Happy Holidays!

There'll be no posts over the last 2 weeks of the year.
I'll be back in 2009 with more interesting views, and here's wishing everyone a Merry Christmas and Happy New Year!
Eric Tan

The "Bezzle" shrinks

The "Bezzle" of Embezzlement
"In many ways the effect of the crash on embezzlement was more significant than on suicide. To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. there is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in - or more precisely not in - the country's business and banks. This inventory - it should be called the bezzle. It also varies in size with the business cycle."

- John Galbraith, "The Great Crash: 1929"

Rush to Convertibles. Week ending 11-Dec-08

Several weeks ago, I wrote about convertible bonds as an asset class that have been overlooked by investors and offer a potentially respectable stable yield in the current market environment.

Convertible bonds have been widely held by hedge funds keen to arbitrage the value of the implied option embedded in bonds, but as leverage available reduced from 5x to virtually zero, hedge funds became forced sellers and that resulted in convertible bond prices falling to all time lows.

There is now an opportunity to make relatively low-risk double digit returns without using leverage or complex hedging strategies. It is as simple as buying a distressed debt with a free option kicker on it, and in many cases, it's cheaper than the straight bond issued by the same company.

Recently, there have been pension funds, sovereign wealth funds (SWFs), and new credit opportunity and distressed bond funds being launched to invest billions of dollars into the convertible bond asset class that has become less opaque and complex with the financial market breakdown.

Eric Tan, London

US employment reaches 6.7%. Markets for the week ending 5-Dec-08.

Economy

This week European central banks (BOE, ECB, Sweden) slashed interest rates in a bid to deal with the worsening global crisis, but the mood remains grim. Investors continue to fret about the global economic and corporate outlook. Bond yields in both US and Europe reached historic lows and credit spreads made all new highs.

So what can we take away from the state of the economy now?

a) Low UK sterling: GBP has had 5 major declines in the last 20 years and each averaged 20% frrm peak to trough against the USD. But since the 26 year high of $2.11/GBP acheived in November 07, it has fallen 30%. The number of short position contracts on the pound is still at historic highs and although there is talk that it may fall further to $1.30, there are more interesting ways to play a weakening gbp such as buying UK companies with high overseas exposure.

b) CDX main, ITraxx X/O all made new highs this week. Looking back at Jan 07 when X/O rose from 340 bps to 550 bps in 2 weeks, the market was shell-shocked, but this week, X/O breached 1000bps, i.e. the cost of buying protection on high yield corporate bonds are > 10% now. Markets seems to be overpricing in a fear of major financial disruptions in the last 2 weeks of 2008, and currently imply a 63% rate fo default versus historic peak of 32% in 1932. IS it the time to sell protection ? Single names are being decimated, but the economy cannot recover until credit spreads fall. To play the credit theme, Insurance names and companies with high FCFs are preferred.

c) US unemployment rose to 6.7% and the non-farm payrolls figures exceeded the worst expectations of economists polled by Bloomberg. However, looking back at the last 2 crisises in the early 1980s and 1992, unemployment rates were 10.1% and 7.8% respectively, so it's highly likely that we can expect more job cuts into the new year.

Eric Tan, London

Inversion of the 30-year US swap rate

Power Reverse Dual Currency (PRDC) bonds are the latest instruments causing havoc in the financial world. This product which have been typically issued in Japan has a average maturity of 30 years with coupons linked to movements in a foreign currency such as Austrialian Dollar or US Dollar.

When the yen weakens against the relevant currency, coupon rises, but the issuer can 'call' or cancel the deal after the purchaser receives a certain return.
It allowed Japanese investors to enjoy a leverage form of the carry trade, where Yen is sold to purchase more risky currencies.

However, the deleveraging of assets in the financial markets has driven Yen to record levels instead of the steady depreciation of the Yen as widely assumed by markets. PRDCs are structured such that when a certain level of exchange rate is breached, the coupon stops but the note is still valid.

With strong volatility and strengthening of the Yen, instead of the bond being called early, banks are now struggling to hedge the longer term problems of the FX exposure and currency option embedded in the PRDC bonds. This left them short in the Yen and with Yen strengthening, the problem was amplified. Dealers had to buy Yen calls or Yen spot which accelerated the Dollar/Yen downward move.

Japanese investors have sought higher returns using US swap rates and recent rally in Yen resulted in dealer having to enter the 30-year swap market to stem rising losses. This has caused the 30-year swap spread in recent weeks to fall 60bps below the yield of the Treasury bond.

Eric Tan, London

Update on US economic outlook

Update on the U.S.
- Preliminary Q3 real GDP growth in the U.S. (revised down to -0.5% from the initial -0.3%) displayed a downward revision to personal consumption from the original -3.1% down to -3.7%.
-The U.S. housing starts plunging, Inventories remain at record highs; Home prices (S&P Case-Shiller C-10) are down 23% from the peak and the pace of decline accelerating every month
-Sudden spike in job losses and filing for jobless claims in November.
-Monthly job losses (a lagging indicator) are expected to hit the 300,000-350,000 range in 4Q08 and early-2009, taking the unemployment rate to 8.5-9% by late-2009/early 2010
-Manufacturing sector is facing tight credit conditions and slowing domestic and export demand
- Auto sector is also in a perfect storm amid slumping vehicle sales and tight credit conditions
- Recent readings of both the PPI and the CPI are showing the beginning of deflation
In a sentence: Slow economic recovery, massive erosion of consumer wealth and demand and double-digit decline in industrial activity

Actions to combat:
- President-elect Barack Obama unveiled a first rate economic team (Larry Summers, Tim Geithner and Christina Romer) to address this most severe financial and economic crisis.
- Consumer confidence got a boost from falling oil prices and new leadership in the U.S. government
- Federal Reserve announced direct purchases of $600bn in conforming MBS and agency bonds ($500bn and $100bn, respectively.)
- Simultaneously, the Federal Reserve is setting up a new $200bn Term Asset-Backed Securities Loan Facility (TALF) for investors of consumer loan-backed securities
- Government provided a $306bn rescue package for Citigroup

Next Steps:
- Significant fiscal stimulus expected over next 4-5 quarters to prevent significant growth contraction and deflation.
- Spending on infrastructure and green technology as endorsed by Obama can provide some stimulus during prolonged growth slowdown
- Democrats are also pushing for unemployment benefits and food stamps which are well-targeted and have the largest bang-for-the-buck.
- Obama has prioritized a large fiscal package as soon as he comes into office in Jan 2009

Where are we in the crisis? Markets for the week ending 21-Nov-08

This week panic seized the markets and we saw citi's share price crippled by a vote of no-confidence. One begins to rethink if equities remains a viable asset class in this turbulent market.

