Fiat Economics

Economics Week Ahead: GDP & Earnings Steal the Show

2009-07-25T13:40:00.005-04:00

We have a rather tumultuous week in terms of economic data, which will focus on the US housing sector, consumer confidence, durable goods, and US GDP. The week kicks off Monday morning with the US Census Bureau reporting June’s new home sales. Recent housing data has been indicative of a bottom for the sector, so it will be important to see whether new home sales data confirms this trend. Mid-week the market will focus on June’s durable goods, looking for any signs of a potential turnaround in industrial production, which experienced a 13.6%yoy decline in June. The week’s main economic event is taking place on Friday with the Commerce Department’s release of the advanced 2Q09 GDP estimates. They will also be releasing changes to the benchmark methodology, which could cause some revisions to past data. But again, this week’s earnings calendar will overshadow most of the week’s economic news. Big names reporting this week include Chevron, Walt Disney, Travelers, Verizon, Viacom, Exxon Mobile, Amgen, Norfolk Southern, Genco Shipping, DryShips, Visa, and International Paper. There will also be a record US$115bn long-dated Treasury auction occurring this week, which coupled with better than anticipated earnings has put some downward pressure on Treasury prices.

Monday July 27^th:

10:00AM: New Home Sales (Risk: Upward, Market Reaction: Significant): Attractive mortgage rates combined with tax incentives and relatively low home prices should place some upward pressure on this release, but sustained weakness in the labor market will prevent this index from realizing its full potential. The current Bloomberg consensus for new home sales is 350K, compared to last month’s reading of 342K.

Tuesday July 28^th:

7:45AM: ICSC-Goldman Store Sales (Risk: Negative, Market Reaction: Marginal): This weekly index tracks aggregate store sales across major US retailers, accounting for roughly 10% of total retail sales. Given recent data supporting an increasing US saving rates and a worsening employment situation, this index could face some downward pressure. Last week’s number indicated a 0.5% gain in store sales over the previous week.

10:00AM: S&P Case Shiller Home Price Index (Risk: Neutral, Market Moderate: xx): The S&P Case Shiller HPI is reported monthly, but on a two month lag. Last month’s report showed the rate at which home prices were declining began diminish, with some major cities even experiencing modest gains. I anticipate this month’s release will reaffirm that trend. But, we would still need to see significant improvements in those regions, which were the hardest hit by the drop in prices, before we can see a strong overall recovery.

10:00AM: Consumer Confidence (Risk: Downside, Market Reaction: Significant): Weakness in the labor market could adversely impact consumer confidence, overshadowing the recent spike in equity prices. Supporting this is the fact that last week’s Reuters/UofM Consumer Sentiment Index fell to 66 in July from 70.8 a month prior. It will also be important to monitor changes in the expectations index, which has remained elevated, and could help buffer any negative surprises in the current conditions index. The current Bloomberg consensus forecast for July’s consumer confidence reading is 50.0, versus an outcome last month of 49.3.

10:00AM: Janet Yellen, San Francisco Federal Reserve Bank President, speaks on the economic outlook to the Idaho/Oregon Bankers Association.

Wednesday July 29^th:

7:00AM: MBA Purchase Applications (Risk: Neutral, Market Reaction: Marginal): This index, which tracks new mortgage applications tends to be a reasonable forward looking indicator for home sales, but issues including customers filling out numerous applications could skew the index. Last week the purchase index rose 1.3%; while the refinance index increased by 4.0% on rising, but still relatively low mortgage rates.

8:30AM: Durable Goods Orders (Risk: Downside, Market Reaction: Significant): This index could face some negative pressure this month as June’s ISM, Philly Fed, NY Fed indices all indicated contractions in new orders. The current Bloomberg consensus forecast is a month over month change of -0.5%, compared to last month’s reading of 1.8%. In May this index was down roughly 26%y/y.

8:30AM: William Dudley, New York Federal Reserve Bank President speaks to the Association for a Better New York on factors driving U.S. growth and inflation.

10:30AM: EIA Petroleum Status Report (Risk: Neutral, Market Reaction: Moderate): This report indicates domestic petroleum inventories, which could have a significant impact on the energy sector.

2:00PM: Fed Beige Book (Risk: Neutral, Market Reaction: Marginal): This report, which is released two weeks before FOMC meetings, outlines economic conditions across the Fed’s 12 districts. Indications of a return to growth for any of the fed’s districts could produce some positive headlines.

Thursday July 30^th:

8:30AM: Jobless Claims (Risk: Downside, Market Reaction: Significant): As expected, initial claims experienced a significant uptick last week to 554K from 522K, after two solid weeks of declines. This increase will likely be continued this week as erroneous seasonal adjustments from early auto plant closures continue to correct themselves. Nevertheless, barring recent data, I due anticipate we will see a modest recovery in claims data over the coming months.

10:00AM: EIA Natural Gas Report (Risk: Neutral, Market Reaction: Moderate): This report highlights domestic natural gas inventories, which could have a significant impact on the energy sector.

4:30PM: Fed Balance Sheet & Money Supply (Risk: Neutral, Market Reaction: Marginal): Since the Fed’s shift to quantitative easing, the balance sheet has become one method to measure to the Fed’s effectiveness. The market will pay close attention to the reserve bank credit component, which measures factors supplying providing reserves into the banking system. Last week the Fed’s balance sheet decreased to US$2.024trn from US$2.057trn. The fed’s balance sheet has slowly been shifting away from emergency lending facilities to Treasuries, agency debt and mortgage-backed securities to help bring down interest rates.

Friday July 31^st:

8:30AM: GDP (Risk: Neutral, Market Reaction: Significant): This will be the key release for the week as investors continue trying to gauge the longevity of the current recession. The current Bloomberg consensus forecast for Real GDP (Q/Q) SAAR is -0.7%, compared to a prior reading of -5.5%. Additionally, the Commerce Department will be releasing their benchmark revisions, which could cause some revisions to past data. In the eyes of the market, this release will likely support the view that there is light at the end of the tunnel. But, make no mistake about it, we are still in the midst of a prolonged recession, which though easing likely won’t abate over the next several months. This data will also reaffirm the Central Bank’s current accommodative policy stance.

8:30AM: Employment Cost Index (Risk: Downside, Market Reaction: Marginal): The current Bloomberg consensus forecast for the ECI is a quarter over quarter change of 0.3%, compared to a first quarter reading of 0.3%. Interestingly, last quarter’s growth rate was the lowest in the 27 year history of this index. Weakness in the labor market combined with cost cutting, affecting benefits, could place some additional downward pressure on this index.

9:45AM: Chicago PMI (Risk: Neutral, Market Reaction: Moderate): The current Bloomberg consensus forecast for the Chicago PMI Business Barometer Index is 44, versus June’s reading of 39.9. Any reading below 50 indicates a contraction. This index includes both manufacturing and non-manufacturing companies. It will be important to monitor the new orders, employment, and prices paid indices, all of which are currently well below the breakeven of 50.

3:00PM: Farm Prices (Risk: Neutral, Market Reaction: Marginal): Given the relationship between farm prices and food prices, this index could have implications on future headline CPI and PPI.

Enjoy the weekend!

Consumer Sentiment Falls on Jobs Weakness

2009-07-24T10:17:00.005-04:00

The Reuters/University of Michigan consumer sentiment index dipped for the fist time in five months to 66, compared to a market consensus of 65 for July. At the same time the July expectations index increased to 63.2 versus July's preliminary reading of 60.9. The drivers behind this month's declines were derived from weakness in the labor market and wages. This reading implies that consumers remain concerned over the current economic conditions, and will likely keep spending restrained until a brighter outlook for the employment situation emerges.

Existing Home Sales Beat Estimates, Rise 3.6%

2009-07-23T13:07:00.002-04:00

US existing home sales came in above the market consensus, rising 3.6% at an annualized rate of 4.89mn. Single family home sales increased by 2.4%, while condo/coop sales increased 14.0%. The months supply of home also improved moving to 9.4 months, compared to 9.8 in May. The median home price rose 4.1%, but still remains negative on a yearly basis. All in all, low prices combined with attractive mortgage rates are helping to stabilize the housing sector.

On a personal note, I was recently speaking to a developer in Boston who said business is once again picking up, but without private financing taking on new projects could be tough. He indicated that local banks were still hesitant on financing new deals, even in cases were the relationship has spanned decades. However, he is still working on several projects in Cambridge, and seems cautiously optimistic about the future.

Initial Claims Climb 30K to 554K

2009-07-23T08:57:00.005-04:00

As I anticipated, and explained in my US Week Ahead, initial claims experienced a significant uptick this morning, which will likely be continued next week. In reality, this increment was probably due to a correction in what has been overly optimistic data stemming from erroneous seasonal adjustment factors.

Fed Chairman Bernanke in his recent testimony to Congress discussed the fact that weakness in the jobs sector and housing market will continue to be an Achilles heel for a US economic recovery. But, I anticipate that, excluding the anomalous data over the past three weeks, claims will slowly begin to improve. However, given such a weak base and initial claims forward looking ability to predict payrolls, it is very probable the overall employment situation will still get worse before it gets better. The unemployment rate likely to move above 10%. Typically, an initial claims level of around or below 350K would lead to increases in payrolls, but we are still far from those levels.

US Initial Claims

Source: St Louis FRED

Leading Indicators Up: A Good Sign for the Economy

2009-07-20T10:57:00.005-04:00

The index of leading indicators was up in June by 0.7%, or slightly above the market consensus of 0.5%. At the same time May's number was revised up to 1.3% from 1.2%. This is the third consecutive month of gains for the index. In the release the Conference Board was quoted as saying, "The behavior of the composite indexes suggest that the recession will continue to ease and that the economy may begin to recover in the near term." The LEI tends to be a good forward looking indicator towards industrial production and the ISM. Seven out of ten of the LEI sub-components were positive for the month with the biggest gains coming from the yield curve and building permits; while money supply was the weakest component. The Conference Board also released June''s coincident and lagging indices, both of which were down.

US Economic Week Ahead: Cue Earnings

2009-07-17T22:31:00.003-04:00

After last week’s barrage of economic data, this week is relatively light. The few exceptions will be Monday’s leading indicator release, Thursday’s jobless claims and existing home sales data, and Friday’s consumer sentiment report. This week’s claims data will likely take on added importance as the market tries to decipher the impact early auto plant shutdowns may have had on the index’s seasonal adjustment factors, leading to better than expected claims data over the past couple weeks. Additionally, starting on Tuesday Fed Chairman Ben Bernanke will deliver his semi-annual monetary policy testimony to House Financial Services Committee, which will almost certainly generate some headlines. But, earnings will again steal the spotlight this week with roughly 33% of the companies in the DJI and 25% of the S&P500 set to report. Some of the major names include Apple, Microsoft, Boeing, Caterpillar, UPS, Morgan Stanley, Yahoo, EBay, Amazon, Texas Instruments, and Advanced Micro Devices.

Monday July 20^th:

10:00AM: Leading Indicators (Risk: Neutral, Market Reaction: Maringal/Moderate): The leading indicators index is a composite index of ten economic indicators considered to be forward looking to economic activity, these include among others jobless claims, building permits, stock prices and the University of Michigan expectations survey. The index climbed in both May and April by 1.2% and 1.1%, respectively. The market is currently anticipating a 0.5% increment in June’s release.

Tuesday July 21^st:

8:30AM: Chicago Fed National Activity Index (Risk: Neutral, Market Reaction: Marginal): The CFNAI is an index of 85 separate data sets designed to represent national economic activity and inflationary pressure. A reading of 0 indicates the economy is growing at the historical trend while a negative or positive result indicates the economy is growing below or above its historical average, respectively. Given the volatile nature of this index the three month moving average is typically quoted. This index remains somewhat obscure in the mainstream media and is likely to have a minimal impact on trading. I anticipate that we will see a marginal improvement from last month’s reading of -2.67 based on improving economic data,

10:00AM: Fed Chairman Ben Bernanke delivers his semi-annual monetary policy testimony to House Financial Services Committee

Wednesday July 22^nd:

7:00AM: MBA Purchase Applications (Risk: Neutral, Market Reaction: Marginal): This index, which tracks new mortgage applications tends to be a reasonable forward looking indicator for home sales, but issues including customers filling out numerous applications could skew the index. Last week the purchase index fell 9.4%; while the refinance index increased by 18.0% on the back of relatively low mortgage rates.

10:00AM: Fed Chairman Ben Bernanke delivers his second day of semi-annual monetary policy testimony to House Financial Services Committee

10:30AM: EIA Petroleum Status Report (Risk: Neutral, Market Reaction: Moderate): This report indicates domestic petroleum inventories, which could have a significant impact on the energy sector.

Thursday July 23^rd:

8:30AM: Jobless Claims (Risk: Downside, Market Reaction: Significant): After two consecutive weeks of positive surprises, stemming from what was likely erroneous seasonal adjustment factors caused by early auto plant shut downs, we will likely see a correction. The current Bloomberg consensus stands at 560K compared to last week’s reading of 522K.

9:30AM: Fed Governor Daniel Tarullo testifies to the Senate Banking Committee, FDIC, and SEC on regulatory restructuring

10:00AM: Existing Home Sales (Risk: Downside, Market Reaction: Moderate/Significant): The Bloomberg consensus for existing home sales stands at 4.850 compared to last month’s reading of 4.770. It will be important to watch the inventory levels, which last month declined to 9.6 months from 10.1 months, the month prior. But, a recent article in the WSJ highlights the fact that a glitch in the California Association of Realtors computer system may have been inflating the number of homes sold in San Diego over the past several months, which means we will likely see some downward revisions.

10:00AM: EIA Natural Gas Report (Risk: Neutral, Market Reaction: Moderate): This report highlights domestic natural gas inventories, which could have a significant impact on the energy sector.

4:30PM: Fed Balance Sheet & Money Supply (Risk: Neutral, Market Reaction: Marginal): Since the Fed’s shift to quantitative easing, the balance sheet has become one method to measure to the Fed’s effectiveness. The market will pay close attention to the reserve bank credit component, which measures factors supplying providing reserves into the banking system. Last week the Fed’s balance sheet increased by US$34.2bn to move back above US$2 trillion.

Friday July 24^th:

10:00AM: Consumer Sentiment (Risk: Neutral, Market Reaction: Significant): Rising stock prices and receding energy prices should bode well for this index, but could be offset by continued weakness on the labor front. The current Bloomberg consensus for July’s final consumer sentiment index is 65.0 compared to mid-July’s reading of 64.6.

Enjoy the weekend!

June Housing Starts Show Big Gains

2009-07-17T09:23:00.003-04:00

June housing starts came in this morning well above expectations increasing 3.6%, totaling 582K (SAAR) units. Economists has been anticipating 530K. This is the index's second consecutive month of gains, which could indicate some stabilization for the sector. There were also some positive revisions to April's and May's starts numbers. The increase was due to a 14.4% increment in single-family home starts, while multi-family housing starts actually declined by 25.8%. Regionally, the South experienced the largest increase in starts with a gain of 13.9%, while the West was the weakest with a gain of only 1.9%. Housing permits were up 8.7% in June. Overall this is a positive report for the housing sector, but we will need to see significant improvements in the level of foreclosures and the supply glut currently on the market prior to any true recovery.

Philly Manufacturing Index Declines More Than Expected

2009-07-16T12:27:00.003-04:00

The Philadelphia Fed Manufacturing Index fell to -7.5 this month compared to -2.2, last month. Looking deeper into the details, the future general activity index remained positive, but declined to 51.9 from 60.1 last month. Further deterioration to this component could indicate continued weakness in in the general business activity index through the beginning of 2010. This manufacturing index is highly correlated with both ISM and industrial production.

The prices paid index increased to -3.5 from -13.0 a month prior. New orders moved to -2.2 from -4.8 a month prior, any reading below 0 indicates a contraction. The labor market conditions index continued facing pressure coming in at -25.3, compared to -21.8 in June.

I believe we are likely still far off from any sustained recovery in the manufacturing sector. But, the worst is behind us.

Jobless Claims Drop, But Reading is too Optimistic

2009-07-16T09:27:00.003-04:00

As I mentioned was a likely scenario in my US Economic Week Ahead, jobless claims fell 47K to 522K. As with last week, early auto company layoffs have likely distorted the index due to misaligned seasonal adjustments. I do believe we should continue to see an improvement in jobless claims, but the levels seen over the past two weeks are too optimistic. Thus, I believe over the next several weeks this issue will begin to correct itself, and we will start to experience what appears to be an increase in jobless claims. The market places a lot of importance on the initial claims number as it is an excellent forward looking indicator to payrolls.

Continuing claims experienced a record drop of 642K to 6.915mn. But, this too was likely a one off event caused by statistical factors.

Empire Survey and Industrial Production Surprise to the Upside

2009-07-15T09:41:00.004-04:00

The Empire State Manufacturing Survey's General Business Conditions Index moved up to -0.6 from -9.4 in June. Both the new orders and shipment indices came in above 0 this month, indicating growth, at 5.9 and 11.0, respectively. But, the employment index remained depressed with a reading of -20.8, almost unchanged from the prior month. It will be important to see if the Philly survey, being released tomorrow shows similar results.

June's Industrial production came in above analysts' expectations this morning, despite a decline of 0.4%. As I expected manufacturing experienced the largest drop of 0.6% followed by mining with a decline of 0.5%. Utilities posted a gain of 0.8%. Capacity utilization set a new historic low for the index finishing the month at 68.0%.

Retail Sales Jump, but the Story is in the Details...

2009-07-14T09:23:00.006-04:00

Retail sales jumped 0.9% last month on the back of higher gasoline prices and increased automobile purchases. Automobile sales were mostly catalyzed by bigger incentives to clear inventories. But, factoring out these components retail sales would have actually declined for the 4th consecutive month. Therefore, despite what appears to be a significant increment on the surface, the details behind this morning's data do not yet indicate a recovery for the sector. Finally, consumers' purchases were centered around basic necessities such as food and gas versus discretionary goods.

Please click here for his week's full economic calendar with analysis and expectations.

US Week Ahead: A Hectic Week on Data & Earnings

2009-07-11T01:22:00.002-04:00

Despite a rather hectic week of economic releases; earnings news will likely steal the show this week. Big names on the earnings calendar this week include Goldman Sachs, JPMorgan, Bank of America, Citigroup, GE, Intel, Google, IBM, and Johnson & Johnson. However, a recent mixture of good and bad economic news, including decreasing consumer sentiment, rising unemployment, and dreadful retail sales have raised concerns over the potential for a prolonged recession. Therefore, it’s important we pay close attention to Tuesday’s retail sales and PPI data, Wednesday’s CPI and industrial production data, and finally Thursday’s jobless claims number, all of which have the potential to move the market in one direction or another. Here is the remainder of the calendar:

Monday July 13^th:

2:00PM: Treasury Budget (Risk: Upside, Market Reaction: Marginal): The current Bloomberg consensus for the Treasury’s monthly budget report is –US$97bn compared to –USD187.7bn a month prior. These large deficits have been fueled by TARP expenditures and buying federal housing agency debt. But, several companies have recently paid back TARP funds, which will likely reduce the level of this month’s deficit.

Tuesday July 14^th:

7:45AM: ICSC-Goldman Store Sales (Risk: Downside, Market Reaction: Marginal): This weekly index tracks aggregate store sales across major US retailers, accounting for roughly 10% of total retail sales. Given recent data supporting an increasing US saving rates and a worsening employment situation, this index could face some downward pressure. Last week’s number indicated a 0.1% increment in store sales over the previous week.

8:30AM: Producer Price Index (Risk: Downside, Market Reaction: Moderate/Significant): Higher energy prices and a small increment in food prices will likely lead to a higher headline number for the PPI, while core-PPI should remain relatively unchanged. According to Bloomberg the current consensus forecast for the PPI and core-PPI is 0.8% and 0.1%, respectively. Any significant upward surprise in this index could amplify rhetoric among inflation hawks. This index is considered a forward looking indicator to profits and the CPI.

8:30AM: Retail Sales (Risk: Neutral, Market Reaction: Significant): The effect of higher gasoline prices in June could cause retail sales to surprise to the upside. But, factoring out gas, recent weakness in other sales indicators imply that June’s sales data will be flat to negative. According to Bloomberg the current market consensus for retail sales and retail sales-ex autos is 0.5% and 0.6%, respectively. Retail sales plunged at the end of last year and have essentially remained flat this year.

