things will likely get worse before they get better. The key to this is GDP is a lagging indicator and the recent GDP number does not represent the pain seen in October or the pain we will see in November and December. I am not saying the markets will fall, I am saying spending will fall on a YOY basis. Although this may be painful for retailers and the economy in the near term I can think of nothing better than U.S. consumers tightening their purse strings and hopefully reducing some of that outstanding debt, not to mention I would love to get our savings rate up there, remember counting on social security to support you in your golden years is a fool hardy proposition.
One thing that is becoming starkly obvious is the stimulus package has not succeeded as many had hoped. It is slowly becoming more evident that another stimulus could possibly be needed. Another large stimulus in the range of $200bn + will be needed to offset the sharp drop in spending relative to income by US households and businesses (i.e., the increase in the private sector financial balance) that is now underway due to the tightening of financial conditions. If left unchecked, this retrenchment raises the risk of yet more adverse feedback effects between the real economy and the financial sector.
Aggressive government responses could limit the impact of the adjustment (in other words no action is clearly the wrong action) both directly via the fiscal boost and indirectly by stabilizing expectations and financial conditions. What is technically worrying about this is that the US budget deficit is already quite large and any further leveraging might damage the system (i.e. our old nemesis inflation might rear its ugly head). But taken in perspective this objection is misguided because it ignores the greater cost of letting the downturn continue unchecked. Net-net I think we will see our federal deficit continue to climb until we see substantial government action. Remember the Federal Deficit equals the sum of private sector surplus and net-foreign capital inflow. Although it is just an accounting identity, this equation has the following, very powerful implication: An increase in the private sector balance must raise the government deficit by the same dollar amount, unless it is offset by a reduction in the current account deficit. Historically higher private sector balances have been a bad thing. In principle, it would be nice to see a package that offsets the entire negative impulse to economic activity since further increases in unemployment – from a level that is already well above what’s needed to control inflation are – a pure social “bad”. In theory, one might argue that this requires an increase in government spending on domestic goods and services of 4% of GDP or a tax cut – which inevitably involves some “leakage” into increased imports – of 6% of GDP. In dollar terms, this would imply a massive $600-$900bn stimulus. Either way I would bet the next administration does something within their first month of office (that’s if something doesn’t get done sooner).
The recent weakness in emerging markets has raised concerns in developed markets about the overall impact on profits as well as the specific risks to companies with high revenue and net income exposure to EM. In general, until very recently, the highly exposed companies have outperformed the broader market and their more domestically exposed counterparts. However, the sharp reversal of performance in these stocks being seen currently reflects the growing concern about further EM activity weakness (For an illustrative example see IBM or YUM). While it is difficult to get a firm conclusion about how much further weakness in EM is ‘priced into’ stocks, we can get some feel for it by comparing the performance of the companies most exposed to EM to their the local market, sector, and the related sector within the emerging markets. Overall, Cyclical sectors such as basic resources and industrials seem to still be the most vulnerable to further emerging economy weakness. Basic resources have possibly priced in the most emerging market weakness in terms of price action, while industrials seem to have reflected the least damage from emerging markets and would seem most vulnerable to further economic deterioration.
Earlier in the year emerging markets were seen to as a pillar of stability since the credit crunch started to emerge in the summer of 2007. Three key factors were at play. Firstly, emerging market banks were seen to be relatively unaffected by the deepening crisis in the US mortgage market, secondly emerging markets were continuing to weather a slowdown in export growth as domestic demand remained robust, and thirdly most of emerging markets benefited from higher commodity prices as they were commodity producers. With the fall in commodity prices and the worsening of the global credit markets EM indexes and stocks have fallen sharply. Emerging countries typically have had limited access to USD funding in proportion to their IMF quota. The Fed, however, on October 30, 2008 announced that it is extending dollar swap lines to the central banks of Brazil, Mexico, Korea and Singapore so as to boost USD liquidity in those emerging markets. The swap lines amount to US$30 billion for each central bank. These swap arrangements allow central banks in the major countries to provide liquidity to their local banks without having to deplete reserves or tap the normal FX market. However, if central banks in the other parts of the emerging world want to provide their banks with USD without impacting the normal FX market, they have to use either their reserves, turn to the IMF or look at less orthodox measures such as capital controls. These fears have made it more difficult to roll over existing liabilities in global capital markets and even harder to issue more debt, putting pressure on countries that do not have enough