A month is a long time between newsletters. However, the holiday break has allowed me plenty of time to reflect on what has happened in the past 12 months and to consider the future. One thing I think is certain, as with every financial crisis, conditions are different after the event. Whether they are better or worse is open to interpretation. I have therefore taken the trouble to rate possible future changes, as illustrated in nine predictions for 2009, as they would affect Hong Kong equity prices, with the upshot that there will be more negatives around than positives in 2009.
It’s the end of what can only be described as a tumultuous year. As is usual for this newsletter, I have had a look at my eight predictions for 2008, and, I have to say, most of the predictions were correct (US$ rally, commodity price collapse, steep yield curve as interest rates fall and a late year equity market rally). Even a Democrat White House and stable Hong Kong property prices were mostly correct (don’t believe what the press are saying: according to my real estate agent my flat has only fallen 10% from its high earlier this year – which is a significant outperformance relative to most other asset classes). However, I have to admit, I did not foresee the extent of the disruption to global financial markets that the bear market brought. Clearly, the turning point was the decision not to save Lehman Brothers. The chain reaction that followed the demise of Lehmans deepened and accelerated the bear market (which I confidently declared in early January). I suppose we need to wait for Treasury Secretary Paulson’s memoirs to find out why the decision was taken. The only forecast I got wrong, therefore, was that most of my predictions would not be correct – I don’t mind taking that mainstay disclaimer as my only error!
If there were a financial markets word-cloud for 2008 it would include words such as: sub-prime/Alt-A, toxic assets, home foreclosures, oil, commodities, bailout, Lehman, de-leveraging, recapitalization, liquidity, commercial paper, crash, TARP (I know, not a word), unprecedented, stimulus, recession, Ponzi/fraud, and inflation/deflation.
What will the word cloud for 2009 look like? I think it will contain words such as: quantitative easing, weak profitability, commercial property foreclosures, tax cuts, regulations, cash flow, US$ strength crisis, RMB flexibility, economic stability/recovery and financial price technicals.
As we enter 2009, I have compiled, once again, a list of predictions for the year ahead (with the last being the usual disclaimer that forecasting is a mugs game, and I will likely get most of the nine wrong – unlike last year). Here they are in no particular order:
1) Technicals will continue to dominate fundamentals. It is quite clear that the extent of the current downturn in economic and financial markets activity is a new and quite dangerous development. The main characteristic of a bear market is always the same (the deflation of inflated relative prices), but the deflation process in the current bear market took some unusually hard knocks post Lehman. The decision to allow Lehman Brothers to fail shook counterparty confidence to such an extent that the whole financial system nearly failed. The recovery process of such a near-catastrophe will be slow, as skeptical financial markets rebuild confidence that was lost. The de-leveraging which brought down Lehmans (and is still being played out) seems to have eased since those desperate days in October. Interbank interest rates and credit spreads have returned to some sort of normality (whatever normal means for that market now). But the seismic wave of October will continue to ripple through 2009. On this basis, fundamentals will remain volatile and difficult to read. The technical picture, which essentially plots money flows (i.e. sentiment or investors “putting their money where their mouths are”), will remain an important guide for the year. Rating +pos
2) Currencies will be the key financial markets battleground. Now that most of the toxic asset have been written off banks’ balance sheets (estimated at US$20 billion in 4Q for the big US banks) and NPL write offs have begun in earnest (estimate is US$25 billion in 4Q), government and corporate credit markets can stabilize further. Corporate bonds and convertibles will perform well (at least those corporates that survive). Commodities have had their day. Although we saw the unraveling of the forex carry trade last year, foreign currencies have still to experience a fundamental sea change: to the same extent as most other asset classes have endured. For Hong Kong investors the most obvious point of interest is the HK$, US$ and the RMB. Although I’m not a currency expert, I have always found that currency prices are determined by four broad factors: the economic position of the host country, interest rates, flows and technicals. Based on these points, I envisage a strong US$ through the year on the expectation that the US economy will recover first. Long end interest rates will be perceived as rising, while inflows into the greenback will be strong on Treasury issuance. Technical levels are determined by day to day activity and news, but I would not be surprised to see the dollar index touch 92 some time this year (+12%) i.e. back to its peak in late 2005. That would match returns from most equity markets for the year (in local currency terms). However, an appreciating US$ would make dollar bloc equities very attractive for the rest of the world. Locally, the HK$ should weaken throughout the year relative to the US$ back to HK$7.80. The Aggregate Balance should decline in tandem and HK$ interest rates should normalize back up to Libor. The RMB will be more volatile than at anytime since its partial unpegging to the US$ in 2004. Most of the volatility will be self inflicted, with the Chinese government making baby step changes regarding free convertibility. Preparations will therefore begin for the HK$’s merger with the RMB. Rating +pos
3) Equities front run the economy. I expect that equity markets around the world will start reflecting the recovery in economic activity that government-rendered stimulus packages will achieve. Remember as well that past recoveries (for what it’s worth) were enacted during the era of fax machines and the telephone. We now live in a world of instant communications, so, just as bad news has been delivered at the speed of light: so the good news will be delivered in a flash. Assuming that technical factors are still relevant, I would expect the HS index to retest its previous low of 11,000. A double bottom is a technical must do. The first year after a double bottom is usually characterized as a slow grind upwards as investors gather information and confidence about the impending economic recovery. If the HS Index achieves something in the region of 15% for the year (to 17,000) then this would be an average first stage recovery. + pos
