Markets live chat transcript for the chat ending at 13:00 on 15 Jan 2009. Participants in this chat were: Paul Murphy, FT (PM) Neil Hume, FT (NH)
By Henny Sender in New York
Published: January 14 2009 23:34 | Last updated: January 14 2009 23:34
Citigroup’s Corporate Special Opportunities hedge fund is returning only 3 cents on the dollar to investors, underscoring the depths of the difficulties at the alternative investment unit once headed by the bank’s current chief executive, Vikram Pandit.
The amount being returned is less than had been expected when the company decided to wind up the fund last year and came as bruising news for investors who had been prevented from withdrawing their money since January 2008.
* Timeline: The making and unmaking of a giant
Citigroup also stands to lose hundreds of millions of dollars it lent to CSO. It provived the fund with as much as $450m in credit lines and $320m in equity, while also placing assets with a nominal value of $1bn that it had bought in the fund.
By June 2008, Citi found itself in the embarrassing position of shutting down Old Lane, a move that forced the bank to put $9bn of the hedge fund’s assets on to its balance sheet and to take a writedown of more than $200m.
Since last year, Citi Alternative Investments has been run by Ned Kelly, who has enjoyed a meteoric rise at the bank since joining Citi from Carlyle in 2008.
Mr Kelly was formerly head of global financial institutions and co-head of investment banking client management at JPMorgan Chase.
The US banking sector was shaken on Wednesday by deepening concerns over Citigroup’s financial health and the revelation that Bank of America is counting on a new multibillion-dollar capital injection from the government.
Several people close to BofA said that it had told the government that it wanted to scrap its takeover of Merrill Lynch last month after realising the depth of the investment bank’s losses in the fourth quarter.
BofA, which has already been given $25bn in federal funds, closed the deal on January 1 only after receiving a pledge that it would receive billions of dollars from Washington, they added.
BofA and the Treasury declined to comment. People familiar with the situation said that no final decision on the amount of funds to be injected in BofA has been taken.
A new capital infusion into BofA would mark the third time, after Citi and AIG, that the federal authorities would have had to inject capital into the same company twice. Such a move would raise fears that other banks might ask Washington for additional capital.
Citi shares plunged on Wednesday, closing down 23 per cent to $4.53, the lowest level since the government’s $300bn bail-out of the troubled financial group in November. At this level, Citi, once one of the world’s largest financial groups, is worth just $24.7bn.
Mr Dimon, whose bank will report fourth-quarter results on Thursday, gave his bleak assessment as shares on both sides of the Atlantic tumbled on rising fears that banks would need more capital and a larger-than-expected fall in US retail sales
“The worst of the economic situation is not yet behind us. It looks as if it will continue to deteriorate for most of 2009,” said Mr Dimon. “In terms of our sector, we expect consumer loans and credit cards to continue to get worse.”
This ex-KGB banking tycoon took over Althorp, the late Princess of Wales’s ancestral home, for a white tie ball this summer. It cost him more than a million and raised nearly as much for Russian children with leukaemia. The guest of honour (in lounge suit rather than tails) was former Russian premier, Mikhail Gorbachev.
Lebedev, Greig points out, owns the paper which employed the late Anna Politovskaya. Here’s a man who uses his wealth to oppose Russia’s gambling syndicates, to preserve historic Moscow from the developers. It’s a bold stance,’ says Greig.
HSBC: A few clarifications – Reiterate U/W
HSBA LN, 588p, U/W, 455p PT
It appears that almost as much has been written by other sell side firms
about our HSBC note than we wrote ourselves. Within the comments we have
seen, there has been some gross mis-statements, which we feel we need to
clarify. We would suggest investors read the report and stick firmly by
the conclusions in it – that HSBC will halve the dividend in 09 and
potentially raise $20bn of capital.
Rest of Asia. In HK, the core capital ratio is 6.8%, which on a Basel 2
group measurement basis for RWA’s falls to 5.5%, the second weakest in
Asia. We appreciate that HSBC has lots of liquidity, but so does Hang
Seng and BOC and they both have core capital ratios materially in excess
of HSBC (>10%). To take the equity tier 1 to 9% we pencil in $5.8bn of
capital injection into HK. This gives a total of $27bn, which we reduce
to $20bn to account for the dividend cut.