Market indicators

a) The flight to safety pushed 10-year US bond yields to a 5-year low of 3.02% and the 30-year bond yields to it ever recorded low of 3.49% since 1977. As investors reduced holdings in riskier assets bond prices could strength further and yields fall further.

2-year Treasury bonds fell below 1% for the first time since it was issued in 1976

b) ITraxx Crossover, a measure of risk aversion, measures the credit spreads of junk-rated bonds at a record high of 942 this week.

c) Tips (inflation linked bonds) moves to levels that only make sense if US prices fell, on average, for the next 10 years.

d) Dividend yield on the S&P500 is higher than the yield paid on a 10-year Treasury note.

IS this the pricing for a deflationary Armageddon? or is it a sign for investors with longer term horizon to buy?

Good economic news is likely to take a long time to arrive as central banks prepare to wrestle with inflation and world growth is projected to decline to a miserly 1.1% (IMF criteria for worldwide recession is <>

But looking further into the wider investment universe, there are convertible bonds out there which have been overlooked by many investors. With some due diligence carried out, investors could yield a hefty 15-20% over the next 12 months, which might not be a bad bargain in these markets conditions.

Eric Tan, London

U.K. to adopt the Euro ? Risks to a further weakening GBP

Read a good article on risks of a further Sterling weakening, here are the main points:

Risks FOR U.K. Bank Runs:
a) The UK banking sector’s balance sheet is about half the size of the Icelandic banking sector as a share of annual GDP: about 450% at the end of 2007 as compared to Iceland’s 900%.
b) The gross external assets and liabilities of the British economy are about the same size relative to UK GDP
c) England’s foreign currency reserves are puny and the government’s foreign currency reserves are small - around US$43 billion
d) Among the larger European countries, the UK government’s exposure, formal or implicit, to its banking sector is by far the highest. Switzerland, Denmark and Sweden are in a similar pickle, with the banking sector solvency gap threatening to become larger than the fiscal spare capacity of the state.

No doubt the Bank of England would be able to arrange swaps, credit lines or overdraft facilities with the Fed, the ECB or the Bank of Japan. And given sound banks and sound fiscal fundamentals, it should be possible for the UK to defend the banking sector against runs or market strikes.

Sterling Risk
By bailing out the banks, and other bits of the financial system, the authorities reduce bank default risk but at the cost of increasing sovereign default risk.

In addition to the debt that has been and will be issued to finance asset purchases by the government, there are the future debt issuance associated with the large cyclical and structural government deficits that will be a feature of the coming recession. A seven percent GDP or higher government deficit for 2009 and 2010 look probable. Together with the explicit or implicit fiscal commitments made to safeguard the British banking system, the numbers are likely to higher.

Costs to U.K. PLC
With the true net public debt to GDP ratio probably already well above 100 percent of GDP and rising, and with massive public sector deficits, partly cyclical and partly structural about to materialise, the markets will question the fiscal-financial sustainability of the government’s programme. The CDS spreads on UK public debt will start rising.

The current deficits limits capacity to engage in a discretionary fiscal stimulus to boost domestic demand. For it to be meaningful, a debt or money-financed stimulus of at least one percent of GDP and more likely two percent of GDP is called for. Higher default risk premia to the longer-dated UK sovereign debt instruments will be priced in if the market believes that the government’s ability to raise future taxes or cut future public spending to safeguard solvency is weak.

The resulting interest rates rise can crowd out completely the stimulus to private demand provided by the tax cut or public spending increase.

Lack of confidence in the government’s fiscal sustainability would also undermine confidence in sterling. In the worst case, we could see a run on the banks, on the public debt and on sterling all at the same time. It provides another strong argument for the UK adopting the euro and for the Bank of England becoming part of the Eurosystem as soon as the other EU member states will let it

Proposals
The British government should go easy on the discretionary fiscal stimulus it applies, lest it risk a triple bank, sterling and public debt crisis. Better to first let the Bank of England use the 300 basis points worth of Bank Rate cuts that it still can play with. Even better to combine rate cuts with measures to directly target the disfunctionalities in the interbank market, such as government guarantees for (cross-border) interbank lending.
The UK shares with the United States of America the predicament that unfavorable fiscal circumstances make the wisdom of a significant fiscal stimulus questionable. In the US as in the UK the twin deficits (government and current account) severely constrain the government’s fiscal elbow room. Both countries need all the help they can get from fiscal stimuli abroad, in China, in Germany and in the Gulf
http://blogs.ft.com/maverecon/

A new president, a new hope? Markets for the week ending 7-Nov-08

Both the International Monetary Fund (IMF) and European Commission (EC) released reports downgrading growth forecasts stressing that output growth had slowed and financial conditions are likely to remain tight for a longer period.

Over the last week, the mood changes have been so quick from emerging market government bonds rallying to bad economic data from the US sending markets sharply lower.

The main themes that dominated a worsening of consumer sentiment are mainly around:

a) Financial crisis has continued to deepen in the rich world, with highly indebted countries like the UK particularly vulnerable

b) Commodity prices show signs of further weakness and is hurting exporters such as Russia and countries in Africa dependent on selling materials overseas

c) General souring of sentiment has hit all emerging markets especially those dependant on foreign investors to finance current account deficits

Further risks to the economy

The big danger is that a severe global economic downturn creates a massive wave of credit losses on both consumer and corporate loans, further destroying and eroding the already shrunken capital bases of financial institutions. This would once again require more rounds of large capital infusions by the governments of the world.

The big question to ask is: Will the election of the new American president signal to the market that powerful forces of natural and policy-induced help is on the way and should arrive before the scenario of a severe global economic downturn materialise...

Eric Tan, London

Does deleveraging really explain this last stage of the crisis?