10:00AM: Business Inventories (Risk: Neutral, Market Reaction: Marginal): On the back of a decline in wholesale inventories, business inventories will likely decline again in June after declining the previous eight months. Look for auto and retail inventories to continue their decline. According to Bloomberg the current market consensus for business inventories is a monthly change of -0.8%. The good news is that with inventory levels so low once a recovery does begin we could see a jump in manufacturing as companies look to replenish their stocks.

Wednesday July 15^th:

7:00AM: MBA Purchase Applications (Risk: Neutral, Market Reaction: Marginal): This index, which tracks new mortgage applications tends to be a reasonable forward looking indicator for home sales, but issues including customers filling out numerous applications could skew the index. Last week the purchase index rose 6.7%, while the refinance index increased by 15.2% on the back of relatively low mortgage rates.

8:30AM: Consumer Price Index--CPI (Risk: Downside, Market Reaction: Significant): As with the PPI, a recent rise in energy prices will likely add some upward pressure on the headline index, while core CPI should remain relatively constant relative to last month. According to Bloomberg the current consensus forecast for the CPI and core-CPI is 0.7% and 0.1%, respectively. Any significant upward surprise in this index could amplify rhetoric among inflation hawks; the inverse is true with a downward surprise.

8:30AM: Empire State Manufacturing Survey (Risk: Downside, Market Reaction: Marginal): This index tracks manufacturing activity in New York state across 175 different companies in a variety of industries. Recent weakness in the overall manufacturing sector will likely add some downside pressure to July’s release. According to Bloomberg, the current market consensus for the general business conditions index is -4.5, compared to -9.4 a month prior. It will be important to monitor the general business conditions, new orders, and prices paid components of the index, all of which were negative last month. Conversely, the future general business conditions index rose last month.

9:15AM: Industrial Production (Risk: Downside, Market Reaction: Significant): Continued weakness in manufacturing sector will likely add downward pressure to the overall index. According to Bloomberg, the current market consensus for June’s IP is a monthly change of -0.7% with a capacity utilization rate of 67.8%. In June capacity utilization stood at 68.3%, or 12.6% below its 1972-2008 average.

10:30AM: EIA Petroleum Status Report (Risk: Neutral, Market Reaction: Moderate): This report highlights domestic petroleum inventories, which could have a significant impact on the energy sector.

2:00PM: FOMC Minutes (Risk: Neutral, Market Reaction: Marginal): Given the three week lag between the FOMC meeting and the release of the minutes this should have only a marginal effect on trading. But, the minutes could elaborate the rationale behind the FOMC’s decision, and give some clues to future decisions, in which case the market could move on the release.

Thursday July 16^th:

8:30AM: Jobless Claims (Risk: Upside, Market Reaction: Significant): Last week’s better than expected initial jobless claims may have been exaggerated by inaccurate seasonal adjustment factors stemming from the timing of automotive and other manufacturing lay-offs, which could be repeated this week. According to Bloomberg the current consensus for initial jobless claims stand at 535K, compared to 565K last week. Although, I do believe we will continue to see a downward trend in the number of new claims, the level last week's number implied is too optimistic.

9:00AM: Treasury International Capital Data (Risk: Neutral, Market Reaction: Marginal): This data highlights the flow of financial instruments to and from the US. Thus, indicating foreign demand for US financial instruments, which tends to have a stronger impact on the dollar and bond markets compared to equities.

10:00AM: Philly Fed Survey (Risk: Downside, Market Reaction: Moderate): This index, which tracks manufacturing activity within the Philly Fed’s district, is correlated to both the ISM and Industrial production indices. According to Bloomberg the current market consensus for the general business conditions index is -5.0 versus -2.2 a month prior. Continued weakness in manufacturing will likely place downward pressure on this index.

10:00AM: EIA Natural Gas Report (Risk: Neutral, Market Reaction: Moderate): This report highlights domestic natural gas inventories, which could have a significant impact on the energy sector.

1:00PM: Housing Market Index (Risk: Downside, Market Reaction: Moderate): The housing market index, published by the National Association of Home Builders, indicates the demand for housing combined with consumer sentiment towards the housing market. The index is calculated by using a weighted average of the following indices; present sales of new homes, sale of new homes expected in the next six months, and traffic of prospective buyers in new homes. Increasing unemployment coupled with waning consumer confidence could place some downward pressure on this index.

4:30PM: Fed Balance Sheet & Money Supply (Risk: Neutral, Market Reaction: Marginal): Since the Fed’s shift to quantitative easing, the balance sheet has become one method to measure to the Fed’s effectiveness. The market will pay close attention to the reserve bank credit component, which measures factors supplying providing reserves into the banking system. Last week the Fed’s balance sheet shrunk to $1.977 trillion from $1.989 trillion the previous week.

Friday July 17^th:

8:30AM: Housing Starts (Risk: Downside, Market Reaction: Marginal/Moderate): After experiencing an unexpected bump in May housing starts are likely to decline in June. According to Bloomberg the current market consensus for starts is 530K, compared to 532K last month. Weak demand for homes will likely place downward pressure on this index.

Have a good weekend!

China's June Exports Fall 21.4%y/y in June

2009-07-10T07:29:00.005-04:00

Chinese exports continued struggling in June falling 21.4% y/y compared to analysts' estimates of 21.0%, and a 26.4% y/y drop in May. Continued declines in exports are being offset by increased domestic demand, which is heavily bolstered by the country's stimulus package. According to Bloomberg, China's Premier Wen Jiabao believes the foundation for China's economic recovery is not yet set and they will continue on a course of easy monetary policy and pro-active fiscal policy.

A continued decline in Chinese exports is a bad omen for shipping rates. Shipping rates over the last several months have been supported almost exclusively by China's record importation of raw materials. Without a return of global demand for Chinese goods, many of these raw materials are just sitting in inventories one way or another. Thus, it is highly likely that China's demand for raw materials will begin to wain. But, presently it appears Chinese iron imports rose 3.4% in June to 55.3mn tons. However, this could be caused by a lag effect of massive congestion of vessels waiting to unload off the coast of China, or possibly increased imports from India via land. Supporting this view is that one of China's primary ports actually reported a 12% drop in ore imports from the previous month. In either case, I anticipate that this number will fall in the coming months.

Initial Claims Come in Better than Expected

2009-07-09T09:22:00.003-04:00

Initial Claims finished came in this morning at 565K versus the previous week's reading of 614K and a consensus forecast of 610K. I believe the improvement may have been exaggerated by inaccurate seasonal adjustment factors stemming from the timing of automotive and other manufacturing lay-offs, which could be repeated next week. Although, I do believe we will continue to see a downward trend in the number of new claims, the level this week's number (and possibly next week's) indicates is too optimistic.

Conversely, continuing jobless claims rose 159,000 to a high of 6.883mn. This increase is primarily due to the lag effect of recently high initial claims coupled with the fact that the unemployed workforce has been unable to find new jobs.

Alcoa's Earnings Come in Above Consensus Estimates

2009-07-08T19:23:00.000-04:00

Kicking of the 2Q09 earnings season Alcoa (AA) reported a loss yesterday of US$0.26/share compared to analysts’ average estimate of US$0.38/share. The company accredited the better than expected result to workforce reductions and production cuts. CEO Klaus Kleinfeld said in a statement, “Alcoa has the staying power and reduced cost base to withstand the most serious downturn in the history of the aluminum industry.” Alcoa showed marginal gains in after-hours trading on the news.

MBA Purchase Applications Composite Index Up 10.9%

2009-07-08T09:06:00.003-04:00

The MBA The Market Composite Index rose 10.9% the week ending July 3rd 2009. The purchase index rose 6.7%, while the refinancing component climbed 15.2%, on the back of relatively favorable interest rates. Remember this index could be skewed by lenders filling out multiple applications, and I would like to see a continued trend in the index before rushing to any conclusions on the housing sector. The 4wk moving average of the market index is still down by 5.6%.

ICSC-Goldman Store Sales-- Shows Growth, But Redbook Says Otherwise

2009-07-07T09:27:00.005-04:00

ICSC-Goldman Store Sales demonstrated a week over week increase of 0.1% and a year over year increase of 0.5% during the holiday week. This likely won't have much effect on today's trading. But, the Redbook, which was released at 8:55AM showed a 4.2% y/y decline in same store sales, which continues to indicate the retail sector remains depressed. Chain stores will be reporting sales later this week.

ICSC-Goldman Store Sales

Source: Bloomberg

Redbook Results:

Year-over-year: Week (w/e 7/04/09 vs year ago)        -4.2 pct
Year-over-year:Month (June 2009 vs June 2008)         -4.4 pct
Month-over-month: (June 2009 vs May 2009)             -4.3 pct
Source: Reuters

Non-Manufacturing ISM 47.0 vs Consensus Forecast of 46.7

2009-07-06T10:04:00.003-04:00

The Non-Manufacturing ISM came in at 47 compared to the consensus forecast of 46.7. This signifies the sector is still contracting, but at a slower pace than in May, which had a reading of 44.0. This was the index's best showing in 9 months. The new orders index, which tends to be forward looking rose by 4.2 percentage points to 48.6. The prices index showed the sharpest increase of 6.8 percentage points to 53.7 percent in June. This is the prices index first positive reading since October 2008. This should help to quell any ongoing fears of deflation, but could help to put concerns over inflation back on the table.

The following six industries reported growth in the survey (in order of magnitude): Real Estate, Rental & Leasing; Arts, Entertainment & Recreation; Accommodation & Food Services; Finance & Insurance; Construction; and Information.

The following 11 industries reported contractions in the survey (in order of magnitude): Mining; Agriculture, Forestry, Fishing & Hunting; Wholesale Trade; Transportation & Warehousing; Retail Trade; Management of Companies & Support Services; Public Administration; Health Care & Social Assistance; Professional, Scientific & Technical Services; Educational Services; and Other Services.

US Economic Week Ahead: The Calm after the Storm

2009-07-03T14:31:00.003-04:00

This week’s economic calendar is relatively quiet, especially compared to the hustle and bustle of last week. Monday’s non-manufacturing ISM report starts the week off, followed by Wednesday’s consumer credit report, Thursday’s jobless claims data, and Friday’s US trade statistics and consumer sentiment. The impact of this week’s non-manufacturing ISM report could be somewhat subdued since its release comes after June’s employment report; negating the importance the report’s employment index. But, significant declines or advances in the report’s business activity index could help shift market sentiment. This week’s big headlines, however, will likely be driven by the start of the 2Q09 earnings seasons, with Alcoa set to announce earnings on Wednesday. There is also a G8 summit taking place this week in Italy, which could produce some headlines. Here is this week’s US economic calendar:

Monday July 6^th:

10:00AM: ISM non-manufacturing Index (Risk: Neutral, Market Reaction: Moderate/Marginal): The non-manufacturing ISM index will likely experience its third consecutive monthly rise. The current Bloomberg consensus for the index is 46.7 compared to last month’s reading of 44.0. The market would take any positive surprises to this index as good news echoing better than anticipated data in the manufacturing sector pointing towards a less severe recession. It will also be important to pay attention to non-manuf. ISM’s new order index, which tends to be a forward looking indicator for the primary business activity index. Since June’s employment report has already been released the employment index is essentially a non-factor.

Tuesday July 7^th:

7:45AM: ICSC-Goldman Store Sales (Risk: Downside, Market Reaction: Marginal): This weekly index tracks same store sales at major US retailers, account for roughly 10% of total sales. Given recent data supporting an increasing US saving rates and a worsening employment situation, this index could face some downward pressure. Last week’s number indicated a 1.6% increment in store sales over the previous week.

Wednesday July 8^th:

7:00AM: MBA Purchase Applications (Risk: Neutral, Market Reaction: Marginal): This index, which tracks new mortgage applications tends to be a reasonable forward looking indicator for home sales, but issues including customers filling out numerous applications could skew the index. A recent drop in refinancing activity caused this index to drop 18.9% on a weekly basis last week, while the level of mortgages to purchase new homes dropped by 4.5%.

3:00PM: Consumer Credit (Risk: Downside, Market Reaction: Marginal): Consumer credit has contracted quite severely over the past several months as saving rates rise and banks tighten consumer credit. The current Bloomberg consensus indicates a month over month change of –US$7.5bn compared to –US$15.7bn a month prior—the second biggest drop on record. Given recent deterioration in the employment situation and a drop in consumer confidence we could see this indicator disappoint.

Thursday July 9^th:

Same Store Sales: (Risk: Downside, Market Reaction: Moderate): This monthly release breaks out same store sales data for individual retail chains. Like weekly the ICSC-Goldman Store Sales index, recent data supporting an increasing US savings rate and a worsening employment situation coupled with deep discounts at some stores, will likely place some downward pressure on same store sales.

8:00AM: Federal Reserve Governor Elizabeth Duke: Is speaking at the FDIC's Interagency Minority Depository Institutions National Conference in Chicago. This could create some headlines.

8:30AM: Initial Claims (Risk: Neutral, Market Reaction: Significant): The current Bloomberg consensus forecast for initial claims is 610K versus last week’s number of 614K. It is likely that after Thursday’s disappointing employment data the market will become more sensitive to changes in claims, as it is an excellent forward looking indicator toward payroll data. I anticipate both initial and continuing claims data will improve as the month progresses.

Friday July 10^th:

8:30AM: International Trade (Risk: Neutral, Market Reaction: Marginal/Moderate): The current Bloomberg consensus for the US trade balance is –US$28.8bn versus last month’s reading of –US$29.2bn. Recent increments in oil prices could add to the current deficit, while placing upward pressure on the import price index.

9:55AM: Consumer Sentiment (Risk: Neutral, Market Reaction: Marginal/Moderate): The current consensus on Bloomberg for the Reuters/University of Michigan Consumer Sentiment Index stands at 71.5 versus last month’s result of 70.8. The sentiment index is broken up into two parts, current conditions and future expectations. Investors are likely to focus more on this report after last week’s disappointing consumer confidence number. A positive or negative surprise in this index could impact the day’s trading.

10:00AM: Treasury Secretary Tim Geithner: Is set to testify before the House Financial Services and Agriculture Committees on derivatives regulation. This could create some headlines.

Have a good weekend!

June ADP, Comes in Below Expectations

2009-07-01T08:47:00.002-04:00

June's ADP release came in at -473,000, implying there could be some downward pressure placed on forecasts for tomorrow's payroll data. Currently, the market is forecasting a -350,000 change in payrolls; I believe we could see this number actually come in around -440,000, which is still much better than the six month average, but below current estimates.

Chinese Manufacturing Shows Marginal Gains

2009-07-01T01:35:00.005-04:00

In some upbeat news from China, the Chinese Federation of Logistics and Purchasing (CFLP) index and the CLSA manufacturing index both demonstrated marginal gains in June. The CFLP increased to 53.2 from 53.1 the previous month, while the CLSA index edged up to 51.8 from 51.2. This performance has been driven by China’s extensive stimulus package leading to higher lending and government spending. Possibly more interesting than the headline number was the CLSA index’s export order sub-component, which indicated a marginal expansion with a reading of 50.9 compared to 49.2 the previous month. But, it is important to keep in mind that this number was calculated from a very small base given recent historical declines. Overall, these numbers alone are unlikely to have much of an impact on the dry bulk sector. But, will reinforce the view of a gradual Chinese recovery. It is important to keep in mind that these gains are not yet sustainable without China’s massive fiscal stimulus package. Additionally, extensive loan growth could cause problems in the future for China as the level of non-performing loans is generally expected to rise.

Consumer Confidence Disappoints, Shipping Stocks Suffer

2009-06-30T12:19:00.007-04:00

As I highlighted in my column on TheStreet.com on Monday shipping stocks will be highly susceptible to any major economic news impacting market's views on the long-term outlook. This mornings consumer confidence number was proof of that, tumbling to 49.3 compared to 54.8 last month. Both the present situation index and the future situation index declined. Most of the recent gains stemmed from increases in the future situation component, which fell this month to 65.5 from 71.5. The present situation index slid to 24.8 from 29.7. The drop was likely fostered by concerns over business conditions and the employment situation.

The recently high betas in the shipping sector over macro data are rooted in the hope that once Chinese demand begins to diminish for dry bulk goods, increases in ex-China demand will offset, or even more than offset, the decline in Chinese imports. But, in order for this to occur it needs to be clear that global economies, especially the US, are on the road to recovery. Any data supporting or opposing this view will significantly impact trading in the shipping sector Nevertheless, today's data may give Thursday's crucial payroll number even more ammunition in the event of an upward or downward surprise.

In other news the Case Schiller Home Price Index came in slightly above analyst's expectations showing a decline of only 18.1%.

Shipping and Mining Stocks

Source: Google (12:42PM)

US Week Ahead: It's all about the jobs!

2009-06-27T00:24:00.013-04:00

Despite the shortened work week, we have a rather busy schedule of US economic data releases, climaxing with Thursday's US employment data. Last month's payroll data caught the market by surprise coming in well above expectations, demonstrating the lowest level of job losses since September 2008. But, the big question remains, was this start of a trend or a one-off anomaly. Other economic news in May sent mixed signals, fueling growing uncertainties, which led to a US treasury rally. What this means is that in many investors' minds this month's payroll data may hold the answer to that important question. Therefore we should expect a signifcant jump in trading volumes on the back of any surprises to that report, with an almost certain equity rally and US rates sell-off on better-than-expected data. However, the opposite is also true. Here is the rest of this week's economic calendar:

Monday June 29^th:

8:30AM: Chicago Fed National Activity Index (Risk: Neutral, Market Reaction: Marginal): The CFNAI is an index of 85 separate data sets designed to represent national economic activity and inflationary pressure. A reading of 0 indicates the economy is growing at the historical trend while a negative or positive result indicates the economy is growing below or above its historical average, respectively. Given the volatile nature of this index the three month moving average is typically quoted. This index remains somewhat obscure in the mainstream media and is likely to have a minimal impact on trading.

Tuesday June 30^th:

7:45AM: ICSC-Goldman Store Sales (Risk: Downside, Market Reaction: Moderate): This weekly index tracks same store sales at major US retailers, and accounts for roughly 10% of national retail sales. Given recent data supporting an increase to the US saving rates, this index could face some downward pressure as people save more and spend less.

9:00AM: S&P Case-Shiller HPI (Risk: Neutral, Market Reaction: Marginal/Moderate): Despite, the significance of US home price data, this index holds a two month lag, meaning this June's data would actually be from April. This lag marginally reduces the index's importance compared to some of the other more timely housing market indicators. Nevertheless, large movements in this index could imply further deterioration or recovery of the US housing market, which could impact trading.

9:45AM: Chicago PMI- Business Barometer Index (Risk: Downside, Market Reaction: Marginal/Moderate): The Chicago PMI measures business conditions in the Chicago area; anything below 50 indicates a contraction while a reading above that level implies an expansion. According to Bloomberg, the market is currently forecasting a reading of 44.5. However, given recent weakness in the auto and manufacturing sectors I expect this number could disappoint. It will be important to pay close attention to the new order and prices paid sub-components. The new oders component tends to be forward looking, while the prices paid component experienced a 60 year low of 28.4 in April.

10:00AM: Consumer Confidence (Risk: Upside, Market Reaction: Moderate): The confidence index, which measures consumers' attitudes towards present and future economic expectations can be a good barometer for consumer spending. This index has recently experienced significant gains as consumers' seem to be focusing on positive economic releases. The current conditions index has remained somewhat stagnant, while the future expectations index experienced an increase of over 20 points last month. However, some deterioration in recent employment data could put some downward pressure on this month's release, but I still believe this index is more likely to surprise to the upside.

Wednesday July 1^st:

7:00AM: MBA Purchase Applications (Risk: Neutral, Market Reaction: Marginal): This index, which tracks new mortgage applications tends to be a reasonable forward looking indicator for home sales, but issues including customers filling out numerous applications could skew the index.

8:15AM: ADP Employment Report (Risk: Neutral, Market Reaction: Moderate): The ADP employment report is typically considered a good indicator of the payroll data released later in the week, so a big swing in this data could shift expectations for the employment data released on Thursday and thus significantly impact trading.