Of the capital discussed above, we acknowledge that the HK capital
requirement probably carries the weaker argument (as the regulator has
been happy so far) however, we will continue to highlight it as a risk.
To get from $20bn to $30bn of capital we highlight the insurance double
counting and the further regulatory arbitrage in the AFS. Allowing for
this would be a more extreme case, but one thing we have learnt over the
last few months is that just because something is extreme, it does not
mean it is not going to happen. Nevertheless, we will continue to focus
on the $20bn as the most likely outcome.
Hope this clarifies the points. We reiterate the Underweight with 455p
PT.
By Emiliya Mychasuk and Emiko Terazono
Published: January 15 2009 02:00 | Last updated: January 15 2009 02:00
In a banking sector reeling from a Citigroup break-up, HSBC loss rumours and fast-spreading job cuts, Barclays had to deal with concerns about a bust-up with chief John Varley that had caused Sir Nigel Rudd to resign as deputy chairman. The subject of the dispute was said to be the valuation of toxic loans on Barclays’ books.
But Sir Nigel maintains it is not so.
“I have spent 13 years on the Barclays board working closely with John Varley. Any suggestion that I will be leaving for any reason other than the pressure of other commitments and my new role at Invensys is simply not true.”
What happened was, Nigel Rudd and John Varley were trying to take a leaf out of Bob Diamond’s book, but it all went catastrophically wrong.
Dear oh dear.
HSBC divi 87$c so HSBC is already on a divi yield of 10%. It is in the price. So Morgan Stanley in order to still be a seller need to argue that HSBC needs $30bn of capital. One thing is certain, if they are right Morgan Stanley is the next Lehmans.
Lastly HSBC management saw this coming very early (Q4 2006). The biggest drivers of banking bad debts is not WHO you lend to, but WHEN you lend to them. While RBS, Fortis, Santander and BARC were fighting it out for ABN, HSBC management were busy de-risking their portfolio.
US depression looking likely. While Chinas 2009 implosion could get ugly.
quickly slide sharply towards our 500 target for the S&P. While economic data in developed
economies increasingly reflects depression rather than a deep recession, the real surprise in
2009 may lie elsewhere. It is becoming clear that the Chinese economy is imploding and this
raises the possibility of regime change. To prevent this, the authorities would likely devalue
the Yuan. A subsequent trade war could see a re-run of the Great Depression.
forecast deep US recession. As it had not suffered one since the early 1980s, we thought
this outturn would shock. Yet recent data has been consistent with something far worse
than deep recession. There is no agreed definition of a depression as opposed to a deep
recession. But The Economist magazine is probably more qualified than many to take a
view. They consider a peak-to-trough decline in GDP in excess of 10% a reasonable
definition link. We had been thinking of deep GDP declines of the order of 5% peak to
trough but we are now thinking that this view might be too optimistic.
of the last few months. They have been broadly flat since we increased our equity weighting
sharply on 23 October. Within that time the intra-day peak-to-trough rally in the S&P was
a creditable 28% from 740 low of Nov 21, but we do not claim to have captured that.
Nevertheless we feel very comfortable that the technicals at the end of October cried out to
close our extreme underweight equity exposure. They now tell us to cut exposure again.
evidence that the Chinese economy is imploding (see chart). Investors should consider what
would happen if China descends into social chaos. Yuan devaluation could spark a 1930sstyle
trade war. Do you really trust the politicians to do the right thing?
potentially bidding for Venture (VPC) confirms our long-held belief that the equity
market is mis-pricing upstream assets and that the UK E&P sector is ripe for M&A
action. Over the past few months European utilities (Bayerngas, Centrica) have
been actively acquiring UK gas assets to reduce their reliance on external
supplies, driven by a UK gas price (NBP) that remains at a significant premium to
oil and continental European contractual prices.
requirements of their clients.
