A sigh of relieve. Markets for the week ending 4-Dec-09

This week, the world's financial markets started the week beset with concerns about the impact of Dubai World's debt, but took a twist for the better on Friday as U.S. job figures provided the optimism for recovery.

U.S unemployment rate fell from 10.2% to 10% and risk assets enjoyed strong gains on the last day of the week as investors were encouraged by the first drop in since jobless rate since April 2008.

The U.S. dollar rallied as interest rate expectations underwent a dramatic shift. Relative to the Japanese yen, the U.S. dollar rose more than 3.5% as investors focused on the impetus for the Federal Reserve to exit from its ultra loose monetary policy stance sooner than forecasted.

Eric Tan,
London

Dubai Inc - Markets for the week ending 27-Nov-09

Question: What is(are) the key lesson(s) from the Dubai World event?

a) A timely reminder that this is a too-quick-to-be-true recovery for the global economy
b) The decoupling story that emerging markets carries higher growth opportunities deserve to be charged higher risk premiums
c) Risky investments NPV-ed against implied state guarantees carries default risk that are typically underweighted by investors

Answer: All of the above.

Eric Tan,
Singapore

How far will the USD carry trade go?

The combined efect of zero Fed funds rate, quantitative easing, credit easing and massive purchases of long term debt instruments by the US government is resulting in a boon for the USD carry trade and boosting highly leveraged global asset bubbles.

However, if the dollar reverse and start to appreciate, this popular leverage trade will result in a stampede of investors to close their risky asset positions across all global asset classes to cover the short USD position.

This can happen as a) the USD will have to stabilise at some point; b) Fed's asset purchase plan will have to end and volatility will rise; c) US GDP growth may start to accelerate leading to raising of interest rates; d) Global economic worsening resulting in flight to safety of the USD; and e) coordinated intervening of the USD depreciation by emerging economies.

Eric Tan,
London

Domino effects. Markets for the week 30-Oct-09

In the last 3 days, global stock markets corrected with the announcement of ING's breakup. As Brussels set the stage for regulating banks which received massive government help during the crisis, other banking groups are reeling from investor's fright of a domino effect on the sector.

The lessons learnt from giant financial groups to the likes of AIG, Citigroup - too big to succeed, impossible to run and too big to fail are becoming the nightmares of regulators who are entrusted with the responsibility of maintaining market stability and preventing systemic risks.

At the height of the crisis, governments had to approve mega consolidations of banks such as Lloyds and HBOS or JPM and BearStearns. This is probably sowing the seeds of new crises unless regulation is revamped.

With poor economic data released this week, optimism for the future is low. So, investors will have to sit tight as it seems like the next few weeks will be a rough ride.

Eric Tan,
London

At the end of the 1st week of Q3 earning reporting, we have seen the entire spectrum of what to expect in the forth coming weeks.

Goldman and JPMorgan announced stunning results to the world ($3.2b and $3.6b respectively), whereas Bank of America posted a $1b loss as continuing consumer credit hurt earnings. General Electric, the bellwether conglomerate of the US ecnonomy reported earnings falling 47% to $2.5b.

However, most of the attention went to the amount put aside as bonuses for Goldman employees, a whopping $16.7b so far for this year. Given the record unemployment number and poor consumer sentiment, this is going to be hard to swallow for the public, especially as recent as just a year ago, Goldman received help for the government to get it through the financial crisis.

Eric Tan,
London

Parallel Universes

Investors diametrically opposed views on everything in the markets from growth prospects, inflationary fears and deflationary pressures are all causing simultaneous rises in assets.

Since March, we have witnessed a surge in the equities markets. Oil,gold, commodities are rising in antipation of a global recovery. On the other hand, bond yields are falling steadily and reports of US mutual funds are increasing net inflows to fixed income funds. In the world of forex, Australian and Brazilian currencies are reflecting the increase in risk appetite and yet Japanese Yen and gold typically reflecting a safe haven currency are at record highs.

The markets have been reflecting the inconsistent economic data with rising unemployment and recovering growth.

With a strong boost provided by Alcoa earnings, over the next few weeks, US companies is likely to announce strong earnings supported by exports and continued cost cuts, but inability to demonstrate revenue growth may result in a fall in momentum leading to a reality check for investors.

Eric Tan
London

Why waste a good crisis?

This week, London Business School celebrates Worldwide Alumni Celebration 2009. A series of lectures and events are held all over the world. In London, a lecture in Lloyds iconic building fired off a series of events - "Where does it go from here?"

The most interesting idea I personally thought was : Why waste a good crisis?
The panel spoke about how we can see the policy makers doing the "easy-but-irrelvant" bits such as targeting the tax haven status of some economies, or pursue the "crowd-pleaser" bits of slamming bonuses and hedge fund/private equity regulations.

However, the big-big issues have not been formally addressed.
- How should banks be sized?
- Taxing by size to discourage too big to fail financial institutions
- Reviewing the Glass-Steagall act
- Tobin Tax
- Living Will
- Ratings agencies
- Cross border issues

Macro prudential regulations have also not been openly addressed. Spain managed to largely avoid the US subprime crisis by having a countercyclical capital ratio which looks increasingly likely to be adopted in the rest of Europe, but the currently prescription may get nowhere near high enough for it to be effective.

So it seems like there are many thoughts to take away from this week of Alumni celebrations in London Business School, but one thing is for sure, the regulators have a lot more work to be done before this crisis is over.