In Oct, we saw that as the crisis intensified, the credit-starved global markets used asset disposal to stay afloat. But as the markets start to discount the prospects of a major economic slowdown driven by lower investments and reduced consumption, focus is shifted to the real economy.
Citadel, Goldman Sachs and Deutsche Bank have all recently announced billion dollar hedge fund losses as we saw the crisis most recently morphing into it's most current form: Asian Vol crisis.
But equally conflicting signals continue to alert the market to falling overnight rates and the normalisation of the commercial paper segment.

We have had several up days in the global markets this week so far, but I continue to think that this is just a short term reprieve from what the markets have suffered in the last month. As year end approaches, more hedge funds are going to face further redemptions and it might be worth our time right now to think about what the stage stage of the delveraging will look like...

Eric Tan, London

The week in numbers (FT). Markets for the week ending 31-Oct

This October was the worst month on record for commodity markets as we saw the CRB index falling almost 24% amid mounting concerns that the global economy was heaing for a recession

The Nikkei hit its 26 year low of 7,162 as the world worried that Japanese banks may need to raise fresh capital and the strong yen takes a toll on exporters

US cut its Fed Funds rate to 1% sparking concerns that the measures taken so far could sow the seeds for the next market bubble if they get out of the current one now

more to be updated on Tuesday when America announces its next leader who will lead them out of this crisis...

Don´t cry for Argentina. Markets for the week ending 24-Oct

Emerging Markets
The flight of capital out of emerging market economies this week showed how countries with substantial reliance on foreign borrowings are being hit this week just as we think the financial crisis in the developed markets have been rescued.

Lenders to these economies (banks, hedge funds, mutual funds) who are now deleveraging is causing the currencies to collapse and pushing up the cost of borrowing for their respective governments bonds as seen by the widening of sovereign credit spreads.
Iceland, Hungary and Ukraine, all of which are in discussions with the International Monetary Fund on a bailout. South Korea won has fallen 29% in the last three months, and shares have fallen more than 20% this week as wholesale funds that are being withdrawn by international markets.

Argentina's credit spreads (1 yr) has risen from 3000bp end of last week to 4600bp on Thursday as the government moved in to nationalise pension funds.
4600 bps means that it costs $4.6m to protect $10m worth of bonds. To put it into perspective, just prior to Brazil defaulting on their bonds in 2001, their Credit Default Spreads also jumped to 4500 bps.

Pound falls to lowest since 1971

In the UK, the aggregate of corporate, personal and public sector debt - is equivalent to three times the its GDP. With financial services shrinking and the global economy slowing down, onone knows when the debts can be paid down , hence its hardly surprising that the market is driving down the pound.

With a sharp rise in public sector borrowing expected from bailing out the banking sector, a structural trade deficit with huge reliance on financial flows, and falling tax revenues from a slowing economy, the government is insisting on pursuing a Keynesian approach to ramp up government spending so as to avoid a economic downturn, but this is huge gamble that this recession will not last more than 2 years or else it may soon find itself impossible to climb out that huge hole it has dug itself into.

Eric Tan, Madrid.

Why hasn't LIBOR collapsed? Markets for the week ending 17 Oct

Economic Indicators

- The University of Michigan consumer sentiment index declined from 70.3 in September to 57.5 in October, far worst than economists expected, as banks cut back on consumer credit.

- The sharp slide raises the danger than US shoppers weighed down by their fall in house and stock prices last month will retrench and send the economy into a deep recession.

- US housing starts fell again in September, indicating that the sector is far from botttoming out.

Credit Crisis Update:

- UK to fast track public spending in a Keynesian fashion to prop up the economy in the hope that a recovery will be underway before a gapping hole emerges in the UK's public debt in 2 years time.

- South Korea offer $100bn debt guarantee to stabilise it's financial markets.

Why hasn't Libor collapsed?

Given the coordinated intervention by central banks in US and Europe last week and recapitalisation of global banks this week, the question to ask is why hasn't Libor fallen?

a) Libor has decreased slightly over the last few days, but one needs to know that Libor is now in a price discovery stage in an uncharted environment so it's unlikely to decline abruptly back to previous levels.

b) Libor could have been too low for too long with the western economies flushed with Asian liquidity, which is unlikely to return anytime soon, so expect it to be at higher levels for now

c) Unsecured liquidity has yet to return although governments in US and Europe has announced various programs to tackle the problem. The 28 day US dollar funding will only commence next week and there is still no indication of when the 84 day funding will be announced.

The December futures are already starting to suggest that dollar Libor may fall to 2.7% and GBP to fall to 5%. So as the European Co-operative lenders lead the way in unsecured interbank lending this week, we hope to soon see an acceleration of liquidity kick in.

Stock market shakes the world. Markets for the week ending 10-Oct

Markets:

This week in numbers:

London -21.1%

Tokyo -24.3%

New York -22.9%

Brazil -22.5%

Russia -21.12%

India -19.3%

Shanghai -12.78%

As the market is facing redemptions and selling their liquid assets to raise cash, prime brokers are predicting as much as $1000-2000 bn could be withdrawn from the industry by early 2009.

Scenario

200 largest privately sponsored UK final salary pension schemes which accounts for more than half of all UK pension funds, are estimated to have lost 45b since end Aug and employers might be forced to invest more to make up funding levels.

History's lessons

On friday morning's trading, S&P500's fall for the decade was almost identical to its fall for the decade on the same date in 1938. Investors are likely to refrain and withdraw from the markets, however, I subscribe that basic balance sheet methods such as measures based on cash flow multiples and dividend yield which can work out how much a stock is worth if the worst came to the worst, should leave investors with a margin of safety and help set out a clear path to proceed with picking out some attractive bargains. Good Luck!

Warren Buffet at his best business

Warren Buffet effectively sold Goldman and General Electric an insurance policy each against the event that their existing equity would not be enough to meet future losses.
a) Preference shares that pay out ahead of common stock
b) high yield can be treated as the fee on the insurance policy

Is Iceland really a worse bet than Kazakhstan or Lebanon? Markets for the week ending 3-Oct

Debt markets seem to think so as sovereign spreads have soared.
Interestingly, combined assets of the top three (Glitnir, Kaupthing and Landsbanki) are about nine times Iceland's gross domestic product.
Maybe someone will start to notice that this tiny nation is over-banked.

but more seriously, this is an update of the repercussion on the emerging market world post developed world credit crunch:

a)MSCI Emerging Markets Index lost 8.8 percent this week, the most since July 2002.
b) Turkey's benchmark index headed for its biggest decline since March 17, falling 6.6 percent, to 33,671.27 at 9:50 a.m. in the first trading day since Sept. 29.
c) Russia's Micex Index extended its loss this year to 49 percent. Russia suspended trading for two days and pledged more than $150 billion in emergency funding last month as the seizure in capital markets, falling oil prices and a five-day war with Georgia in August drove away investors.
d) India's Sensex index is at its lowest in a year.
e) Commodities, as measured by the Reuters/Jefferies CRB Index of 19 raw materials, have tumbled 9.9 percent this week, the most since at least 1956. The index has slumped 31 percent from a record on July 3.

