John Crow, a former governor of the Bank of Canada, remembers the stealth with which inflation wormed its way into the Canadian economy the last time that oil and food prices were soaring and the U.S. dollar was tumbling in the early 1970s -- exactly as they are today.
Canada’s annual inflation rate rose from 1% in late 1970 to 5% in 1971. By 1974 it was at 12%.
“The bank was kind of shocked,” said Mr. Crow, who joined the bank’s research department in 1973 and finally vanquished the inflation beast when he was governor in the 1990s. “If you look at the numbers, they really moved up very quickly. There was a time at the beginning of the 1970s when the exchange rate shot up - and this is interesting from the point of view of today’s exchange rate -- inflation was very low.... It wore off pretty quickly.”
Now, with oil hitting a new record above US$110, food costs soaring, and the United States hurtling toward recession, fears are growing North America could face a repeat of that nasty 1970s’ affliction: stagflation, an ugly mixture of both slow growth and high inflation.
It will not be North American wages that drive inflation higher however. The new twist this time is that inflation could start to drift higher on the back of rising costs and currencies in emerging markets, which have long been a source of downward price pressure.
“I think we are in danger of what happened in the 1970s,” said John Cochrane, professor of finance at the University of Chicago Graduate School of Business. “This is about 1972, or 1973 not yet 1979. But remember that it started the same way. Inflation in the late 1960s and early 1970s was in the 2% to 3% range...And then it slowly got out of hand.”
A press release on Wednesday from Pilgrim’s Pride Corp., the largest U.S. chicken processing company, illustrates vividly the challenges facing U.S. companies.
The Pittsburg, Tex.-based company said it was closing a plant and 13 distribution centers, laying off 1,100 people as it struggles to absorb feed costs that will rise an estimated $1.3-billion in 2008 from two years ago.
“We simply must find a way to pass along these higher costs,” said Clint Rivers, president and chief executive officer “Additionally, we believe that the recent impact of food-based inflation, coupled with the need for producers to continue to increase prices for their products, will further stimulate inflation, weaken consumer confidence and negatively affect demand for products in certain market channels.”
Inflation, as economist Milton Friedman famously put is “always and everywhere a monetary phenomenon,” that is, caused by monetary policy that is too loose. But for Mr. Cochrane it can be most quickly seen in a shrinking pocketbook rather than in loose policy.
“Inflation is that the dollars in your pocket buy less of everything around,” he said. “You can see it most quickly in foreign exchange markets. That’s where you see what the dollar is worth and then it takes a while to wind its way through domestic prices.... bit by bit you can see the price going up.”
In the United States, the annual inflation rate is at 4.0%, not far from the recent peak of 4.7% in September 2005. Previous to these two highs, U.S. inflation had not been above 4% since 1991.
Eerily similar to the 1970s, the strong Canadian dollar is for now holding down inflation this side of the border. Lower import prices have kept inflation to a manageable 2.2%.
But in countries with both strong growth and ties to the increasingly powerless U.S. dollar, inflation has reached nosebleed levels. In Russia, it is up 12% on a year-over-year basis, in China it has reached 9% and is cresting double-digit levels in many countries in the Middle East.
Strike food and energy from the inflation measures however and core prices are a more quiescent 2.5% in the United States and a scant 1.4% in Canada.
But it is the monetary policy part of inflation equation that worries economists most. The fear among some analysts is that the United States is holding interest rates far too low and easy money, combined with the slide in the dollar and the greatest surge in commodity prices since the 1970s will inevitably result in an inflationary blowback.
The Fed cut interest rates to 1% in 2003 to fight off deflation after the tech crash and 9-11 and has been furiously slashing rates again to combat the slump in housing and the global credit crisis.
These inflation fears can most readily be seen in the price of gold, considered by many to be the ultimate inflation hedge, which reached a record US$1,000 an ounce this week.
“The Fed has become a good deal more dovish since 2002 - they cut rates more and were much slower to hike than they were in the past and they are basically doing it again now,” said Tim Bond, head of global asset allocation for Barclays Capital in London.
In its zeal to prevent recessions - or to avoid upsets on U.S. financial markets - some analysts believe the Fed has damaged the U.S. economy’s ability to cleanse itself of building inflation.
“In choosing to aggressively reflate, the U.S. is pursuing a high risk strategy that threatens to increase inflation and macroeconomic volatility in the years ahead,” Mr. Bond said. “Any central bank that so clearly targets growth over inflation is destined to lose control over inflation expectations.”
Interest rate cuts have also gutted the U.S. dollar and only exacerbated the inflation problem, other analysts say.
“The upsurge of food and energy prices in response to the Fed’s deliberate trashing of the dollar has significantly worsened consumer confidence and real incomes,” said Charles Dumas at Lombard Street Research in a research note on Friday.