liquid assets to offset the shortage in foreign liquidity. Asian countries are less exposed to this risk relative to Eastern European countries, Latin America and Asian economies that have recently come under pressure (like Indonesia and Korea) rank somewhere in the middle in terms of exposure. The growing focus on the vulnerability of Central and Eastern European economies has been reflected in weakening currencies in the region, prompting several EM central banks to tighten liquidity either by intervening in the FX markets (and reducing reserves) or through higher overnight rates (for example the National Bank of Hungary raised rates by 300 bps, while overnight rates in Romania reached a peak of 500% last week). Weakening currencies have two major impacts. First, Eastern European countries have borrowed in foreign currencies and will face higher repayments when their national currency weakens. Second, for foreign companies exposed to this region, they will have lower profits when they translate them in their reporting currency. Growth expectations for the region have come down aggressively. While Russian GDP growth accelerated to 8% in 2007-2008H1, the pace of activity had already slowed before the banking crisis hit. The slowdown started on the back of a rapidly tightening labor market and widespread price pressures. The banking crisis has significantly added to the problems. Despite significant injections of liquidity into the banking system by the Central Bank of Russia and Finance Ministry, inter-bank lending has ground to a virtual halt over recent weeks with significant negative impacts on banks funding. Working capital constraints have emerged and anecdotal evidence suggests this is causing stoppages at a number of manufacturing facilities; this will ultimately result in starkly lower productivity. On top of the risks to growth, several countries in the region have needed to turn to the IMF for financial support. While Iceland and the Ukraine have already negotiated broad packages with the IMF, Hungary reached an agreement with the IMF for a package amounting to US$25.1 billion (including €6.5 billion from the EU and €1 billion from the World Bank). Interestingly, in contrast to what we saw in the Asian crisis, the programs have less conditionality than in the past. These are likely to be supported by at least some extension of liquidity support from central banks in advanced economies through the expanded use of swap lines and similar instruments. Together these should boost investor confidence and trigger a return of capital inflows. However, the sheer size of the external funding requirements in these countries means that some may still have to experience a sharp contraction in import demand.
While it is difficult to get a firm conclusion about how much further weakness in EM is ‘priced into’ stocks, we can get some feel for it by comparing the performance of the companies most exposed to EM to their the local market, sector, and the related sector within the emerging markets. Overall, high EM-exposed banks and telecoms have only recently started to underperform the broader market and their own sectors. In both cases, however, the recent falls seem to have overshot their peers in emerging markets. Cyclical sectors such as basic resources and industrials seem to still be the most vulnerable to further emerging economy weakness. Amongst this group basic resources have possibly priced in the most emerging market weakness in terms of price action, while industrials seem to have reflected the least damage from emerging markets and would seem most vulnerable to further economic deterioration.
The real question in my mind is when the developed markets calm are the EMs going to be the first to “pop” back up? As the world is painfully learning, the problem with leverage is that it is much easier to create than to reign in. Banks can, in effect, create leverage out of thin air. For example, when a bank makes a loan, it creates both an asset for the borrower (the proceeds from the loan) and a liability (the obligation to repay the loan). However, if the bank wants to reduce its leverage, things are not so easy. The bank can either wait until the loan is repaid (which can take a long time) or sell the loan to a third party. And even if there is a secondary market for such a loan – and recently such markets have become increasingly illiquid – selling the loan does nothing to reduce overall leverage in the financial system. This is because of the iron law of finance: for every buyer there has to be a seller. The liquidity that the bank gets from selling the loan is offset by the liquidity lost by the party that purchases the loan. But this creates an obvious problem. If most institutions are trying to delever at the same time, then asset prices must decline until enough investors with sufficient liquidity are lured back into the market. Needless to say, this dynamic has the potential to be particularly damaging to emerging markets (as we have seen over the past few weeks). On balance, the question of whether we see another full-blown EM crisis (i.e. worse than it is today) will hinge on the speed and vigor of the policy response. Thus far, the response from policymakers has been encouraging, which suggests to us that a baseline scenario in which all but the most levered EMs face a soft-landing is still the most likely outcome. That being said I think it might be time to look into the best positioned EM. I personally am most fond of Brazil as I think they have the cleanest balance sheet and should benefit from either their strong natural resources or/and their buoyant domestic economy.
Hopefully next week I hope to present a stock idea, I know I have been saying this for some time, problem is I am finding a lot of flaws in numerous ideas so I have yet to find one that I am comfortable presenting. Rest assured I will find one, so keep reading.