10:00AM: ISM Manufacturing Index (Risk: Neutral, Market Reaction: Significant): The ISM measures national manufacturing conditions, a reading of over 50 signifies expansion while under a retraction. The current consensus on Bloomberg is 45. It will be very important to look at the new orders component of the ISM, which tends to be a forward looking indicator for the overall index. New orders finished over 50 last month, for the first time in 17 months, but will likely move back below 50 this month.

10:00AM: Construction Spending (Risk: Upside, Market Reaction: Marginal): This index tracks the value of new construction activity on residential, non-residential, and public projects. Recent stimulus spending should help drive up the public projects component of the index, and we will likely see a marginal increase in residential spending.

10:00AM: Pending Home Sales (Risk: Neutral, Market Reaction: Moderate): A strong number in this index would help support the case of a recovery in the US housing market, which could have a moderate impact on trading. However, it is important to note that not all pending home sales turn into actual sales, but it is a good indicator of sentiment.

June Motor Vehicle Sales (Risk: Downside, Market Reaction: Moderate): Increasing savings rate, tight credit conditions, and a weak job market will likely cause car owners to extend the life of their current vehicles, despite incentive offers, reducing total car sales. This will also be exacerbated by what has recently been increasing gas prices. 7.4mn cars and light trucks were sold in May.

Thursday July 2^nd:

8:30AM: Employment Situation Report (Risk: Neutral, Market Reaction: VERY Significant): According to Bloomberg, the current market consensus for the change in payrolls stands at -350,000 with an unemployment rate of 9.6%. The average decline in payrolls for the six months preceding April was 643,000 versus 345,000 in May. The market will likely interpret another positive surprise as the beginning of a recovery in the US employment situation, which would lead to a strong rally in equities and selloff for US treasuries; a negative surprise would have the opposite effect. Nevertheless, the unemployment rate will likely drift above 10% in the comings months.

8:30AM: Initial Claims (Risk: Downside, Market Reaction: Significant): This report will be overshadowed by the payroll data, released simultaneously, but is an excellent forward looking indicator for the employment sector. We could see an unexpected jump in claims as the school year ends and teachers who have lost their jobs due to budget cuts begin filing for claims.

10:00AM: Factory Orders (Risk: Upside, Market Reaction: Moderate): Given the recent increment in durable goods orders we could see factory orders surprise to the upside. According to Bloomberg the current consensus forecast for May is a month over month increase of 1.4%.

Friday July 3^rd:

Enjoy the long weekend!

FFA Market Rises

2009-06-26T15:59:00.005-04:00

Forward Freight Agreements (FFAs), especially for capesize contracts, appreciated significantly today leading to strong trading in the dry bulk sector.

BDI FFA Curve

Source: Imarex

BCI FFA Curve

Source: Imarex

Market and Sector Performance:
Source: Bloomberg, my calculations, Capital Link Shipping

Brazilian Iron Ore Exports Drop in May

2009-06-05T11:58:00.006-04:00

A recent release by Brazilian officials showed that iron ore exports fell to 15.3mn tones in May, a drop of 35% from last month and a 2009 low. This is likely due to diminishing demand by the country's largest custom, China. A note released by Goldman Sachs confirms this theory stating, "Heavy rains in the north of Brazil and port congestion in China could have had a negative impact on Brazilian iron ore exports, but the main reason ... is likely lower iron ore demand from China due to high steel and iron ore inventories."

Over the past several weeks, the shipping industry has been experiencing a strong resurgence in activity primarily due to Chinese iron ore imports. However by the end of this week those gains began to reverse, as indicated by a drop in the Baltic Dry Index (BDI). I anticipate the BDI will continue to moderate as Chinese demand continues to diminish, and an over supply of new capacity hits the shipping sector. This will likely add risk not currently priced into equities trading within the space. Companies that have high leverage ratios due to over expansion will be most suscetpible to any downward pressure to shipping prices, while companies with limited expansion plans and low leverage will be better position to weather the coming storm.

For a more detailed analysis please see my column on international trade at TheStreet.com:
http://www.thestreet.com/author/1145075/michael-mcdonough/all.html

Swine Flu

2009-06-03T11:08:00.002-04:00

If anyone is interested here is a piece I recently published on H1N1 for a patient advocacy group:

http://patientsandpatents.wordpress.com/2009/06/02/a-historical-view-of-flu-pandemics-a-reason-to-remain-vigilant/

Additionally, if you find that interesting you may also enjoy this supplemental piece, which highlights companies that could benefit in the unfortunate event of a H1N1 resurgence.

http://news.newamericamedia.org/news/view_article.html?article_id=38fadb7a58ef4addc245a451e474b8a1

BDI to face downward pressure

2009-05-29T11:24:00.022-04:00

As I have discussed in great detail in my TheStreet.com articles; I believe the recent rally in the Baltic Dry Index (BDI) cannot be sustained, and we are likely to see a pullback in the index; along with dry bulk shipping and mining sector stocks. The BDI’s rally has been driven almost exclusively through China’s record demand for raw material stemming from the government’s USD586bn stimulus package. Currently, despite record raw material imports China’s industrial production has actually begun to wane and export growth has turned negative. To put it simply, there’s a lot more going in than coming out; this cannot be sustained.

Without a significant, yet unlikely, increase in global demand for Chinese goods, current imports will only add to record breaking inventory levels. China is currently at or near its maximum inventory levels; meaning it is very likely we will soon begin to see a drop in China’s extraordinary import levels. This diminishing demand will translate into a correction for the BDI and those sectors with high correlations to the index (i.e. miners, shippers, etc…)

The retraction in the BDI will be exacerbated by a record increment in fleet expansions scheduled to be completed over the next 1.5 years. In fact according to my calculations and data from Barry Rogliano Salles, a Paris based shipbroker, the size of the global capesize fleet, which is the largest class of bulk carrier, is expected to rise by 50%. Many analysts believed this magnitude of expansion was irrational even at the peak of shipping in 2008.

Currently, 10% of the estimated 855 global capesize fleet is idle off the shores of China waiting to unload at congested ports, with an average 9 day wait. The growing supply of new vessels combined with the freeing of idle ships off the coast of China will create a supply glut in the sector dragging down shipping prices. Hence my bearish short-term view on the mining sector (BHP, RTP, VALE), and my generally bearish view on the shipping industry, especially for highly leveraged shippers such as Eagle Bulk Shipping (EGLE); companies with lower leverage such as Diana Shipping (DSX) should be better positioned to weather the coming storm.

Again for more details please check out my articles on TheStreet.com.

TheStreet.com

2009-05-18T10:38:00.003-04:00

I just wanted to let everyone know that I have also started writing for TheStreet.com, and my articles can be found here:
http://www.thestreet.com/author/1145075/michael-mcdonough/all.html

The Anatomy of a Global Financial Crisis

2009-01-22T03:36:00.021-05:00

I apologize for the recent lack of posts as I got rather caught up with travel and other activities during the holiday season. To start off the year I decided we need to look back before we can look forward. Since the onset of the current crisis we have witnessed what seems like a never ending barrage of unprecedented market conditions and government actions from across the globe. This compiled timeline is meant to act as reference for both the readers and myself, helping us fully comprehend the crisis that has been the past 2 years. So let us begin… (I apologize for the length, but I was hoping to make it as comprehensive as possible using multiple sources) This will be a work in progress and I will likely make numerous additions and deletions over the next several days as I gain access to more sources.

1H 2007:

02/08/07: HSBC announces it is setting aside 20% more than analysts estimated for loan losses in 2006 due to the companies deteriorating US mortgage business. The company announced that home loans to riskier borrowers were going bad faster than estimates. Concurrent with the announcement an index tracking swaps on sub-prime dropped sharply, indicating a significant increase in implied risk. (S&P500: -0.1% TED Spread: 0.3)

02/22/07: Two HSBC top mortgage executives announce departure from US business. (S&P500: -0.1% TED Spread: 0.3)

03/04/07: HSBC confirms they will write off USD11bn to cover mounting losses in its US based HSBC Finance Corporation. (S&P500: -1.1% TED Spread: 0.4)

03/05/07: New Century Financial Co. leads massive drop in US subprime lenders. (S&P500: -0.9% TED Spread: 0.4)

03/12/07: DR Horton CEO announces to investors his company’s fortunes are likely to ‘suck’ in 2007. During the same day trading is suspended on New Century Financial shares as fears rise firm is headed toward bankruptcy. (S&P500: 0.3% TED Spread: 0.4)

03/21/07: Mortgage delinquencies and defaults continue to rise and short sellers reap large rewards for their positions in the US subprime lenders. (S&P500: 1.7% TED Spread: 0.4)

04/02/07: New Century Financial officially files for Chapter 11 bankruptcy; immediately cuts 3,200 jobs. (S&P500: 0.3% TED Spread: 0.4)

04/05/07: Subprime mortgage lender Novastar announces they will stop funding independent mortgage bankers. (S&P500: 0.3% TED Spread: 0.4)

05/30/07: UK mortgage lender Kensington agrees to USD561mn takeover by Investec, a South African Bank. The subprime lender also announces revenues for the current year will be significantly below the previous years. (S&P500: 0.8% TED Spread: 0.7)

2H 2007:

06/23/07: Bear Stearns pledges USD3.2bn to rescue one of its internal hedge funds after it placed bad bets on subprime mortgages. (S&P500: -1.3% TED Spread: 0.8)

07/30/07: IKB cuts profit forecast and replaces its CEO after feeling the effects of the US subprime rout. Additionally, according to Bberg more than 40 companies globally have reorganized or abandoned borrowing plans over the past month. (S&P500: 1.0% TED Spread: 0.5)

07/31/07: American Home Mortgage announces it does not have the cash flow to fund new loans, shares plunge 90%. Bberg reported that creditors made ‘very significant margin calls’ against the company over the past 3 weeks and it still has ‘substantial unpaid margin calls pending’. (S&P500: -1.3% TED Spread: 0.5)

08/02/07: Accredited Home Lenders announces merger with Lone Star Funds may be in doubt and bankruptcy is a distinct possibility. (S&P500: 0.4% TED Spread: 0.6)

08/06/07: American Home Mortgage files for bankruptcy after laying off 7,000 employees. One reason cited is repeated interest rate increases pushing up loan repayments and borrower defaults. (S&P500: 2.4% TED Spread: 0.6)

08/08/07: German WestLB Mellon suspended redemptions from its asset-backed security fund amid concerns over the US subprime mortgage market. The company was quoted as saying current market conditions were making it impossible to calculate the fair net asset value of the fund. (S&P500: 1.4% TED Spread: 0.6)

08/09/07: BNP Paribas halts redemptions from three investment funds due to complications over calculating fair net asset value due to the mortgage markets effects on credit markets. (S&P500: -3.0% TED Spread: 0.8)

08/14/07: Goldman Sachs in conjunction with a group of investors announce a USD3bn injection into the bank’s Global Equity Opportunities Fund, after losing 30% of its value in 1 week. (S&P500: -31.8% TED Spread: 1.0)

08/15/07: Countrywide falls 13% on fears of bankruptcy if conditions continue to deteriorate. (S&P500: -1.4% TED Spread: 1.4)

08/17/07: FOMC approved changes to the primary credit discount window facility reducing the spread between the fed funds target to 50bps. The Fed also announced it would allow term financing for up to 30 days. Finally, in the statement the Fed recognized that ‘downside risks to growth have increased appreciably’, and that they were prepared to take action. Nevertheless, there was no change in the target rate. (S&P500: 2.5% TED Spread: 1.9)

08/21/07: It is reported that German SachsenLB holds USD4bn in US subprime assets. (S&P500: 0.1% TED Spread: 2.0)

08/22/07: H&R Block unable to tap US commercial paper markets due to market turmoil is forced to borrow USD200mn from its credit line. Also, Lehman Brothers becomes the first Wall Street firm to shut down its subprime lending unit, laying off 1,200 employees. Other mortgagee companies announced layoffs totaling 3,700. (S&P500: 1.2% TED Spread: 1.9)

08/23/07: BoA, Citi, & DB borrow USD2bn from the Fed via the discount window to help reduce the ‘last resort’ stigma associated with this lending facility. (S&P500: -0.1% TED Spread: 1.7)

08/29/07: Australian firm Basis Yield files for bankruptcy over subprime defaults. (S&P500: 2.2% TED Spread:1.7)

09/06/07: Inter-bank lending rates continues to soar; the ECB lends USD57bn to banks in a move to help counter the ongoing global credit squeeze. (S&P500: 0.4% TED Spread: 1.5)

09/14/07: Northern Rock receives emergency funding from the Bank of England after rising borrowing costs left the company unable to make new loans. (S&P500: 0.0% TED Spread: 1.7)

09/17/07: Fears of a Northern Rock and/or other financial institution failures cause the government to guarantee Northern Rock deposits to avoid a potential bank run. The same day Novastar, US subprime home lender, forfeits its REIT status as it decides not to pay a dividend on 2006 profit in an effort to conserve cash. (S&P500: -0.5% TED Spread: 1.5)

09/18/07: Stocks rally as Fed announces 50bp rate cut moving the target rate to 4.75%. (S&P500: 2.9% TED Spread: 1.7)

10/05/07: Merrill Lynch announces it will be forced to write down a USD5.5bn loss associated with defaulted US sub-prime mortgages. Analysts are concerned ML’s losses may continue to mount. (S&P500: 1.0% TED Spread: 1.4)

10/24/07: Merrill Lynch announces largest loss quarterly loss in its 93 year history after taking USD8.4bn in write downs. Rating agencies reduce ML’s rating and described the quarterly loss as ‘startling’. (S&P500: -0.2% TED Spread: 1.3)

10/31/07: FOMC decreases fed funds target by 25bps to 4.25%. (S&P500: 1.2% TED Spread: 1.1)

11/08/07: Morgan Stanley reveals a USD3.7bn loss from its US sub-prime mortgage exposure. The bank attributes the loss to the record level of defaults by subprime borrowers. (S&P500: -0.1% TED Spread: 1.6)

11/27/07: Citigroup announces it is selling a USD7.5bn stake to Abu Dhabi to bolster its depleted capital base due to recent acquisitions and credit market turmoil. (S&P500: 1.5% TED Spread: 2.0)

12/10/07: UBS writes off USD10bn in debt linked to subprime mortgage market. The company also reported that losses would total more than the previous year’s profits. Additionally, UBS announced it received USD9.7bn in funds from the Singapore Government Investment Corporation. MBIA, the world’s largest bond insurer announces it will raise as much as USD1bn by selling a stake to a private equity to avoid losing its AAA credit rating. Finally, Bank of America announced it will liquidate a USD12bn cash fund due to turmoil in credit markets. These type of funds attempt to return a higher yield vs. traditional money market funds via positions in riskier assets. (S&P500: 0.8% TED Spread: 2.2)

12/11/07: The Fed reduces target rate 25bps to 4.25%. However, markets reacted adversely interpreting the action and the statement as too weak considering current market conditions. (S&P500: -2.5% TED Spread:2.2)

12/13/07: Due to fears of what effects a elevated inter-bank lending rates could have on the global economy the Fed in conjunction with the central banks of Canada, England, Switzerland, and the EU announced’ measures designed to address elevated pressures in short-term funding markets.’ This announcement setup the temporary Term Auction Facility (TAF) designed to ‘auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window’. (S&P500: 0.1% TED Spread: 2.2)

12/14/07: Citi announces it will take over seven troubled Special Investment Vehicles (SIVs) and assume USD58bn in debt to avoid forced assets sales. On the news Moody’s lowered Citi’s credit rating to Aa3 from Aa2, and warned of further potential downgrades. As an interesting aside, Citi invented SIVs in 1988. (S&P500: -1.4% TED Spread: 2.2)

12/17/07: Fed auctions USD20bn to major banks in an attempt to alleviate the global credit crunch as banks remain hesitant to lend based on market uncertainty. (S&P500: -1.5% TED Spread: 1.9)

12/18/07: In response to the Fed the ECB allocates USD500bn to banks at below market rates in a refinancing move to ease tightened credit markets and lower LIBOR. (S&P500: 0.6% TED Spread: 1.9)

12/19/07: As default risks rise, Standard & Poor’s reduces the rating outlooks for many bond insurance companies including MBIA, XL Capital Assurance, and Ambac Financial. According to Bberg industry-wide downgrades would lead to losses of USD200bn on securities as banks would be forced to sell bonds due to investment guidelines. (S&P500: -0.1% TED Spread: 2.1)

12/24/07: Merrill Lynch after experiencing the largest loss in the company’s history receives a USD6.2bn cash injection from Singapore’s Temasek Holdings. At this point in the crisis sovereign wealth funds have already invested over USD25bn in Wall Street banks. (S&P500: -0.8% TED Spread: 1.6)

1H 2008

01/11/08: Bank of America purchases faltering US home lender Countrywide Financial for USD4bn in an all stock deal. (S&P500: -1.4% TED Spread: 1.2)

01/15/08: Citi announces USD18.1bn in write-downs related to its subprime mortgage exposure. Concurrently, in a move to shore up its capital base Citi announces it will cut its dividend. The same day, Merrill Lynch reported it sold a USD6.6bn stake to foreign investors including the Korean and Kuwaiti governments. (S&P500: -2.5% TED Spread: 0.9)

01/22/08: As global financial conditions continue to deteriorate the Fed announces a rare inter-meeting rate cut of 75bps to 3.50%, this was the largest cut in 25 years. (S&P500: -1.1% TED Spread: 1.4)

01/30/08: The Fed cuts rates by an additional 50bps to 3.00% in an attempt to help avoid a US recession. Statement reads; "Financial markets remain under considerable stress, and credit has tightened further for some businesses and households." (S&P500: -0.5% TED Spread: 1.1)

02/14/08: UBS confirms loss for 2007 as exposure to US housing market hits earnings. The firm warned of poor performance and USD18.4bn in write downs weeks earlier. The firm also revealed an additional USD26.6bn in exposure to risky mortgages. UBS’s losses were far worse than analysts’ estimates. (S&P500: -1.3% TED Spread: 0.8)

03/03/08: HSBC announces a USD17.2bn loss derived from the effect of the decline in the US housing market on its loan values. However, annual profits still rose 10%. (S&P500: 0.1% TED Spread: 1.3)

03/06/08: A large hedge fund run by Peloton Partners collapses as it can no longer make interest payments on loans made to the company to buy assets, forcing the fund to sell assets at substantial losses. (S&P500: -2.2% TED Spread: 1.6)

03/07/08: Ambac raises roughly USD1.5bn in a sale of convertible stock to maintain AAA credit rating. Some analysts report this will only work as a short-term fix. (S&P500: -0.8% TED Spread: 1.5)

03/08/08: The Fed announces two new initiatives to address growing liquidity pressures in the term funding markets. These include increases in the amounts outstanding to the TAF to USD100bn, and a series of term repurchase transactions totaling an additional USD100bn. (S&P500: -0.8% TED Spread: 1.5)

03/11/08: The Fed issues a statement that G10 central banks continue to work closely together on liquidity issues, but pressures have continued to rise. Further coordinated actions between the Fed, Bank of Canada, Bank of England, ECB, and Swiss National Bank were also announced, which included expansion of its securities lending program and the introduction of a Term Securities Lending Facility (TSLF). Also, Carlyle Fund, a mortgage-debt investment fund, asked lenders to halt further liquidation of collateral worth roughly USD16bn. (S&P500:3.7% TED Spread: 1.4)

03/14/08: JPMorgan and the Fed bailout Bear Stearns ending the banks 85 year run; the Fed released a statement declaring, ‘The Board voted unanimously to approve the arrangement announced by JPMorgan Chase and Bear Stearns this morning.’ (S&P500: -2.1% TED Spread: 1.6)

03/16/08: The Fed announces two new initiatives intended to bolster market liquidity and stabilize volatile market conditions. The first created a lending facility to assist primary dealers to provide financing to the securitization markets. The second was to reduce the primary credit rate to 3.25% from 3.50%. Finally, they approved increasing the maximum maturity of primary credit loans to 90 days from 30, and approved the financing agreement for JP Morgan to purchase Bear Stearns. (S&P500: -2.1% TED Spread: 1.6)

