Wednesday, October 8, 2008

The way it is


It is as if the approval of the $700bn Troubled Asset Relief Program (TARP) was a complete non-event for the markets. Money and credit markets around the world effectively seized up in the aftermath of Lehman’s default, which in hindsight proved to be a truly systemic event. In order to stop contagion from spreading to the non-financial corporate sector, on October 7, the Federal Reserve announced the establishment of a new special purpose vehicle (SPV) whose aim is to buy investment grade commercial paper directly from eligible companies (list tbd.) Yields on the shortest CP maturities declined and T-Bill yields increased but the stress in interbank and credit markets continued to build throughout the day.

Next to welcoming the liquidity extension to corporates he advocated for some time, Nouriel Roubini in his latest writing, points to the need for an immediate coordinated rate cut of 100bp and the extension of a temporary blanket guarantee on ALL deposits in the U.S. to prevent a potential bank run especially on cross-border interbank lines. The FDIC could invoke its Systemic Risk Exception authority for this purpose as it did for the first time ever with the Citi-Wachovia deal.

According to commentators, the heavy-duty CDS settlement auctions taking place this month weigh heavily on market sentiment. On October 6, the auction of (now government guaranteed) GSE bonds resulted in high recovery values from 91-99 cents on the dollar, meaning that payouts by protection sellers are in the range of 1-9 cents on the dollar. On an estimated $200-500bn notional amount outstanding, payouts are a cumulative $2-5bn. More worrisome is Lehman’s settlement on Friday, October 10. Its defaulted bonds are currently trading at 10 cents on the dollar, meaning that payouts on an estimated $400bn gross amount insured could reach $360bn. The outlook for WaMu bondholders recovery value is similarly bleak (ISDA auction taking place on October 23.)

Meanwhile, the Credit crisis is killing the carry trade. Currency and stock markets around the world are taking their last breaths for this cycle, with some already having fallen into cardiac arrest (trading halts) or needing life support (government liquidity injections). Currencies plunged versus the dollar and more so against the yen - the carry trade's two most popular funding currencies - as investors and banks deleverage. High yield alone no longer protects countries from currency depreciation - fundamentals such as indebtedness matter too (finally). Even the Indonesian rupiah and Brazilian real weakened despite recent policy rate increases to a whopping 9.50% and 13.75% respectively. EUR/USD dropped to $1.34 and the USD touched 100 yen on October 6, the day DJIA fell below 10000. Other developed markets suffered similar percentage losses, but emerging markets took the biggest hit: the MSCI Emerging Markets Index slumped 11%, the biggest intraday loss since 1987. According to S&P, the world's stock markets have lost $10.5 trillion this year as of end-September. VIX shot up to an all-time high level of 58 on October 6 and remains above 50, new territory for the volatility indicator. Worse, even this record high VIX may not mark the bottom for stocks. See RGE’s detailed coverage of the global financial crisis.

The IMF’s latest growth forecast, to be released today, suggests a significant economic downturn and risk of recession. While most of the G7 has already experienced a quarter of negative growth, big emerging economies are likely to feel the heat from this global credit crisis, tip the global economy into recession (3% global growth). See “Are We Headed Towards a Global Recession? ”

The U.S. economy is set for a full-blown recession in the next few quarters since policy actions so far have failed to prop up demand and put a floor on home prices. Pending correction in the housing market, worsening job losses, falling personal incomes and tighter credit lending standards will cause privateconsumption (71% of GDP) to contract, thus exacerbating the ongoing decline in retail sales andmanufacturing activity. Capex plans and exports have also begun taking a hit from the credit crunch, sluggish corporate earnings and global slowdown. Given risks to the dollar and fiscal deficit, the economy is now extremely vulnerable to a more severe and prolonged U-shaped downturn.