has significantly disrupted gas deliveries into Europe, serving as a good reminder
to market participants of the importance of security of supply. As a result, we
believe that utilities will attempt to take advantage of currently depressed
valuations to bridge their supply gap. *Main read-across: Dana and Tullow The
reported potential bid of £7/sh for VPC implies an EV/boe multiple of US$8.9,
broadly in line with recent transactions in the North Sea (eg, Wintershall-Revus,
Dyas-Ithaca). The sector trades at a 20% discount to the implied bidding price
and we believe that valuation may close quickly to reflect that now the sector is in
play.
significant exposure to the UK-gas market, provide the best read across in the
sector. In the case of Tullow (c40MMboe of UKCS resources) the potential
disposal of the UK gas business could help finance the development of the
Jubilee field. In the case of Dana (c160MMboe of UKCS resources) the proceeds
could fund (and accelerate) further exploration activity in Africa (Egypt, Morocco,
Senegal). Using the VPC implied take-out multiple we value the UKCS business
of Tullow and Dana at 33p/share and 850p/share respectively. We re-iterate our
detail on the financial positions of the major stocks in our coverage universe.
Cash is king…for the moment — Forecasting yields any distance out is little
more than guesswork at the moment. Much depends on the ability and
willingness of banks to lend and on the level of distressed sales. In selecting
stocks, we look for stable or growing cash flows, feeding through to dividends
much investor concern over covenants. Assuming management do nothing
(which is unlikely) we estimate that UK companies can cope with another
c28% fall in values from September 2008, while Europe is less geared and
can cope with another c35%. This represents the ability to withstand around
a 40% peak to trough value decline: not a weak position by historical
standards but also not a particularly strong one given current headwinds.
£2.0–£2.6 billion of equity needed or wanted by top UK REITs — We
estimate that the top UK REITs would benefit from £2.0–£2.6 billion of new
equity to avoid breaching covenants or to free up available facilities. The
major Europeans have less need for equity, although Citycon appears most
at risk from covenant limits and Corio may need equity to fund its
development pipeline.
SEGRO, Liberty and Citycon may need equity — SEGRO may need equity if it
fails to negotiate a relaxation of its banking covenants; Liberty may need
equity to fund its development pipeline as its available facilities fall short;
and Citycon is the first of the Europeans to hit potential covenant problems,
at a 20% value fall from June 2008. Before completing the Trillium disposal,
we estimate that Land Securities would have needed additional equity to
remain within covenant limits.
The Europeans and Central London REITs look most comfortable — Unibail,
Wereldhave, Great Portland Estates and Derwent London have plenty of
capacity, with the first three able to withstand >40% value falls from end-
September by our estimates. British Land, Land Securities and Hammerson
are in the middle: they may wish to raise equity to fund opportunities, but
may also have to wait while investors are asked to fund those more in need.
pipeline now comprises just one shopping centre in Aberdeen. Leicester,
Bristol and O’Parinor have opened 86%, 91% and 94% full, boosting rents
by £30 million over time. Old Broad Street is nearly 50% let and tenants are
moving in; Threadneedle Street will complete by year-end but remains unlet.
Empty rates will impact near-term income — A half-full Old Broad Street and
empty Threadneedle Street will incur empty rates charges which will
undermine near-term earnings.
Covenants are more stringent than most — The tightest covenant requires
group gearing to remain below 150%, while the tightest interest covenant
requires 1.25x coverage. Gearing at end-June was 77%, while interest cover
was 1.71x. The debt secured against Bishops Square has only an interest
cover requirement.
estimate that Hammerson’s covenants could cope with a 24% further
decline in capital values, after adjusting for the sale of Moorhouse and a 6%
portfolio value decline in 3Q (based on IPD).
Limited near-term refinancing requirements — The company has no
refinancing requirements on its drawn facilities until 2010 (£54 million) and
2011 (£50 million). Within its undrawn facilities of £527 million, £300
million is due to be renewed at end-2009 and management is confident that
this will be achieved.
Recent underperformance has opened up attractive value — We note the
recent underperformance of the shares and believe that the market is being
too pessimistic about Hammerson’s ability to navigate the downturn.