03/18/08: The Fed announces an additional 75bp cut in the fed funds target moving the rate to 2.25% as the market continue to deteriorate and the probability of a US recession rises. (S&P500: 4.2% TED Spread: 1.6)

03/25/08: JPMorgan increases original USD2/share Bear Stearns offer to guarantee quick deal after pressure from shareholders. (S&P500: -0.2% TED Spread: 1.4)

03/31/08: Treasury Secretary Henry Paulson proposes the largest overhaul of US financial regulations since the Great Depression, saying the system for overseeing American capitalism needs to be better prepared for ‘inevitable market disruptions.’ (S&P500: 0.6% TED Spread: 1.3)

04/01/08: UBS announces additional write downs of USD19bn related to the US housing market. At the same time Deutsche Bank discloses write downs totaling USD4bn on US real estate loans and assets. Total write downs by banks at this point now equal roughly USD200bn. (S&P500: 3.6% TED Spread: 1.3)

04/04/08: Fitch downgrades MBIA to AA from AAA stating the bond insurer no longer has enough capital to warrant the top ranking. Fitch reported MBIA would have needed as much as USD3.8bn more in capital to deserve an AAA. (S&P500: 0.1% TED Spread: 1.4)

04/08/08: Washington Mutual raises USD7bn from an investment group led by private equity group TPG after failing to shore up finances. The nation’s largest savings and loans bank had been adversely affected by rising delinquencies and mortgage defaults. The company’s efforts to shore up financing via cutting dividends and a USD3bn stock sale fell short forcing WAMU to seek external financing. (S&P500: -0.5% TED Spread: 1.3)

04/14/08: Wachovia, considered to be a relatively conservative player in the banking world, announces a USD393mn quarterly loss and a 41% dividend cut. (S&P500: -0.3% TED Spread: 1.6)

04/18/08: Citigroup reports a better than estimated loss of USD5.11bn for Q1, rallying 4.5% for the day. At this point Citi’s write-downs and credit losses total almost USD40bn. (S&P500: 1.8% TED Spread: 1.6)

04/21/08: A group of mutual and hedge funds led by Corsair Capital invest USD7bn to recapitalize National City Bank, 10^th largest in the US, after losing USD333mn in 4Q07. (S&P500: -0.2% TED Spread: 1.6)

04/22/08: As banks continue trying to raise capital, Merrill Lynch receives USD9.6bn via bond and preferred share sales after writing down USD6.5bn in assets. Concurrently, RBS announces additional losses of USD11.7bn related to the US subprime market and will attempt to raise USD24bn in new capital to shore up reserves. (S&P500: -0.9% TED Spread: 1.7)

04/29/08: Citi announces it will sell USD3bn of stock to improve capital reserves. Analysts were upset with this move as they were hoping Citi could avoid an equity sale as it will dilute shareholder equity. Also on this day HBOS, the UK’s largest mortgage lender, announced it will sell USD8bn in shares to bolster capital depleted by asset write downs and a deteriorating housing market. (S&P500: -0.4% TED Spread: 1.4)

04/30/08: The Fed again reduces the fed funds target this time by 25bps to 2.00%. Concurrently, Citi sells USD4.5bn worth of stock vs. the USD3bn originally planned. The company is raising capital to avoid further credit-rating downgrades, maintain client relationships, and preserve access to financing. Analysts estimate Citi would need to raise USD 10-15bn to truly sure up its capital reserves. (S&P500: -0.4% TED Spread: 1.4)

05/02/08: The Fed, ECB and Swiss National Bank announce expansions to the ongoing liquidity measures, including increases to the TAF, and expansion of accepted collateral for the Term Securities Lending Facility (TSLF). (S&P500: 0.3% TED Spread: 1.3)

05/06/08: Fannie Mae receives permission from regulators to expand activities in light of failing mortgage market, and plans to raise USD6bn in capital and cut its dividend to USD0.25 from USD0.35. Regulators also reduced the company’s surplus capital requirement to 15% from 20% to expand business. (S&P500: 0.8% TED Spread: 1.2)

05/07/08: Vallejo CA plans to file for bankruptcy as the decline in the housing market cuts into the town’s tax revenues. (S&P500: -1.8% TED Spread: 1.1)

05/09/08: Citi CEO Vikram Pandit announces plans to ‘wind down’ roughly USD400bn in assets over the next three years to help return the bank to profitability. According to Robert Olstein, CIO of Olstein Capital, ‘He's carting off the non-significant operations and raising money so that he can reinvest it in the business he's in, which is loaning money.’ (S&P500: -0.7% TED Spread: 1.0)

05/13/08: Federal Reserve Chairman Bernanke sends letter to Congress requesting expedited approval to pay interest on reserves deposited by commercial banks to help alleviate tension in the credit market. (S&P500: 0.0% TED Spread: 0.9)

05/19/08: Regulatory filings show that banks and securities firms are keeping USD35bn of markdowns off income statements. At this point total write downs total about USD344bn. (S&P500: 0.1% TED Spread: 0.9)

05/26/08: UBS announces ‘the bank’s losses on non-US residential and commercial real-estate securities could increase in the future’. UK home prices dropped for the eighth straight month with no slowdown in sight. (S&P500: -1.3% TED Spread: 0.8)

2H 2008

06/02/08: S&P cuts credit-ratings for Morgan Stanley, Merrill, & Lehman. These downgrades could potentially have adverse business impact via selling derivative products, increased counter-party risk, etc… S&P said, ‘…actions reflect prospects of continued weakness in the investment banking business and the potential for more write-offs, though not of the magnitude of those of the past few quarters.’ Risks of further equity dilution via equity sales to bolster capital reserves remain high. Additionally, shares of Britain’s largest buy-to-let mortgage lender Bradford & Bingley plunge on profit warnings and sale to TPG. (S&P500: -1.1% TED Spread: 0.9)

06/05/08: Despite efforts to maintain credit ratings MBIA and Ambac Financial, the world’s largest bond insurers, are downgraded from AAA to AA by S&P. These companies together insure roughly USD1trn in debt. Moody’s announced they were placing both companies on review for a possible downgrade the day prior. (S&P500: 1.9% TED Spread: 0.9)

06/09/08: Lehman Brothers reports a Q2 loss of USD3bn and will raise USD6bn in stock sale. This was Lehman’s first loss since going public. "I am very disappointed in this quarter's results. Notwithstanding the solid underlying performance of our client franchise, we had our first-ever quarterly loss as a public company," said Chairman and Chief Executive Richard Fuld Jr. "However, with our strengthened balance sheet and the improvement in the financial markets since March, we are well positioned to serve our clients and execute our strategy." (S&P500: 0.1% TED Spread: 0.8)

06/12/08: KeyCorp plunges in trading on its move to raise USD1.5bn through equity sales and plan to cut dividends by 50%, citing unforeseen charges. "The loss, in our view, seems one-time in nature since it stemmed from an unfavorable court ruling. Also, KeyCorp reaffirmed its guidance for charge-offs in 2008 at 100-130 basis points and said that the new capital was only done due to the quarterly loss," DB’s financial analyst Mike Mayo wrote. "Yet, KeyCorp is raising $300-$400 million more than the loss given the environment." (S&P500: 0.3% TED Spread: 0.8)

06/18/08: Fifth Third Bancorp falls in trading after announcing it will cut dividends and raise USD2bn in capital to shore up capital reserves. (S&P500: -1.0% TED Spread: 0.9)

06/25/08: The Fed votes to keep rates unchanged at 2.00%. Also, California sues Countrywide Financial which lost USD2.5bn amid rising defaults and foreclosures over lending practices. (S&P500: 0.6% TED Spread: 1.0)

07/07/08: Freddie Mac & Fannie Mae drop sharply to 13 year lows on concerns over capital. A credit strategist at DB said, ‘There's a lot of apprehension about write downs… If they have write downs, they have to raise capital. How much do they raise and how easily can they do that? Those are the questions that everybody is asking’. Mortgage delinquencies continue growing at a record pace while home prices continue to plummet. (S&P500: -0.8% TED Spread: 1.0)

07/11/08: IndyMac is seized by US regulators after a run by depositors left the mortgage lender short on cash. IndyMac specialized in Alt-A mortgages (no documentation mortgages), which undoubtedly was one of the primary catalysts for its downfall. (S&P500: -1.1% TED Spread: 1.2)

07/13/08: Treasury Secretary Paulson announces a plan to temporarily increase the line of credit available to the GSEs to ensure they have sufficient capital to conduct business and protect the financial system from systemic risk moving forward. The Fed also approved a measure to lend to Fannie and Freddie if necessary. (S&P500: -1.1% TED Spread: 1.2)

07/18/08: A rights offering to shareholders of Barlcays and HBOS receive lukewarm response achieving minimal participation. (S&P500: 0.0% TED Spread: 1.3)

07/25/08: National Australia Bank makes additional provisions of USD830mn for credit crisis exposure. “Although current losses on the assets underlying the CDOs in our portfolio relating to the provision average approximately 2 per cent of the total portfolio, out detailed analysis and recent default activity indicates the portfolio will continue to deteriorate.” (S&P500: 0.4% TED Spread: 1.1)

07/28/08: Merrill writes down an additional USD5.7bn and is forced to sell more equity. Merrill’s CEO John Thain is pushing to rid the firm of its collateralized debt obligations (CDOs), the primary driver behind the firms USD18.7bn loss to date; many of these instruments are linked to subprime mortgages. (S&P500: -1.9% TED Spread: 1.1)

07/30/08: Fed announces additional measures to enhance the effectiveness of its existing liquidity facilities. These measures include longer maturities to the Fed’s Term Auction Facility (TAF) and increases in the level of swaps with the ECB and Swiss National Bank. (S&P500: 1.7% TED Spread: 1.1)

08/05/08: Fed leaves target rate unchanged at 2.00% and indicates a tightening bias in minutes. (S&P500: 2.9% TED Spread: 1.1)

08/20/08: Analysts announce Fannie and Freddie may need to raise as much as USD100bn to cover potential losses from declining mortgage market. Shares drop sharply in trading on the news. Higher implied credit risk and tight credit markets make it increasingly difficult for either organization to raise funds. It has also been revealed secret talks by Lehman Brothers to sell a 50% stake to South Korean or Chinese investors have failed. The reason for the failure is said to be Lehman was asking for too high of a price. (S&P500: 0.6% TED Spread: 1.1)

09/07/08: Government seizes control of Fannie and Freddie by placing both companies into a special conservatorship by the Federal Housing Finance Agency & US Treasury. The Treasury will be able to purchase USD100bn of a special class of stock in each company to maintain a positive net worth, and also be able to provide short-term funding. (S&P500: 0.4% TED Spread: 1.2)

09/15/08: The effects of US housing crisis force Lehman Brothers to file for nation’s largest bankruptcy after being unable to find a suitor. Almost simultaneously, Bank of America announced they would acquire Merrill Lynch. Additionally, fears of an AIG failure continue to mount. Despite the Fed announcing several measures to enhance existing liquidity measures, due immeasurable uncertainties testing the market in face of the this news the market experienced a significant decline for the day. (S&P500: -4.7% TED Spread: 1.8)

09/16/08: The market still reeling from yesterday’s news learns that in order to prevent the imminent failure of AIG the Fed will lend the company USD85bn and receive a 79.9% equity stake. In an attempt to calm the market Treasury Secretary Paulson is quoted saying, ‘We are working closely with the Federal Reserve, the SEC and other regulators to enhance the stability and orderliness of our financial markets and minimize the disruption to our economy,’ At the same time, despite expectations the Fed keeps rates unchanged at 2.00%. (S&P500: 1.8% TED Spread: 2.0)

09/17/08: The US Treasury at the request of the Fed introduces a supplementary financing program to provide cash for use by the Federal Reserve. (S&P500: -4.7% TED Spread: 3.0)

09/18/08: At 3:00pm EST the Fed in conjunction with the ECB, Bank of Canada, Bank of England, and Swiss National Bank announce an unprecedented coordinated action to improve liquidity conditions in global financial markets. The Fed authorized an additional USD180bn expansion of current swap lines to provide USD funding. At this point it seems clear the Fed preferred to manage credit vs. conducting monetary policy to deal with the current crisis. Markets reverse declines over the course of the day. (S&P500: 4.3% TED Spread: 3.0)

09/19/08: Congress and Treasury officials reveal negotiations are underway to establish a rescue akin to the Resolution Trust Corporation (RTC) setup to liquidate the assets of failed savings and loan associations (S&Ls) in the early 90s. The idea would be for the government to relieve financial markets of toxic debt adversely impacting market conditions. The fed also announces two further enhancements to its liquidity program 1) extending non-recourse loans at primary credit rate to US depository institutions and bank holding companies in order to purchase high-quality asset backed commercial paper from money market funds, & 2) to purchase agency discount notes from primary dealers. (S&P500: 4.0% TED Spread: 2.2)

09/21/08: Goldman Sachs and Morgan Stanley place requests and are reclassified as bank holding companies from investment banks. The Fed provides both banks with liquidity to smooth the transition against any collateral ‘that may be pledged at the Federal Reserve's primary credit facility for depository institutions or at the existing Primary Dealer Credit Facility (PDCF).’ The G7 finance ministers via a statement to reaffirm their strong and shared commitment to international financial stability. (S&P500: x% TED Spread: x)

09/24/08: Additional swap lines are setup between the Fed, the Reserve Bank of Australia, Denmark’s National Bank, Norges Bank, and Sverriges Riksbank to alleviate pressure in the USD short term funding market. (S&P500: -0.2% TED Spread: 3.0)

09/25/08: Washington Mutual fails after concerns cause customers to withdraw USD16.7bn of deposits since September; this is the largest bank failure in US history. Remaining assets were sold to JP Morgan Chase. (S&P500: 2.0% TED Spread: 3.0)

09/26/08: The Fed along with the Bank of England, ECB, and Swiss National Bank again agree to increase swap lines to further alleviate funding pressure. (S&P500: 0.3% TED Spread: 2.9)

09/29/08: UK mortgage lender Bradford & Bingley and Iceland’s Glitnir bank are nationalized, Fortis NV is bailed out by the Belgium, Netherlands, and Luxembourg governments, and finally the Fed, ECB, Bank of England, and Bank of Japan inject more liquidity into the system via special term financing and TAF increases. The FDIC also announces that Citi will acquire the banking operations of Wachovia, ‘in a transaction facilitated by the Federal Deposit Insurance Corporation and concurred with by the Board of Governors of the Federal Reserve and the Secretary of the Treasury in consultation with the President.’ Finally, the Bush administrations financial rescue plan was rejected by Congress leading to a 777 point drop in the Down Jones Average. (S&P500: --8.8% TED Spread: 2.9)

09/30/08: In order to prevent further bank failures the Irish, Belgium, Luxembourg, and French monetary authorities move to action. The Irish authorities guarantee deposits at major banks, while the remainder injects money into Dexia SA to prevent its failure. (S&P500: 5.3% TED Spread: 3.2)

10/01/08: The US Senate approves financial rescue plan, which had been rejected by the House earlier in the week. The House will re-vote on a modified version of the bill October 3^rd. (S&P500: -0.3% TED Spread: 3.3)

10/03/08: US House approves modified Emergency Economic Stabilization Act of 2008. Furthermore, in a change of plans Wachovia agrees to a merger with Wells Fargo, walking away from FDIC assisted deal with Citi. It is also announced portions of Fortis bank are being nationalized by Dutch government. (S&P500: -1.4% TED Spread: 3.8)

10/06/08: With new authority granted by the rescue act the Fed announces plans to begin paying interest on depository institutions’ required excess reserve balances, and approve substantial increases in the size of the TAF. Germany’s second largest property lender Hypo Real Estate receives USD68bn rescue package. (S&P500: -3.9% TED Spread: 3.7)

10/07/08: Central banks across the world move to counter the growing financial crisis ranging from additional nationalizations in Iceland to rate cuts in Australia. The Fed unveils its Commercial Paper Funding Facility (CPFF), ‘a tool that will complement the Federal Reserve's existing credit facilities to help provide liquidity to term funding markets’. (S&P500: -5.7% TED Spread: 3.5)

10/08/08: To prevent a collapse in the banking sector the UK Treasury announces the availability of at least USD350bn under a special liquidity scheme to recapitalize the system. Additionally, the US, UK, Canada, Sweden, Switzerland, and the EU conduct a coordinated rate cut of 50bps. Hong Kong and China also cut rates, but by 100bps and 27bps, respectively. Finally, the ongoing short-selling ban expires at midnight and the Fed reduces the minimum fee of the System Market Account securities lending program to 0.10% from 0.50% while also increasing the aggregate limit to USD5bn from USD4bn. (S&P500: -1.1% TED Spread: 3.9)

10/09/08: Fed authorizes NY Federal Reserve Bank to borrow securities from AIG for up to USD37.8bn. (S&P500: -7.6% TED Spread: 4.2)

10/12/08: G7 central bankers and finance ministers release a plan of action which includes injecting capital into banks and guaranteeing interbank loans. Further measures were announced by the Fed, ECB, Bank of England, Bank of Japan, and Swiss National Bank to improve liquidity in the short-term USD funding market. Australia also announces to will guarantee bank deposits for three years to combat global financial crisis. (S&P500: -1.2% TED Spread: 4.6)

10/13/08: RBS, HBOS, and Llyods will receive USD64bn from the British government to improve tier one capital ratios. Germany pledges USD681bn to recapitalize banking sector. (S&P500: 11.6% TED Spread: 4.5)

10/14/08: US Treasury, Fed, and FDIC announce measures to implement the newly approved USD750bn rescue package (TARP), which will guarantee loans, extend insurance to non-interest bearing account, and inject capital into banks. The Fed also increases the magnitude of its swap lines with Japan. (S&P500: -0.5% TED Spread: 4.3)

10/15/08: ECB injects a further USD250bn of liquidity into the market in a continued attempt to reignite credit markets; it also announces they will accept lower rated securities and a wider range of currencies as collateral from banks. Finally, the ECB approved a USD6.7bn loan to the fledgling economy in Hungary. (S&P500: -9.0% TED Spread: 4.3)

10/16/08: The Fed makes two announcements, the more significant of the two now permits bank holding companies to account for its senior perpetual preferred stock issue to the Treasury as Tier 1 capital. The Swiss National Bank injects USD5.3bn into UBS, taking a 9.3% stake in the company, while Credit Suisse is able to raise capital from private investors and the Qatar Monetary Authority. (S&P500: 4.3% TED Spread: 4.1)

10/21/08: The Fed introduces the Money Market Investor Funding Facility (MMIFF). The facility is designed to provide liquidity to US money market investors through providing, ‘senior secured funding to a series of special purpose vehicles to facilitate an industry-supported private-sector initiative to finance the purchase of eligible assets from eligible investors.’ In other news, Bank of Canada reduces its overnight rate by 25bps to 2.25%, and cash injections by European banks continue to be well received by market participants. (S&P500: -3.1% TED Spread: 2.7)

10/22/08: Wachovia reports a 3Q08 loss of USD23.9bn on write-offs and mortgage losses. The Fed alters its formula to calculate interest rate paid to depository institutions on excess balances reducing the spread between the target funds rate and rate paid on excess balances to help propagate trading in the funds market at levels closer to the target. (S&P500: -6.1% TED Spread:2.5)

10/23/08: Reserve Bank of New Zealand and Sveriges Riksbank both cut reference rates 100bps and 50bps, respectively. (S&P500: 1.3% TED Spread: 2.6)

10/27/08: Japanese authorities indicate they would be willing to intervene to bring down the price of the yen after it experience sharp appreciation as investors continued to unwind the carry trade. (S&P500: -3.2% TED Spread: 2.7)

10/28/08: In a response to the decline in the AUD Australian government officials intervene in the market for the third consecutive day to prop up the currency. Declining commodity prices and a weaker economic outlook are the primary drives behind the currency’s recent weakness. The Fed also announces a new swap line with the Reserve Bank of New Zealand for US15bn. Finally, the IMF, World Bank, and ECB agree to lend a combined USD25.1bn to the Hungary in a bid to restore confidence. (S&P500: 10.8% TED Spread: 2.7)