The blanket deposit guarantees adopted in several European countries have indeed created an uneven playing field. Nonetheless, EU finance ministers on October 6 find no common agreement to tackle the common banking crisis. Daniel Gros and Stefano Micossi warn that behind the banking crisis, the likelihood of a serious economic downturn – exacerbated by fixed exchange rates as shown byDenmark’s untimely rate hike- looms ever larger. The Eurozone GDP contracted in Q2 and may do so again in Q3 – the PMI are already signaling recession and European banks and economies are exposed to both domestic and U.S. housing markets. Deleveraging has hit EMU countries asymmetrically, re-enforcing divergences within the eurozone. The ECB recently opened the door rhetorically for earlier rate cuts, likely before the end of the year.

The UK economy is setting its path towards a severe recession , which the OECD suggests may have started in Q308, as the housing sector continues to face double digit losses and a marked slump in both consumer and business confidence. On the top of the mutually reinforcing vicious circle of recession, asset price declines and financial stress the economy is now facing the burdens of a serious global credit crisis. The government hasn’t hesitated to rescue the financial system injecting liquidity into the main banks and purchasing mortgage securities through Special Liquidity Scheme (SLS). Many analysts expect a 50bps cut from the BoE meeting this week as it tries to curb the continuing macro deterioration.

While not officially in recession, there is no question that Japan is in the midst of an economic downturn. GDP in Q2 contracted an annualized 3.0%, and the weakness was broadly based. Nevertheless, analysts are divided over how long and severe the contraction will be, with a growing number forecasting a protracted recession. While Japan’s direct exposure to the global financial turmoil has so far been minimal, the global slowdown combined with an appreciating yen has hit exports, which had been Japan's key growth engine in recent years. Meanwhile, the Bank of Japan has kept the target rate on hold at 0.5% since February 2007 and no change is expected in the near future unless it is part of a coordinated international effort to stabilize financial markets.

Canada, which only narrowly missed a recession in the first half of 2008, could, surprisingly, be the best off of the G7 in the coming months according to the IMF, but growth is at a standstill. With 25% of the economy dependent on U.S.- bound exports, Canada can’t decouple. Canada’s banks are relatively healthy, buttressed by the Bank of Canada’s liquidity provision  but higher credit costs will depress corporate profits. Meanwhile the slowing in the housing market might not unfold as benignly as some might hope and domestic demand, is slowing sharply as consumer confidence fades and household wealth suffers from asset price declines. Despite the candidates promises ahead of next week’selection, a fiscal deficit is in sights.

Thanks to asset deflation and the slump in commodity prices (WTI oil fell to $87/barrel Monday) due to the global growth slowdown, most central bankers are shifting focus from inflation to deflation and/or recession. Signs of decelerating inflation remove the impetus for further rate hikes (except for countries like Denmark and South Korea that need rate hikes to support their currencies) and, for some, opens up room for cuts. Some analysts believe the Reserve Bank of Australia's surprise 100bps cut today fired the opening salvo to rate cuts by major central banks, coordinated or not. See “Global Monetary Policy Outlook: Growth Worries Trump Inflation” and “Will the Credit Crisis Cause Emerging Market Central Banks to Turn Around and Cut Rates?

With the G7 in recession, the myth of decoupling seems by now forgotten and the global credit crisis seems well set to be accompanied by a global recession.

The credit crisis will definitely work its way into the Brazilian economy mainly through much weaker balance of payments as global demand falters and capital flows to EM economies fade. But most analysts still predict a healthy 5.3% growth in 2008 followed by a slowdown towards around 3.5% in 2009. The Brazilian real has lost 22% in the past month against the dollar, the worst performance among the 16 most- actively traded currencies. Last week the central bank eased rules on reserve requirements for a second time to make more cash available for the banking system aside from therecently announced intervention in the derivative market to curb some of the BRL losses. Brazil's benchmark stock index plunged 15% on Monday before trading was halted twice in the session. Thestance of monetary policy in Brazil is also changing from inflation oriented to a more growth oriented and the BCB is now expected to reduce the speed of rate hikes.