In other economic news real GDP fell -0.3% in Q3, better than economists' -0.5% consensus, according to advanced estimates. Last quarter it grew 2.8%. The largest contributors to the downturn were lower prices for nondurable goods and a deceleration in exports. While the GDP shrinkage was more modest than expected, things will likely get worse before they get better. The key to this is GDP is a lagging indicator and the recent GDP number does not represent the pain seen in October or the pain we will see in November and December. I am not saying the markets will fall, I am saying spending will fall on a YOY basis. Although this may be painful for retailers and the economy in the near term I can think of nothing better than U.S. consumers tightening their purse strings and hopefully reducing some of that outstanding debt, not to mention I would love to get our savings rate up there, remember counting on social security to support you in your golden years is a fool hardy proposition.
One thing that is becoming starkly obvious is the stimulus package has not succeeded as many had hoped. It is slowly becoming more evident that another stimulus could possibly be needed. Another large stimulus in the range of $200bn + will be needed to offset the sharp drop in spending relative to income by US households and businesses (i.e., the increase in the private sector financial balance) that is now underway due to the tightening of financial conditions. If left unchecked, this retrenchment raises the risk of yet more adverse feedback effects between the real economy and the financial sector.
Aggressive government responses could limit the impact of the adjustment (in other words no action is clearly the wrong action) both directly via the fiscal boost and indirectly by stabilizing expectations and financial conditions. What is technically worrying about this is that the US budget deficit is already quite large and any further leveraging might damage the system (i.e. our old nemesis inflation might rear its ugly head). But taken in perspective this objection is misguided because it ignores the greater cost of letting the downturn continue unchecked. Net-net I think we will see our federal deficit continue to climb until we see substantial government action. Remember the Federal Deficit equals the sum of private sector surplus and net-foreign capital inflow. Although it is just an accounting identity, this equation has the following, very powerful implication: An increase in the private sector balance must raise the government deficit by the same dollar amount, unless it is offset by a reduction in the current account deficit. Historically higher private sector balances have been a bad thing. In principle, it would be nice to see a package that offsets the entire negative impulse to economic activity since further increases in unemployment – from a level that is already well above what’s needed to control inflation are – a pure social “bad”. In theory, one might argue that this requires an increase in government spending on domestic goods and services of 4% of GDP or a tax cut – which inevitably involves some “leakage” into increased imports – of 6% of GDP. In dollar terms, this would imply a massive $600-$900bn stimulus. Either way I would bet the next administration does something within their first month of office (that’s if something doesn’t get done sooner).
The recent weakness in emerging markets has raised concerns in developed markets about the overall impact on profits as well as the specific risks to companies with high revenue and net income exposure to EM. In general, until very recently, the highly exposed companies have outperformed the broader market and their more domestically exposed counterparts. However, the sharp reversal of performance in these stocks being seen currently reflects the growing concern about further EM activity weakness (For an illustrative example see IBM or YUM). While it is difficult to get a firm conclusion about how much further weakness in EM is ‘priced into’ stocks, we can get some feel for it by comparing the performance of the companies most exposed to EM to their the local market, sector, and the related sector within the emerging markets. Overall, Cyclical sectors such as basic resources and industrials seem to still be the most vulnerable to further emerging economy weakness. Basic resources have possibly priced in the most emerging market weakness in terms of price action, while industrials seem to have reflected the least damage from emerging markets and would seem most vulnerable to further economic deterioration.