10/29/08: The Fed once again cuts the target rate by 50bps to 1.00%; statement highlighted moderation in inflation and risks to growth. The Fed also announced new swap lines for up to USD30bn with Banco Central do Brasil, Banco de Mexico, Bank of Korea, and the Monetary Authority of Singapore. (S&P500: -1.1% TED Spread: 2.8)

10/31/08: The Bank of Japan cuts its reference rate by 20bps to 0.30%. (S&P500: 1.5% TED Spread: 2.6)

11/03/08: Recent data releases point to continue tightening in US loans market for both commercial and residential uses. US auto sales reach lows not experienced since the early 80s. (S&P500: -0.3% TED Spread: 2.4)

11/04/08: The Reserve Bank of Australia cuts rates by 75bps to 5.25%. (S&P500: 4.1% TED Spread: 2.2)

11/05/08: The Fed again changes formula use dot determine the interest rate on required and excess reserve balances. Rate will now equal the lowest FOMC target rate in effect during the reserve maintenance period. (S&P500: -5.3% TED Spread: 2.1)

11/06/08: Both the Bank of England an ECB cut reference rates by 150bps to 3.00% and 50bps to 3.25%, respectively. Wells Fargo sells USD11bn in stock to help fund purchase of Wachovia, and states it may sell an additional 61mn shares. (S&P500: -5.0% TED Spread: 2.1)

11/10/08: Fed approves application of American Express to become a bank holding company; at which point Amex requests funds via the emergency rescue package. (S&P500: -1.3% TED Spread: 1.9)

11/12/08: Secretary Paulson announces the TARP will be used primarily to inject capital into banks and extend loan guarantees to credit cards, auto loans, and student loans. (S&P500: -5.2% TED Spread: 2.0)

11/19/08: Citi announces it will purchase the remaining USD17.4bn in assets held by its structured investment vehicles (SIVs), market responds adversely shares plunge 23% in trading. (S&P500: -6.1% TED Spread: 2.1)

11/20/08: Swiss National Bank cuts its target range for 3-month LIBOR by 100bps to 0.5%-1.5%. Ailing auto lender GMAC submits application to become bank holding company in order to gain access to TARP funds. ‘As a bank holding company, GMAC would obtain increased flexibility and stability to fulfill its core mission of providing automotive and mortgage financing to consumers and businesses,” the company said in a statement. “GMAC also expects to have expanded opportunities for funding and for access to capital as a bank holding company.’ (S&P500: -6.7% TED Spread: 2.1)

11/23/08: Citigroup receives a bailout from the US government which includes guarantees, liquidity access and injection of USD20bn in capital. The government receives USD27bn in preferred shares, or roughly a 4.5% stake in the company. (S&P500: 6.3% TED Spread: 2.1)

11/25/08: The Fed introduces the Term Asset-Backed Securities Loan Facility (TALF) designed to assist the credit needs of households and small businesses via issuing asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the SBA. Another program was initiated to purchase obligations of the housing-related GSEs and MBS back by Fannie, Freddie, and Ginnie. Additionally, US mortgage lender Downey Financial files for Chapter 7 bankruptcy. (S&P500: 0.7% TED Spread: 2.1)

11/26/08: People’s Bank of China lowers one-year lending and deposit rate by 108bps, and reduces reserve requirements by 200bps. Meanwhile, Iceland’s Glitnir Bank files for Chapter 15 bankruptcy in the US. (S&P500: 3.5% TED Spread: 2.1)

11/28/08: A failed stock offering by RBS forces the UK government to become a majority stakeholder with a 58% stake in the company. (S&P500: 1.0% TED Spread: 2.2)

12/01/08: NBER officially recognize US recession, place start date as December 2007. (S&P500: -8.9% TED Spread: 2.2)

12/02/08: Fed announces that the PDCF, AMLF and TSLF will be extended through April 2009. US auto sales continue to plummet. The Reserve Bank of Australia cuts rates by a further 100bps to 4.25%. (S&P500: 4.0% TED Spread: 2.2)

12/03/08: The Reserve Bank of New Zealand follows suit and cuts rates by 150bps to 5.00% as economic conditions deteriorate. (S&P500: 2.6% TED Spread: 2.2)

12/04/08: ECB cuts rates by 75bps to 3.25%. Bank of England cuts rate 100bps to 2.00%. Sweden’s Riksbank cuts rates 100bps to 2.00%. (S&P500: -2.9% TED Spread: 2.2)

12/05/08: US non-farm payrolls see biggest decline (-533k) since 1974. (S&P500: 3.6% TED Spread: 2.2)

12/08/08: US government irons out deal with US automakers to provide bridge financing through 1Q09. Deal entails some government oversight and requirement to construct a plan of action for the reorganization of the industry. Deal still requires Congressional approval. (S&P500: 3.8% TED Spread: 2.2)

12/09/08: Bank of Canada reduces rates by 75bps to 1.50%. Yield on 4-wk US T-Bill reaches 0%. (S&P500: -2.3% TED Spread: 2.1)

12/11/08: US Senate fails to approve bridge loan to automakers which was previously approved by House to guarantee funding for the remainder of the year. (S&P500: -2.9% TED Spread: 2.0)

12/15/08: AIG sells USD39.3bn in assets to NY Fed. The move was designed to help rid AIG of its obligations on mortgage debt. (S&P500: -1.3% TED Spread: 1.8)

12/16/08: The Fed once again takes an unprecedented action moving the fed funds target rate to a range of 0%-0.25% from 1.00%. The statement said, "The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability," and "The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level." This action represents a shift from traditional monetary policy to quantitative easing. (S&P500: 5.1% TED Spread: 1.8)

12/18/08: Citi’s credit rating is lowered by Moodys to A2 from Aa3 reflecting, ‘weakened earnings prospects, in combination with an average quarterly preferred dividend of approximately $1.4 billion’ according to Moodys. (S&P500: -2.1% TED Spread: 1.5)

12/19/08: The Fed modifies the TALF program extending the term of loans from 1 year to 3 years and adds additional specifications of eligible ABS collateral. Loans will also now be available to all eligible investors rather than being distributed through an auction. The bank of Japan also reduced its uncollateralized overnight target by 20bps to 0.10%. Bush administration and US Treasury officials work out a deal with US automakers to use TARP funds to keep companies afloat through March 2009. (S&P500: 0.3% TED Spread: 1.5)

12/20/08: Latvia receives USD10.4bn loan from the IMF and EU to strengthen the country’s economy and banking system. (S&P500: x% TED Spread: x)

12/22/08: People’s Bank of China cuts rate for the 5^th time. (S&P500: -1.8% TED Spread: 1.5)

12/23/08: AMEX, now a bank holding company, receives USD3.39bn from TARP to ensure the company’s survival. (S&P500: -1.0% TED Spread: 1.4)

12/24/08: The Fed approves GMAC’s request to become a bank holding company permitting it to access TARP funds. (S&P500: 0.6% TED Spread: 1.5)

12/29/08: GMAC receives USD5bn equity investment through TARP funds, while GM obtains USD1bn in assistance to purchase equity in GMAC. (S&P500: -0.4% TED Spread: 1.4)

12/30/08: The Fed announces it will start TALF operations in January to purchase mortgage-backed securities backed by Fannie, Freddie, and Ginnie. In addition, now government controlled Indymac Bancorp is set to be sold to a group of private investors. (S&P500: 2.4% TED Spread: 1.4)

1H 2009

01/05/09: Fed begins purchasing fixed rate MBS backed by Fannie, Freddie, and Ginnie via TALF. (S&P500: -0.5% TED Spread: 1.3)

01/07/09: The Fed adopts two changes to the MMIFF 1) expansion of the institutions eligible to participate & 2) adjustments to several parameters including minimum yield on assets, "to enable the program to remain a viable source of backup liquidity for money market investors even at very low levels of money market interest rates." (S&P500: -3.0% TED Spread: 1.3)

01/08/09: The Bank of England cuts rates by 50bps to 1.50% citing declines in confidence and tight credit markets. (S&P500: 0.3% TED Spread: 1.3)

01/13/09: Citi sells Smith Barney to Morgan Stanley in a bid to raise cash, in turn ending its ‘financial supermarket’ legacy. (S&P500: 0.2% TED Spread: 1.0)

01/15/09: Citi announces it will be split into two units to separate its core business from its troubled assets. It is also announced BoA will receive an additional USD20bn to guarantee against loan losses. Ireland is forced nationalize third largest bank, Anglo Irish, as funding position receded. JPMorgan announces profits fell 76% due to rising defaults and the ongoing US recession. (S&P500: 0.1% TED Spread: 1.0)

01/19/09: UK introduces further bailouts for the financial sector including increasing stake in RBS in return for an increment in lending. (S&P500: 0.8% TED Spread: x)

01/20/2009: The Bank of Canada cuts rates by 50bps to 1.00% citing a deteriorating outlook for the global economy. S&P downgrades Spain from AAA quoting structural weakness in the Spanish economy. (S&P500: -5.3% TED Spread: x)

The Baltic Dry Index Revisited

2008-11-08T02:17:00.010-05:00

I have been receiving a significant amount of email regarding an old entry I wrote back in March 2008 regarding the Baltic Dry Index (BDI). Back in March the BDI was recovering for an interim low it experienced in January on fears of a global economic slowdown, however, since then the situation has become far worse. The BDI is now trading at levels not seen since 2001. To help put this into perspective a recent article by “The Independent” noted that in the beginning of June the total cost of a shipment of coal from Brazil to China would have totaled USD15mn per voyage compared to USD1.5mn currently. At the same time, the article noted that the daily cost of chartering a capsize bulk carrier during this cycle's peak amounted to USD234.0K vs. USD5.6K presently. This is a drop of around 98%!

The Baltic Dry Index's recent plunge

Source: Bloomberg

Now on to what is important… Why has this happened? Unlike the drop the index experienced earlier this year, based primarily over concerns of a global economic slowdown; the current plunge also takes into account the ongoing liquidity crisis and commodity deflation. The shipping industry relies heavily on an instrument called “Letters of Credit” (LC), which is a guarantee issued by a bank that the buyers funds will be transferred to the seller at the completion of the transaction (i.e. traded goods properly received). As liquidity tightened around the world so has the issuance of these instruments, further slowing global trade. According to Trade Finance Magazine to cope with this, the market has begun to see a resurgence in export credit (i.e. the seller issues loan to the buyer via an export credit agency), but as the magazine pointed out this is a “relatively slim corridor”, and holds significantly more risk for the exporter compared to a traditional LC.

As if this alone were not bad enough it would appear that deflation in commodity prices has caused many companies to begin using up raw material inventories rather than importing new stocks. This is basic economics, why buy something today that will be cheaper tomorrow? Nonetheless, these industries will eventually run low enough on inventories where they will be forced to purchase more, which should put some upward pressure on shipping costs.

The CRY Commodity Index has also dropped significantly

Source: Bloomberg

If prolonged this ’suspension’ in global trade will have significant adverse effects for export oriented economies, and increase the likelihood of further reductions to 2009 growth rates . Nonetheless, I do believe that as companies run low on inventory and as global credit markets continue to unlock we will see a stabilization and marginal recovery in shipping costs. However, it is unlikely we will see BDI levels anywhere close to those at the beginning of this year anytime before the end of this decade. In the short-term yet another piece of negative news for the global economy...

As an aside I created a monthly market cap weighted shipping index starting in May 2005 to compare against the BDI. I used the following companies for the index 1) AP Moller - Maersk 2) Mitsui OSK Lines 3) China Shipping Development Co 4) Nippon Yusen 5) Kawasaki Kisen Kaisha 6) Evergreen Marine Corp 7) Orient Overseas International 8) Neptune Orient Lines 9) Hanjin Shipping Co. & 10) CSC Nanjing Tanker Corp. Maersk alone makes up roughly 50% of the total market vap of the index.

Global shipping companies could continue to face downward pressure until the BDI begins to moderate.
Source: Bloomberg

A Graphical Look at October's Senior Loan Officer Survey:

2008-11-03T21:55:00.022-05:00

Back in January I did a piece discussing the predictive power of the Senior Loan Officer Survey, and found that there was some significance to the data. For the survey banks’ senior loan officers are asked to answer multiple questions based on their lending standards and demand for commercial/residential loans as well as consumer loans. The survey is conducted during the first month of the applicable quarter. (i.e. Q108 data is collected during Jan. 2008) This more or less implies the data has a forward looking aspect, since the applicable quarter has only begun when the data is collected. This data is reviewed by the Federal Reserve for conducting monetary policy.

Unfortunately, the October 2008 survey doesn’t look much better than it did back in January. Lending standards have continued to tighten and demand has diminished. Currently, the survey concurs with the view that US economy is in a recession, which shows no immediate signs of abating. Here is a quick outline on where the survey can be important in analyzing future trends:

Non-residential Investment:
We found that the strongest relationship exists between non-residential investment and the data in the survey related to the number of banks tightening lending standards to businesses , businesses' demand for lending, and the cost of lending. In fact, the correlation between this data and non-residential investment is strong enough to pass-through to overall real GDP growth, but as you would expect with a smaller magnitude. We found that the reason for the relationship is because the level of business lending drops when costs and lending standards increase and demand drops, all of which are measured in the survey. Presently, all of these indicators point towards continued deterioration of non-residential investment.

Residential Investment:
We also found that the lending standards and demand for mortgages data is correlated with residential investment, although not at the same significance as business lending with non-residential investment. We found the strongest result between residential mortgage demand and residential investment, but unlike the non-residential relationship it was not strong enough to pass-through to overall real GDP growth. Nonetheless, without a loosing in lending standards it is unlikely we can see a sustained recovery in the US housing sector.

Personal Consumption Expenditure:
Unfortunately, historically we did not find any significant relationships. However, there has never been an instance over the available time series where credit card and consumer loan lending standards have increased by the magnitude we are currently experiencing. With this said, I do expect this to continue having a negative impact on consumer spending.

Here is the Data:

Net Percentage of Domestic Respondents Tightening Standards for C&I Loans

Notes: This graph would imply a continued slowdown for non-residential investment. Also interesting to note but not represented in this data is that many banks not only increased lending standards, but also reduced the maximum size and maturities on loans to all sized of businesses.

Net Percentage of Domestic Respondents Increasing Spreads of Loan Rates over Banks' Cost of Funds

Notes: Like the graph above, this graph also implies a continued slowdown for non-residential investment.

Net Percentage of Domestic Respondents Reporting Stronger Demand for C&I Loans

Notes: This graph implies that demand for business loans has not collapsed bu has shown signs of slowing. This is likely due to businesses requiring less credit to finance equipment, plant, and inventory expansions: Again pointing to a slow down in the business sector.

Commercial Real Estate Market

Notes: This graph implies there could be further deterioration in the commercial real estate market.

Net Percentage of Domestic Respondents Tightening Standards for Mortgage Loans

Notes: Lending standards for the residential mortgage sector continue to tighten. However, we did see marginal improvement for the prime mortgage sub-component.

Net Percentage of Domestic Respondents Reporting Stronger Demand for Mortgage Loans

Notes: After showing some signs of recovery demand for residential mortgages has once again begun to drop according to the survey.

Net Percentage of Domestic Respondents Tightening Standards on Consumer Loans

Notes: This graph implies tighter lending standards for credit cards and consumer loans could have an adverse effect on consumer spending. I agree with this assumption and do not see US GDP growth to move above trend until post 2010, mostly due to a decrease on consumer spending.

All in all in my opinion the implications of this survey are that things will get worse before they get better. Not only are tough times at hand for consumers, but also for businesses and the real estate sector. Over the next couple months, I expect we will see disappointing holiday sales, which should lead to lower than currently anticipated 4Q08 earnings and a prolonged period of below trend economic growth. This will likely continue to stoke the current volatility we have seen in the worlds' financial markets.

The Age of Despondency…

2008-10-10T00:03:00.013-04:00

One could argue we have moved from an age of exuberance to an age of despondency. Not long ago our major concern was sky rocketing commodity prices, and its effect on global inflation; enter the credit crisis. We are currently witnessing an unprecedented global sell-off with no regards to asset classes or quality, or as I like to call it the age of despondency. We have achieved capitulation. One positive result of this is this action is that it was a necessary step to bring us out of these uncertain times. In the end we should establish a clear bottom, and eventually stage a sustained comeback. Important to highlight is that in this age of despondency many assets, regardless of quality, have been pulled down to interim lows. For example right now, you can purchase the 30 stocks that make-up the Dow and receive a 3.8% dividend, plus of course any appreciation or depreciation of the assets. I won’t even begin to get into the credit market…

Looking ahead, what will happen? Global governments have made it clear they are willing to take significant action to stem the adverse effects of this current crisis. However, markets have been acting faster than these governments can react. Nonetheless, it is important to keep in mind that government and especially monetary policy tend to work on a lag. We still have not realized the effects of the recent rates cuts, and more importantly the Troubled Assets Relief Program (TARP). It is extremely likely we will see an additional set of global rate cuts sometime in the near future. This despite the fact the real effect of these cuts won’t be immediately realized, nonetheless, the psychological effect will be immediate. And of course, given the unbiased sell-off across all assets and qualities, investor psychology has definitely played a major role in this sell-off.

I believe that current and potential future government/monetary policies will eventually lead to stabilization in global markets over the next couple months. Prior to this however we face what could be a volatile earnings season, poor holiday sales in the US, and what will likely be worsening economic news from the US and Europe. Also, downgrades to either Morgan Stanley or Goldman Sachs could significantly extend the current market uncertainty, and this should be monitored closely. Nevertheless, unlike developed nations which are facing both the credit crisis and an economic slowdown, for the most part emerging markets are only facing the latter. What does this mean? I believe that once markets stabilize Russia, China, & Brazil will likely benefit the most over the mid-term. These markets are all significantly off their highs, yet domestically are still experiencing relatively strong GDP growth. What we want to monitor in these markets is the ability of domestic demand to make-up for slowing export markets. As for the developed nations, especially the US, there will be a critical shift from what were major consumers to major savers; given the importance of consumption in these economies we will likely see Real GDP growth remain below trend through the rest of this decade.

Here are some basic trading ideas, however, these are only suggestions; I in no way advocate undertaking them. I personally am hesitant to make any moves until I see some easing in the credit markets and proof that the TARP and other policies have begun to unlock credit markets… There is without question some great values out there on an individual equity basis, but the real question is whether or not you have the capital to stay in the market for as long as the market remains irrational…

Cash:
Overweight Cash! (at least until we see the credit markets stabilize)

Pair Trade:
Long US Staples / Short Luxury (short to mid-term idea)

Commodities:
Overweight Grain (long-term idea)
Overweight Livestock (long-term idea)

Countries:
Overweight Russia/China/Brazil (mid to long-term idea once credit markets settle)

Defensive:
You can always Long Gold, and potentially Short Platinum
Long Financial Ultrashort ETF (potential hedge against Goldman or Morgan downgrade)

**Please email me for further ideas or questions:
Email Me

A Blast From the Past... How the Housing Crisis Will End (Revisited)

2008-09-17T12:23:00.023-04:00

This piece is simply an updated version to a piece I published back on March 5th 2008 titled 'How will it end'. Despite the fact we are much deeper into this financial crisis; the root of the problem has not changed, and that is the US housing market.

As an interesting exercise consider that in March 2007 the total value of US subprime mortgage market was estimated at USD1.3trn; now lets combine that with the fact that 12% of these mortgages have or are in the process of defaulting. What this implies is that the total value of subprime mortgages effected by these foreclosures equals USD156bn. Now compare that to the cost of write-downs (~USD517bn) and the Fed's bailouts (USD85bn just for AIG)... Of course no one, including the Fed, could have possibly predicted the detrimental wide-spread effect the housing crisis would have on the global economy; my point is solely to demonstrate how a small piece can have a very significant impact on the entire picture in an over simplified manner.

Here it is with updated data and some small changes!

We are continuously being barraged with mixed news concerning the housing crisis. One day we hear signs are pointing towards a bottom; the next housing numbers came in much lower than expectations. So we raise this question: What indicators should we be looking at to truly signal a recovery in housing?

With this question in mind our analysis focused on creating the stages we believe would be necessary to facilitate a recovery. We were able to define 7 chronological stages which need to occur in order for the crisis to end. Additionally, the progress for each of the stages can be measured by several key indicators. The stages we outline below are meant to help to average investor better understand how a recovery will most likely unfold, and includes indicator that anyone with a basic internet connection will be able to easily access.