Still, there are many analysts on Wall Street who say worrying about inflation when the U.S. is facing its biggest housing recession in decades, financial institutions are insolvent and global credit market keeps seizing up would be even more short-sighted.
“It’s like the guy who’s on his way to the guillotine and he’s worried about his haircut,” said Marc Chandler, global head of currency strategy at Brown Brothers Harriman.
Inflation is a lagging indicator.
David Rosenberg, chief North American economist at Merrill Lynch, notes core inflation rose to 2.8% from 2.7% in the 2001 recession but dropped to 2% in the recovery. In 1990-91 it rose to 5.2% from 5% and dropped to 3.9% in the recovery.
With the average house price dropping like a stone and consumers likely to pull in their horns U.S. inflation could be tamed by the slowdown.
As well, the circumstances that allowed inflation to spiral out of control in the 1970s simply do not exist today. Policymakers made a series of errors in the 1970s that allowed inflation to take root, Mr. Crow said.
The Bank of Canada tried to counteract the surge in the dollar with lower rates in an effort to buffer exports. The federal government brought in expansionary budgets and unions were just beginning to infiltrate the public sector.
“Monetary policy was more expansionary than it should have been in order to ease the pressure on exchange rates,” Mr. Crow said. “It compounded an expansionary fiscal policy and a feeling in the country the government was prepared to see inflation go up as the price of keeping unemployment down. It didn’t work.”
The federal government had little experience with unions and in both Canada and the United States unions contracts were soon being written to tie wage increases directly to rises in the consumer price index. An inflationary mindset set in.
“In those days there was cost-push inflation, which meant wages were rising, which pushed up prices, which pushed up wages.” said Sherry Cooper, chief economist at BMO Capital Markets.
It took double-digit interest rate increases on both sides of the border and a severe recession in the early 1980s to finally break the back of inflation but it took until the 1990s, when Mr. Crow’s dogged pursuit of inflation targets finally got it under control in Canada.
Both Canadian and U.S. wages have drifted up recently but analysts say the next round of inflation pressure will come from overseas.
Already China has let its currency rise to battle inflation and other Asian and Gulf countries are likely to do the same.
Benjamin Tal, senior economist at CIBC World Markets says U.S. import prices have soared 30% since 2004 and are rising at an annual pace of 13%, up from 3% in May 2007. “Now that’s the dollar clearly, but in the background we also have a situation where wages are rising in China and other places,” Mr. Tal said. “If the story today is subprime losses and recession, the story in 2009 is accelerated inflation and higher interest rates.”
Chen Zhao, managing editor for Global Investment Strategy at Bank Credit Analyst, notes Chinese wages are rising at about an 8% annual pace.
“They have had a very low interest rate policy, very low currencies for a long period of time - since the Asian crisis over the last 10 years. Now this policy has outlived it’s usefulness.”
Both emerging countries and the major economies may find that a new more useful policy will be to zero in more rigidly on inflation again. And that means higher interest rates for everyone.
Until recently, the outlook for China was as bullish as ever but more and more bad news has emerged in the past few months
By TEH HOOI LING Business Times - 15 Mar 2008
INVESTORS who are still holding on to their stocks, especially China stocks, would know how severe a drubbing the stocks have suffered in the past five-and-a-half months.
But given the revamping of the numerous indices - and that now they are not widely available - investors may not know to what extent the various groups of stocks have fallen as a whole.
Here are the numbers - and they are not pretty.
Between Oct 1, 2007 and yesterday, the Straits Times Index has fallen 24.4 per cent. The UOB Catalist Index, used as a proxy for small-cap stocks, has plunged 42.2 per cent.
But the stocks hammered most are China stocks. The Prime Partners China Index has melted to the tune of 56 per cent.
Is this walloping justified? Well, to an extent. Until very recently, the outlook for China was as bullish as ever. But in the past few months, more and more bad news has emerged.
In a bid to cool the economy, the Chinese government implemented several policies. It slashed value-added tax rebates on exports and ordered banks to tighten credit for certain products. The central bank also raised interest rates four times last year to rein in liquidity and investment, and is allowing the currency to appreciate.
The moves are aimed at taming inflation, which is running at an 11-year high. But they also have the effect of eroding Chinese companies’ cost-competitiveness.
Materials, energy and labour costs are all climbing in mainland China. Wages are rising 10-15 per cent a year, and a new labour law requiring stronger employment contracts will raise costs even more. Meanwhile, the yuan, after rising 7 per cent last year, is expected to appreciate another 12 per cent in the coming 12 months.
‘The sum of parts of all the policy changes and the rising costs and higher currency is bigger than each on its own,’ says an investor. In other words, companies in China are being hit more than most anticipated.
Indeed, cracks are beginning to appear on the bottom lines of Chinese companies.