Economic Indicators
US Payrolls plunged
US PMI indicates significantly faster rate of decline in manufacturing during Sept (lowest since Oct 2001)
Markets are pricing in rate cuts in Europe after dovish comments from ECB this week
VIX (measure of US equity volatility, market's so-called fear guage) remains at historic highs
Money markets still frozen and companies are being shut out of commercial paper market

European Market Commentary
All main European markets closed up on Friday (between 2 to 4 percent) as U.S. House of Reps voted to prevent amendments to the proceedings
Materials and Financials sector outperformed. +4.3% and +3.7% respectively.

Eric Tan, London

What are they waiting for? Markets for the week ending 26-Sep

Market Commentary

- With the market anxiously anticipating when and how the Paulson bailout plan will be decided, news of Wamu's sale to JPMC was almost overshadowed.

- Short term funding is still an issue with 3month $Libor at its highest since 1999.

- w-o-w, SX5E and UKX is 3% and 4.2% lower

- Oil is marginally higher

Economic Indicators

-Latest Data Shows U.S. Housing Sector is Still Far From Bottoming Out

Stabilization in the U.S. housing sector is not yet in sight: Inventories and vacancies are still at a record high and continue to put downward pressure on home prices, which continue to fall translating into trillions of real wealth losses for the engine of the economy: the U.S. consumer -

- New Home Sales (Aug 2008): at 469K, 17-year low and down -67% from the peak of July 2005 (1.389 mn). This is 11.5% below the revised July rate of 520k and is 34.5% below the Aug 2007 estimate of 702K

- US economy grew less than forecasted last quarter

- Personal consumption lower than estimated

How the market is getting around the Financials short sell ban:

A) Naked Shorting Continues in CDS Market: Even as naked short sales are banned around the world, hedge funds can still bet against a company in the unregulated over the counter CDS market without the need to own the underlying bonds in order to place a bet

B) Spread Betting: Fixed-odds betting on financial markets has surged in recent days as traders find ways to get around the ban on short-selling financial stocks.

C) Proxy bets: Shorting real estate, property companies and builders (most asset managers have been added to the list in the second round of banned names)

D) and if you're a large investment bank running an index arbitrage (-futures vs. +cash) desk, you have the capacity to short banks/financials up to the long cash positions

Next week should get more interesting...and in the meantime, let's turn our focus to the Singapore F1!

Eric Tan, London

Fed bailout plan drives rally! Markets for the week ending 19-Sep.

Markets
Spectacular finish for the FTSE100 today as it closed 8.8% higher than yesterday, and posting a record 1 day move.
Globally, stocks surged as the US bailout plan was announced (with further details due next week)
Comment: Confidence to financial institutions have been restored, but the liquidity boosting measures performed in sync by central banks worldwide this week, bear some resemblance to the post Sep-11 measures which fuelled this crisis to begin with.

So, how near are we to the end of this crisis?
Long period of rapid growth, low inflation, low interest rates and macro economic stability bred complacency and increased willingness to take risk.
It seems like an unwinding of excesses may be required to undo the key elements that led to this crisis.
Checklist:
1) Fall of inflated asset prices back to a sustainable level
2) Deleveraging of the private sector
3) Recognition of resulting financial losses
4) Recapitalisation of the financial system

In 2), we should see large buyout deals breaking, and sectors which are traditionally over-geared underperforming as liquidity continues to be a rare commodity
This week, large and highly geared investment banks came under pressure as there was a crash of confidence that they will be able to meet regulatory demands on their capital. They were saved by the Fed's proposal to create a giant government sponsored vehicle to take on toxic assets and ban on short selling.
However, we might soon find the speculators at the door steps of Transport, Autos, Builders, Real Estate...

Other Scenarios
A) Over a longer time frame, much of the flow of funds from the developed world into emerging equities and commodity assets is likely to come home, and the underperformance of emerging versus developed equities, energy, materials and technology, all look likely in a liquidation environment.

Eric Tan, London

Fundamental Investing is failing..Markets for the week ending 12-Sep

Market Commentary
Obviously, with the market's fixatation on Lehman, the consensus is that a LEH deal is likely to happen this weekend (generally expected); leading contenders BofA+JCFlowers+CIC (Chinese Soverign fund)
Financials continue to be the limelight - specifically LEH, WM, AIG

With the deteriorated environment around us ("EM blowing up", "financials blowing up", "AIG stock down", "Merrill stock down") it is hard to feel optimistic.
(Note: only when everyone is bear-ish, is that an indication we are reaching the bottom.. so who's game to join me to plough their money in right now?)

Overall summary of US economic indicators,
A) Pending home sales worsened, initial jobless claims and continuing jobless claims up, unemployment up
B) Import prices, Producer prices fell -> petroleum story
C) Retail sales fell unexpectedly

Key Risks/Scenario
A) Hedge fund losses (see HFRI indices: Relative Value Strategy, -13% worst performing strategy ytd) might have led to another round of deleveraging this week
Another related story: RAB Capital might be winding up their Special Sit fund if they don't get support from investor

B) Emerging market feels the heat. If anyone has been following Russian equities, you might have noticed that RTS fell 22% mtd. or -48% from high in May.
Spreads on Turkey and Russia has been widening.

