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Sunday, 24 August 2008
Not time for bottom fishing
Stocks, bonds, properties are still in bear markets. They have at least one year to go before hitting bottoms. When they do, they won’t recover quickly. Investors should not hurry for bottom fishing.
One year ago, Jim Cramer, a stock promoter on CNBC, screamed like a cry-baby on TV for the Fed to save the Wall Street. It was probably the starting point for the crisis. Soon the European Central Bank injected EUR95bn into the eurozone banking system to resuscitate the interbank market. One year on, the crisis continues with no end in sight. Losses at prominent financial institutions are still piling up, having reported $450 billion of losses. Their survival is often in doubt.
The economies, however, have done better than I expected. The fiscal stimulus in the US prevented a technical recession. Europe and Japan also avoided a technical recession in the first half. Inflation, however, has picked up more than I expected. The core CPI in the US surpassed 5%, eurozone 4%, and Japan 3%. Emerging economies are experiencing double-digit inflation on average. The global inflation is probably around 5.5% now, the highest in a quarter century.
The growth and inflation surprises are related. Central banks around the world have put growth ahead of inflation. Through repeated market bailouts with liquidity injections, they have prevented financial markets from clearing, i.e., postponing the economic impact of the financial crisis. Hence, growth rates have surprised on the upside. On the other hand, liquidity injections, as I predicted in August 2007, would push up commodity prices. Oil price doubled, and rice price trebled at their recent peaks from one year ago. Despite its recent 17% decline, the CRB index remains 50% higher than the level in August 2007.
What happens now? First, the financial crisis due to property price decline will continue. The losses at global financial institutions may be only half over. The US financial institutions increased their debts by $1 trillion to $15 trillion in the past year. Deleveraging has not happened. Without deleveraging assets remain stuck on the balance sheets of the financial institutions. We don’t know how much they are really worth. As long as central banks continue to support the failing financial institutions, they have no incentives to sell their assets and recognize the losses. Hence, the financial crisis continues in slow motion with occasional explosions to shock the market.
Second, the economic impact will become more obvious in the second half of 2008. The US and Japan may experience negative growth and Europe is likely to slow down sharply. East Asia depends on manufacturing exports and is hurt badly between weakening demand and rising oil price. They will likely slow down dramatically also. The reasons for the slowdown are (1) credit crunch depressing investment, (2) trade slowdown, and (3) negative wealth effect from property deflation.
Third, the second round of financial crisis from economic slowdown will begin to unfold. In addition to the build-up of leverage related to property, leverage has risen in many other areas like credit card debt, merchandize financing, and business debt due to LBOs. As economies slow down and unemployment rates rise, the resulting income slowdown could cause highly leveraged businesses and households to default. As with debts in the property sector, financial institutions have kept massive amounts in those sectors on their books in the form of securitized assets or derivatives.
Some financial institutions are already reporting losses from holding credit debts. This is just the beginning. The US unemployment rate has risen only one percentage point from one year ago. It may have two percentage points more to go. Unemployment rates in Europe, Japan, and manufacturing part of the emerging economies are just beginning.
In the business world, apart from financial institutions, there are no major bankruptcies yet. In the past five years, private equity funds (PEs) have acquired companies worth trillions of dollars mostly with debt financing. The businesses they own have very high debt equity ratio. If their businesses slip, they are likely to go into bankruptcy. The PE boom of the past five years was powered by cheap debt financing like the property boom. I believe the PE industry is heading towards a major crisis.
The auto sector, for example, already exposes the debt problems on consumer side, business side, and PE side. As oil price surges and property price falls, auto demand is falling around the world. Auto production has high fixed cost. If sales fall, auto producers can go into deep losses. If they have high debts, bankruptcies are likely to follow. The US auto makers, for example, are most vulnerable. They depend on financing incentives to promote big car sales. High oil price and the credit crisis are destroying this business model. The auto financing business is also in deep trouble. The US government may be soon forced into bailing out the US auto sector. But a bailout would still wipe out the share value that PEs hold.
Stagflation remains the dominant trend. Only the economies that export oil continue to boom. The emerging economies that depend on manufacturing exports suffer from rising cost and weakening demand. These forces push them towards stagflation. The prices of commodities have dropped sharply in the past month. The CRB index has declined by 17% from its recent peak. Oil price, for example, has dropped by $20/barrel from its recent peak of $147. Many analysts attribute it to worries over weakening demand. However, demand weakness has been around for a long time. It didn’t stop the oil price doubling from August last year to its recent peak. Further, commodity prices are still high. The CRB index remains higher than its previous peak.