I decided to study how much the Chinese companies have been hit, especially in the final quarter of 2007, and how they compare with non-China-based companies listed on the Singapore Exchange.
Here’s what I found. Although China stocks on the whole have shown faster top-line growth than non-China stocks, they chalked up significantly lower earnings per share (EPS) expansion.
In fact, for the whole of 2007, the median EPS growth of China stocks in Singapore was zero. The aggregate EPS of all the China stocks actually shrank 4.6 per cent compared with 2006.
Of the China companies that release quarterly numbers, 82 per cent showed an improved revenue in the last quarter of 2007 vis-a-vis the same period a year earlier.
The percentage is actually higher than non-China companies, of which 76 per cent registered higher revenue.
The magnitude of the revenue growth among Chinese companies was also higher. The median change in revenue was 24.5 per cent, while the aggregate increase was a strong 42.6 per cent. In comparison, non-China stocks saw a median 14 per cent rise in revenue and a 35 per cent surge in aggregate revenue.
Median revenue would simply be the middle performer, ranking all the stocks on their revenue growth, say from highest to lowest. As for aggregate revenue, it is the total of revenue for all the companies. The sum for 2007 was compared with the total in 2006 to arrive at the aggregate change.
The bigger aggregate revenue change, as compared with median revenue growth, means it was the bigger companies which accounted for much of the aggregate revenue growth.
But while Chinese companies as a whole managed to expand their sales, they were not able to translate this into fatter bottom lines. Just over half the Chinese companies managed to improve their earnings per share.
Overall, their EPS grew only 5.1 per cent, with the median at 6.9 per cent. In contrast, the median EPS growth of non-China stocks was a much stronger 14.1 per cent. In aggregate, the EPS of non-China stocks rose 38 per cent.
In other words, Chinese companies experienced significant margin erosion in the final quarter of 2007, while non-Chinese companies on the whole managed to maintain their margins.
Another worrying sign for China companies is that on average the revenue growth appeared to slow in the last quarter of 2007, albeit marginally.
The median change in revenue between October and December last was 24.5 per cent, slightly lower than the 27.3 per cent chalked up in the first nine months of the year.
It is, however, the same for non-China stocks - median revenue growth fell slightly to 14 per cent from about 15 per cent.
For both China-based and non-China stocks, however, the percentage of companies that managed to improve their earnings per share fell - to 53 per cent in the final quarter of 2007, from 59 per cent in the first nine months of the year for the former, and to 59 per cent from 64 per cent for the latter.
The full-year picture looks even worse for China stocks. Included in the full-year tally would be companies that might not release quarterly numbers due to their small size. In all, only 53 per cent of China stocks showed improved EPS. This compared with 65 per cent for non-China stocks.
And as mentioned, the median full-year EPS growth for the China stocks was zero, and the aggregate minus 4.6 per cent. In comparison, the median full-year EPS growth of non-China stocks was a healthy 25 per cent. And aggregate EPS growth was a whopping 44 per cent.
Going by the dividend payout, it appears that Chinese companies realise that things will get tougher in 2008. In aggregate, they actually halved their dividend payout, from 34 per cent of earnings per share in 2006 to just 17 per cent in 2007.
Non-China stocks also reduced their dividend payout, but more moderately. Last year, they proposed paying out 35 per cent of their EPS as dividends - a reduction from the very generous 46 per cent payout in 2006.
As can be seen, the operating conditions for Chinese companies have taken a turn for the worse. Indeed, of the 40 SGX-listed companies that have suffered the biggest downgrades by analysts in the past 30 days, 15 - or 37.5 per cent - are China stocks. And that is more than their fair share, given that China stocks made up about 18 per cent of all listed companies on SGX.
Of the 15 Chinese companies that have been downgraded, the mean and median forward earnings - based on the lower expectations - are 8.4 times and 6.3 times respectively, according to data from StarMine Professional.
According to the list, companies with the lowest PE ratios are Sunshine Holdings, C&G Industrial, Ferrochina and China Auto Electronics Group. They are trading at 3.3 to 4.2 times their forecast earnings in the next 12 months.
Those still trading at high earnings multiples are Asiapharm, Delong and Midas Holdings. They are transacting at between 16.2 and 22.8 times their forecast earnings.
The Federal Reserve’s unusual decision to provide emergency assistance to Bear Stearns underscores a long-building concern that one failure could spread across the financial system.
Wall Street firms like Bear Stearns conduct business with many individuals, corporations, financial companies, pension funds and hedge funds. They also do billions of dollars of business with each other every day, borrowing and lending securities at a dizzying pace and fueling the wheels of capitalism.
The sudden collapse of a major player could not only shake client confidence in the entire system, but also make it difficult for sound institutions to conduct business as usual. Hedge funds that rely on Bear to finance their trading and hold their securities would be stranded; investors who wrote financial contracts with Bear would be at risk; markets that depended on Bear to buy and sell securities would screech to a halt, if they were not already halted.