C) Dollar Strength
Not really a reflection of strength in the US economy, but more so an indication of weakness elsewhere

Interesting Chart:
Short SXEP vs Long SXPP
With China's thirst of materials declining, this trade may start to collaspe as we have already seen this week. SXPP fell 9% this week

Eric Tan, London

SP500 at 25x P/E ? Markets for the week ending 5-Sep-08

Market Commentary
- Wall Street had its steepest decline in more than two months on Thursday, as more signs of weakness in the labour market and increasingly sluggish growth overseas fuelled fears about the ability of the U.S. economy to stage a recovery. Weekly government data showed an unexpected jump in the number of filings for jobless benefits and a decline in non-farm payrolls.
- The president of the European Central Bank, Jean-Claude Trichet, said euro zone data points to weakening growth and slashed forecasts
- Asian stocks fell consecutively for a week setting the biggest weekly decline in a year

Strength in US dollars tied to global FX reserves ?
Trend: rising reserve accumulation appears to be peaking amid increasing signs of global slowdown,
- If growth of global FX reserves has indeed peaked: less reserve diversification away from USD in favour of other major currencies expected
Previously : Inflationary concerns and tight monetary policies kept Asian currencies supported,
- But South Korea, Thailand, Philippines faced with weakening currencies has reduced need for central banks to intervene to stem the rise of their EM currencies
- Russia and Thailand has been dipping into their coffers to support their currencies
- Impact of reduced growth expectations: triggering waves of capital flight from EM currencies

S&P P/Es at 25x ?
A combination of rising prices and falling earnings caused S&P 500 valuations to surge more than 20 percent this quarter, the biggest increase of any major market, making them the most expensive since November 2003. The index's price-earnings ratio rose above 25 three times in the last five decades, data compiled by Bloomberg show. The last was in 2001, during the bear market that followed the bursting of the dot-com bubble. The increase in valuations preceded a plunge that helped erase about half the market value of U.S. companies.

Eric Tan, London

What to do with Babcock and Brown?

B&B specialises in buying assets such as ports and utilities and bundles them into listed and unlisted funds, from which it earns management fees
Macquarie, specialises in infrastructure, real estate and aircraft leasing

As hedge funds woke up to the fact that the entire model is unsustainable and they exacerbated things by short-selling back in June, B&B has seen their market value tumble.
B&B is undergoing a strategic review that seeks to cut the level of its balance sheet leverage and non-strategic assets
Babcock & Brown’s satellite funds have announced writedowns or sold assets at knockdown prices to repay debts

Implications:
A) Reduction in demand for Infrastructure plays which have previously been hoarding headlines for the last few years as Macquarie, B&B, Private Equities and Soverign funds competed with each other to take these companies private on the notion of strong cash flows, etc (cheap funding)

B) Average premium of share price over Regulated Asset Base still at a high of 14-16% for UK water companies which I believe may reduce in the coming quarters

C) Utilities, Infrastructure being traditionally defensive in downturns may see some erosion in their built-in merger premium from the years of cheap and easy credit

D) Until liquidity returns to the market, Private Equity players will be careful about making large acquisition of Infrastructure assets. However, possibility of trade acquisitions by cash rich incumbents is likely to persist and the next test case will be the amount of interest in BAA's divesture of Stanstead and Gatwick airports

Falling incomes? Markets for the week ending 29-Aug

Economic Update
U.S. stocks rose sharply on Thursday as the government reported the economy grew at a surprisingly robust clip in the second quarter and oil prices eased, driving gains in major industrial and financial companies and bolstering optimism exporters' earnings will improve. The brighter economic outlook coupled with a management shake-up at top U.S. mortgage finance company Fannie Mae boosted financial shares, which led market gains.

However, spending numbers released on Friday showed that U.S. consumers felt the impact of the tax rebates fading and a pickup in inflation eroding the American buying power.
Incomes dropped 0.7 percent, the first decrease since August 2005, reflecting the end of the rebates, after a 0.1 percent gain the prior month. The median projection was a decline of 0.2 percent.


Wider Financial Concerns
Loan book deterioration starting to hit a wider array of financial institutions as credit losses migrate from subprime into other sectors of household finance such as credit card, prime morrtgages and auto loans
S&P estimates losses on loan books could reach 265bn a year fior the next 2-3 years
Banks have used capital raising to offset losses incurred from writedoens,
Much of the capital raised has been in the form of hybrid securities with both debt and equity characteristics, i.e quality of the bank's capital has eroded

Idea?
With US getting itself slowly sorted while Europe struggling with a lagging economy and uncompetitive currency it may just be a good time to put on a US-outperformance trade?

Eric Tan,London

Softening commodity fundamentals. Markets for the week ending 22-August

Update: Markets/Indicators
- US PPI came out at 1.2% in July vs consensus of 0.6%.
- European stocks declined on concerns that financial firms will post more losses and reports signaled faster than expected forecast inflation
- July 2008 Housing starts at 965K (lowest since March 2001), this is 11% below July and 59% below the peak of January 2006 (2.292 million)

Commodities
- Softening of oil market fundamentals, seen since the start of the year, are finally being reflected in prices.
- A deteriorating economic outlook is leading to lower demand, and the performance of non-OPEC supply is improving
- OPEC further revised down its estimates for oil consumption in 2009. It had previously suggested that 2009 would be the first year in which demand for OPEC oil fell since 2002, leading some to suggest that it may trim production in its September meeting.

However, Oil rose to $120 on 21-Aug driven by political tensions that Russia was infuriated by US and EU's response on Georgia and has ordered oil exports to be reduced

Recap of economic developments so far:
- Downturn driven by asset deflation and deleveraging in the banking and household sectors
- Bank asset growth has stalled or fallen, with limited access to dearer credit
- Political economy swinging towards more government intervention
- Losses on traditional assets such as mortgages, credit cards, consumer and corporate loans yet to be taken
- Global economy could be in recession by 2009 with little material economic recovery until after 2010
- Next focus would be on consumer-led global economic weakness

Eric Tan, London

Moulton's conspiracy theory

The trend towards private equity companies buying at a discount the debt of the companies they took private may not be illegal but it raises the concern that during a situation that where other creditors are pressing for a debt renegotiation, these private equity groups with large debt positions could influence the talks to protect their equity.
Justifications
- prevent fire-sale of debt to hostile hedge funds
Concerns
- Usage of knowledge attained as bidders or shareholders to asess the true value of the debt.
Mitigating factors?
- Chinese walls between debt funds and buy-out funds in PE industry?

