Western financial stocks have been rallying of late and they can rally some more if a political “solution” can be found to the bond insurer problem, says CLSA’s Christopher Wood in his weekly client newsletter, Greed & Fear. But recent market trends suggests a classic bear-market pattern, with the financials again plunging 7 per cent so far this week as a consequence of Wall Street’s bearish response on Wednesday to the shock ISM service sector report.

The 12.5-point, one-month plunge in the US Institute for Supply Management’s non-manufacturing business activity index was the largest since that particular “data point” began to be published in 1997. If there is not an established track record, “this is still the biggest recessionary signal yet in terms of published data on the service-sector dominated US economy,” says Christopher Wood.

Wednesday’s shock data had been preceded by a “seemingly benign interlude”, says Wood, which he had viewed as a “renewed opportunity to go short or underweight Western financial stocks”. The reason for the recent counter-trend rally, apart from the technical need to fill a gap in the charts, has been clear:

This is the relief that the Federal Reserve has finally become aggressive, or to borrow the favoured phrase of the bulls, “shown leadership”, with 125bp of cuts implemented within a period of nine days.

On the upside in America, the Fed has turned proactive and a bipartisan $145bn fiscal stimulus package (surprisingly) has been agreed in a US presidential election year. But, he notes, the fixed-income market is still very far from giving a ringing endorsement that Fed monetary easing will work:

This is most clear from the price action of the two-year Treasury bond yield which remains 109bp below the federal funds rate. The two-year maturity has been giving a clear signal of more Fed easing to come since last summer when the credit crisis first erupted… As for the US 10-year Treasury bond yield, it is true that it is now 56bp above the federal funds rate.

Wood’s guess is that the yield will be heading down again the next time more evidence of financial stress emerges, “as it surely will”. It is not, he notes, as “easy to steepen the yield curve, in the current macro context of a deflationary unwind of securitisation, as most of the
mechanical monetarists still seem to believe”.

One of the nastier aspects of “securitisation gone wrong” for bankers is clearly loans being forced back on to the balance sheet. This, and the fact that banks cannot easily securitise new loans, explains the rise in banks’ commercial and industrial loans in recent months. Thus, commercial and industrial loans rose by 20.4 per cent YoY to $1,450bn in the week ended January 23, and are up 13 per cent since late July and the start of the credit crunch. Yet, seemingly paradoxically, the Fed’s latest quarterly survey of senior loan officers shows overwhelming evidence of an intensifying credit crunch in America, notes Wood.

To put a finer point on it: Banks continue to tighten standards for all sorts of lending. They also expect a deterioration in loan quality in 2008. Thus, 75-85 per cent of domestic and foreign banks expect a deterioration in the quality of their commercial and industrial loan and commercial real estate loan portfolios. While about 70-80 per cent of domestic respondents expect the quality of their residential mortgage loans and revolving home equity loans to deteriorate in 2008.
It would, therefore, be a mistake to believe that the present US credit problems are only confined to the area of residential mortgages, warns Wood. In commercial real-estate loans, for example, a total of 80.3 per cent of domestic US banks reported a tightening of lending standards in this area over the past three months – a record since figures began to be published in 1990. This caution about new lending has, not surprisingly, gone hand in hand with a decline in securitised lending in commercial real estate.

All of the above suggests it would be foolish in the extreme not to assume an intensifying credit crunch in America, and indeed, “beyond America”.

This has to be stressed, says Wood, because “ordinary mortals are still obviously having a hard time drawing a connection between the seemingly abstract area of credit and what is usually referred to as the ‘real world’.” This is clear, he notes, from the “grinning faces recently observed on CNBC opining from places like Chicago that Wall Street was getting too depressed about the “macro” because of investment banks’ own specific problems.

Unfortunately, the world of credit and real life do eventually collide, as will be only too evident to the 161,000 British holders of credit cards issued by “Egg”, an internet bank, who were told last week they would no longer be able to spend on their cards. Egg was bought by a now restructuring Citigroup in May last year, just three months before the credit crisis blew up.

Meanwhile, in yet another sign of lender caution, this time in the UK, notes Wood, the number of loans approved for house purchase in Britain fell in December to 73,000 – the lowest monthly figure since July 1995.

From a narrower financial sector standpoint, Wood says, “the other aspect of this credit crunch is that it becomes ever harder for better-positioned individual institutions to avoid the escalating distress”.

Take, for example, a recent research update on Standard Chartered from CLSA’s head of regional banks research, Daniel Tabbush, he says. The main trigger for Tabbush’s new SELL recommendation was the bank’s decision last week to move $7.15bn of SIV assets onto its balance sheet. “This is more than double the $3.4bn that it was intending to provide as back up liquidity for its Whistlejacket SIV based on statements made by the bank late last year,” notes Wood.

This is another reminder that it remains difficult for banks to refinance in the current climate. It is also not a small burden, given StanChart’s total shareholders’ equity of $19bn. The other point, noted by Tabbush, is the potential for a period of relative underperformance for StanChart given that its earnings have so far been cut dramatically less than the likes of Citigroup and HSBC. This will be due to slowing Asian GDP growth and SIV impairment costs.

Still, Wood argues, StanChart is not at risk of falling to the sort of “distressed franchise valuations which remains the prospect facing Western financials whose preferred business model of slice and dice is broken”. StanChart is also, obviously, a far more attractive acquisition target give its relatively unique emerging-market franchise.

Finally, to commodity prices which, Wood notes, remain “remarkably resilient despite the bearish news from America while, in the case of current investor-favourite coal, press hype about winter weather in China has caused a further surge in prices”. Wood’s guess is that if an oil-led commodity correction is ever really to happen, it is “likely to coincide with a US dollar bounce against the likes of the euro”.

That, however, may have to wait for the end of spring wage negotiations with the German unions, as Wood has pointed out, though, he says, it is interesting to note that the dollar has stopped declining despite the present combination of Fed panic and weakening data.

This entry was posted by Gwen Robinson on Thursday, February 7th, 2008 at 14:00 and is filed under Capital markets. Edit this entry.