“In a trading firm, trust is everything,” said Richard Sylla, a financial historian at New York University. “The person at the other end of the phone or the trading screen has to believe that you will make good on any deal that you make.”
Commercial banks, mutual fund companies and other big financial firms with deep pockets would presumably weather such turmoil. Firms that traded extensively with Bear Stearns could be at great risk if the bank failed.
For individual customers, the Federal Deposit Insurance Corporation insures deposits up to $100,000. Furthermore, when a Wall Street firm fails, the Securities Investor Protection Corporation steps in to take over customer accounts.
The Fed’s action was intended simply to keep the financial markets functioning. Since various trading markets seized up in August, credit conditions have steadily worsened, and interest rate cuts, the main tool central bankers use to bolster the economy, have become less effective.
Policy makers anticipated some of the problems now affecting the financial world. In 2006 and 2007, Timothy F. Geithner, president of the Federal Reserve Bank of New York, asked major Wall Street institutions to gauge the impact on their portfolios if a large bank failed.
The volume of financial contracts that are not traded on any major exchanges has ballooned in recent years after the bailout of a big hedge fund, Long-Term Capital Management, in 1998. Now, much of the trading in derivative contracts tied to stocks and bonds takes place in unregulated transactions between financial institutions.Policy makers have been wrestling with questions about when and how they should provide assistance since the last major bailout of a tottering bank, Continental Illinois, in 1984. At the time, Continental was considered too big to fail without sending waves of losses through the financial system.
Regulators are facing an unprecedented and widespread deterioration in many markets. Last summer, the value of risky and exotic securities plummeted in value. Now, even top-rated securities once deemed as safe as Treasuries have hit the skids. Financial firms have written down more than $150 billion of their assets. Some analysts are predicting that losses in various credit markets will reach $600 billion.
Bear Stearns was one of the first firms to experience a direct blow from the subprime mortgage crisis when two of its hedge funds collapsed because of the declining value of mortgage-backed securities.
It is also among the biggest firms in the prime brokerage business, or the financing of hedge funds. In recent weeks, nervous fund managers have scrambled to protect themselves. Robert Sloan, who is the managing partner at S3 Partners, a financing specialist that works with hedge funds, has shifted $25 billion out of Bear Stearns accounts in the last two months, he said.
“The problem is the financing of the hedge fund industry is very concentrated and very brittle,” Mr. Sloan said. “If they go under, you will have thousands of funds frozen out,” he said, adding that everyone might then have to wait for a court to name a receiver before business could resume.
Hedge funds rely on Wall Street for a range of services from the humdrum, like holding their securities, to the critical, like providing loans they use to increase their bets. As Wall Street has buckled under multibillion-dollar write-downs, the firms have cut financing to hedge funds and asked the funds to put up more assets to back their borrowing, forcing managers to sell en masse.
This has caused a series of hedge fund blowups, including Carlyle Capital, an affiliate of the powerful private equity firm Carlyle Group; Peloton Partners, a hedge fund founded by former Goldman Sachs traders; and Drake Capital, a blue-chip fund that has been struggling.
A manager at one hedge fund that uses Bear Stearns as its prime broker said his firm had been nervously watching the situation. The manager, speaking on the condition that he or his fund not be identified, said the fund had lined up backup firms that could clear its trades and keep its portfolio, though as of Friday afternoon it had not left Bear Stearns.
Customer accounts at financial institutions are kept separate from banks’ and dealers’ own holdings to protect those funds if the broker has to seek bankruptcy protection.
But the bigger worry for hedge funds and others that do business with Bear Stearns is whether the firm will be able to honor its trades. Of particular concern are the insurance contracts known as credit default swaps in which one party agrees to guarantee interest and principal payments in case an issuer defaults on its bonds. Investors in such contracts with Bear Stearns are closely studying whether they can get out of them or have them transferred to a more stable firm.
Compounding the problem, some big investment banks this week stopped accepting trades that would expose them to Bear Stearns. Money market funds also reduced their holdings of short-term debt issued by Bear, according to industry officials.
“You get to where people can’t trade with each other,” said James L. Melcher, president of Balestra Capital, a hedge fund based in New York. “If the Fed hadn’t acted this morning and Bear did default on its obligations, then that could have triggered a very widespread panic and potentially a collapse of the financial system.”
Already, investors are considering whether another firm might face financial problems. The price for insuring Lehman Brothers’ debt jumped to $478 per $10,000 in bonds on Friday afternoon, from $385 in the morning, according to Thomson Financial. The cost for Bear debt was up to $830, from $530.
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A repeat of 1970’s style stagflation?