We have a Buy rating, price target 800p — Despite the poor outlook for
direct real estate and the economy generally, Hammerson’s properties and
tenants are amongst the highest quality of the majors.
stance…while the company continues to go for growth in a declining market this is having an impact on operational performance, and consensus EPS outlook for 2010 (14.1p) will now have to come down closer to our estimates (12.1p) with guidance of 12-13p. The EPS outlook for 2009 surrounds the current consensus of 12.7p, being a similar 12-13p range.
Best Buy put in a creditable top line performance helped by Sterling’s decline and a gain in market share, with £1,010m revenues, up 13%, 3% on constant currency basis. Lfl was down 1% on a constant currency basis.
Like for like gross profits at the retail arm, however, declined 3.7% on constant currency. The group expects full year GM to decline 150bp this year
decline in the non-broadband base, offset by slightly weaker broadband adds (36k,
versus our 70k forecast) but with a higher broadband ARPU (up 5% to £23.13)
• 91,000 customers were unbundled during the quarter bringing the total to 78% of the
broadband base.
Strategic goals were outlined for 2010, being a maintained focus on growth and
investment (so still looking at gaining market share in handset retail at the expense of
margin, and more worryingly still on track for value destruction in a European big box rollout), but underpinned by a commitment to cost control and cash generation (targeting £100m (talk talk) and £50m (Best Buy) of operating free cash flow, but “before” the big box rollout) coupled with improved clarity and transparency for investors (so a split of the business is on the cards as soon as they can do it and peer group comparable reporting is on the cards)
13p (cons. 12.7p), YTM10 ‘similar’ to YTM09 (cons. 14.1p). The company
notes there will be significant FCF generation. But structural pressures grow.
The broadband market is peaking. The recession is hurting Best Buy Europe
from three angles – 1) fewer customers updating phones, 2) operators
reducing SACs, 3) operators lengthening handset replacement cycles.
TalkTalk Group Stalling — Broadband net adds remain slow at 2.8k/week (2.6k
2Q09, 8.4k 4Q08). This is partly due to Sky/O2 share take but mainly due to
market growth slowing (UK b’band penetration >60%). Higher margin other
billed customers (traditional voice/dial-up) fell –104k q-o-q (vs. cons. -123k,
2Q09 -137k, 1Q09 -359k). Efforts to stabilise this base are clearly helping.
Best Buy Europe: Christmas Disappoints — 3Q connections came in at 3.7m (in
line with. cons, -6% vs. CIR). The iPhone failed to prop up contract
connections at 1.34m (cons. 1.42m).
Saving Itself Below the Top Line? — Given top-line pressures, management
has placed a new focus on FCF. A positive step. But, we are unlikely to see any
evidence of success before 1H10 results in November.
* $4.1 billion (pretax) increase to loan loss reserves, resulting in coverage ratios of 4.24%1 for consumer businesses and 2.64% for wholesale businesses
* $2.9 billion (pretax) net markdowns due to leveraged lending exposures and mortgage-related positions in the Investment Bank
* $1.1 billion (after tax) benefit from merger-related items
* $854 million (after tax) benefit from MSR risk management results
* $680 million (after tax) private equity write-downs
* $627 million (after tax) gain due to dissolution of Paymentech joint venture
# Grew the franchise in 2008, as demonstrated by the following accomplishments2:
* More than one million new checking accounts opened in Retail Financial Services
* Double-digit growth in loans and liability balances in Commercial Banking and in liability balances in Treasury & Securities Services
* #1 rankings for Global Investment Banking Fees and Global Debt, Equity & Equity-related volumes for the fourth quarter and full-year 20082
# Continued to focus on safe and sound lending activities, and launched significant enhancements to mortgage modification programs:
* Extended more than $100 billion in new credit during the fourth quarter alone to consumers, corporations, small businesses, municipalities, and non-profits (including more than five million card, home equity, mortgage, auto and education loans)
* Announced plan to help 400,000 U.S. homeowners avoid foreclosure over the next two years through loan modifications
Average loans retained were $73.1 billion, an increase of $4.2 billion, or 6%, from the prior year. Average fair-value and held-for-sale loans were $16.4 billion, down $8.6 billion, or 34%, from the prior year.