Our stages and key indicators to watch:

1. The number of defaults from subprime borrowers needs to drop substantially. This will help to stabilize growing inventory levels. Key Indicator(s): RealtyTrac foreclosure data (monthly) & MBA foreclosure data (quarterly)

Subprime ARM mortgage resets continue to be the primary driver behind subprime foreclosures (July 2007-November 2009)

Foreclosures as a percent of total mortgages continue to rise...
Source: Bloomberg

2. Banks need to lower lending standards for home mortgages. This will allow existing and new home sales to increase and prices to stabilize. Key Indicator(s): Fed Senior Loan Officer Survey, mortgage rates, Case Shiller Home price index (monthly), & New and Existing home sale prices

However, lending standards have tightened across all mortgage types according to the Senior Loan Officer Survey

Source: FRB

30Y fixed mortgage rates have fluctuated but remain elevated especially when considering the recent rate cuts ...
Source: Bloomberg

3. Once people are again able to buy homes we will see a reduction in inventory levels. When this occurs demand will rise for new constructions. Key Indicator(s): New home sales data (monthly) & Existing home sales data (monthly)

But for now increased foreclosures and tighter lending standards have caused new home sales to drop

Source: Census

The recent crisis has begun to negatively effect the housing affordability index
Source: Bloomberg

4. The rise in demand for new construction will first show up in building permits. The rise in building permits will lead to our next step... Key Indicator(s): Building permits data (monthly)

But, building permits have shown no signs of a sustained recovery

Source: Census

5. Very soon after the rise in building permits we will see an increase in housing starts. Key Indicator(s): Housing starts data (monthly)

However, with permits still depressed, starts have shown no signs of recovery

Source: Census

6. The increase in starts will lead to an increase in construction spending. Key Indicator(s): Construction Spending (monthly)

As you can see from this chart, this is not yet the case

Source: Census

7. Finally, residential investment begins to rise and the housing crisis is over. Key Indicator(s): Residential Investment via GDP release (quarterly)

Residential investment continues to be a drag on real GDP growth

Source: Bloomberg

Conclusion:

Essentially, this crisis is occurring due to a substantial increase in the supply of houses through subprime foreclosures, and a decrease in demand to buy houses through harder to get mortgages. As more homes enter the market and less people are able to acquire mortgages to by them the price drops. Hence, the first major step in a recovery for the sector will be a slow-down in the number of foreclosures, which has likely been pushed back until second half 2009. Secondly, and equally important banks need to reduce lending standards to allow qualified buyers to purchase new homes. These two actions combined will begin to reduce the inventory of homes on the market and stabilize price. Once the amount of inventory of homes for sale begins to drop, we will see demand for new constructions begin to rise. This will first show up in the building permits index, followed by housing starts, and finally private construction spending. All in all, this will not be a fast process, with the reduction in foreclosures and lowering of lending standards being the hardest hurdle to overcome.

Currently, the primary driver for subprime foreclosures are interest rate resets. When these borrowers we first given their mortgages they were given low teaser rates which would eventually reset into higher adjustable rates. Meaning some mortgage holders who were paying USD1,200 a month for their mortgage in November could be paying USD3,200 a month in December. For a lot of these borrowers it has been nearly impossible to pay the new amount and they have been forced to default. On a positive note, based on available market information we should see the number of resets for adjustable rate subprime mortgages peak sometime in late spring/early summer. However, it is tough to estimate the lag time between mortgage resets and actual foreclosures, which prolong this situation. The deteriorating employment situation in the US will add additional downward pressure to this indicator. All in all there is no quick easy fix on the housing front, and we will likely have to deal with these conditions for quite some time.

Investment Idea:
Once a the market starts showing signs of a sustained recovery we feel that US home builders could significantly benefit. US homebuilder stocks have been pounded since the housing crisis first began, and will be poised to make a recovery as demand for new homes eventually rises. However, as we said this could take some time, but it will happen. I currently hold a long position in ITB, a US home builder ETF.

My Thoughts on the Next 24 Hours...

2008-09-16T04:46:00.010-04:00

These are very interesting times... At this point in time, after passing up some deals which could have saved AIG, I wouldn't be surprised if we saw at least part if not all of AIG being bought at bargain basement prices by one of its major competitors. I think it will be tough for them to find financing any other way, especially after the recent downgrades. However, I haven't been following the industry too carefully, so it would be tough for me to speculate on an appropriate suitor (list could include ING, Allianz, AXA, etc...). Nonetheless, I am rather glad I haven't taken on any new long positions in the sector recently. Something else we should all be paying close attention to is the effect these failures have on the CDS market, this could open up a whole new bag of worms. I recently read an article which stated that PIMCO alone currently guarantees USD760mn of AIG debt.

As for the Fed, I would be surprised, but not shocked, if we saw the Fed move 50bps today, however they will almost certainly switch to an easing bias in the statement and very likely modify and extend some of the current lending schemes (i.e. changes to the discount window and/or TAF, accepting more assets as collateral, possibly even allowing the Fed funds rate to trade well below target over the next couple of weeks, etc...). I don't really believe a rate cut would be the right course of action, liquidity is the issue not price. However, psychologically it may help the market. All in all the Fed's announcement will likely bring some calm to the market, which could easily be undone by an AIG collapse. We will all get a much better idea within the next 24 hours, as it has been reported an AIG deal would need to be completed by Wednesday. Currently, I am staying on the sidelines, but monitoring the situation closely. Finally, I did notice that the financial sector ultrashort ETF is trading nowhere near its July highs, which I found somewhat interesting. I am not very familiar with this fund, so if anyone has some insight on this please feel free to email me.

As an aside, and as I mentioned was a possibility in my previous post, China has begun easing monetary policy. This could be an important factor once the market does start recovering. Many of China's issues were self-inflicted and reversing policy could have a big impact as investors (eventually) become a bit less risk adverse.

UltraShort Financials ProShares (AMEX:SKF)

Source: Bloomberg

A Quick Look at Global Sub-indices (& An Aside on China)

2008-09-14T04:22:00.005-04:00

A while back I created an excel file that tracks the conditions of global sub-indices. Essentially, I took over 600 sub-indices from around the world and I broke them out by best and worst performing over the past 6 months, P/E and P/B ratios, and dividend yield. I extracted the 15 best and worst performing indices from each of these categories and consolidated them in the chart below . I am eventually planning on using this data to look at global trade ideas or to spot mis-pricings between markets. All in all I extracted this data form Bberg last week and I hope you enjoy the data. I will follow up with a more detailed analysis on markets that may look attractive after I conduct further research.

As an aside, given the recent economic data out of China (inflation, IP, exports, etc...), I anticipate the government is closer to moving towards a more accomodative monetary policy. The shift will likely include reductions in reserve requirements and an easing of lending standards. It is also possible, but unlikely at this point in time, that we could see a rate cut before the end of 2008. Any action by the government to stimulate the domestic economy should have positive effects on Chinese markets. I currently hold an upward bias towards some of China's housing, health care, and financial names. (Please see earlier posts for more details).

Top and Bottom 15 Global EQ Sub-Indices by 6M performance, PE, PB and dividend yield

*Source: Bloomberg

A Look at China’s P/E Ratios:

2008-08-25T00:00:00.007-04:00

Quite a few readers have been wondering whether the relatively high P/E valuations of China’s equity markets were justified. This is my response: I would say that type of PE valuation is reasonable for most of the Chinese companies. As everyone knows, growth in China has been very robust over the past several years, and should remain strong over the next several, despite a slowdown in the rate of growth. To quickly quantify this argument we can take a look at the Shanghai SE Composite’s 2Q08 aggregate PE and divide that by China’s YoY GDP growth for the same period, and compare the data to against other markets (see chart below).

Select market PE's to underlying country's GDP growth

Source: Bloomberg

Looking at the chart above, despite China’s seemingly high PE valuations, in terms of PE to GDP they are actually the cheapest market in the set with a PE/GDP ratio of 2.1. Looking ahead, Chinese growth will continue outpacing its industrialized counterparts over the next several years, and this should help support its market. In fact, during this period we will likely see China’s domestic sector replace the export sector as the main engine of growth. This should partly be catalyzed by higher domestic incomes and growing domestic demand, coupled with a slowdown in consumption by industrialized nations. Of course from my experience, one of the big question marks for China’s market is the impact of any new government policies. However, given the expected weakness in the export sector, recent inflation moderation, and the slowdown of the GDP growth rate, I expect future policy to be accommodative to domestic growth.

Also, I will be traveling for the next couple of weeks, so I may be slow to post new entries. However, I will randomly be checking email.

Thanks!

Mengniu, A Look at A Chinese Dairy Company

2008-08-23T00:22:00.011-04:00

Overview:

Chinese Mengniu Dairy: China’s Mengniu dairy was founded in 1999 by a group of seasoned dairy market professionals previously employed by the state-owned Yili Dairy. Mengniu began trading on the Hong Kong Stock Exchange in June 2004.

Our DCF based price target is currently HKD26.16: Given Mengniu’s historically strong growth, its ability to generate cash, and continued leading market position in the liquid milk industry we have decided to run a DCF model to value the company’s equity. Using a 10.6% WACC, based on our calculated cost of equity, and a terminal growth rate of 2% starting in 2019 we calculated a price target of HKD26.16. According to our calculations a price target of HKD26.16 would imply a 12 month forward P/E ratio of x26.79 and a 24 month forward P/E ratio of x19.95. This is in-line with Mengniu’s recent performance.

New high-value added products should help sustain Mengniu’s robust growth: We believe that Mengniu through its strong brand, innovative products, and efficient distribution network will be able to ride the wave on the transitioning

The Details:

China’s Mengniu dairy was founded in 1999 by a group of seasoned dairy market professionals previously employed by the state-owned Yili Dairy. Mengniu began trading on the Hong Kong Stock Exchange in June 2004. The company’s products include UHT milk, yoghurt, milk beverages, ice cream, milk powder and milk tablets. In 2007 Mengniu reported holding a market share of 40.7% in China’s liquid milk market. This is a significant increase from the 33.3% market share Mengniu held at the end of 2006. Mengniu has experienced significant growth since its creation, primarily through the introduction of UHT milk. As you can see from the chart below the majority of Mengniu’s revenue is derived from the liquid milk business.

Mengniu’s composition by product

Source: Company

Mengniu’s management has brought the company from an industry start-up in 1999 to a market leader in less than 10 years. They have achieved this by developing a strong brand and implementing an innovative business model that led to the successful introduction of new products, such as UHT. However, the biggest challenge for Mengniu’ management will be keeping up with the changing Chinese dairy sector. As we mentioned in the industry outlook section, the industry is undergoing an important transition, where UHT will likely no longer be the dominant force behind the industry’s growth. As it currently stands, management not only seems to be aware of this shift, but appears to once again be positioning itself on the cutting edge. They have started to invest more heavily in R&D projects aimed at designing higher-end products, and are training its raw milk suppliers on how to increase productivity and reduce disease. Nonetheless, it will be very important for management to maintain stable margins amid potential pricing pressure from increased competition and rising marketing costs. Unlike the western dairy market Chinese consumers are more brand conscience, so it will be essential for Mengniu to continue building its name. This notwithstanding, we believe Mengniu is well positioned to take advantages of the changes in the dairy sector given management’s strong track record of innovation, brand development, and efficient distribution networks.

Investment Thesis:

New high-value added products should help sustain Mengniu’s robust growth: We believe that Mengniu through its strong brand, innovative products, and ultra efficient distribution network will be able to ride the wave on the transition from traditional milk products to higher value dairy products. Mengniu has already demonstrated its ability to take advantage of new products and markets when it first introduced UHT milk to the Chinese market. Concurrently, we believe growing UHT sales to rural communities should help off-set someone of the growth slow-down from near saturated urban markets.

ASP should remain stable or see a slight increase as higher value products reach market: A recent increase in government price caps coupled with solid performance of Mengiu’s products should help sustain Mengniu’s ASP for the foreseeable future. We anticipate that despite some downward pressures Mengniu’s new higher value products and price cap increases should help maintain or slightly improve its 2008 ASP.

Higher costs should be offset by rising and eventually stable ASP coupled with falling raw milk prices: Higher costs via new product development, company branding and distribution could place downward pressure on Mengniu’s margins. Yet, we anticipate that in 2008 margin pressure will be more than off-set by reductions in raw milk prices and increases in the ASP for Mengniu’s products. We currently expect Mengniu’s gross margin to improve to 22.8% in 2008 vs. 22.5% in 2007 and to remain somewhat stable in 2009. Since Mengniu owns only a very small percentage of its own livestock and pastures, it remains extremely susceptible to changes in raw milk costs, both on the upside and downside. Meaning a continued moderation in raw milk prices could have a large positive impact on Mengniu’s bottom line. Based on the current inflation outlook we expect raw milk prices will continue to moderate, eventually stabilizing by year end.

Our DCF based price target is currently HKD26.16: Given Mengniu’s historically strong growth, its ability to generate cash, and continued leading market position in the liquid milk industry we have decided to run a DCF model to value the company’s equity. Using a 10.6% WACC, based on our calculated cost of equity, and a terminal growth rate of 2% starting in 2019 we calculated a price target of HKD26.16. Please take a look at the chart below for our model’s sensitivities to changes in WACC and the terminal growth rate. According to our calculations a price target of HKD26.16 would imply a 12 month forward P/E ratio of x26.79 and a 24 month forward P/E ratio of x19.95. This is in-line with Mengniu’s recent performance as can be seen in the chart below.

Mengniu's price vs. PE Ratio

Source: Bloomberg

DCF Sensitivities to Changes in WACC & Terminal Growth Rates

Source: My Calculations

As you can see from the performance chart above Mengniu’s share price has fallen significantly from its peak in October 2007. Year over year Mengniu is down 12%, while ytd the stock is down 26%. The primary driver behind this weak performance was escalating raw milk prices coupled with price controls in the dairy sector. Raw milk prices have begun to retreat over the past several months as overall food inflation in China begins to moderate. This should help alleviate some of the downward pressures the stock has been facing in the short-term. Also, on August 1st 2008 company employees sold 57mn existing shares into the market at a selling price of HKD22.02, or a 6.7% discount to the market price. This may have led to some downward pressure on the stock during that period. Important to note is that none of the company’s senior management sold shares during the swap.

Key Risks:

There are several significant risks to our forecast. First and foremost, any significant spikes in raw milk prices or supply constraints could have a detrimental impact on Mengniu’s business. Raw milk is the essential input for all of Mengniu’s products, and unlike some of its competitors Mengniu does

not own its own livestock or pastures making the company extremely vulnerable to price shifts or supply shocks in the raw milk market. With this said, given the current CPI outlook we believe raw milk prices will continue to moderating and remain flat by year’s end. Also important to note is that Mengniu has setup an extremely efficient supply chain in Inner Mongolia to source raw milk. It essentially holds a duopoly with Yili Dairy on all raw milk sources in Inner Mongolia, so a supply shock is unlikely.

Another risk is Mengniu’s new higher value added products failing to capture market share. This would significantly hamper Mengniu’s business given the expected slowdown in its core UHT milk sales. However, based on Mengniu’s prior track record of successfully developing and introducing new products we do not find this outcome to be very probable. However, there is a real possibility Mengniu may not meet our aggressive sales forecast.

A number of factors could put downward pressure on Mengniu’s ASP: We expect the higher value dairy products market to become increasingly competitive as China’s other dairy producers introduce new high-value products. We also anticipate higher penetration and sales volumes through China’s hypermarket/supermarket format retail chains. These format stores, given the large volumes purchased, tend to place considerable pricing pressure on producers, adversely effecting ASP. Mengnui’s strong brand name and innovative products should help buffer some of these negative effects on ASP. Lesser risks are potential changes to the 2008/09 effective tax rate, and any potential increase in sales and distribution costs effecting bottom line margins. Additionally, there is always a possibility new government policies related to the price caps of dairy products could adversely affect Mengniu’s future performance.

A Look at the Financials:

Turnover: We anticipate turnover will continue to grow at a healthy pace of around 33% for FY2008. This will be in response to a combination of higher sales volumes and better than market anticipated ASP. We expect yoghurt to experience the highest level of growth for the year at 44%. However, UHT will remain the dominant product consisting of 59% of Mengniu’s sales, but only growing 32%y/y. We believe the recent moderation in overall CPI should help benefit Mengiu as middle class consumers may be more inclined to spend as incomes and disposable income continue to rise.

Mengniu's Sales Growth by Product

Source: The Company & My Forecasts

Margins: We believe that given the increase in price caps for Mengniu’s products, coupled with the moderation in raw milk prices, gross margin should regain some footing lost in 2007. We are currently forecasting the gross margin to finish 2008 at 22.8% vs. 22.5% in 2007. For 2009, we expect the gross margin to remain relatively stable finishing the year at 22.9%. Mengniu’s gross margin will likely remain below that of its major competitors, primarily due to the company’s limited scope. On the plus side, if raw milk prices continue their current decline until year end, then we could see higher than anticipated margins, given Mengniu’s susceptibility to input prices. At the same time, given increased marketing and selling costs we anticipate operating and net margins to remain in-line with 2007’s level of around 5.3% and 4.4%, respectively.

COGS & Selling, Distribution Costs: A significant portion of Mengniu’s COGS is raw milk prices, which up until the beginning of this year have experienced a sharp rise. Raw milk prices have begun to moderate, but given the strong base increase at the beginning of the year we are anticipating COGS to increase around 33% for the year versus 31.2% in 2007. Compared to its competitors Mengniu maintains among the lowest selling and distribution expenses. This is primarily due to management’s ability to conduct concise and effective marketing and the company’s strong distribution network. We believe Mengniu’s strong distribution network and talented marketing team will off-set some of the costs pressures to the new Chinese dairy market dynamics leading to an increase in selling distribution of around 33% for 2008, permitting the company to maintain its competitive advantage vs. its competitors in this area.

Net Profit: We are currently forecasting net profit growth of 34.6% for 2008 and 32.7% in 2009. This would imply a net profit margin of 4.4% for both 2008 and 2009. We believe increased in the effective tax right will likely prevent these margins form realizing any significant upside.

An Overview of the Chinese Dairy Market

2008-08-19T00:16:00.007-04:00

China’s robust economic growth has led to significant increases in wealth, which has ultimately led to a shift in consumer preferences. This shift has been especially realized in the food and beverage industry. Chinese caloric intake has increased substantially over the past decade, and will continue to climb likely doubling over the next decade. The Chinese dairy sector has been no exception to this trend. As you can see from the chart below, dairy consumption experienced a considerable increase over the past several years, and is showing no signs of diminishing. In 2006 Chinese dairy consumption stood at 0.012kg/capita, in comparison Japan’s per capita milk consumption totaled 2.08kg, implying significant growth potential as the Chinese market catches up to its peers. But what does this mean for the future of the industry?

Chinese Dairy Consumption 2003-10

Source: KPMG 'The milk and dairy market in China'

Over the past 8 years the bulk of the dairy sector’s growth came through liquid milk, specifically ultra high temperature (UHT) milk. However, we believe as consumer tastes become more sophisticated and income rises the primary growth engine will shift to higher value products such as ice cream, yoghurt, and milk based products, especially in China’s urban centers. Currently, studies imply that the CAGR 2005-2010 of cheese desserts (38%), milk beverages (22%), infant formula (17%), and yoghurt (31%) will all match or exceed that of milk (17%). (Please see the chart below for a more detailed breakout). These growth rates are congruent with bringing China’s dairy distribution in-line with that its major Asian peers. China’s increased consumption of dairy products is also being assisted by the government’s ‘500 Gram Declaration’ which essentially is the government’s hope that every Chinese citizen, especially children, are able to drink 500 grams of milk on a daily basis. This initiative was primarily motivated by the potential health benefits of dairy products. One of the major roadblocks for the dairy industry is the dispersion of Chinese consumers between urban areas with easy access to a wide variety of dairy products and rural sections with limited access and infrastructure challenges. Nevertheless, infrastructure in China is slowly being developed and the large untapped potential of China’s rural areas should continue to be unlocked.