Jacqueline Thorpe, Financial Post
March 14, 2008
John Crow, a former governor of the Bank of Canada, remembers the stealth with which inflation wormed its way into the Canadian economy the last time that oil and food prices were soaring and the U.S. dollar was tumbling in the early 1970s -- exactly as they are today.
Canada’s annual inflation rate rose from 1% in late 1970 to 5% in 1971. By 1974 it was at 12%.
“The bank was kind of shocked,” said Mr. Crow, who joined the bank’s research department in 1973 and finally vanquished the inflation beast when he was governor in the 1990s. “If you look at the numbers, they really moved up very quickly. There was a time at the beginning of the 1970s when the exchange rate shot up - and this is interesting from the point of view of today’s exchange rate -- inflation was very low.... It wore off pretty quickly.”
Now, with oil hitting a new record above US$110, food costs soaring, and the United States hurtling toward recession, fears are growing North America could face a repeat of that nasty 1970s’ affliction: stagflation, an ugly mixture of both slow growth and high inflation.
It will not be North American wages that drive inflation higher however. The new twist this time is that inflation could start to drift higher on the back of rising costs and currencies in emerging markets, which have long been a source of downward price pressure.
“I think we are in danger of what happened in the 1970s,” said John Cochrane, professor of finance at the University of Chicago Graduate School of Business. “This is about 1972, or 1973 not yet 1979. But remember that it started the same way. Inflation in the late 1960s and early 1970s was in the 2% to 3% range...And then it slowly got out of hand.”
A press release on Wednesday from Pilgrim’s Pride Corp., the largest U.S. chicken processing company, illustrates vividly the challenges facing U.S. companies.
The Pittsburg, Tex.-based company said it was closing a plant and 13 distribution centers, laying off 1,100 people as it struggles to absorb feed costs that will rise an estimated $1.3-billion in 2008 from two years ago.
“We simply must find a way to pass along these higher costs,” said Clint Rivers, president and chief executive officer “Additionally, we believe that the recent impact of food-based inflation, coupled with the need for producers to continue to increase prices for their products, will further stimulate inflation, weaken consumer confidence and negatively affect demand for products in certain market channels.”
Inflation, as economist Milton Friedman famously put is “always and everywhere a monetary phenomenon,” that is, caused by monetary policy that is too loose. But for Mr. Cochrane it can be most quickly seen in a shrinking pocketbook rather than in loose policy.
“Inflation is that the dollars in your pocket buy less of everything around,” he said. “You can see it most quickly in foreign exchange markets. That’s where you see what the dollar is worth and then it takes a while to wind its way through domestic prices.... bit by bit you can see the price going up.”
In the United States, the annual inflation rate is at 4.0%, not far from the recent peak of 4.7% in September 2005. Previous to these two highs, U.S. inflation had not been above 4% since 1991.
Eerily similar to the 1970s, the strong Canadian dollar is for now holding down inflation this side of the border. Lower import prices have kept inflation to a manageable 2.2%.
But in countries with both strong growth and ties to the increasingly powerless U.S. dollar, inflation has reached nosebleed levels. In Russia, it is up 12% on a year-over-year basis, in China it has reached 9% and is cresting double-digit levels in many countries in the Middle East.
Strike food and energy from the inflation measures however and core prices are a more quiescent 2.5% in the United States and a scant 1.4% in Canada.
But it is the monetary policy part of inflation equation that worries economists most. The fear among some analysts is that the United States is holding interest rates far too low and easy money, combined with the slide in the dollar and the greatest surge in commodity prices since the 1970s will inevitably result in an inflationary blowback.
The Fed cut interest rates to 1% in 2003 to fight off deflation after the tech crash and 9-11 and has been furiously slashing rates again to combat the slump in housing and the global credit crisis.
These inflation fears can most readily be seen in the price of gold, considered by many to be the ultimate inflation hedge, which reached a record US$1,000 an ounce this week.
“The Fed has become a good deal more dovish since 2002 - they cut rates more and were much slower to hike than they were in the past and they are basically doing it again now,” said Tim Bond, head of global asset allocation for Barclays Capital in London.
In its zeal to prevent recessions - or to avoid upsets on U.S. financial markets - some analysts believe the Fed has damaged the U.S. economy’s ability to cleanse itself of building inflation.
“In choosing to aggressively reflate, the U.S. is pursuing a high risk strategy that threatens to increase inflation and macroeconomic volatility in the years ahead,” Mr. Bond said. “Any central bank that so clearly targets growth over inflation is destined to lose control over inflation expectations.”
Interest rate cuts have also gutted the U.S. dollar and only exacerbated the inflation problem, other analysts say.
“The upsurge of food and energy prices in response to the Fed’s deliberate trashing of the dollar has significantly worsened consumer confidence and real incomes,” said Charles Dumas at Lombard Street Research in a research note on Friday.
