My Diary 346 --- Fed Implies Worst Is Over, Housing & Earning Drag Spread, A & H Both Down, Go Go Go, HKMA and Gold

November 2, 2007

Overnight, news flows on Citigroup and renewed focus on the potential for big losses in other financial giants caused an about face in UST with the front end of yield curve moving in 22bps from the peak. 

World equity markets also  fell sharply In Europe and US, with losses ranging from 1-3% (S&P500& Dow Jones -2.6%). The US Dollar moved sideways in broad trade-weighted terms.  While Oil prices declined to $93.49/bbl for Dec WTI, down about $1.

As a result, we saw a selling mood in Hong Kong markets... well, first thing first, let us begin with Fed’s outlook on the US economy.

Fed Implies Worst Is Over

The "risk to growth" assessment lasted 6 weeks and the risks are now "balanced" between a slow-down & inflation (Oil=$94/bbl today). While the US Fed cut its Fund rate by 25bps, its comments..."the upside risks to inflation roughly balance the downside risks to growth"... shows an increasing nervousness about inflationary pressures in the US economy.

Frankly speaking, the latest macro data has reduced my conviction in the pronounced slowdown story in the US.  The basis for my bias in recent months has been that the housing sector meltdown and subsequent financial crisis would impact consumers significantly and lead to a consumption led slowdown with unemployment rising and expenditure falling off significantly.  However, what has become clear in recent weeks is that the US economy was carrying significantly more momentum into the credit crunch than previously thought, and that the impact of the subprime story on the real economy, on jobs and retail spending, was less significant than expected in Q3. With the dollar so weak, the export sector contribution is already having a significant offsetting impact on overall growth in the economy. Additionally, claims have remained stubbornly low and other employment indicators do not yet show a significant deterioration. Although I continue to believe unemployment is going to rise and consumption fall, but the question I am now asking myself is will the slow down be significant enough to warrant Fed Funds below 4.00%? We don't yet have the data to answer that question, but given the latest Fed statement, they clearly do not believe so.  Last point, regarding tonight’s NFP, one would have to assume that FOMC members had preliminary estimates for the job numbers, so perhaps the best assumption is somewhere near consensus…No Surprise…Fed should know more than us…but remember they do not “foresee” the sub-prime problems as well…

Housing & Earning drag Spreads

Credit spreads widened quite some over past few days and I think that this trend is likely to continue over the next several weeks.  There are numerous tidbits of news (and rumors) that are being cited as the reason for today's move – 1) The Citigroup news has ignited fears that the bank may have to sell a huge amount of assets to meet capital requirements; 2) Freddie Mac has been selling MBS in size ($6B or so over the past month) to shore up their capital for a write-down of their subprime holdings, and two decent sized SIVs in the process of liquidating(total over $5B  assets) ; 3) ABX AA's are down massively this month, ABX-HE-AA 07-2 is down nearly 40 points this month !! …Wow O.O.O

All these look to me that even the worst may be over, but the markets may not sleep well as housing and earning negative news still stay in the corner. The recent data coming out of the US housing market suggests that, even with a Fed bail-out, the problems of that sector would likely remain for some time, as reiterated by Secretary Henry Paulson. The widely expected Fed rate cut of 25bp did seem to fuel some strength into the credit markets, but this was only because the Fed guided the markets toward a balanced view, implying that the Fed may be done with further rate cuts. But I still hold my view that one more rate cut remains highly likely, although largely depending on the data to come.

The past week's consumer confidence (95.6, the lowest level in 2 years) and weaker-than-expected earnings from companies such as P&G, US Steel, and Alcatel-Lucent, plus higher losses reported by investment banks such as Merrill and UBS, and plus rising oil prices seemed to support concerns of the possibility of a sharp slowdown in the US economy and rising inflation risks. All these have more than offset the robust 3Q GDP growth of 3.9%, which was above consensus forecast of 3.1%. Certainly, at this moment, markets are looking for more guidance for direction with focus on the NFP numbers to be announced and more earnings announcements from European investment banks over the next few weeks.

A & H Both Down

Its rarely to watch both A and H-share markets come down… A share market falls 2.3% today following the big drop in US, the launch of 2 additional QDII funds, China Railway Engineering A-share IPO, plus rate hike concern over the weekend.  The “2-8” rule dominates the market recently, with 80% stocks slide. Sector wise, 3Q results weakness brought Bao Steel (-5.7%), Angang (-6.6%) and (Magang -6.7%) down, while aggressive risk reduction on potential resources tax hike had a hit on JX Copper (-5.6%) and Chalco (-3.1%).

Hong Kong side, Hengseng Index dropped 3.25%, losing 1025 ppts, and HSCEI followed the suit, down 3.32%.  I still remain positive to the H-shares based on strong liquidity flows from China (QDII, CIC and Direct Train) and expected earning revisions, plus asset injections. A more important factor is that strong earnings growth due to asset injections, continued margin expansion, and potential upside to oil prices may offset some valuation concerns after an ytd 89% rally in HSCEI (28x FY08). Sector wise, I think bank, property, domestic consumption and some materials are top picks.

Go Go Go, HKMA and Gold

HKMA is quite busy over the past few days as currency traders are betting in the forward exchange rate market that the Authority will abandon the 24-year currency peg in the next year. On November 1, HKMA sold HKD7.83bn to defend the peg, a sales amount that was 10 times larger than two previous purchases this month after HKD climbed to 7.75/USD, the top of its permitted trading range.  Its counter-party, US Dollar headed for a fourth weekly loss against the Euro on speculation on slower job creation, bolstering the Fed’s further rate cut. Interest rate futures see 60% odds of 25bp cut to 4.25% on Dec. 11. The USD closed at $1.4479 per Euro after it reached $1.4504 on Oct. 31, the lowest since the European currency's debut in January 1999. The USD was at 114.72 Yen.

Bottom-Line: I think the continued weakness in the US economy, a lower demand for US assets, plus a robust European economy should keep the USD weak and EUR supported in Q4.

The most shinning asset class over the past week is no doubt, GOLD. With inflationary fears coming closer, gold continues to rise and hit $800/oz on the Comex (Dec 07 contract) this morning. Traditionally, gold behaves like a real currency, providing a natural hedge to inflation. Thus, we should have no surprise to see the yellow metal tracking oil's meteoric rise towards $100/bbl.  Since August, the correlation between US WTI oil and gold is over 93%, and gold price has up nearly 22% since then.

Whether oil will have an inflationary effect on the US economy is debatable (particularly as inflation has been relatively benign during oils rise from $40 to $90 per bbl over the past three years), but it appears the market has chosen to focus on this.  Then the remaining questions for gold’s next move are on how we look at inflation and oil price in the near term. Overall, I think global inflation risk is on the upside, particularly in emerging economies which are rich in capitals, including China (5.6%), Middle East (10.1%), and Russia (8.5%). At the mean time, oil supply/demand is still tight and China and India remain the key incremental demand (50%) to the black oil. The other arguments I have provided in my previous diary …So I better run for a dinner tonight…It is a long week so far….

Good night, my dear friends