Chinese dairy industry revenue distribution

Source: McKinsey 'China's booming dairy market'

In 1998 only 29% of China’s milk sales were made at modern supermarket/hypermarket stores, but by 2005 this number totaled 58% and is expected to reach 2/3’s of total sales by the end of the decade. China’s entry into the WTO, among other things, significantly reduced barriers for foreign retailers to start or expand operations in China. Based on this fact and the continued development of rural infrastructure we expect the penetration of foreign and domestic supermarket/hypermarket style retail chains to continue growing sharply in China. However, this can be a double edge sword for the Chinese dairy industry. While sales volumes are likely to increase dramatically through higher consumer access to super/hypermarkets, we anticipate greater pricing pressures on dairy manufacturers as these companies tend to have strong bargaining power. This could potentially place stress on dairy products ASP, leading to a reduction in margins. To counter this, dairy companies will need to increase spending on brand recognition and developing new innovative products. Chinese consumers, unlike western consumers, tend to be very brand conscience in relation to the dairy industry.

Key players in the Chinese dairy market:

In 2006 China’s four largest dairy companies represented 44% of the total dairy market share. The largest of these was Mengniu with a market share of 16% during the period followed by Yili with 15% market share. Market share for both of these companies has been increasing over the past several years, while China’s other top two companies by market share Bright (5%) and Sanlu (8%) have been decreasing. The remaining 56% of market share is split between over 1000 other smaller dairy companies. (See chart below for further details). Mengniu and Yili were the first companies to introduce UHT milk into China, which was an important driver behind their substantial market share growth. However, we have already begun seeing a

Chinese companies market share in 2006

Source: China Dairy Yearbook 2006

A major challenge for China’s dairy producers is the distribution and price sensitivity of raw milk (the sector’s primary input). Throughout 2007 raw milk prices grew substantially as food inflation rose. Raw milk prices were further exacerbated by droughts, the EU’s removal of milk powder export subsidies, and livestock being slaughtered due to higher feed costs. Making matters worse for Mengniu and Yili, neither own significant cattle ranches, forcing them to source raw milk from third parties, making these companies even more susceptible to increases in raw milk prices and supply disruptions. Mounting raw milk prices coupled with the government’s dairy price controls have placed significant pressure on the industry. Nevertheless, on a positive note food inflation has begun to moderate, and the government recently approved price increases for a number of dairies. All in all this should help alleviate some of the pressure the sector has experienced over the past year.

Foreign competition has been somewhat limited in the Chinese dairy sector, primarily existing only in the powdered milk segment. Given entry barriers to the sector and China’s, in many cases, inefficient raw milk suppliers we do not expect foreign competition to increase significantly in the short-term. Moreover, we expect to see considerable consolidation in the domestic Chinese dairy industry. Many of China’s smaller dairies are regionally focused in China’s rural areas. As China’s larger dairies continue accessing these areas, smaller producers will likely be unable to compete in terms of costs, and could be forced out of business our acquired by bigger names. Furthermore, given the increased competition amongst domestic players and the likely shift to higher value added products in urban areas dairies will need to increase spending on R&D and marketing to for product development and brand recognition. Only those companies with strong cash flow and significant market share will likely be able to cannibalize these necessary extra expenses.

Chinese Healthcare Sector ADRs

2008-08-07T12:55:00.034-04:00

As an additional follow-up to my ADR series, I am going to take a look at the Chinese and Hong Kong healthcare sector. There are 6 key Chinese and Hong Kong ADRs within the GICS healthcare sector: Mindray Medical International (MR), Chine Medical Technologies (CMED), Wuxi PharmaTech (WX), Simcere Pharmaceutical (SCR), 3SBio (SSRX), and Tongjitang Chinese Medicines (TCM)

Chinese & HK Helathcare Sector ADRs

Source: Bloomberg (Closing prices 8/7)

The Companies:

Mindray Medical International (MR, Outperform): Mindray Medical International Limited develops, manufactures, and markets medical devices. The Company offers patient monitoring devices, diagnostic laboratory instruments, and ultrasound imaging systems. (Bloomberg)

MR’s outlook in a nutshell: Unlike the other companies discussed in this piece MR has significant exposure to both Chinese and ex-China markets; it is also the country's largest medical device company. The medical devices sector is still in its infancy in China, and MR is well poised to benefit from an expanding market. MR specializes in patient monitors, diagnostic lab equipment, and anesthesia & ultrasound machines. Earlier in 2008 MR acquired a U.S. patient monitoring business from Datascope (DPM). MR is currently in the process of integrating DPM's operations; it will likely take 1.5 to 2 years for the full synergies of this deal to be unlocked. Nonetheless, unlike MR, DPM's sales were mostly targeted around hospitals in the U.S. and Europe, this should prevent most sales cannibalization, and give MR good exposure to new markets and technologies. This acquisition adds significant upside potential to MR's future growth potential. Looking at the immediate impact, MR just received FDA approval for DPM’s next generation AS3000 anesthesia delivery system, which is a strong entry into a USD250mn a year market. On the home front, MR has been partially supported by public healthcare reforms, and an initiative to provide medical equipment to rural hospitals; this trend will likely not let up anytime soon. Additionally, MR's robust pipeline should continue supporting the companies bottom line. MR's pipeline includes digital radiography equipment, a digital defibrillator, and various other patient monitoring and chemical analysis equipment. The digital radiography system is a high-res X-Ray machine utilizes digital vs. traditional film, allowing for simpler analysis and digital storage. I see significant upside for MR given its strong domestic position, and growing international presence. This together with stronger medical device demand in China, a successful integration with DPM, and its innovative product line MR should continue to experience strong growth for the foreseeable future. (Expected Q208 Earnings Report 8/20/08)

Events which could improve outlook:

Exceeding 2008’s company guidance of USD560-580mn in revenues and USD132-134mn for income.
Successful integration of DPM, with stronger than anticipated synergies (i.e. cross-selling)
Stronger domestic and international demand for MR’s product line.

Events which could deteriorate outlook:

Higher costs and potential FX risk.
Increased competition in both the domestic and foreign markets.
Changes in government policy reducing domestic sales or prices.

MR vs. Hang Seng

Source: Bloomberg

China Medical Technologies (CMED, Outperform): China Medical Technologies, Inc. is a medical device company that develops, manufactures, and markets products using high intensity focused ultrasound, or HIFU, for the treatment of solid cancers and benign tumors in China. (Bloomberg)

CMED’s outlook in a nutshell: CMED has a unique characteristic when it comes to Chinese healthcare companies; it is the only company in China certified to conduct FISH testing. FISH testing (fluorescence in situ hybridization) is a genetic test that can detect chromosome abnormalities, and can be used prenatally to detect Down’s syndrome among other genetic conditions. Given CMED’s currently monopoly and China’s untapped potential, this segment should help support CMED in both the short and long term. CMED’s other primary segments include ECLIA (electrochemiluminescence immunoassay) and HIFU (high intensity focused ultrasound). These segments should also continue to demonstrate growth, but at a slower pace than the company's FISH business. It is expected CMED will be granted further approvals by the SFDA that will permit it to increase FISH advertising, and and widen the scope of the testing. Additionally, we seen significant improvements in the company’s margins, primarily due to an increased emphasis on high margin reagent products, and limiting the sale of low margin equipment, such as microscopes. This strategy has led to a non-GAAP margin increase to 79.1% from 72.3% for 1Q08 vs. 1Q07; I anticipate this growth rate will moderate, yet remain slightly above current levels. Recently, the company initiated a new business model where by it gives free ECLIA equipment to new customers, who in turn end up purchasing high-margin reagent products to operate the machine. In the short-term this may add some pressure onto CMED's bottom-line, but will be more than offset via longer-term reagent sales. All in all, I believe CMED is a great play in the Chinese healthcare industry given its unique position regarding the FISH test, and new strategy emphasizing higher margin products. (1Q08 Earnings Report 8/04/08 Est: 0.52 Act: 0.42)

Events which could improve outlook:

Further SFDA approvals for new FISH probes.
Continued growth in company margins.
Reaching or exceeding expectations of 500 hospitals with FISH capabilities by the end of 2008.

Events which could deteriorate outlook:

Increased competition.
Lower than anticipated FISH sales.
Changes in government policy adversely affecting the sector.

CMED vs. Hang Seng

Source: Bloomberg

Wuxi PharmaTech (WX, Neutral): WuXi PharmaTech Cayman Inc. provides pharmaceutical and biotechnology research and development outsourcing. The Company's services include discovery chemistry, service biology, analytical, pharmaceutical development, and manufacturing. (Bloomberg)

WX’s outlook in a nutshell: While the CRO business should remain robust in China, WX's recent acquisition of AppTech, a biologics manufacturing company raises some concerns. WX is a market leader in China’s CRO industry, and this portion of its should remain strong over the next several years. In fact, on June 24^th 2008 WX announced a memorandum of understanding to create a 50-50 joint venture for contract research with Covance. The joint venture will be located at WX’s Suzhou facility; specific financial terms are expected to be released once the deal is complete. This deal should help bolster WX’s CRO business over the next several years. However, WX’s USD169mn acquisition of U.S. based Apptech add a cloud of uncertainty over the company's overall outlook. It is likely this deal will create significant cost pressures, and lead to higher earnings variance due to the volatility of biologics manufacturing. All in all, given the recent Apptech acquisition and the potential for increased costs and compressed margins we do not see much upside potential for WX. (Expected Q208 Earnings Report 8/13/08 Post-market)

Events which could improve outlook:

Strong demand for biologics manufacturing.
Significantly higher CRO business in China.
Streamlined integration of Apptech combined with successful cross-selling initiative.

Events which could deteriorate outlook:

Increased costs from Apptech acquisition.
Decrease in biologics demand.
Slow-down in CRO business

WX vs. Hang Seng

Source: Bloomberg

Simcere Pharmaceutical (SCR, Neutral): Simcere Pharmaceutical Group manufactures and supplies branded generic pharmaceuticals to the China market. The Company's products include antibiotics, anti-cancer medications and anti-stroke medications. (Bloomberg)

SCR’s outlook in a nutshell: SCR and the Chinese generic drug sector in general face strong competition. SCR’s sales suffered in Q208, primarily due to shifting to a lower margin sales model in the face of potential competition. I expect SCR will continue to face growing competition in many of its existing lines, further compressing margins. Nonetheless, SCR has at least one first-to-market generic expecting approval during 2H08, which could help bolster sales and sustain margins. Given China's untapped potential in the healthcare industry, SCR should continue experiencing sales growth in its generic markets. SCR will likely continue to target the large potential in small & medium sized hospitals and pharmacies, which should help sales volumes. Nonetheless, increased volumes may not be enough to off-set the impact of lower prices in an environment of increased competition. Looking at 1Q08 we can already see some of the potential impact on margins. Furthermore, a SCR competitor that manufactures a Yidasheng rival, is selling its drug slightly below Yidasheng’s current price, which could lead to further pricing pressure. SCR noted on its 2Q08 earnings call that it is considering acquisitions given its strong cash base. All in all, despite the fact that we believe SCR’s sales volume will continue to expand, it will likely be at least partially off-set by lower prices due to increased competition. (2Q08 Earnings Report 8/05/08 Est: 1.44 Act: 1.48)

Events which could improve outlook:

Stronger than anticipated drug sales.
Competitors bringing rival drugs onto market slower than expected
Approval and eventual ability to market drugs in SCR’s pipeline including Biapenem, Palonosetron, Iguratimod, and Levamisole.
Any significant acquisition that could improve SCR’s bottom line.

Events which could deteriorate outlook:

Continued pricing pressure from competitors.
Lower than anticipated drug sales.
Rejection of drugs in SCR’s pipeline.
Any government regulation regulating drug costs.

SCR vs. Hang Seng

Source: Bloomberg

3SBio (SSRX, Outperform): 3SBio, Inc. is a biotechnology company. The Company researches treatments in the areas of nephrology, oncology, supportive cancer care, inflammation, and infectious diseases. (Bloomberg)

SSRX’s outlook in a nutshell: SSRX is a growing company in a Chinese growth sector. SSRX’s two main products are EPIAO and TPIAO, experienced record sales increases in 1Q08 of 42% and 104%, respectively. EPIAO is an EPO drug, which helps stimulate the body’s red blood cell production that can be prescribed to patients with anemia, or who are undergoing chemo-therapy. According to the company, in Europe roughly 17% of chemo-patients are prescribed EPO, while in China the ratio stands at 2%, implying significant growth potential. TPIAO is a THPO treatment, which increases the body’s production of platelets; this drug can also be prescribed to oncology patients. Looking ahead SSRX has a potentially strong pipeline, with its high dosage EPIAO treatment and second generation IL-2 treatment, both finishing Phase III trials. SSRX expects to file with the SFDA regarding both these drugs during 2H08. By the end of 2008, SSRX also intends on filing with the SFDA in order to be granted permission to use TPIAO as a treatment for ITP, a bleeding disorder. Management expects to continue investing heavily into the company's core business, increasing sales force and expanding capacity. Despite the potential for rising costs due to managements expansion plans, I foresee SSRX further penetrating China’s oncology market while maintaining strong and stable margins. All in all given SSRX’s growth and future pipeline, I believe SSRX is a good play in the Chinese healthcare industry. SSRX is a growth company with a management team who appear to be making wise investment decisions towards long term sustainable growth. Interesting to note is that SSRX has the right to buy-back company shares through March of 2009. Lastly, I expect the company could upwardly revise its 2008 guidance during its Q208 earnings call, this of course depending on 2Q results. (Expected Q208 Earnings Report 8/12/08 Post-market)

Events which could improve outlook:

Improved 2008 company guidance.
Stronger than anticipated EPIAO & TPIAO sales.
Approval of new treatments by the SFDA.

Events which could deteriorate outlook:

Strong competition from other market players, which could reduce market share or add pricing pressures.
Any pipe-line drugs failing to get approval from the SFDA.
Higher than anticipated costs reducing margins.

SSRX vs. Hang Seng

Source: Bloomberg

Tongjitang Chinese Medicine (TCM, Neutral): Tongjitang Chinese Medicines Co. is a pharmaceutical company. The Company develops, manufactures and markets modernized traditional Chinese medicines. (Bloomberg)

TCM’s outlook in a nutshell: I am hesitant on TCM’s outlook for several reasons 1) nearly 80% of TCM’s revenue comes from its Xianling Gubao product alone, which is used to treat osteoporosis; 2) the traditional Chinese medicine industry is extremely competitive; & 3) canceling its privatization due to what was reported as a deteriorations in the credit market. All in all, if it were not for this equities recent sell-off after the cancellation announcement I would have rated them ‘underperform’, but given the sell-off and challenges the company still faces I don’t see much upside or downside for TCM.

Events which could improve outlook:

Higher than expected earnings.
Re-initiating privatization.
Creating a more robust product base.

Events which could deteriorate outlook:

Slower than anticipated sales of Xianling Gubao.
Earnings below expectations.

TCM vs. Hang Seng

Source: Bloomberg

Chinese Financial Sector ADRs

2008-08-05T04:18:00.020-04:00

As a follow-up to my energy sector ADR piece I am going to take a look at the Chinese and Hong Kong Financial sector ADRs. There are 3 Chinese and Hong Kong ADRs within the GICS financial sector: China Life Insurance (LFC), E-House (EJ), and Xinyuan Real Estate (XIN).

Chinese & HK Financial Sector ADRs

Source: Bloomberg

The Companies:

China Life Insurance (LFC, Outperform): China Life Insurance Co., Limited offers a wide range of life, accident, and health insurance products and services. LFC is the largest life insurance provider in China. (Bloomberg)

LFC’s outlook in a nutshell: Several factors have gone into LFC’s poor ytd performance, including large potential payments due to the Sichuan earthquake and poor overall market performance. But in retrospect, it does not appear Sichuan earthquake related payments will be as high as some analyst had anticipated. In fact, it appears the Sichuan earthquake may have increased demand by Chinese consumers for life insurance related products; this should help bolster LFC's premium growth through-out 2008. Recently, it was estimated that LFC’s life insurance premiums increased 50% during the first 5 months of 2008. Based on continued strong demand and LFC’s vast potential client base and large distribution network, especially in rural China; I expect strong premium growth to be supported for the foreseeable future. Nonetheless, LFC could face some downward pressure from its investment business and the possibility of compressed new business margins due to the increased sale of single-premium products vs. regular premium. Investment income could also be affected this year by a recent rule preventing insurance companies from guaranteeing Chinese corporate debt. The Chinese government has also recently introduced new solvency rules for the insurance industry. The new solvency rule break insurance companies into three categories based on their solvency margins, insolvent (<100%),>150%). The good news is as of Dec. 2007 LFC’s solvency margin was over 5x the government minimum, so we expect the regulations to have minimal short-term business impact. All in all I believe strong demand for insurance products coupled with the under-development of the Chinese insurance industry and LFC’s strong distribution network, LFC could see some considerable upside in the future. (Expected Q208 Earnings Report 8/25/08)

Events which could improve outlook:

Continued premium growth through the second half of 2008.
Strong performance of Chinese equity markets.
Higher than anticipated investment yields.

Events which could deteriorate outlook:

Slow-down in premium growth and/or tightening margins.
Poor equity market performance.
New government regulation affecting LFC’s bottom line.

LFC vs Hang Seng

Source: Bloomberg

E-House (EJ, Outperform): E-House China Holdings Ltd. offers real estate services. The Company offers primary real estate agency services to residential real estate developers; lists and brokers properties for resale; and offers land acquisition consulting and property development consulting services. (Bloomberg)

EJ’s outlook in a nutshell: The Chinese real estate sector has been facing significant downward pressure. Unlike the US however, the primary catalyst for this adjustment is derived from escalating government restrictions targeting the sector. These regulations include everything from restrictive lending policies to quotas for land development. (Click here for a more comprehensive list) Consequently, the performance of all real estate related equities has suffered including EJ. Nonetheless, despite this EJ was still able to post solid 1Q08 numbers beating analysts’ estimates, demonstrating 107%yoy revenue growth. Looking ahead to 2Q08 earnings EJ has affirmed its revenue projections of between USD41mn to USD44mn, or a roughly 75% increase from the year prior. We believe that EJ is also in a relatively good position for the remainder of 2008 for the following reasons: 1) Continued growth in EJ’s real estate consulting and information services segment. This should be driven by EJ’s leading market position in the real estate consulting service industry and by subscriptions to EJ’s innovative CRIC information database; 2) Developers demand for increased cash flow and sales turnover should help sustain revenues and growth for EJ’s primary real estate agency services, which could also lead to further developer alliances. Given current conditions it is also likely some developers are holding off some projects until the end of 2008, which could help 2H08 earnings for EJ, or at least indicate a potential turn-around for the sector; & 3) A potential loosening of restrictive government policies related to the real estate sector. The recent slowdown in economic growth will likely cause the Chinese government to reconsider certain restrictions placed on the sector to help bolster domestic growth. Based on analysts’ earnings projections and our back of the envelope discounted free cash flow model we believe a target price of $18.00-$20.00 would be a fair value for EJ. Regardless of the current conditions in the Chinese real estate industry, we believe EJ is well positioned for growth and is a good play in the Chinese financial sector ADR universe. (Expected Q208 Earnings Report 8/20/08 Pre-market)

Events which could improve outlook:

Government easing restrictions related to the real estate sector, especially leading to easier credit.
Increased consulting fees or higher than expected subscriptions to the CRIC system.
Growth in home prices and/or real estate transactions.
Announcing additional alliances with developers.

Events which could deteriorate outlook:

Further government restrictions in the real estate sector
Lower than expected consulting fees and CRIC subscriptions
Missing 2Q08 earnings target of USD41 – USD44mn or 2008’s, which could put in question 2008’s full year target of USD210mn to USD240mn.