Noninterest expense was $2.7 billion, down 9% from the prior year, reflecting lower performance-based compensation expense, largely offset by additional expenses relating to the Bear Stearns merger.
Home announced trading for the 18 weeks to 3 January. Sales at Argos were
down 7.5% and at Homebase down 10.2%, inline versus our forecasts of -7.6%
and -9% respectively. However gross margins were worse than expected down
125bp at Argos and down 50bp at Homebase, versus our forecasts down 70bp
and up 100bp respectively. Management expects to meet full year consensus
PBT, £320mn, as better than expected cost control has benefited.
Homebase’s 50bp margin decline ends a 3 year positive trend – a big miss and
emphasises how difficult the environment is. Promotions have driven the decline,
Home’s significant Far East sourcing, with up to 6 months lead time causing extra
pressure (i.e. forecasts 6 months ago looked a lot different to how they turned
out). But at least current forecasts should be attuned to weaker sales.
We have trimmed our FY 09 PBT forecast to £320mn, but we are cutting FY 2010
PBT by 21% reflecting lower gross margin assumptions, -150bp from -120bp at
Argos and -60bp from -50bp at Homebase. This results in EBIT down 13%, but
lower forecast interest income of £9mn from £34mn leads to the full decline.
Reiterate Underperform on Homebase concerns
We downgraded the stock last week on concerns at Homebase and the prospect
of a dividend cut. Homebase’s margin swing (and Argos’s) means FY 2010 is
likely to be uncertain and on our new numbers, DPS cover is just 1.1x below
management’s 2.0x target. We lower our PO to 160p from 185p based on 10x
rolling 12 month EPS estimates. We have increased this from 9x as we are closer
the possible trough.
post Christmas promotional trading, this implies a weaker underlying trend
across both businesses. The outlook for the consumer in the 1H 2009 remains
bleak while potential catalysts to support consumer spending (deflation, fiscal
stimuli) are likely to be accompanied by pressure on the bought-in gross
margin. Accordingly we retain a cautious stance.
Consensus February 2009 PBT likely to remain at £320m — On the back of
these results and updated guidance, we expect consensus to remain at £320m
(EPS 24.6p). For February 2010, consensus PBT is £240m (EPS 18.4p)
management the combination of volatile declining LFL and gross margin risk
limits our enthusiasm for the shares. We have a target price of 150p, based on
a 10x Feb 2011E PE, a premium to UK peers, reflecting the strong balance
sheet, net cash and market positioning.
from crisis to catastrophe during 2009 and possibly well beyond, in our
view. Housing transactions are crashing to post-war lows and we believe
new starts will hit the lowest peacetime level since 1920. Some brave souls
are predicting a recovery this year. We concur with the late Karen
Carpenter: “We’ve only just begun”.
third but the futures market appears to be pricing in them halving. We veer to the
latter view. But volumes (or lack of them) rather than falling prices will be the real
body blow for distressed housebuilders in our view.
covenants. The problem is … to generate cash you need to sell homes (not
merely to stop buying land).
Housing starts will fall below 60,000 this year, we believe – the worst since the
29,700 completions in 1920. The most cash strapped developers, we
understand, are fighting to sell stock and work in progress at almost any price.
On consented land selling prices often barely cover build costs, suggesting
residual values are at negative land values. Our industry sources suggest many
developers are also doing anything in their power to scupper planning consents,
which can trigger payment demands.
and prolonged period of hibernation and preserve cash until the market starts to
thaw. The big question is how long banks will support the most indebted builders
in what could be many months and possibly years of pitiful transaction numbers.
The evidence of the volume freeze can be seen in RICS figures that showed that
the average estate agent sold only 10.1 properties in the three months to
December – 0.78 per week.