India’s recent strong growth will take a hit during 2008-09 as high interest rates and global liquidity crunch reduce consumer spending and capex while the selloff by foreign investors sell-off, decline in stock market and rupee, and ballooning fiscal and current account deficits make the economy increasingly vulnerable.

China’s Q3 data, to be released next week will likely to show the first single digit growth rate in five years and the fifth consecutive quarterly decline. A recession in the U.S. and EU, which absorb 40% of China’s exports could push its growth to 8% in 2009.  While some of the decline in industrial production and manufacturing may reflect Olympic slowdowns, China’s imports of several commodities have slowed. It remains to be seen whether China’s nascent private consumption can pick up some of the slack, particularly as housing price growth is slowing. China’s government has already cut interest ratesand further fiscal responses or asset market interventions are likely as it tries to maintain employment growth.

The global slowdown and accompanying fall in the price of oil, gas and other commodities is exacerbating Russia’s already slowing growth trajectory. Some of its plentiful fx reserves have been spent to support the rouble (which weakened 4.8% against the dollar in September) and its benchmarkequity index fell almost 2/3 this year to its lowest level since 2005. The government has pledged nearly $170 Bln to the banking system aimed at restoring confidence. Despite the macro effects of the crisis and asset price correction, Russia’s fiscal surplus, large FX and gold reserves may cushion its trajectory unless the oil price plummets further.

The slowing in the BRICs, which account for 40% of global growth, as well as the G7 will likely have knock on effects for other emerging markets. As a group, emerging markets have suffered significant outflows from the equity and bond markets in the past quarter, with many equity markets down 40-60% this year. Emerging markets with current account deficits and exposed banks like TurkeyIceland andKorea have been particularly hard hit amid deleveraging and flight to the dollar (and yen).

The impact of global turmoil on new EU member states has been moderate so far, but effects are likely to be more visible later. Eastern European emerging markets are more vulnerable than Asian and Latam peers, due in part to their dependence on foreign capital inflows which have dried up.

Key Latin American economies are also facing challenging times with Chile and Mexico already showing clear signs of economic slowdown. In response, the Chilean central bank is now expected to perform a less aggressive rate hike while the central bank of Mexico is now on hold.   

The G-7 and EM slowdown is pinching Asian exports and manufacturing activity, enticing many central banks to ease rates or keep a lid on currencies in spite of high inflation. Price pressures and high borrowing costs will prevent domestic demand from offsetting external slowdown. But despite the moderation in growth, the ongoing turmoil in money and stock markets, exit by foreign investors and downward pressure on currencies which pose significant risks to Asia, the region retains strong external balances and forex reserves, compared to the 1997-98 crisis.

South Africa’s growth is expected to slow to 3.5-4% (from 6% in 2007) as falling commodity prices will erode the value of exports and high inflation limits domestic demand.   South Africa is somewhat shielded from direct fallout from the global credit crisis directly but the volatile Rand has been one of many high-yielding current-account deficit currencies that have been depreciating as carry trades are unwound.

Equity selloffs through much of the Middle East and North Africa suggest the region is not insulatedfrom a global recession. In fact the Bank of Israel cut its benchmark rate in a unexpected move yesterday as growth slows. Tightening of global credit, falling oil price and the withdrawal of foreign investors (Egypt, GCC) has contributed to tightening of domestic liquidity and property market pressures(Dubai) in the Middle East. If the price of oil falls further, fiscal and external balances will come under strain and some oil exporters might have to start dipping into their accumulated savings, which might decrease their investments in neighboring countries and slow domestic demand. Meanwhile, the European slowdown will weigh on non-commodity exports. Yet falling commodity prices may restrain inflation and overheating while the dollar’s rally removes some pressure from dollar pegs.


Michael Ejercito said...

The price of oil will rise over the next few decades, as oil is being consumed much faster than it is generated by natural forces.

But this is a long-term trend. There is and will be short-term price declines.

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