EJ vs. Hang Seng

Source: Bloomberg

Xinyuan Real Estate (XIN, Neutral): Xinyuan Real Estate Company, Ltd. is a residential real estate developer that focuses on Tier II cities in China. The Company develops large scale residential projects that include multi-layer buildings, sub-high apartment buildings, hospitals, schools, and others. Xinyuan also develops small scale properties as well. (Bloomberg)

XIN’s outlook in a nutshell: Due to credit restrictions and other policies aimed at real estate developers we believe XIN will remain under pressure for the rest of 2008. Nevertheless, XIN primarily focuses on tier II Chinese cities with projects primarily centered in Chengdu, Zhengzhou, Hefei, & Jinan. On average these cities have fared better than tier 1 cities in terms of slowing home price growth and diminishing demand. However, while year over year housing prices remain positive in these cities, we have begun to see a significant slow-down in recent data. June’s yoy housing price growth in Chengdu and Zhengzhou has slowed by -19.6% and -10.0%, respectively, from the month prior. The drop-off in demand for housing will likely continue to strain prices and sales in XIN’s target markets. However, any pro-real estate shifts in government policy that would bolster demand (i.e. increase credit), could have a significant impact in XIN’s business. XIN like many developers are likely in a wait in see mode when it comes to future expansion plans. We believe given the current stress on the Chinese real estate industry, and XIN’s front-line position we would prefer waiting for clear indications of the sectors recovery before considering an investment. We anticipate having a clearer picture of the Chinese real estate developer landscape by the end of 2008.

Events which could improve outlook:

Government easing restrictions related to the real estate sector, especially leading to easier credit
Strong sales on current projects.
Recovery in real estate transaction volume combined with stable or rising housing prices.

Events which could deteriorate outlook:

Further restrictions on credit availability.
Rising construction costs on current projects.
Deterioration of sales on current projects.
Continued slow-down of housing price growth in target cities.

XIN vs. Hang Seng

Source: Bloomberg

Chinese Government policies on real estate sector (Supplement)

2008-08-05T04:04:00.008-04:00

This is a working list of Chinese government policies aimed at stemming growth in the Chinese real estate sector. Please feel free to comment if there is something I am missing. A major source for this was E-House's annual report.

The following regulations were put in place in 2003:

Real estate developers are required to internally finance 35% of the total projected capital outlays for new developments vs. 20% previously.
Monthly housing expenses, which include mortgage payments and property service fees, cannot exceed 50% of the borrowers’ monthly income. Additionally, borrowers’ total debt servicing payments cannot exceed 55% of total income.
The government also tightened regulations around mortgage lending and restricted the approval of areas for new developments.

The following additional regulations were put in place in 2006:

70% of land approved for residential development for any year must be used to develop low to medium and small to medium sized unites and low cost rental policies.
70% of any construction which commenced on or after June 1^st 2006 within each city or county consists of units with floor areas of less than 90 square meters.
The minimum down payment for the purchase of any property over 90sqm was increase to 30% of the purchase price vs. 20%.
A business tax was put in place for re-selling properties held for less than 5 years.

The following additional regulations were put in place in 2007:

Down payments for first time home owners buying properties larger than 90sqm were increase to 30% from 20%.
Minimum down payment for second-time home owners were increased to 40% and the minimum home mortgage rate was set at 110% of the benchmark index.
On the commercial real estate front, banks are not permitted to finance purchases of pre-sold properties, minimum down payment was increased to 50%, minimum interest rate of 110% of benchmark, and loans can be for no more than 10 years. At the same time, banks are permitted some flexibility based on its own risk assessments.
Minimum down payments for dual listed residential/commercial properties were increased to 45%.

The following additional regulations were put in place in December 2007:

The National Development and Reform Commission and the Ministry of Commerce issued a new regulation, effective Dec 1, 2007, which placed real estate brokers and agencies in a restricted category of foreign investment industries.
Credit curbs were put in place to cap total lending for 2008 at RMB3.6trn, matching the previous year’s level.

Chinese Energy Sector ADRs

2008-07-30T15:02:00.032-04:00

The first sector I am going to break-out is the Chinese energy sector, primarily because this sector has the highest market cap of all the sectors I outlined in my last piece. There are 5 Chinese and HK ADRs withing the energy sector: PetroChina (PTR), Sinopec (SNP), CNOOC (CEO), Yanzhou Coal Mining (YZC), and Gushan Environmental Energy (GU).

Chinese & HK Energy Sector ADRs

Source: Bloomberg, analyst targets are an average provided by Bberg &for reference only

The Companies:

PetroChina (PTR, Neutral): PetroChina Company Limited explores, develops, and produces crude oil and natural gas. The Company also refines, transports, and distributes crude oil and petroleum products, produces and sells chemicals, and transmits markets and sells natural gas. All of PTR’s oil and gas production and reserve facilities are located within China. (Bloomberg)

PTR’s outlook in a nutshell: China’s continued strong economic growth should support increased demand for natural gas and petroleum products. However, domestic production of crude oil and natural gas has not and will not be able to keep up with the demand for refined energy products. This means PTR and other energy companies will have to rely more heavily on imported energy products. Currently, China imports roughly 50% of its crude oil, and we anticipate this percentage will rise, as China is now a net importer of oil. One of the catalysts behind the pickup of energy imports is the government’s oil tax rebate which rebates 75% of the 17% VAT tax on crude imports, and a full discount on the importation of gas and diesel. Currently, it appears this discount will stay in place through 3Q08, but it will be important to watch. It is likely that without these imports China could face more significant domestic energy shortages. All in all we believe that PTR’s margins will continue to come under pressure, and the ADR has limited upside, especially verses other ADR plays. With this said however, we believe PTR is in the better position than SNP. The reason being PTR holds the majority in both domestic crude oil and natural gas production. (Expected Q208 Earnings Report 8/21/08)

Events which could improve outlook:

Slowdown in global oil prices.
Increase in domestic price caps in gas.
New oil field discoveries.

Events which could deteriorate outlook:

Sharp rise in global oil prices.
End to energy import tax rebate.
New or stronger government regulations which could increase PTR’s cost.

PTR vs. Hang Seng

Source: Bloomberg

Sinopec (SNP, Underperform): China Petroleum and Chemical Corporation (Sinopec) explores for and produces crude oil and natural gas in China. The Company also owns refineries that make petroleum and petrochemical products such as gasoline, diesel, jet fuel, kerosene, ethylene, synthetic fibers, synthetic rubber, synthetic resins, and chemical fertilizers. In addition, Sinopec trades petrochemical products. SNP is currently China’s largest oil refiner. (Bloomberg)

SNP’s outlook in a nutshell: Like PTR, Sinopec is expected to face difficultly due to high oil prices compressing margins. Unlike, PTR however, SNP is much more vulnerable to the current government tax reductions for crude importation; SNP currently imports roughly 80% of the crude oil it refines. Good news for SNP is that it appears the VAT reductions should remain in place through Q3, but any changes to that could significantly impact SNP’s bottom line. Even with the recent drop in WTI prices it has been reported by company officials by the Xinhua news agency that the company’s break-even point is a WTI price of around USD80, far below current levels. Given this pricing pressure I see limited upside for SNP. It is also hard to predict what type of government intervention may take place to support the local energy industry, given this unknown it is an area I would like to avoid. (Expected Q208 Earnings Report 8/25/08)

Events which could improve outlook:

Slowdown in global oil prices.
Increase in domestic price caps for refined products.
Greater expansion at its Tahe oil-field.
New oil-field discoveries bolstering E&P earnings

Events which could deteriorate outlook:

Further drop in refining margins.
Any changes to reduce the magnitude or length of the VAT subsidies.
New or stronger government regulations which could increase PTR’s cost.

SNP vs. Hang Seng

Source: Bloomberg

CNOOC (CEO, Outperform): CNOOC Limited, through its subsidiaries, explores, develops, produces, and sells crude oil and natural gas. (Bloomberg)

CEO’s outlook in a nutshell: Unlike PTR & SNP, CEO has significant exposure to E&P, which in a period of high oil prices should add considerably to the bottom line. At the same time, CEO has recently started production at its Xijuan 23-1 oil field and has numerous more scheduled to go online during the remainder of 2008. This should help CEO reach their roughly 15% production increase from last year. All in all, in the current oil piece environment, and with numerous projects already or nearly ready to go online we believe CEO is a good play in the Chinese energy sector. (Expected Q208 Earnings Report 8/27/08)

Events which could improve outlook:

Higher international oil prices.
New oil and/or gas discoveries could improve CEO’s long-term outlook
Better than expected production especially at newly operational Xijian 23-1 oil field or others scheduled to come on line this year.

Events which could deteriorate outlook:

A significant drop in global oil prices
Not reaching 2008’s target production growth.
Increased costs which could impact the bottom line.

CEO vs. Hang Seng

Source: Bloomberg

Yanzhou Coal Mining (YZC, Outperform): Yanzhou Coal Mining Company Limited operates underground mining and coal preparation and operation businesses. Its products are sold in domestic and international markets. The Company also provides railway transportation services. (Bloomberg)

YCZ’s outlook in a nutshell: Like its oil and gas counter parts YZC is susceptible to Chinese government price control policies. Despite this coal prices have remained elevated and this should benefit YCZ’s bottom line. Looking at YZC’s 1Q08’s earning release it would appear that YCZ has begun to shift its focus to producing coking coal vs. thermal coal, which has helped company margins. WE believe this trend will continue for the following reasons: According to a Wall Street Journal article coking coal, unlike thermal coal, isn’t effected by recent government price caps. At the same time the article quotes UOB Kayhian analyst Karen Li as saying, "We are bullish on China's coking-coal sector because of the current tight-market-supply situation.” YZC saw profits from coking coal exceed that of thermal coal for the first time in 2007. Addtionally, YZC owns a majority stake in a new methanol project, which is scheduled to begin production this year. The operation will use thermal coal to produce ethanol, with the first deliveries being made in 2H08. All in all, factoring out any potential government intervention further regulating coals prices or impacting YZC’s cost, we believe YZC is a good play in the Chinese energy market. (Expected Q208 Earnings Report 8/15/08)

Events which could improve outlook:

Continued strength in coal prices.
Further shift into higher margin coking coal.
Success of methanol project and increased coal production at plants in operation.

Events which could deteriorate outlook:

Weakening in coal prices.
New Government policies restricting coal prices or export quotas.
Transportation issues regarding coal delivery.

YZC vs Hang Seng

Source: Bloomberg

Gushan (GU, Outperform): Gushan Environmental Energy Limited produces biofuel. The Company produces biodiesel and by-products of biodiesel production, including glycerin, plant asphalt, erucic acid and erucic amide. (Bloomberg)

GU’s outlook in a nutshell: GU essentially turns waste oil into bio-diesel, and they do this rather successfully. In fact 1Q08 saw impressive increases in net income and revenue. This was primarily due to higher sales volume and prices. For the remainder of 2008 June’s diesel fuel price increase, and any future increase, should help benefit GU's margins. Additionally, GU has started selling its bio-diesel product to the chemical industry, which according to the company sells at an average RMB800 premium over sales to the diesel industry. In 1Q08 this accounted for 10% of total sales volume; the company expects this could reach 30% by the end of 2008. GU also has numerous ongoing projects to increase bio-diesel production, which is expected to total 400tons by the end of 2008 vs. 240tons in 2007. GU’s Shanghai plant began operations in June while Beijing’s plant became operational in January and is expected to double capacity in 4Q08. Moreover, two new plants are expected to become operational during that time period. It is anticipated that GU will announce 2009’s expansion plans during 2Q08’s conference call on August 11th. According to company officials all expansion is being paid for through cash on hand and cash flows without the use of leverage. Costs increased somewhat significantly for GU in 1Q08 due to higher than expected inflation caused by the Sichuan earthquake, but more recently costs have begun to moderate as Chinese inflation growth has slowed. Moreover, GU’s proprietary technology allows them to use lower quality waste oils than their competitors giving them a cost advantage in the sector. On average GU expects input costs to increase roughly in-line with the Chinese inflation rate. All in all given the current demand and potential shortages for diesel combined with GU’s entrance into the chemical market; we are optimistic about the company’s future, and believe the company could have significant upside. This is my favorite play in the Chinese ADR energy sector. (Expected Q208 Earnings Report 8/11/08)

Events which could improve outlook:

Increases in the governments diesel fuel price cap
Larger volumes being sold into the higher margin chemical industry.
Meeting production targets and bringing new plants online within the targeted time frame.

Events which could deteriorate outlook:

Significant rise in input prices effecting margins.
Drop off in business to the chemical industry.
Supply chain issues on sourcing waste oils.

GU vs. Hang Seng

Source: Bloomberg

A Look at Chinese and Hong Kong ADR’s

2008-07-27T09:12:00.015-04:00

In this piece I highlight 66 Chinese and Hong Kong ADRs by sector, broken out by market cap, average 30 day volume, and a series of performance metrics. This piece will eventually be followed-up with specific analysis on Chinese sectors and companies. Before getting to the nitty gritty lets formulate a quick outlook on the global and Chinese economies.

As everyone by now has realized decoupling of the financial markets holds less credibility than the Loch Ness monster. This notwithstanding, I anticipate growth in developing emerging market economies, especially China, will continue to outpace their industrialized counter parts in the years to come, albeit it not at the pace we have grown accustomed to seeing. It is also very likely we will see domestic demand take over as the new engines of growth in these economies. The cause is simple, industrial nations, particularly the US, will experience slowdowns in consumption, hence overall growth over the next several years as wealth continues to deteriorate. The effect, less demand for foreign goods will likely cause trade balances to become a drag on growth for many EM export oriented economies On the other hand, this should be at least partially off-set by what I expect to be continued strong growth in the domestic sector. Domestic Consumption and investment should remain robust for many EM countries after experiencing high growth and a developing domestic economies.

With that said lets look at China, where the global slow-down coupled with an appreciating currency is a double whammy for exports. But how has the Chinese domestic market performing? In a nutshell the answer is good. According to China’s 2Q08 GDP figures domestic investment and consumption continue to experience significant growth. In fact, the June retail sales figure demonstrated 23%yoy growth. So why have Chinese equities faced such a bad year? Well I don’t believe there is any one specific reason for this, but a combination of factors including fears of monetary tightening, investors’ flight to quality, and liquidity issues in the global financial sector stemming from the housing crisis. I anticipate that as fears ease and liquidity returns to the market we could see a significant buy-back of Chinese equities. Additionally, as the Chinese export sector continues to deteriorate there is a growing possibility we could see a pull-back of domestic macro-policies aimed at preventing the over-heating of the domestic economy. This could include anything from increasing loans quotas to reducing reserve requirements. With this said, in the long-run I am bullish on the Chinese domestic sector, while slightly bearish on export oriented industries. There are of course risks, and I advise you to read some of my previous posts and other research. I will go into further detail on sectors and companies in future posts. Now let’s look at the ADRs:

Year to date the 66 Chinese and Hong Kong ADRs I tracked lost 24.0% of their value in market weighted terms, significantly outperforming the domestic Shanghai SE Composite Index which returned -45.6% during the same period, but underperforming Hong Kong’s Hang Seng Index which returned -18.4%. The best performing company was China’s VisionChina Media (VISN) which returned 167.1%ytd, while the worst performer was Hong Kong’s Corgi International (CRGI) which lost 73.0% during the same time period. Interesting to note is that in 2007 nearly 70% of Corgi’s revenues were derived from the US. The best performing GICS sectors for the ADRs were consumer discretionary, health care and IT which all lost 15%ytd in market weighted terms. The worst performing sector has been industrials, which lost 54%ytd. Please look at tables below for further details:

ADR’s sorted by Sector & Market Cap*

*Sector Performance is Market Cap Weighted

Source: Bloomberg

To be continued...

Quick Description from Bloomberg of top 10 ADRs by Market Cap

PetroChina (PTR): PetroChina Company Limited explores, develops, and produces crude oil and natural gas. The Company also refines, transports, and distributes crude oil and petroleum products, produces and sells chemicals, and transmits markets and sells natural gas.
China Mobile (CHL): China Mobile Limited, through its subsidiaries, provides cellular telecommunications and related services in the People's Republic of China and Hong Kong SAR.
China Petroleum & Chemical (SNP): China Petroleum and Chemical Corporation (Sinopec) explores for and produces crude oil and natural gas in China. The Company also owns refineries that make petroleum and petrochemical products such as gasoline, diesel, jet fuel, kerosene, ethylene, synthetic fibers, synthetic rubber, synthetic resins, and chemical fertilizers. In addition, Sinopec trades petrochemical products.
China Life Insurance Company (LFC): China Life Insurance Co., Limited offers a wide range of life, accident, and health insurance products and services.
CNOONC (CEO): CNOOC Limited, through its subsidiaries, explores, develops, produces, and sells crude oil and natural gas.
China Telecom (CHA): China Telecom Corporation Limited, through its subsidiaries, provides wire line telephone, data, and Internet, as well as leased line services in China.
China Unicom (CHU): China Unicom Limited, through its subsidiaries, provides telecommunications services in the People's Republic of China. The Company's services include cellular, paging, long distance, data, and Internet services.
Aluminum Corporation of China (ACH): Aluminum Corporation of China Limited is a producer of alumina and primary aluminum in China. The Company refines bauxite into alumina and smelts alumina to produce primary aluminum.
China Netcom (CN): China Netcom Group Corporation (Hong Kong) Limited is a fixed-line telecommunications operator in China and an international data communications operator in the Asia-Pacific region. The Company provides broadband and other Internet-related services, including DSL and LAN services, business and data communications.
Yanzhou Coal Mining (YZC): Yanzhou Coal Mining Company Limited operates underground mining and coal preparation and operation businesses. Its products are sold in domestic and international markets. The Company also provides railway transportation services.

**Disclaimer: Author holds long positions in China Mobile(CHL) & EHouse (EJ)

Impending Chinese Financial Crisis…

2008-07-13T05:00:00.010-04:00

Sitting here in Hong Kong, I know few people who aren’t transferring money into China to take advantage of the appreciating RMB and attractive domestic rates. In fact a study conducted by the Chinese Academy of Social Sciences estimates there could be over USD1.0trn of such money within China, with USD150bn coming during the first five months of 2008. The good news for these investors is that the RMB is still expected to appreciate over the next 1 to 2 years as the Chinese government continues to correct economic imbalances. However, there is bad news. Eventually, the RMB appreciation will peak, and those investors’ solely within the country to take advantage of the appreciating currency will begin to pull-back. This will likely cause liquidity problems within the Chinese economy, and will lead to further depreciation as more investors attempt to withdraw their funds. This potential crisis has not gone unnoticed. *The branch head of the Jiangsu province China Banking Regulatory Commission released in a paper this week the following comments;

“The initial judgment is that China's financial crisis will kick off between 2009 and 2010, though it may be a year or two later, and will be triggered by a turning point in yuan appreciation…”

“By that time, international capital will flow out instead of coming in and the yuan will face depreciation instead of appreciation pressure. China will face a liquidity shortage and financial crisis will therefore follow.”

In fact looking at the RMB NDF rates, we can see that the market is currently pricing in a slight RMB depreciation around the 3-year time horizon (chart below). In fact, back in May we even saw the 1-month contract briefly imply depreciation for the RMB, demonstrating the potential volatility of the market. This notwithstanding, we have begun to see the growth rate of Chinese exports slow, a trend we expect to continue. This coupled with an unwavering demand for imports, will place a stronger weight on the domestic sector to support China’s growth. To make matters worse for the export sector the Chinese government has initiated new capital controls to reduce the amount of 'hot money' that may be hidden within the sector (i.e. through over-invoicing). Some estimates have placed the amount of hot money hidden within the sector at around 2% of exports. The good news is that the increased importance of the domestic market within China could cause the government to reduce some restrictions on the sector, meant to reduce over-heating within the economy. Yet, a conundrum could arise if Chinese inflation rates once again begin to accelerate. However, at this point most analysts’ estimates are calling for inflation to slow.

The Current RMB NDF Implied Rates show the RMB Depreciating Slightly in 3-Years

Source: Bberg

The bottom line is that China is facing a potential financial crisis that could occur sometime over the next 2 to 4 years. I will continue to look at the RMB NDF market and changes to the government’s foreign exchange policy as potential forward looking indicators to this crisis. In the meantime, the slow-down in Chinese exports will likely have 2 short term effects, 1) a decelerated RMB appreciation, & 2) the potential for authorities to lift some regulations put in place to prevent the domestic economy from over-heating. This could have positive effects on the local equity markets, after facing significant losses from their previous highs. In fact, last week we already began to see the local equity markets respond favorably to the possibilities of less stringent economic policies.

*http://www.quamnet.com/newscontent.action?articleId=889534