Pound falls off the cliff. Markets for the week ending 14-Aug-08

Story of the week: Pound falls off the cliff
- BOE delivered gloomy assessment of the economy paving possibility of rate cuts?
- UK Unemployment rose 60k in Q2 from 13k in Q1
- Jul UK CPI jumped 0.6% to 4.4% and may remain elevated and rising to 5% in coming months - resulting in soaring prices destabilsing the UK economy
- Prospect of 'near term' rate cut unlikely
- UK home sales dropped to 30 year lows
- Dollar may have reached bottom levels and is at the start of long-term uptrend


European GDP contractions
German economy, Europe's largest, contracted 0.5 percent from the first quarter
French economy contracted 0.3 percent from the first quarter
- slump in construction
- stronger euro and slower global growth have damped demand for exports
- exports declined and companies cut spending
- faster inflation erodes domestic spending power.


Bank de-risking. Or are they ?
Qn: Does a bank's practice of lending a large proportion of the finance for the purchase of their assets at a discount factor a cause for concern ?
A) RBS - disposal of $8bn of loans outstanding to private equity
B) Merrill Lynch provided 75% financing of it's $30bn CDO sale to lone star

In the above situations, the banks argue that the finance has been cleverly structured to make it extremely unlikely that the exposure would materialise
But the toxic assets remains a residual exposure if they fell below the equity buffer invested by the private equity firms

Eric Tan, London

How Amex's results may give us an insight into the economy in the next 12 months. Markets for the week ending 8-Aug.

Market commentary
- This week, the Federal reserve, MPC and ECB all voted to keep interest rates unchanged.
- Weakening economies left the central banks with little scope to toughen their stance on rising inflation.
- Medium term inflation outlook has improved slightly due to recent drop in oil prices.

How Amex's results may give us an insight into the economy in the next 12 months:Profile of Amex:
- Considered the creme de la creme of credit card lenders
- Premium upscale consumer and business clientele that generally does not carry balances on their cards.

Results:
- 2Q2008 net income from continuing operations :$655 million, down from $1.04 billion in 2Q2007,
- Higher-than-expected provisions on its credit card lending portfolio
30 days past due card loans and 90 days past due card receivables rising to one of their highest levels ever at 3.9% and 3.0%
- Predict delinquent credit card payments, credit cards defaults and losses to rise over the current levels as US housing price decline, rising unemployment levels and increasing energy, commodity and food prices borne from burgeoning inflationary pressures continues to take it's toll on the economy.

Eric Tan, London

US indicators hit recessionary levels - Further deterioration likely ? Markets for the week ending 1-Aug

- Initial jobless claims rose to 448k (highest since April 2003)
- Payrolls: July non-farm payrolls fell 51,000 after 62,000 decline in June 08
- Unemployment rate rose to 5.7% with Goldman and Merrill forecasting it to hit 6.25% to 8% from 2H08 to 1H09
- US treasuries advanced as market took the view that interest rate rises before year-end were becoming more unlikely

Scenario:
Although the U.S. economy expanded at 1.9% in Q2 2008, led by the boost of tax rebates on real consumer spending, there's a good chance that growth will slowdown again in Q3 and hit a trough in Q4-08 and Q1-09 as economic and financial weaknesses continue.

Commentary
This week we have seen record earnings announcements from oil companies, alongside depressing results from GM, BA, BT, Vodafone and continuing concerns in the financial sector. Market continues to look towards oil prices after a $20 fall in July for more relief. However, given that US inventories are low, futures curve are flattish till 2016, there is little to suggest that prices will collapse in the short term. Although US motorists are driving less and airlines are grounding uneconomical flights, China and India's thirst for energy will offset any fall in demand for petroleum and keep prices higher for longer.

Eric Tan, London

Merrill's CDO sale - Long a Put Spread ?

- Interestingly Merrill's partial financing of the purchase essentially constitutes a put underwritten by MER on its CDO exposure
- However, the short put represents only one leg of a complex three-part transaction which synthetically results in Merrill’s purchase of a protective put-spread for its CDO.

CDO sale = long ATM put
75% financing of purchase = short OTM put

Meltdown in Europe :Indicators point towards a worsening. Markets for the week ending 25-Jul.

Market commentary:
- Gains in financials continued as Citigroup Inc., JPMorgan and Bank of America Corp., reported second-quarter earnings that beat analysts' estimates. Investors are hopeful this may be the real thing, seeing a glimmer of hope within the financials.

European Outlook:
- German Finance Ministry reported that GDP shrank "considerably" in the second quarter and estimates to be released in August. Significantly deteriorating German business climate and outlook suggests that the economic upswing is coming to an end.
- Spain's manufacturing PMI set a new record low --> indicators point to Q2 growth around 0.2% q/q and then turn negative
- Ireland: Economic and Social Research Institute forecast that GDP growth in Ireland will be negative in 2008 at -0.4% from 5.3% growth in 2007. The Irish economy is likely to face its first recession since 1983 as the slump in housing construction is likely to wipe out all growth in rest of the economy
- The UK economy grew 0.2% in the second quarter of the year, as the credit crunch took its toll on the housing market and consumer spending. The figure is the lowest growth quarter-on-quarter for three years.

UK Banking
After a ridiculous rally in UK banks over last week's sessions from a very low level, we will soon have a better picture in the next couple of weeks as to their health.
(interim reporting period starting with Lloyds on Wednesday)
Scenarios:
A) over a year of writing off debt, market believes that they must be somewhere near the bottom
B) further credit writedowns as signaled by Citigroup cutting European banks to "underweight" from "neutral"

Interesting note:
In the four bear markets since 1973, rallies of 10 percent or more lasted an average of 54 days for a gain of 14.5 percent.
In every case, the S&P 500 fell again, dropping an average of 21.5 percent over 114 days.
The same pattern this time would send the S&P 500 to a peak in September before giving way to a slump that would continue until the start of 2009.

Eric Tan, London

Downshift in global growth momentum. Markets for week ending 18-Jul.

- The coincidence of combined financial, commodity, and more recently corporate profitability shocks continues to hammer the global economy.
- Global growth having held up above trend for the last few years is now bringing serious capacity constraints to the global economy.
- Unwinding of the above constraints is rarely gradual or smooth, which suggests that a rapid deterioration is likely to lead to an intensification of the global slowdown well beyond baseline scenarios.
- We are now witnessing negative second round effects through trade flows.

U.K. inflation climbed 3.8 percent from a year earlier, more than economists forecast in June to the fastest pace in at least 11 years.
The high inflation number exceeds the government's 3 percent upper limit for a second month, putting pressure on the Bank of England to avoid cutting interest rates as the threat of a recession looms.