Earlier in the year emerging markets were seen to as a pillar of stability since the credit crunch started to emerge in the summer of 2007. Three key factors were at play. Firstly, emerging market banks were seen to be relatively unaffected by the deepening crisis in the US mortgage market, secondly emerging markets were continuing to weather a slowdown in export growth as domestic demand remained robust, and thirdly most of emerging markets benefited from higher commodity prices as they were commodity producers. With the fall in commodity prices and the worsening of the global credit markets EM indexes and stocks have fallen sharply. Emerging countries typically have had limited access to USD funding in proportion to their IMF quota. The Fed, however, on October 30, 2008 announced that it is extending dollar swap lines to the central banks of Brazil, Mexico, Korea and Singapore so as to boost USD liquidity in those emerging markets. The swap lines amount to US$30 billion for each central bank. These swap arrangements allow central banks in the major countries to provide liquidity to their local banks without having to deplete reserves or tap the normal FX market. However, if central banks in the other parts of the emerging world want to provide their banks with USD without impacting the normal FX market, they have to use either their reserves, turn to the IMF or look at less orthodox measures such as capital controls. These fears have made it more difficult to roll over existing liabilities in global capital markets and even harder to issue more debt, putting pressure on countries that do not have enough liquid assets to offset the shortage in foreign liquidity. Asian countries are less exposed to this risk relative to Eastern European countries, Latin America and Asian economies that have recently come under pressure (like Indonesia and Korea) rank somewhere in the middle in terms of exposure. The growing focus on the vulnerability of Central and Eastern European economies has been reflected in weakening currencies in the region, prompting several EM central banks to tighten liquidity either by intervening in the FX markets (and reducing reserves) or through higher overnight rates (for example the National Bank of Hungary raised rates by 300 bps, while overnight rates in Romania reached a peak of 500% last week). Weakening currencies have two major impacts. First, Eastern European countries have borrowed in foreign currencies and will face higher repayments when their national currency weakens. Second, for foreign companies exposed to this region, they will have lower profits when they translate them in their reporting currency. Growth expectations for the region have come down aggressively. While Russian GDP growth accelerated to 8% in 2007-2008H1, the pace of activity had already slowed before the banking crisis hit. The slowdown started on the back of a rapidly tightening labor market and widespread price pressures. The banking crisis has significantly added to the problems. Despite significant injections of liquidity into the banking system by the Central Bank of Russia and Finance Ministry, inter-bank lending has ground to a virtual halt over recent weeks with significant negative impacts on banks funding. Working capital constraints have emerged and anecdotal evidence suggests this is causing stoppages at a number of manufacturing facilities; this will ultimately result in starkly lower productivity. On top of the risks to growth, several countries in the region have needed to turn to the IMF for financial support. While Iceland and the Ukraine have already negotiated broad packages with the IMF, Hungary reached an agreement with the IMF for a package amounting to US$25.1 billion (including €6.5 billion from the EU and €1 billion from the World Bank). Interestingly, in contrast to what we saw in the Asian crisis, the programs have less conditionality than in the past. These are likely to be supported by at least some extension of liquidity support from central banks in advanced economies through the expanded use of swap lines and similar instruments. Together these should boost investor confidence and trigger a return of capital inflows. However, the sheer size of the external funding requirements in these countries means that some may still have to experience a sharp contraction in import demand.
While it is difficult to get a firm conclusion about how much further weakness in EM is ‘priced into’ stocks, we can get some feel for it by comparing the performance of the companies most exposed to EM to their the local market, sector, and the related sector within the emerging markets. Overall, high EM-exposed banks and telecoms have only recently started to underperform the broader market and their own sectors. In both cases, however, the recent falls seem to have overshot their peers in emerging markets. Cyclical sectors such as basic resources and industrials seem to still be the most vulnerable to further emerging economy weakness. Amongst this group basic resources have possibly priced in the most emerging market weakness in terms of price action, while industrials seem to have reflected the least damage from emerging markets and would seem most vulnerable to further economic deterioration.
The real question in my mind is when the developed markets calm are the EMs going to be the first to “pop” back up? As the world is painfully learning, the problem with leverage is that it is much easier to create than to reign in. Banks can, in effect, create leverage out of thin air. For example, when a bank makes a loan, it creates both an asset for the borrower (the proceeds from the loan) and a liability (the obligation to repay the loan). However, if the bank wants to reduce its leverage, things are not so easy. The bank can either wait until the loan is repaid (which can take a long time) or sell the loan to a third party. And even if there is a secondary market for such a loan – and recently such markets have become increasingly illiquid – selling the loan does nothing to reduce overall leverage in the financial system. This is because of the iron law of finance: for every buyer there has to be a seller. The liquidity that the bank gets from selling the loan is offset by the liquidity lost by the party that purchases the loan. But this creates an obvious problem. If most institutions are trying to delever at the same time, then asset prices must decline until enough investors with sufficient liquidity are lured back into the market. Needless to say, this dynamic has the potential to be particularly damaging to emerging markets (as we have seen over the past few weeks). On balance, the question of whether we see another full-blown EM crisis (i.e. worse than it is today) will hinge on the speed and vigor of the policy response. Thus far, the response from policymakers has been encouraging, which suggests to us that a baseline scenario in which all but the most levered EMs face a soft-landing is still the most likely outcome. That being said I think it might be time to look into the best positioned EM. I personally am most fond of Brazil as I think they have the cleanest balance sheet and should benefit from either their strong natural resources or/and their buoyant domestic economy.
Hopefully next week I hope to present a stock idea, I know I have been saying this for some time, problem is I am finding a lot of flaws in numerous ideas so I have yet to find one that I am comfortable presenting. Rest assured I will find one, so keep reading.
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