- and can get a mortgage – are increasingly finding surveyors are providing valuations so low that they scupper not only their purchase but several in each buyer chain. The impact of down-valuations can be seen in the latest Home Builders Federation survey below
developers’ fire sales, auctioned repossessions and panic selling by investors (all mainly apartments) will increasingly become the only comparable local transactions for surveyors to base their view on, forcing valuations
down further and further scuppering the mid market.
cover) will eventually be the best positioned companies to pick away at the bones. Price targets based on PBV considerations. Our removal last year of price targets for the most indebted companies, Barratt and Taylor Wimpey reflects our view of the two stocks as investment grade considerations, debt restructuring or no debt
restructuring.
Cazenove Comment
Today’s statement provides some comfort on debt reduction but the group remains very highly borrowed and will, in our view, struggle to generate sufficient profits to cover interest costs given margin pressure. As it concentrates on generating cash, the group is likely to be unable to take full advantage of any improvement in market conditions.
We believe other housebuilders with lower debt levels are better placed.
At 82p Barratt trades on a FY2009E price to book of 0.14x and an EVAP of 1.02x, we remain Underperform.
FD Mark Pain to stand down at 30 June 2009 to ‘to pursue a wider range of business and personal interests’
Total completions in H1 2009 declined by 24% to 6,905 (H1 2008: 9,065), of which private completions were down 16.4% at 5,997 (H1 2008 7,177). Social housing completions reduced by almost 52% to 908 units
Total average selling prices down 9.6% to £160,900 (H1 2008: £178,000)
Forward sales down by 64% in value to £456m and 53% by volume to 3,529 units
The Group has been allocated funding for around 3,000 units for the Government’s HomeBuy Direct scheme
Operating margins are ‘expected to be below previous guidance’
Land bank reduced to 72,200 plots (89,400 June 2008)
Land spend during H1 2009 was around £141m. Land spend for the full year is expected to be around £400m
Stock levels continue to decline, although the Group has not made as much progress as its peers who have already reported.
Further land write downs expected and additional write downs of the Wilson Bowden commercial properties that the Group has so far failed to dispose of.
Debt £1.42bn
Interest cost in H1 2009 was £110m
Moody’s changes outlook for Hammerson’s Baa2 rating to negative
Approximately EUR1.75 billion in rated debt affected
London, 14 January 2009 — Moody’s Investors Service today changed the outlook to negative from stable for the Baa2 issuer rating of Hammerson plc.
“The change to negative outlook relates to the expected further weakening of the overall economic environment in Europe and in the property markets of the UK and France, and the potential impact that rising yields, reduced occupier demand and their credit profile, and moderating rent levels could have on the company’s operating income, interest cover and leverage,” explains Lynn Valkenaar, a Vice President — Senior Analyst in Moody’s Corporate Finance group.
Moody’s believes the ratings could stabilise if, despite the downturn in the economy, Hammerson’s occupancy rates and, by extension, rental income are maintained and the market decline in property values moderates, such that interest coverage and leverage no longer appear likely to deteriorate.
The first chart below highlights just how close the link is between financial and banking sector disruption and real economic weakness in an environment of a broken money multiplier (broken credit markets encourage liquidity hoarding in both the financial industry and among businesses and consumers). As expected, monetary easing and liquidity injections by the ECB and other major central banks have not forestalled further deterioration in global economic conditions. While G10 governments’ structural measures helped put a floor beneath financial systemic risks after Lehman, the global economic cycle has continued to head lower.
All this argues for a cut in the ECB rate of at least 100bps today, which would equate to a deposit facility rate of 0% as of 21 January when the corridor around the ECB’s marginal lending facility widens back to 100bps, en route to a shift towards unorthodox measures to restart credit flows. When classical economist assumptions have failed, it’s time to change the monetary rule book – see the second chart below.
What is the rationale behind this? The ECB’s communication and actions “decoupled” following Lehman’s bankruptcy, which marked an abrupt change versus the ECB strategy of the past year. After joining major central banks for a concerted cut of 50bps on 8 October the ECB went on to deliver cumulative easing of 175bps in Q4, including a record 75bps rate cut in December, which was in line with our forecast but against the message from earlier policy comments and the market consensus. Crucially, none of this coincided with the ECB’s communication even in the immediate aftermath of Lehman’s collapse.