Short-run policy implication: unchanged fed funds rate for some time
Bernanke’s semi-annual Monetary Policy Report to Congress on Tuesday is that the FOMC views the current 2.0% Fed funds rate as appropriately calibrated to restoring acceptable growth and acceptable inflation over the medium-term given the information available today ?

Eric Tan, London

Another deleveraging scenario this summer? Markets for the week ending 10-Jul

Market Update: Standard & Poor's 500 Index fell into a bear market
The benchmark index for American equities plunged to a two-year low on Tuesday, bringing the loss since its October record to 20 percent.
Shares have been declining for five straight weeks, and a drop in the index of another 12 percent would match the average retreat of 11 bear markets since 1946.

Reasons suggesting another deleveraging scenario this summer:
- Nervous investors sell bonds, driving prices down; Traditional bond managers may start losing their clients if they have another poor quarter.
- Hedge-fund managers may find prime brokers cutting off funding if their positions deteriorate.
- Bank loans have been contracting at an annualised rate of 8% over the past 13 weeks to June 25th.
- Fundamentals for the corporate-bond market have worsened since last August.
- Expectations for corporate profits are being revised down, as margins come under pressure from slower growth and higher commodity prices.
- Headline inflation is well above target, so central banks are unlikely to ride to the rescue with interest-rate cuts, preferring to tighten monetary policy.


? Sell Signal : Financials
Fannie Mae, Freddie Mac, speculations runs rife
- Rising borrowing costs spurred concern that America's biggest sources of home-mortgage financing may not be able to fund their businesses.
- Fannie Mae and Freddie Mac fell to their the lowest since 1992.
With $5.2 billion more owed than its assets were worth in the first quarter, Freddie Mac would be technically insolvent under fair value accounting rules.
Implications:Until investors see what write-offs are going to be and second-quarter earnings of financial companies, they're not interested in buying at any price.
Word on the street is that it's been far too early to buy and the loan-loss reserves need to stabilize before investors return to the markets.

Worth noting:
Lehman-LEH put volume & volatility Spike; LEH down 12%
LEH is recently down $2.54 to $17.20. LEH call option volume of 15,588 contracts compares to put volume of 41,549 contracts.
LEH July option implied volatility is at 188, August is at 170; above its 26-week average of 75, suggesting larger risk.

Earnings announcements:
JPM : 17-Jul
MER : 17-Jul
Citigroup : 18-Jul

Eric Tan, London

Steady deterioration... markets for the week ending 27-Jun-08

Tightened credit standards since the last recession is making life harder for existing borrowers and with inflationary worries that are expecting to send interest rates higher again, the banks ability to be flexible is limited because of higher financing costs on the interbank market.

Troubled areas:
- Britain's untested areas of specialist lending, such as buy-to-let and self-certification mortgages, are coming under stress. Analysts expect 23% of the total stock of British mortgages by value is due to reset in 2008, against a mere 4% of stock in America last year.
- Car-loan defaults may grow as drivers decide to throw their car keys in the same dustbin as their house keys as record fuel costs are also guzzling more of consumer's disposable income.
- Untapped loan commitments to corporate customers continue to crowd out space on bank's balance-sheets, estimated $6 trillion overhang of committed lending facilities to be drawn down, most of it at more generous terms than borrowers could get now.

No surprise given the above, that some of the less well-capitalised UK banks ( AL/, BB/, HBOS) have fallen between 61-76% this year

Scenarios:
- Loan provisions increasing
- Credit cycle goes into a prolonged U-shape recovery instead of V-shape
- Flat or negative GDP growth for 2-4 quarters
- ECB and BOE raises rates due to inflationary pressures
- What more? Oil above $170? may not be impossible with summer round the corner.

Economic Update:
- The U.K. economy grew less than previously estimated in the first quarter, weighed down by the weakest services expansion in 12 years. Overall GDP rose 0.3 percent in the three months through March, the least in three years.
- Royal Bank of Scotland Group Plc, the second-biggest bank in Britain, had its credit rating lowered at Moody's Investors Service, which cited ``higher volatility'' in its securities unit and greater risk of loan defaults in the U.K.

Inflation stories:
- Spanish inflation accelerated to the fastest pace on record in June as oil and food prices surged. Consumer prices rose 5.1 percent from a year ago after increasing 4.7 percent in May
- Inflation in Germany, Europe's largest economy, rose 3.4 percent from a year ago after gaining 3.1 percent in May led by surging energy costs. (more than forecasted)

Eric Tan, London

Update: basis risk and credit value adjustments as potential sources of losses

Lots of assets don't have a corresponding index so banks have to mix and match several indexes for your hedges. Some work, some don't.
However when a hedge goes wrong, i.e moves in an adverse direction, you are caught in a situation where you own protection that has cost you more than what's now available in the market place.

Implications
As the value of protections (that you would assume is equivalent to an asset) gets marked to market, hedge-related losses are looking ever more conspicuous as investment banks unveil their results

- Goldman Sachs reported roughly $500 million in losses related to its leveraged-finance positions.
- Lehman Brothers, the big shift in the underlying assets and their corresponding derivative positions played a significant role in its $2.9 billion worth of losses.
- Citigroup on 19-Jun warned of further large writedowns and credit losses in the second quarter
- Morgan Stanley reported $800 million in losses from trading and leveraged loans

Comments:
There's certainly going to be a lot more uncertainty facing the financial markets in the weeks to come. Banks are going to struggle with replacing the record profits made in the yester-years from fixed income structuring with new sources of income. So far, most have jumped onto the Commodities trading bandwagon and Goldman has done particularly well. but with the commodities market fast-becoming crowded and less of an alternative bet to equities/fixed-income, no one knows when the music is going to stop.

Eric Tan, London

More Inflation stories - Markets for week ending 20-Jun-08

- India's inflation accelerated to a 13-year high and stocks and bonds fell on concern the central bank will have to raise interest rates again. Wholesale prices jumped 11.05 percent in the week to June 7, after gaining 8.75 percent in the previous week

- India increased retail prices of gasoline and diesel this month, joining China, Indonesia, Malaysia and Sri Lanka, as a near doubling of crude oil prices pushed up costs

- China, the world's second-biggest oil-consuming nation, unexpectedly raised gasoline and diesel prices by at least 17 percent and increased power tariffs to rein in energy use, potentially driving up inflation.
Implications: Chinese refiners gained, airlines fell on narrowing margins.
Crude prices tumbled more than $4 a barrel on Thursday after the unexpected announcement that China would increase petrol and diesel prices by 18%.

