Monday, January 28, 2008

[Greed & Fear:] Avoid panic and take a long-term view

(FT Alphaville) Logic and chart patterns suggest to CLSA’s Christopher Wood some near-term respite in the markets after recent partial capitulation — though in his view, it will be a radically different market from now on, particularly when it comes to “slice and dice” securitisation.

In his weekly client newsletter Greed & Fear, Wood notes that Ben “Billyboy” Bernanke (one of his favourite central-banker punching bags) has “duly panicked”, while the US authorities are desperately seeking some well-capitalised buyers for the two large and troubled bond insurers, or rather debt insurers.

Warren Buffett’s Berkshire Hathaway, says Wood, is an “obvious candidate” to buy the least disastrous of the two, MBIA, since it already decided to enter this niche business area in November.

It is also the case that folk hero Warren Buffett has always liked insurance and also likes to be seen riding to the rescue, paving the way for more cheesy interviews with fawning females on CNBC.

Still, a bond insurer owned by Berkshire Hathaway will not be insuring CDOs, as the big bond insurers have done in the recent past, he notes. That business model is dead, as, most likely, “is the whole securitisation slice-and–dice model”.

Meanwhile, in the absence of a private sector buyer, there is always the hope of a government bailout. Consider, he says, the recent news [first revealed in the FT] that New York State’s insurance regulators met major US banks to discuss a possible bailout plan for bond insurers:

It is clear that perceived resolution of the current concerns that the debt insurers are themselves going bust would prove to be a significant tactical positive. For it would alleviate the near-term risk of a self-feeding vicious cycle leading to an ugly unwind of the $45,000bn credit default swap market.

This positive mood will be further enhanced if Billyboy actually tries to get ahead of expectations by cutting the Federal funds rate by a further 50bp at the FOMC meeting on Jan 29-30. Hank “the Hunk” Paulson, who sensibly cancelled a scheduled trip to [last week’s] annual Davos talking shop, will likely be urging this. The Fed funds futures market is now pricing in a 76 per cent chance of a 50bp cut at [this week’s] FOMC meeting to 3 per cent and a 24 per cent chance of a 75bp cut to 2.75 per cent.

If there is then likely further upside for financials in the near term, it will be another bounce which traders should look to short aggressively, “the further that bounce extends”.

For, if the stress test of the CDS market is avoided in the near term by defusing the debt-insurer issue, and it still may not be, that stress test will come sooner or later as the securitised credit mess spreads with the slowing US economy.

The best analogy for developments in this crisis, concludes Wood, remains “the grim one of a spreading cancer”:

In this context, it is worth noting that the issuance of securitised auto loans and credit-card loans has so far slowed much less dramatically than securitised mortgages. There is, therefore, now significant room for these other products to play catch up on the downside as credit quality inevitably deteriorates.

So, Wood - unsurprisingly - still advises fundamental long-term investors to remain underweight Western financials.

Meanwhile, market action is making it ever clearer that US growth is slowing and that there will be a knock-on impact around the world. Thus, in the initial rally off the lows precipitated by the Fed’s 75bp inter-meeting cut on Tuesday, it was the financial stocks which rallied while the cyclicals failed to bounce. Similarly, commodities have turned weak with oil finally breaking $90.

Wood continues to advise investors in 2008 to stay underweight in cyclical stocks geared to external demand in both global and emerging-market portfolios. This means continuing to underweight stocks which were big outperformers in 2007, in his view.
The likelihood of a coming commodity correction, however, raises the risk of more short-term underperformance for Asia and the emerging markets. Even Wood, a die-hard Asia advocate, says he “will admit as much”.

The worst case for the benchmark MSCI AC Asia ex-Japan index, in his view, would be a one-third decline from the all-time high of 686.9 reached Oct 29, to 458 points. “A retreat to that level, or lower will come sooner or later if US and therefore global growth continues to slow, and credit problems to intensify,” guesses Wood.

But, he urges Asia hands, remember that corrections in Asia and emerging markets in 2008 are in the big-picture, long-term buying opportunities, “since this is the next bubble in the making”.

In this respect, long-term global investors who are not yet five times overweight Asia and emerging markets in a global equity portfolio should use any period of underperformance as an opportunity to increase weightings. The sharp pullback in India this week is one obvious example.

Meanwhile in currencies, growing evidence of a slowing US economy, and related commodity weakness, is likely to go hand in hand with a rally in the dollar, notes Wood.

If this has been just a theory until recently, the latest market action has begun to support it in the sense that the dollar did not collapse as a consequence of last week’s 75bps Fed rate cut. Contrary to some views, Wood believes the currencies most vulnerable to a dollar rally are the euro, sterling and commodity currencies, with the Asian currencies least vulnerable.

As for the yen, it may even rally more than the dollar given that both are “funding” currencies. This is a relevant point to consider in 2008 for global equity investors who are euro or sterling based. Meanwhile, the resilience of the yen means that domestic Japan stocks are likely to continue to outperform in dollar terms when global stock markets are declining.

If one reason for Wood’s “tactical bullish view” on the dollar is the potential for a dramatic short squeeze on borrowed dollar positions, another is that “other countries will be forced to cut rates sooner or later since the global credit crunch is not confined to America”, he reasons.

On this point, the ECB and the Bank of England continue to talk tough. But betting that the ECB will be in rate-cutting mode before the end of 2008 remains one of the biggest “lay-up” trades in the world of finance, and certainly more clear-cut than any short-term equity trade. The same applies for the Bank of England - even though [BoE governor] Mervyn “King of England” King “continues to talk tough on moral hazard issues and the like.

But, he long ago should have resigned over the Northern Rock fiasco, and should now resign again in protest at the latest effort by Britain’s Labour Government to avoid the humiliation of nationalisation.”

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