Still, there are many analysts on Wall Street who say worrying about inflation when the U.S. is facing its biggest housing recession in decades, financial institutions are insolvent and global credit market keeps seizing up would be even more short-sighted.
“It’s like the guy who’s on his way to the guillotine and he’s worried about his haircut,” said Marc Chandler, global head of currency strategy at Brown Brothers Harriman.
Inflation is a lagging indicator.
David Rosenberg, chief North American economist at Merrill Lynch, notes core inflation rose to 2.8% from 2.7% in the 2001 recession but dropped to 2% in the recovery. In 1990-91 it rose to 5.2% from 5% and dropped to 3.9% in the recovery.
With the average house price dropping like a stone and consumers likely to pull in their horns U.S. inflation could be tamed by the slowdown.
As well, the circumstances that allowed inflation to spiral out of control in the 1970s simply do not exist today. Policymakers made a series of errors in the 1970s that allowed inflation to take root, Mr. Crow said.
The Bank of Canada tried to counteract the surge in the dollar with lower rates in an effort to buffer exports. The federal government brought in expansionary budgets and unions were just beginning to infiltrate the public sector.
“Monetary policy was more expansionary than it should have been in order to ease the pressure on exchange rates,” Mr. Crow said. “It compounded an expansionary fiscal policy and a feeling in the country the government was prepared to see inflation go up as the price of keeping unemployment down. It didn’t work.”
The federal government had little experience with unions and in both Canada and the United States unions contracts were soon being written to tie wage increases directly to rises in the consumer price index. An inflationary mindset set in.
“In those days there was cost-push inflation, which meant wages were rising, which pushed up prices, which pushed up wages.” said Sherry Cooper, chief economist at BMO Capital Markets.
It took double-digit interest rate increases on both sides of the border and a severe recession in the early 1980s to finally break the back of inflation but it took until the 1990s, when Mr. Crow’s dogged pursuit of inflation targets finally got it under control in Canada.
Both Canadian and U.S. wages have drifted up recently but analysts say the next round of inflation pressure will come from overseas.
Already China has let its currency rise to battle inflation and other Asian and Gulf countries are likely to do the same.
Benjamin Tal, senior economist at CIBC World Markets says U.S. import prices have soared 30% since 2004 and are rising at an annual pace of 13%, up from 3% in May 2007. “Now that’s the dollar clearly, but in the background we also have a situation where wages are rising in China and other places,” Mr. Tal said. “If the story today is subprime losses and recession, the story in 2009 is accelerated inflation and higher interest rates.”
Chen Zhao, managing editor for Global Investment Strategy at Bank Credit Analyst, notes Chinese wages are rising at about an 8% annual pace.
“They have had a very low interest rate policy, very low currencies for a long period of time - since the Asian crisis over the last 10 years. Now this policy has outlived it’s usefulness.”
Both emerging countries and the major economies may find that a new more useful policy will be to zero in more rigidly on inflation again. And that means higher interest rates for everyone.
Financial Post
China stocks not looking pretty
Until recently, the outlook for China was as bullish as ever but more and more bad news has emerged in the past few months
By TEH HOOI LING
Business Times - 15 Mar 2008
INVESTORS who are still holding on to their stocks, especially China stocks, would know how severe a drubbing the stocks have suffered in the past five-and-a-half months.
But given the revamping of the numerous indices - and that now they are not widely available - investors may not know to what extent the various groups of stocks have fallen as a whole.
Here are the numbers - and they are not pretty.
Between Oct 1, 2007 and yesterday, the Straits Times Index has fallen 24.4 per cent. The UOB Catalist Index, used as a proxy for small-cap stocks, has plunged 42.2 per cent.
But the stocks hammered most are China stocks. The Prime Partners China Index has melted to the tune of 56 per cent.
Is this walloping justified? Well, to an extent.
Until very recently, the outlook for China was as bullish as ever. But in the past few months, more and more bad news has emerged.
In a bid to cool the economy, the Chinese government implemented several policies. It slashed value-added tax rebates on exports and ordered banks to tighten credit for certain products. The central bank also raised interest rates four times last year to rein in liquidity and investment, and is allowing the currency to appreciate.
The moves are aimed at taming inflation, which is running at an 11-year high. But they also have the effect of eroding Chinese companies’ cost-competitiveness.
Materials, energy and labour costs are all climbing in mainland China. Wages are rising 10-15 per cent a year, and a new labour law requiring stronger employment contracts will raise costs even more. Meanwhile, the yuan, after rising 7 per cent last year, is expected to appreciate another 12 per cent in the coming 12 months.
‘The sum of parts of all the policy changes and the rising costs and higher currency is bigger than each on its own,’ says an investor. In other words, companies in China are being hit more than most anticipated.
Indeed, cracks are beginning to appear on the bottom lines of Chinese companies.