- German producer-price inflation, an early indicator of price pressures in the economy, accelerated to the fastest pace in almost two years in May on energy costs.

- Mexico has frozen the price of 150 basic foods to curb inflation, in the government's biggest set of price controls in more than a decade.

Next week:
Wimbledon - 23 Jun
US June Consumer confidence - 24 Jun
US FOMC meeting - 25 Jun

Eric Tan, London

'Infl-animal' runs amok. Week ending 13-Jun-08

U.S. consumer prices rose 0.6 percent (more than forecasted) in May as Americans paid more for fuel, underscoring the Federal Reserve's concern that inflation will pick up.
The surge in oil and food expenses has caused inflation expectations to rise, stirring concern among Fed officials after they lowered interest rates seven times since September.
Investors expect the central bank will raise rates as soon as August, futures prices show.



Implications/analysis:
If Interest rates are raised?
- Target inflationary pressure
- Avoid wage-price crisis that may ultimately lead to endemic inflation
- Correct prices which have been caused by loose monetary policies and cheap lending. However,
There may be a large impact on Real estate values, investors, lenders and service providers and it may not actually reduce demand much further if people are already cutting back on spending. Another concern on a rapidly deteriorating economic environment means short term unemployment numbers may worsen further..

Justification:
US Retail sales for May did show surprising strength, rising 1 percent

If Interest rates were lowered?
- Provides short term support for asset prices - political agenda?
- Improve business confidence and reduce impact of recessionary pressures
- Further emphasize the effect of easy money...
- Asset prices may become uncontrollable

Justification:
Sudden surge in structural demand for commodities caused by rapidly emerging economies is just a short term blip which may stabilise soon
Jump in energy prices due to speculation

My take is that FED/ECB/MPC will watch the oil prices and the following releases very closely to gauge for an escalated need to tame the loose 'Infl-animal' (couldn't resist coining it, but you saw it here first)

Eric Tan, London

Worth noting this week:
EMU CPI data (euro zone) 16-Jun
US PPI data 17-Jun
UK May retail sales data 19-Jun

Peak Oil ? Markets for the week ending 6-Jun-08

U.K. producer prices increased at the quickest rate in two decades in May, double the median forecast of 32 economists in a Bloomberg News survey. From a year earlier, prices rose 8.9 percent. Core producer prices, which exclude food, beverages, tobacco and petroleum, rose an annual 5.9 percent in May, the most since 1991.
Implication:
Increases the odds the Bank of England will refrain from interest-rate cuts even as the economy edges toward a recession.


After hitting above $139, crude oil for July delivery declined as much as $3.27, or 2.4 percent, to $135.27 a barrel in after-hours electronic trading on the New York Mercantile Exchange. Friday's jump was the biggest-ever oil gain in dollar terms and the largest on a percentage basis since June 1996.
Implication:
Rising oil prices cut earnings prospects for airlines and automakers.
Inflation is now the biggest threat to the global economy as the credit crisis starts to recede
Oil will remain the focus this week.


US Payrolls fell 49,000 in May, the jobless rate increased by half a point to 5.5 percent, higher than every forecast in a Bloomberg News survey.
The U.S. lost jobs for a fifth month and the unemployment rate rose by the most in more than two decades
Implications:
European stocks fell, heightening concern the US economy won’t rebound from its slowest growth in six years.
The dollar traded near a one-week low against the yen on speculation an industry report today will show the worst housing slump in a quarter century is weighing on the U.S. economy.
The dollar was at the lowest in almost two weeks versus the euro .
The dollar traded near its weakest level in 25 years against Australia's currency as investors reduced bets the Federal Reserve will raise interest rates this year.

Eric Tan, London

Market for week ending 30th May 08

Been meaning to start somewhere to share information I've collected from various sources and decided this might just be the start of my feeble blogging attempt. This is "my take on the market".


European Inflation accelerated faster than economists forecast this month as oil prices jumped to a record. The inflation rate in the euro area rose to 3.6 percent, matching a 16-year high, from 3.3 percent in April. Economists had forecast a 3.5 percent rate.

U.S. Consumer Spending Slowed: Increased 0.2 Percent in April as compared to 0.4 percent increase in March - a sign the biggest part of the economy may be faltering.
Higher fuel costs, smaller wage gains and lower home values have shaken Americans' confidence, raising the odds that spending will keep slowing. Government tax rebates may only provide a temporary boost to economic growth in coming months. Incomes grew 0.2 percent, bolstered in part by the government's tax rebates

U.K. consumer confidence dropped in May to the lowest level since Margaret Thatcher was ousted from office in 1990, as people became more pessimistic that the economy will slip into a recession

Retail sales in Germany, Europe's largest economy, unexpectedly dropped for a second consecutive month in April as faster inflation left consumers with less money.

Commodities-wise
- Slump in oil spurred declines in other raw materials. Crude oil lost 3.6 percent this week on signs record prices will slow economic growth.
- Gold headed for its first weekly drop in four in London as oil fell and the dollar rose, curbing the metal's appeal as a hedge against inflation and declines in the U.S. currency.
- Corn heading for the first monthly drop since August, on speculation a stronger dollar and lower energy costs will reduce demand.
- Tin headed for its steepest weekly drop since August in London after stockpiles expanded and investors judged that a record reached this month didn't reflect the outlook for demand.
- Copper rose 0.8 percent, to $7,950 a ton, rebounding from two-month low. Market expectation for softness in copper prices has been realized and view dips below $8,000 a ton as a buying opportunity given tightening concentrate supply
Overall: The dollar's rally has dampened market sentiment for grains and other commodities

Hot off the press:
Billionaire investor George Soros is to tell US lawmakers that "a bubble in the making" is under way in oil and other commodities.
Recent ability of investment institutions to invest in the futures market through index funds is exaggerating price rises and creating an oil market bubble.
Commodity index buying is eerily reminiscent of a similar craze for portfolio insurance which led to the stock market crash of 1987.

Implications
With financial institutions piling in on one side of the market, they have sufficient weight to unbalance it. So, if the trend was reversed and the institutions as a group headed for the exit as they did in 1987 there would be an unwelcomed crash.

Eric Tan, London