The trigger for the recent correction was due to euro’s depreciation against the dollar. The market pushed euro up since the crisis began, believing that the ECB would continue to raise interest rate to hold down the eurozone’s inflation in contrast to the Fed’s priority of financial stability over inflation. The recent weak data on the eurozone economy have shaken the market’s confidence in the ECB’s ability to raise interest rate. The re-pricing of the ECB policy has led to euro depreciation.
The dominant trade since the crisis began was to short financials, long commodities, and short dollar. We cannot get the accurate data on how much money has been deployed in these related trades. My guesstimate is that it involves hundreds of billions of dollars. When euro depreciates, traders need to unwind their short dollar position, which triggers unwinding of the ‘long commodities and short financials’ positions. For example, US financial stocks have rebounded by one third from their recent lows. It is not really due to improved outlook for their earnings outlook. The technical trading dynamic is the driving force.
The theory for the ‘long commodities and short dollar’ combination is that commodities are priced in dollars and, when dollar depreciates, commodity prices should rise. However, when inflation picks up everywhere, even if the dollar remains stable, commodity prices will rise. Moreover, I believe that the dollar’s strength is temporary. It is due to deteriorating outlook for other economies, not improving outlook for the US. When the bad news on eurozone economy is fully priced in, the spot light will switch back to the deteriorating situation in the US.
The US monetary policy means dollar weakness for years to come. The US financial system may be bankrupt as a whole, if their assets are priced at market clearing levels. Through credit default swaps, financial institutions are tied together and, if one goes under, the whole system may go under. The Fed may be forced into bailing out everybody. Printing money would be its main source of funds. Monetization of financial losses on such a scale dramatically increases dollar supply. Hence, dollar will likely remain weak for years. Of course, it is not a straight line down. The dollar may bounce from time to time due to bad news elsewhere.
This is why the prices for commodities will resume upward trend and precious metals may make new highs soon. The main force is monetary growth, not weak dollar. Money eventually becomes price. It first goes into goods or services where demand and supply are relatively inelastic. Commodities and agriculture inflate first due to their relative inelasticity on both demand and supply side, at least in the short term. The manufactured goods and services inflate next due to ‘cost push’. Wages rise last as labour demands compensation for inflation.
Many prominent economists (e.g., Martin Fieldstein) argue that wages won’t rise with inflation because labour unions are weak in the US, Japan and many other major economies. This view may be naive. Labour unions may be demand rather than supply driven. In the past two decades OECD economies saw declining inflation and robust growth. Labour didn’t need to defend their share of the economic pie. As inflation erodes their share of the pie, labour has incentives to organize. Even in Hong Kong, labour unions have successfully negotiated in several sectors for wage rise to compensate for inflation. Union power may return quickly across the world. The bottom line is that money will find its way to become inflation. As long as central banks keep printing money, i.e., keeping interest rates below inflation, inflation will remain high. And, it is not realistic to assume that labour won’t demand wage increase when everything else is inflating.
The global economy may experience a recession in 2009. The definition for a global recession is for growth rate to fall below 2.5%. The global growth rate may be 3.5% in 2008 (2% for developed economies and 7% for developing economies). Next year the developed economies may see growth rate below 1% and developing economies about 5%, about 2% growth rate for the global economy, while inflation may rise to 6.5%-developed economies at 5% and developing economies at 10%-vs. 5.5% in 2008. Stagflation fits 2009 perfectly even better than 2008.
Beyond 2009, the US, Europe, and Japan will remain sluggish with high inflation, i.e., stagflation will haunt them for years. Developing economies could break out of the stagflationary trap through promoting trade among themselves. In particular, strengthening the trade between manufacturing part of the emerging economies and the resource part could allow them to regain growth and tame inflation.
The resource block of the emerging economies has gained income share in the global economy due to rising commodity prices. Compared to the 90s, oil alone has given them extra $1.5 trillion per annum or 10% of the whole emerging economy GDP. As long as the Fed, ECB and BoJ tolerate negative real interest rates, their income gain will last. This source of income is the foundation for demand within the emerging economy block.