I decided to study how much the Chinese companies have been hit, especially in the final quarter of 2007, and how they compare with non-China-based companies listed on the Singapore Exchange.
Here’s what I found. Although China stocks on the whole have shown faster top-line growth than non-China stocks, they chalked up significantly lower earnings per share (EPS) expansion.
In fact, for the whole of 2007, the median EPS growth of China stocks in Singapore was zero. The aggregate EPS of all the China stocks actually shrank 4.6 per cent compared with 2006.
Of the China companies that release quarterly numbers, 82 per cent showed an improved revenue in the last quarter of 2007 vis-a-vis the same period a year earlier.
The percentage is actually higher than non-China companies, of which 76 per cent registered higher revenue.
The magnitude of the revenue growth among Chinese companies was also higher. The median change in revenue was 24.5 per cent, while the aggregate increase was a strong 42.6 per cent. In comparison, non-China stocks saw a median 14 per cent rise in revenue and a 35 per cent surge in aggregate revenue.
Median revenue would simply be the middle performer, ranking all the stocks on their revenue growth, say from highest to lowest. As for aggregate revenue, it is the total of revenue for all the companies. The sum for 2007 was compared with the total in 2006 to arrive at the aggregate change.
The bigger aggregate revenue change, as compared with median revenue growth, means it was the bigger companies which accounted for much of the aggregate revenue growth.
But while Chinese companies as a whole managed to expand their sales, they were not able to translate this into fatter bottom lines. Just over half the Chinese companies managed to improve their earnings per share.
Overall, their EPS grew only 5.1 per cent, with the median at 6.9 per cent. In contrast, the median EPS growth of non-China stocks was a much stronger 14.1 per cent. In aggregate, the EPS of non-China stocks rose 38 per cent.
In other words, Chinese companies experienced significant margin erosion in the final quarter of 2007, while non-Chinese companies on the whole managed to maintain their margins.
Another worrying sign for China companies is that on average the revenue growth appeared to slow in the last quarter of 2007, albeit marginally.
The median change in revenue between October and December last was 24.5 per cent, slightly lower than the 27.3 per cent chalked up in the first nine months of the year.
It is, however, the same for non-China stocks - median revenue growth fell slightly to 14 per cent from about 15 per cent.
For both China-based and non-China stocks, however, the percentage of companies that managed to improve their earnings per share fell - to 53 per cent in the final quarter of 2007, from 59 per cent in the first nine months of the year for the former, and to 59 per cent from 64 per cent for the latter.
The full-year picture looks even worse for China stocks. Included in the full-year tally would be companies that might not release quarterly numbers due to their small size. In all, only 53 per cent of China stocks showed improved EPS. This compared with 65 per cent for non-China stocks.
And as mentioned, the median full-year EPS growth for the China stocks was zero, and the aggregate minus 4.6 per cent. In comparison, the median full-year EPS growth of non-China stocks was a healthy 25 per cent. And aggregate EPS growth was a whopping 44 per cent.
Going by the dividend payout, it appears that Chinese companies realise that things will get tougher in 2008. In aggregate, they actually halved their dividend payout, from 34 per cent of earnings per share in 2006 to just 17 per cent in 2007.
Non-China stocks also reduced their dividend payout, but more moderately. Last year, they proposed paying out 35 per cent of their EPS as dividends - a reduction from the very generous 46 per cent payout in 2006.
As can be seen, the operating conditions for Chinese companies have taken a turn for the worse. Indeed, of the 40 SGX-listed companies that have suffered the biggest downgrades by analysts in the past 30 days, 15 - or 37.5 per cent - are China stocks. And that is more than their fair share, given that China stocks made up about 18 per cent of all listed companies on SGX.
Of the 15 Chinese companies that have been downgraded, the mean and median forward earnings - based on the lower expectations - are 8.4 times and 6.3 times respectively, according to data from StarMine Professional.
According to the list, companies with the lowest PE ratios are Sunshine Holdings, C&G Industrial, Ferrochina and China Auto Electronics Group. They are trading at 3.3 to 4.2 times their forecast earnings in the next 12 months.
Those still trading at high earnings multiples are Asiapharm, Delong and Midas Holdings. They are transacting at between 16.2 and 22.8 times their forecast earnings.
Bear Rescue Plan: A Wall St. Domino Theory
By JENNY ANDERSON and VIKAS BAJAJ
The Federal Reserve’s unusual decision to provide emergency assistance to Bear Stearns underscores a long-building concern that one failure could spread across the financial system.
Wall Street firms like Bear Stearns conduct business with many individuals, corporations, financial companies, pension funds and hedge funds. They also do billions of dollars of business with each other every day, borrowing and lending securities at a dizzying pace and fueling the wheels of capitalism.