Since then, the effectiveness of the ECB’s communication and its ability to affect forward market rates have weakened. This has resulted in an additional loss of policy ammunition, with the main policy rate standing just 250bps above the zero limit ahead of today’s announcement.
The fact that the ECB has already sought, unsuccessfully, to reclaim the “communication arm” of its policy ammunition renders the press conference today a high-risk event for the market. ECB President Trichet’s last press conference in December and a number of subsequent comments from Governing Council members on the wires signalled the desire for a pause in the easing cycle and a move towards smaller rate cuts of 25bps.
Furthermore, ECB Governing Council Stark is scheduled to speak at 15:30 today. In his comments made on 11 December he argued that the central bank “does not have a lot of room for manoeuvre” and “any further reductions could be done only in small steps”. The risk lies in a repeat of the communication strategy used after the December press conference, when ECB’s Mersch issued the comments:
“We have taken a great step – now for the time being, a pause. We want to wait until we have new information, and see whether the current measures take effect.”
“Without doubt the question of room for manoeuvre is coming closer. But with 2.5 percent we still have a little bit of margin. However, in the future we will not see such clear rate cuts. We are returning to normal territory, with changes to benchmark rates of 0.25 percentage points.”
Ultimately, we think that the ECB would like to pause soon based on the following arguments:
1. No deflationary scenario is seen in medium term. On 9 January, ECB President Trichet said: “deflation is a serious problem… which currently is not in the ECB’s forecasts for Europe in 2009″. So far the market’s arguments lean in the ECB’s favour.
2) The ECB have already signalled the need to assess the impact of previous cuts. Moreover they will need time to assess the implications from the Fed’s quantitative easing.
3) Finally, we believe that the ECB has a distinct bias against quantitative easing and will be concerned about the impact that such expectations would have on both market risk behaviour and public sector borrowing.
But given the huge amount of spare capacity being created in the world
economy over the next couple of years…
.. the bigger risk is that inflation falls by more than expected.
On the calendar today is the ECB rate decision: we expect a 25bp cut.
The onslaught of bad economic data – US retail sales plunged 2.7% in
December – and poor earnings news from the financial sector took its toll
on US equities yesterday with the SPX closing -3.4%. Asian stock markets
are also sharply lower overnight, with the Nikkei dropping over 5% at one
stage, before paring losses. The record decline in Japan machinery orders,
down 16.2% in November, clearly weighed on sentiment.
The key focus of today will be on ECB meeting. We expect them to cut rates
by 25bp, followed by another 25bp in February and then a halt at 2.0% –
until we get the negative headline inflation numbers (and still negative
growth and higher unemployment) in the spring, which probably will lead
them to cut again down to 1.5%.
We are closing our longs in NZD 2-yr swap rate after reaching the target
of 3.75% with a gain of 175bp (we were long in the front-end of this
market in April-July 2008 too). We have also gained from a strong rally in
EUR 2-yr swaps, and think it is prudent to take profits now (the trade is
up almost 100bp since the last time we re-opened the position).
In the first Global Economics Weekly of the year, Jim O’Neill suggested
that while markets are preoccupied with deflationary risks, a potentially
nasty surprise for markets could be if inflation were to remain sticky
rather than decline somewhat sharply as per our forecasts (See “Global
Deflation – A Likely Trading Theme in 2009”, 15 December).
Recently some clients are beginning to wonder that given the aggressively
easy stance of global monetary policy at present, whether the accelerated
move towards easier fiscal policy in the major OECD economies (and
elsewhere such as China) will ignite global inflationary pressures earlier
than generally expected. We would be extremely surprised if this were to
occur any time soon, since our forecasts envisage that world growth is
unlikely to expand rapidly enough to make significant inroads into unused
capacity.
We tend to view core inflation pressures as a function of spare capacity
in an economy (since headline inflation is also a function of agricultural
and energy prices): when the level of output is below trend, inflation
tends to decline, and vice versa. This relationship is by no means perfect
but for the world as a whole, the relationship is reasonably reliable.