The manufacturing block of the emerging economies has been trading with developed economies to benefit from labor cost difference. This trading model is running unto insurmountable barriers as the demand from the developed economies wither with falling property price and the cost of production surges with rising commodity prices. They need to reorient their trade towards the resource block of the emerging economies that have money to spend. Of course, the trade platform needs to be restructured to fit the needs of the new consumers. The process may take a couple of years.
The next upturn will begin with a new trade boom among emerging economies. When trade takes off, the emerging economies are in a position to tighten monetary policy and strengthen their currencies to combat inflation. Trade upturn and strengthening currencies are necessary conditions for the next bull market.
If emerging economies manage to create an upturn among them, which has never happened before, it would reinforce the stagflation within the developed economies: their currencies will weaken relative to emerging economies’s while the boom of emerging economies keeps commodity prices high. Pundits are already debating if the shape of the current downturn is V, U, W, or L. I think that it is probably L- a long bottom.
The above discussion is to shed some light on the appropriate timing for bottom fishing. Investors around the world are anxious that they may miss the bottom. The sovereign wealth funds have participated in the recapitalization of loss-making financial institutions. They have lost big and should have. In previous financial crises only the third round of recapitalization was profitable. Asset prices in the current cycle are still some distance from the bottom. Stock markets may hit bottom in the second half of 2009. Property market may bottom in 2010. It is too early for bottom fishing.
Further, when markets hit bottom, they will remain at the bottom for a long time. The odds of a quick recovery like in 1999 and 2003 are extremely low. I think that, after hitting bottom, stock markets will remain low for one year and property for two years. Hence, investors don’t have to hurry even when markets bottom. There is plenty of time for investors to put together a portfolio at the bottom to benefit from the next upturn.
The current economic downturn is only beginning. The downward trajectory will last at least for another year. When the bottom is reached, the global economy will remain sluggish for one year and much longer for developed economies. The hope for the next upturn is for trade among emerging economies to take off.
Stagflation remains the dominant macro theme. Commodities and precious metals remain in bull territory. Their recent decline is a correction. As long as central banks tolerate negative real interest rates, they will do well. Indeed, similar to the 70s, they may do well for the next decade. Of course, investors should watch out for their high volatility.
Stocks, bonds, properties are still in bear markets. They have at least one year to go before hitting bottoms. When they do, they won’t recover quickly. Investors should not hurry for bottom fishing.
1 comment:
Not time for bottom fishing
Andy Xie
19 August 2008
One year ago, Jim Cramer, a stock promoter on CNBC, screamed like a cry-baby on TV for the Fed to save the Wall Street. It was probably the starting point for the crisis. Soon the European Central Bank injected EUR95bn into the eurozone banking system to resuscitate the interbank market. One year on, the crisis continues with no end in sight. Losses at prominent financial institutions are still piling up, having reported $450 billion of losses. Their survival is often in doubt.
The economies, however, have done better than I expected. The fiscal stimulus in the US prevented a technical recession. Europe and Japan also avoided a technical recession in the first half. Inflation, however, has picked up more than I expected. The core CPI in the US surpassed 5%, eurozone 4%, and Japan 3%. Emerging economies are experiencing double-digit inflation on average. The global inflation is probably around 5.5% now, the highest in a quarter century.
The growth and inflation surprises are related. Central banks around the world have put growth ahead of inflation. Through repeated market bailouts with liquidity injections, they have prevented financial markets from clearing, i.e., postponing the economic impact of the financial crisis. Hence, growth rates have surprised on the upside. On the other hand, liquidity injections, as I predicted in August 2007, would push up commodity prices. Oil price doubled, and rice price trebled at their recent peaks from one year ago. Despite its recent 17% decline, the CRB index remains 50% higher than the level in August 2007.
What happens now? First, the financial crisis due to property price decline will continue. The losses at global financial institutions may be only half over. The US financial institutions increased their debts by $1 trillion to $15 trillion in the past year. Deleveraging has not happened. Without deleveraging assets remain stuck on the balance sheets of the financial institutions. We don’t know how much they are really worth. As long as central banks continue to support the failing financial institutions, they have no incentives to sell their assets and recognize the losses. Hence, the financial crisis continues in slow motion with occasional explosions to shock the market.
Second, the economic impact will become more obvious in the second half of 2008. The US and Japan may experience negative growth and Europe is likely to slow down sharply. East Asia depends on manufacturing exports and is hurt badly between weakening demand and rising oil price. They will likely slow down dramatically also. The reasons for the slowdown are (1) credit crunch depressing investment, (2) trade slowdown, and (3) negative wealth effect from property deflation.