4) Long dated US Treasuries/HKEFNs will be a poor investment. Pretty obvious, but it’s worth a say, so that I can get at least one prediction correct. Supply (to pay for the deficit spending) and inflation targeting will lift US Treasury yields over the course of the year. Although the curve will stay positive, it will be an engineered version, because the main means for US taxpayers to get their investments in their banking system back is through higher retained earnings of US bans. Widening banks’ NIM is the most efficient and recurrent way for banks to recapitalize (similar to the recovery after the S&L crisis). Rating -neg
5) Quantative easing/stimulus package exit strategies. Although QE will be quoted often early in the year, the more crucial issue for the markets will be the ability to exit without major disruption. This has eluded Japan for decades and finding a solution will severely tax the US central bank. The Fed is talking about inflation targeting, but, as Hong Kong/Japan found out after their recent financial crises, price deflation can drag on for years after a housing collapse. How the Fed manages expectations on interest rates will be a key issue for the markets in the latter part of the year. Expect to hear a new term – meaning the opposite of QE by mid-year. Rating -neg
6) US housing/real estate. The root cause of a lot that has gone wrong with the world’s financial markets has stemmed from the US real estate market (residential and soon commercial). The problems in the residential market appear to be easing, with federal help. But the commercial market still has to start its descent. The crash landing here will be just as messy. Rating -neg
7) Increased regulation: Glass-Stegal part 2. This prediction has already started, and the signs are that financial market regulations will become more draconian – in stages. In Hong Kong the regulators are already flexing their muscles. It is likely that a cooling off period will be introduced for sophisticated investment product sales. A proposal to set up separate entities to sell investment products sounds like a version of the divisions carved up during the 1930s in the US. However, one thing is clear, the hard sell is out. This means that local bank profits will become more capital intensive/dependent. For banks globally, it will be back to basics: know your customer, what is your cash flow? is this a bankable credit? Do I understand what this is? Is this too good to be true? Etc. Regulations can’t force the financial markets to ask these questions, but the depth of feeling on the issue of regulation will mean that some regulators will give it a try. If the regulations become too onerous, the old system of get rich quick will reverse to: “it’s not how much you make: it’s how much less you lose”. This will have a strong influence on corporate profitability with future returns on equity likely to be lower than in the past. As the value of equities is a reflection of the long-term, discounted cashflows of a company, long term returns for equities will be lower than in the past. Let’s hope the current lip service of regulators holds true. Most legislators around the world are saying that there needs to be a balance to ensure that entrepreneurial urges are not chocked off. I have a couple of other suggestions for Hong Kong’s regulators: a) professional investors must pass a financial knowledge test similar to the account officers that serve them. It is not enough to say that a person is a professional at investing if he/she has a million dollars in the bank. This is only a measure of wealth not expertise b) the regulators should all take the same test. The quality of people at the SFC is not up to scratch (according to former employees I know). Rating -neg
8) Middle East politics will harden so badly, that the world will not even notice the staged withdrawal of coalition troops from Iraq. However, news of heavy defeats in Afghanistan will lead to a rejection of further US overseas military ventures. Calls for a peace dividend will rise. Paranoid Russia will flex its military muscle, within its sphere, despite an attempt by the EU to warm relations. Rating -neg
9) Most of the above predictions will be wrong. Rating n/a
The long term outlook doesn’t look to nasty, and will not likely reach the scale of last year. In the very short term, the Hang Seng Index is likely to trade sideways, with a upwards bias ahead of the month end Chinese New Year holidays. Effectively, the January futures contract closes at the end of next week, making January a 15-day month. The main pressure on the downside will come from rising long end interest rates (the yield on the 10 year HKEFN has risen 25bp YTD) and selling of China bank shares (as the so called “cornerstone investors” at their IPOs dump their still-profitable positions at big discounts to spot prices). This new supply, plus attempts at raising new capital by corporate such as China Resources etc, has almost reversed the short term technical picture for the index, which had been showing signs of revival. A skeptic would say that the recent share price rally was engineered, in thin holiday volume, by the investment banks that are now handling these share placements – with the double whammy of the ibanks shorting the market and the placement targets on the way up. However, one has to wonder if in fact the term investment banker is still applicable, as, technically, they are commercial bankers who should be asking the questions posed in prediction 7 above.
The main focus in the current bear market has been on the technicals of equities, because fundamentals have been so badly disrupted. Chartists (I’m thinking of Charles Nenner for instance: not the 19th Century UK political and social reform movement) have been the only ones able to make head or tail of what has been going on. Following equities has always involved two elements: fundamentals and sentiment (which is best shown through technical analysis). As the fundamental picture has become so obscure in recent months, the technical view has risen in stature. The table below illustrates how sentiment moved in waves (known as fans) during 2008, and how the short-term technicals are showing an unsustainable recovery from the low of October.
The pattern that stands out with the fans is that they start by opening quite slowly, and only finish with a flurry at the end of the opening. As the index is currently trading below the end of the last fan wave, I would expect a better performance from the index ahead of the month end as the patterns suggests that a month is about average for each phase. I’ll be looking to lock-in profits during the current fan-3 period above 14,412, and brace for the arrival of the big bottom.