Given our approximate estimates for the output gap (measured as % of GDP),
there appears to be little reason to be concerned about a rise in global
inflation in the next couple of years (at least):
*
In the US, we expect the output gap to widen to a staggering -8% by end
2009 (as was seen in the early 1980s downturn).
during the second half of 2008 as growth plummeted and should widen
further to -4% by the end of this year and remain roughly there through
2010. The UK output gap is also expected to reach -2.7% by the end of the
year, from -1.4% at the end of last year.
widening to around -7% by the end of 2010 – a wider gap than in the
previous recession.
On a global basis we therefore expect significant capacity to open up,
with the global output gap widening from -1% in 2008 to -4% this year
and -5% in 2010 (assuming world trend growth of 4%). Of course, the size
of the gap is of course not the only determinant of the change in
inflation. For individual countries, we also need to take account of
elements such as imported inflation, which will be affected by exchange
rate changes. At the global level, commodity prices – and notably oil
prices – can be an important factor. In the current situation, our
commodity strategists consider that the path for oil prices is likely to
drop by further in the near term reflecting weaker global demand.
The bottom line is that given the behaviour of output gaps and the size of
spare capacity opening up in the world, it would be extremely surprising
if significant world inflationary pressures were re-ignited over the next
couple of years (even if world growth returned to trend more quickly than
anticipated). Given the high credibility of central banks’ commitment to
price stability, well anchored inflation expectations, particularly in the
US and Europe, should also prevent excessive inflation (and of course help
reduce deflation risks at the present time).
Four caveats are in order, however. The first is that there are, of
course, problems with analysis based on output gap estimates. Indeed, the
measurement of the output gap at any particular time is subject to great
uncertainty, especially following a sharp economic slowdown which may
cause capacity in the economy to shrink. As Jim implied in his piece,
inflation would be stickier if trend growth had weakened. But even if
world trend growth had slowed to 3% – as a result of last year’s oil shock
coupled with the current credit crisis and the cut back in investment –
significant global capacity would still be opened with the output gap
increasing to 2% this year.
The second caveat is that if existing policy settings were maintained
after economic recovery became established, they no doubt would at some
point beyond 2010 lead to unsustainably rapid growth and hence inflation
pressures. But the risk of that happening seems small in an era of
forward-looking monetary policy. By the time global recovery gets going,
the output gap will be sufficiently wide that central banks will have
ample time to move rates back to neutral levels before economies come
close to approaching capacity limits.
The third caveat is that the world continues to benefit from the
disinflationary effects of globalization. In a recent Daily
(“Protectionism: Another Risk to Watch in 2009”, 6 January) we warned that
another risk to watch this year is the raising of trade barriers,
something that would likely have inflationary consequences. But after
earlier concerns to the contrary, it is interesting to note that
disinflationary forces are again building in China, judging by the recent
downturn in import prices from China into the US.
Finally, world inflation would inevitably stand to be adversely affected
by a flare-up in oil prices triggered by either an earlier than expected
pick-up in global demand and/or a supply shock (perhaps on increased
instability in the Middle East).
1. Stay long Chinese A-shares at 2,079, target 2,600, currently 1,929.
2. Stay long/short EM FX Differentiation Basket (with 20% long EUR/PLN,
30% long EUR/CZK, 15% long EUR/TRY, 20% short US$/MXN, 15% short US$/BRL)
at 100, target 106 in spot (plus carry), carry adjusted performance 3.04%.
3. Stay short Dec-11 crude oil futures at US$67.97, target US$60,
currently $69.12.
4. Stay long US 30-yr current coupon Fannie Mae MBS at 4.7%, currently
3.44%.
5. Sell credit protection on Sweden through 5-yr CDS at 148bp, target
60bp, currently 102bp.
6. Stay long the Wavefront housing basket at 58.97 for a target of 70,
currently 61.33.
7. Stay long cable, at 1.48, for an initial target of 1.65, currently
1.4587, carry adjusted performance -1.13%.
8. Stay short EUR versus an equally-weighted basket of NOK, SEK and GBP at
100, for a target of 110, carry adjusted performance 1.23%.
