Financial markets hang on the brink, says CLSA’s Christopher Wood in his weekly client newsletter Greed & Fear. If the US authorities can come up with a package that defuses the bond-insurance issue, more of a bear-market relief rally can definitely unfold, with the rally centred on financials. Still, if no such package is forthcoming, Wall Street-correlated world stock markets remain highly vulnerable despite this week’s further 50bp Fed rate cut.
That no policy on bond insurers, or rather debt insurers, has as yet been finalised is itself perhaps surprising, given the importance of this potentially systemic issue and the political risks of doing nothing, says Wood.
Indeed, the bond insurers are the equivalent in the financial world to an open wound. Still, solutions are not easy, precisely because of the nature of the problem - short of outright nationalisation - which remains difficult in the absence of a real market crisis. In the meantime, reported efforts to get the banks to recapitalise the bond insurers do not inspire confidence. Indeed this is the sort of circular arrangement that characterised Japan in the 1990s. Like the Treasury’s ill-fated Super SIV proposal, it is unlikely to get off the ground.
On the subject of Japan, Wood notes that the Japanese market is actually outperforming Asia so far this year in a relative sense in US-dollar terms.
The MSCI Japan index has fallen by 7.2% in US-dollar terms so far this year, while the MSCI AC Asia ex-Japan index is down 14.4%. This reflects both that Japan has already fallen a long way and that the yen has been rising on a risk-aversion trade, though the latter development remains bearish for exporters. Still, sentiment on Japan remains grim for both structural and cyclical reasons.
Meanwhile, it is “time for a change” in Greed & Fear’s global portfolio for US dollar-denominated pension funds, says Wood, a self-confessed and long-standing bull on Treasury bonds - “on the view that the deflationary risk posed by securitisation run amok was a greater reason to buy Treasury bonds than faddish fears about stagflation was a reason to sell them”. For this reason, he says, the “long- standing 3 per cent target for the US 10-year Treasury bond yield, which was nearly reached in June 2003 when the yield hit a low of 3.1 per cent was lowered to 2.5 per cent in June 2005″.
Still a bond-related switch was made in the global portfolio in May 2006, when the 20% position in US 10-year Treasury bonds was first switched to Singapore-dollar cash and subsequently to Singapore government bonds in July 2006. “The prime reason for this change was currency risk.”
This move made sense since the Singapore dollar has since then appreciated 12 per cent against the US dollar, while the yields of both long-term bonds have declined by a similar amount. The 10-year Singapore government bond yield has fallen by 143bp since July 2006 to 2.21 per cent, while the 10-year US Treasury bond yield has declined by 136bp to 3.67 per cent over the same period
Still, in Wood’s view, it is now time to reverse the trade.
The US dollar is due a bounce in coming months… while there is a growing risk that US Treasury bond yields diverge on the downside relative to Asian government yields. This is because the deflationary forces unleashed by the implosion of structured finance is primarily an American and Western European phenomenon, while Asia is experiencing a secular pickup in inflation, as reflected most clearly in rising food prices.
Accordingly, the Singapore-government-bond position will be sold and replaced with a similar weighting in US Treasury bonds, maintaining the fixed-income-investment allocation in the global portfolio.
After all, he says, US Treasury bond yields are “only likely to bottom when Western financial stocks bottom”, which in Wood’s view is “not yet”.
Returning to the theme of incipient inflationary pressures in Asia in Wood’s trot around the world this week, he says it is “clearly a fundamental reality”.
Still, from the practical perspective of investors in Asian equities in 2008, rising inflationary pressures will continue to be overshadowed by the collateral fallout from the continuing credit crunch in the West. This is why Asia will gain the following wind from Fed easing in 2008, even though easing is the last thing Asia really needs. Faced with this, Asian central banks are likely, at most, to keep rates on hold, though declining US rates will lead to pressures to lower domestic rates to prevent arbitrage-related inflows putting further upward pressure on currencies.
Meanwhile, even further afield, investors “should not forget about the emerging distress in Europe”, Wood reminds us.
The growing problems in Europe are clear from the widening in sovereign spreads on PIIGS (Portugal, Italy, Ireland, Greece and Spain) sovereign bonds relative to German bonds. The PIIGS 10-year government bonds’ average yield spread over 10-year German bund yield has risen to 29bp at present from 1bp in June 2007.
This, he says, is a “long recommended macro trade which absolute-return investment funds should maintain”.
And back to Asia, where Wood says a key issue for the region’s stock markets this year is whether China is going to step up the pace of tightening in the face of the US slowdown.
Wood continues to believe this is “extremely unlikely” given the pragmatic nature of the Chinese leadership when faced with the deteriorating newsflow from America.
If this is the view, more importantly, an anonymous PBOC official was quoted this week in a press report saying effectively that it would be difficult for the central bank to tighten further this year because of the external environment. This confirmation, says Wood, would suggest it’s wise to “maintain China for now as neutral in the relative-return portfolio”.
The H shares have fallen considerably this year and are now 39 per cent below their October 2007 high, he reminds us.
For intrepid bottom fishers, however, he recommends buying the blue chip national property developers such as Chinese Overseas Land and China Vanke, since “the worse the newsflow gets the more likely the PRC is to reverse the present policy of cooling down the residential property market”.