The sudden collapse of a major player could not only shake client confidence in the entire system, but also make it difficult for sound institutions to conduct business as usual. Hedge funds that rely on Bear to finance their trading and hold their securities would be stranded; investors who wrote financial contracts with Bear would be at risk; markets that depended on Bear to buy and sell securities would screech to a halt, if they were not already halted.
“In a trading firm, trust is everything,” said Richard Sylla, a financial historian at New York University. “The person at the other end of the phone or the trading screen has to believe that you will make good on any deal that you make.”
Commercial banks, mutual fund companies and other big financial firms with deep pockets would presumably weather such turmoil. Firms that traded extensively with Bear Stearns could be at great risk if the bank failed.
For individual customers, the Federal Deposit Insurance Corporation insures deposits up to $100,000. Furthermore, when a Wall Street firm fails, the Securities Investor Protection Corporation steps in to take over customer accounts.
The Fed’s action was intended simply to keep the financial markets functioning. Since various trading markets seized up in August, credit conditions have steadily worsened, and interest rate cuts, the main tool central bankers use to bolster the economy, have become less effective.
Policy makers anticipated some of the problems now affecting the financial world. In 2006 and 2007, Timothy F. Geithner, president of the Federal Reserve Bank of New York, asked major Wall Street institutions to gauge the impact on their portfolios if a large bank failed.
The volume of financial contracts that are not traded on any major exchanges has ballooned in recent years after the bailout of a big hedge fund, Long-Term Capital Management, in 1998. Now, much of the trading in derivative contracts tied to stocks and bonds takes place in unregulated transactions between financial institutions.Policy makers have been wrestling with questions about when and how they should provide assistance since the last major bailout of a tottering bank, Continental Illinois, in 1984. At the time, Continental was considered too big to fail without sending waves of losses through the financial system.
Regulators are facing an unprecedented and widespread deterioration in many markets. Last summer, the value of risky and exotic securities plummeted in value. Now, even top-rated securities once deemed as safe as Treasuries have hit the skids. Financial firms have written down more than $150 billion of their assets. Some analysts are predicting that losses in various credit markets will reach $600 billion.
Bear Stearns was one of the first firms to experience a direct blow from the subprime mortgage crisis when two of its hedge funds collapsed because of the declining value of mortgage-backed securities.
It is also among the biggest firms in the prime brokerage business, or the financing of hedge funds. In recent weeks, nervous fund managers have scrambled to protect themselves. Robert Sloan, who is the managing partner at S3 Partners, a financing specialist that works with hedge funds, has shifted $25 billion out of Bear Stearns accounts in the last two months, he said.
“The problem is the financing of the hedge fund industry is very concentrated and very brittle,” Mr. Sloan said. “If they go under, you will have thousands of funds frozen out,” he said, adding that everyone might then have to wait for a court to name a receiver before business could resume.
Hedge funds rely on Wall Street for a range of services from the humdrum, like holding their securities, to the critical, like providing loans they use to increase their bets. As Wall Street has buckled under multibillion-dollar write-downs, the firms have cut financing to hedge funds and asked the funds to put up more assets to back their borrowing, forcing managers to sell en masse.
This has caused a series of hedge fund blowups, including Carlyle Capital, an affiliate of the powerful private equity firm Carlyle Group; Peloton Partners, a hedge fund founded by former Goldman Sachs traders; and Drake Capital, a blue-chip fund that has been struggling.
A manager at one hedge fund that uses Bear Stearns as its prime broker said his firm had been nervously watching the situation. The manager, speaking on the condition that he or his fund not be identified, said the fund had lined up backup firms that could clear its trades and keep its portfolio, though as of Friday afternoon it had not left Bear Stearns.
Customer accounts at financial institutions are kept separate from banks’ and dealers’ own holdings to protect those funds if the broker has to seek bankruptcy protection.
But the bigger worry for hedge funds and others that do business with Bear Stearns is whether the firm will be able to honor its trades. Of particular concern are the insurance contracts known as credit default swaps in which one party agrees to guarantee interest and principal payments in case an issuer defaults on its bonds. Investors in such contracts with Bear Stearns are closely studying whether they can get out of them or have them transferred to a more stable firm.
Compounding the problem, some big investment banks this week stopped accepting trades that would expose them to Bear Stearns. Money market funds also reduced their holdings of short-term debt issued by Bear, according to industry officials.
“You get to where people can’t trade with each other,” said James L. Melcher, president of Balestra Capital, a hedge fund based in New York. “If the Fed hadn’t acted this morning and Bear did default on its obligations, then that could have triggered a very widespread panic and potentially a collapse of the financial system.”
Already, investors are considering whether another firm might face financial problems. The price for insuring Lehman Brothers’ debt jumped to $478 per $10,000 in bonds on Friday afternoon, from $385 in the morning, according to Thomson Financial. The cost for Bear debt was up to $830, from $530.
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