Third, the second round of financial crisis from economic slowdown will begin to unfold. In addition to the build-up of leverage related to property, leverage has risen in many other areas like credit card debt, merchandize financing, and business debt due to LBOs. As economies slow down and unemployment rates rise, the resulting income slowdown could cause highly leveraged businesses and households to default. As with debts in the property sector, financial institutions have kept massive amounts in those sectors on their books in the form of securitized assets or derivatives.
Some financial institutions are already reporting losses from holding credit debts. This is just the beginning. The US unemployment rate has risen only one percentage point from one year ago. It may have two percentage points more to go. Unemployment rates in Europe, Japan, and manufacturing part of the emerging economies are just beginning.
In the business world, apart from financial institutions, there are no major bankruptcies yet. In the past five years, private equity funds (PEs) have acquired companies worth trillions of dollars mostly with debt financing. The businesses they own have very high debt equity ratio. If their businesses slip, they are likely to go into bankruptcy. The PE boom of the past five years was powered by cheap debt financing like the property boom. I believe the PE industry is heading towards a major crisis.
The auto sector, for example, already exposes the debt problems on consumer side, business side, and PE side. As oil price surges and property price falls, auto demand is falling around the world. Auto production has high fixed cost. If sales fall, auto producers can go into deep losses. If they have high debts, bankruptcies are likely to follow. The US auto makers, for example, are most vulnerable. They depend on financing incentives to promote big car sales. High oil price and the credit crisis are destroying this business model. The auto financing business is also in deep trouble. The US government may be soon forced into bailing out the US auto sector. But a bailout would still wipe out the share value that PEs hold.
Stagflation remains the dominant trend. Only the economies that export oil continue to boom. The emerging economies that depend on manufacturing exports suffer from rising cost and weakening demand. These forces push them towards stagflation. The prices of commodities have dropped sharply in the past month. The CRB index has declined by 17% from its recent peak. Oil price, for example, has dropped by $20/barrel from its recent peak of $147. Many analysts attribute it to worries over weakening demand. However, demand weakness has been around for a long time. It didn’t stop the oil price doubling from August last year to its recent peak. Further, commodity prices are still high. The CRB index remains higher than its previous peak.
The trigger for the recent correction was due to euro’s depreciation against the dollar. The market pushed euro up since the crisis began, believing that the ECB would continue to raise interest rate to hold down the eurozone’s inflation in contrast to the Fed’s priority of financial stability over inflation. The recent weak data on the eurozone economy have shaken the market’s confidence in the ECB’s ability to raise interest rate. The re-pricing of the ECB policy has led to euro depreciation.
The dominant trade since the crisis began was to short financials, long commodities, and short dollar. We cannot get the accurate data on how much money has been deployed in these related trades. My guesstimate is that it involves hundreds of billions of dollars. When euro depreciates, traders need to unwind their short dollar position, which triggers unwinding of the ‘long commodities and short financials’ positions. For example, US financial stocks have rebounded by one third from their recent lows. It is not really due to improved outlook for their earnings outlook. The technical trading dynamic is the driving force.
The theory for the ‘long commodities and short dollar’ combination is that commodities are priced in dollars and, when dollar depreciates, commodity prices should rise. However, when inflation picks up everywhere, even if the dollar remains stable, commodity prices will rise. Moreover, I believe that the dollar’s strength is temporary. It is due to deteriorating outlook for other economies, not improving outlook for the US. When the bad news on eurozone economy is fully priced in, the spot light will switch back to the deteriorating situation in the US.
The US monetary policy means dollar weakness for years to come. The US financial system may be bankrupt as a whole, if their assets are priced at market clearing levels. Through credit default swaps, financial institutions are tied together and, if one goes under, the whole system may go under. The Fed may be forced into bailing out everybody. Printing money would be its main source of funds. Monetization of financial losses on such a scale dramatically increases dollar supply. Hence, dollar will likely remain weak for years. Of course, it is not a straight line down. The dollar may bounce from time to time due to bad news elsewhere.
This is why the prices for commodities will resume upward trend and precious metals may make new highs soon. The main force is monetary growth, not weak dollar. Money eventually becomes price. It first goes into goods or services where demand and supply are relatively inelastic. Commodities and agriculture inflate first due to their relative inelasticity on both demand and supply side, at least in the short term. The manufactured goods and services inflate next due to ‘cost push’. Wages rise last as labour demands compensation for inflation.
Many prominent economists (e.g., Martin Fieldstein) argue that wages won’t rise with inflation because labour unions are weak in the US, Japan and many other major economies. This view may be naive. Labour unions may be demand rather than supply driven. In the past two decades OECD economies saw declining inflation and robust growth. Labour didn’t need to defend their share of the economic pie. As inflation erodes their share of the pie, labour has incentives to organize. Even in Hong Kong, labour unions have successfully negotiated in several sectors for wage rise to compensate for inflation. Union power may return quickly across the world. The bottom line is that money will find its way to become inflation. As long as central banks keep printing money, i.e., keeping interest rates below inflation, inflation will remain high. And, it is not realistic to assume that labour won’t demand wage increase when everything else is inflating.
The global economy may experience a recession in 2009. The definition for a global recession is for growth rate to fall below 2.5%. The global growth rate may be 3.5% in 2008 (2% for developed economies and 7% for developing economies). Next year the developed economies may see growth rate below 1% and developing economies about 5%, about 2% growth rate for the global economy, while inflation may rise to 6.5%-developed economies at 5% and developing economies at 10%-vs. 5.5% in 2008. Stagflation fits 2009 perfectly even better than 2008.
Beyond 2009, the US, Europe, and Japan will remain sluggish with high inflation, i.e., stagflation will haunt them for years. Developing economies could break out of the stagflationary trap through promoting trade among themselves. In particular, strengthening the trade between manufacturing part of the emerging economies and the resource part could allow them to regain growth and tame inflation.
The resource block of the emerging economies has gained income share in the global economy due to rising commodity prices. Compared to the 90s, oil alone has given them extra $1.5 trillion per annum or 10% of the whole emerging economy GDP. As long as the Fed, ECB and BoJ tolerate negative real interest rates, their income gain will last. This source of income is the foundation for demand within the emerging economy block.
The manufacturing block of the emerging economies has been trading with developed economies to benefit from labor cost difference. This trading model is running unto insurmountable barriers as the demand from the developed economies wither with falling property price and the cost of production surges with rising commodity prices. They need to reorient their trade towards the resource block of the emerging economies that have money to spend. Of course, the trade platform needs to be restructured to fit the needs of the new consumers. The process may take a couple of years.
The next upturn will begin with a new trade boom among emerging economies. When trade takes off, the emerging economies are in a position to tighten monetary policy and strengthen their currencies to combat inflation. Trade upturn and strengthening currencies are necessary conditions for the next bull market.
If emerging economies manage to create an upturn among them, which has never happened before, it would reinforce the stagflation within the developed economies: their currencies will weaken relative to emerging economies’s while the boom of emerging economies keeps commodity prices high. Pundits are already debating if the shape of the current downturn is V, U, W, or L. I think that it is probably L- a long bottom.
The above discussion is to shed some light on the appropriate timing for bottom fishing. Investors around the world are anxious that they may miss the bottom. The sovereign wealth funds have participated in the recapitalization of loss-making financial institutions. They have lost big and should have. In previous financial crises only the third round of recapitalization was profitable. Asset prices in the current cycle are still some distance from the bottom. Stock markets may hit bottom in the second half of 2009. Property market may bottom in 2010. It is too early for bottom fishing.
Further, when markets hit bottom, they will remain at the bottom for a long time. The odds of a quick recovery like in 1999 and 2003 are extremely low. I think that, after hitting bottom, stock markets will remain low for one year and property for two years. Hence, investors don’t have to hurry even when markets bottom. There is plenty of time for investors to put together a portfolio at the bottom to benefit from the next upturn.
The current economic downturn is only beginning. The downward trajectory will last at least for another year. When the bottom is reached, the global economy will remain sluggish for one year and much longer for developed economies. The hope for the next upturn is for trade among emerging economies to take off.
Stagflation remains the dominant macro theme. Commodities and precious metals remain in bull territory. Their recent decline is a correction. As long as central banks tolerate negative real interest rates, they will do well. Indeed, similar to the 70s, they may do well for the next decade. Of course, investors should watch out for their high volatility.
Stocks, bonds, properties are still in bear markets. They have at least one year to go before hitting bottoms. When they do, they won’t recover quickly. Investors should not hurry for bottom fishing.
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