Eric Tan,
London

A weaker dollar. Markets for the week ending 25-Sep-09

The dollar has been falling steadily against its main trading currencies for the last 8 weeks. So, what does a weaker dollar imply and what kind of policy responses might that provoke in the EU given the euro has more to lose with a weaker dollar.

A super weak USD could risk exporting deflation to the rest of the world
since central banks around the world are now enagaged in managing the recession with a cocktail of a) quantitative easing, b) loose monetary policies, and c) low interest rates and it leaves them very little to combat a sudden appreciation of their currencies against the dollar. This could lead to a liquidity trap and result in them being unable to dig their economies out of a deflationary scenario.

Looking back into the history books, in the last 30 years the world has witnessed several instances of central bank intervention:
1985, G7 signed the Plaza accord to weaken the dollar
1987, G7 pledged to support falling dollar
1995, G7 intervened to help dollar
1998, Americaand Japan sold dollars to prop yen
2000, ECB, Fed, BOJ and UK, Canada supported the Euro.

So, does this mean we're going to see another round of central bank intervention in 2009?
Maybe. Coordinated intervention can work(as seen in the past), but needs to be consistent with changes in interest rates globally.
So why not do it straight away?
Central bankers hate to mess around with free markets, besides it's difficult to predict the precise consequences of interventions.

Eric Tan,
London

Is the worst over for the US economy ? Week ending 14-Aug

This week, the Fed announced that the longest period of US economic decline is coming to an end and the top economic outlook supporting that was that headline unemployment rate in Jul-09 fell from 9.5% previously to 9.4%.

In the US. the monthly rate of job losses in July has slowed to 250,000 from 600,000 at the start of the year, but the statistical computation of unemployment only improved because 400,000 workers dropped out of the labour force and are no longer looking for work.

So, the thing is, if the state of the economy is getting worse at a slower rate than before, can one argue that the worst is over?

I foresee that given the high rates of foreclosure in the US mortgage market and the continuing high unemployment rates, US household income is going to continue to be put under pressure and any economic recovery will be sluggish for the rest of the year.

Eric Tan, London

Investment Philosophy

Strong fundamental analysis on companies has never been more important during these testing times.
A good framework provides some downside protection on portfolio investments which could be competitive advantage against peers.
Here are some useful points I've recently picked up at a talk given by Anthony Bolton, which my opinion even if you’re not a research analyst, can be used as a framework for investment philosophy

1) Companies
- always start by looking at the company
- how good/strong is the franchise?
- note that businesses vary in quality and can change over time
- prefer strong franchise and simple businesses
- what are the key variables that affect the business?
- MEAN REVERSION
2) Management
- Integrity and openness are the most important
- Avoid questionable or untrustworthy management
- Meet them, if possible several times (first impressions may be misleading)
- Has detailed knowledge : Strategically, operationally and financially
- Are management and shareholders interest aligned?
- Do their trades conflict with or confirm their statements?
- People rarely change…
3) Shares
- Every stock you own should have an investment thesis
-Test investment thesis regularly and if no longer valid, sell
- Look at a share price the same way you’d look at buying the whole business
- Forget the price you pay, take a loss to reduce future opportunity costs
- Keep an open mind and know the 'counter' thesis
- Think in terms of conviction rather than price targets
4) Sentiment
- Sentiment is the stock market's extra dimension
- The stock market is both a weighing (time-value) and voting (short term) machine
- In the shorter term, perception is very important
- Sentiment extremes suggest major opportunity or risk
- Stand your own ground but also listen to the market
- Not what you know, but what you know versus what everyone knows
- How many people have already heard this story?
5) Portfolio
- Position size should as much as possible reflect conviction
- Portfolio should be close to a start from scratch portfolio (if you were to start from scratch)
- Don’t pay too much attention to index weights
- Make incremental rather than large moves
- Never become emotionally attached to a holding
- Investment is an odds game and about making fewer mistakes
- Sell if the investment thesis is broken, you lose conviction or you find something better
- Compare new holdings against existing. which is more attractive?
6) Risks
- Win by not losing too often or too much
- Poor balance sheets drives main source of mistakes
- One loses the most in these companies when business deteriorates
- H- Scores or Z-scores (Company watch)
- Look at a stock differently if it does well for several years
- Avoid 'Pass-the-Parcel' stocks, e.g. momentum. Don't be the last one holding
- Poor management and poor business franchise are also risky
- Not just debt, look at pension deficits
7) Financials
- Read the original company documents for important news (IPO and Rights Issue documents are verified)
- Look at the notes to the accounts
- Models are only as good as their assumptions
- Dislike capital intensity
- If in doubt, follow the cash
8) Valuations
- don’t look at only one valuation such as P/E
- Newer valuation methods
- PEGs and Dividend discount models can be misleading
- As bull market progresses, valuation method can become conservative
- Never forget absolute valuation
- Look at today's valuations in context of at least 20 years of history
9) Technical Analysis
- The first thing is the share chart
- Cross check fundamental views
- Find an approach that works for you and use it consistently
- More useful for larger stocks
- Run profits, cut losses
10) Information Sources
- Use brokers
- Meet face-to-face
- Use lots of inputs
- Choose a delivery system (hardcopy/online)
- Use non-broker research e.g. consultants, specialists
- Balance monitoring what you own with working on new ideas and prospects
11) Market timing
- Consistently successful market calls are very difficult to make
- Market is a excellent discounter, anticipates events
- Need to be contrarian to successfully time the market
- Use patterns of history; valuations and sentiment
- Don’t just use economics and think about how your view differ from consensus
- Be most on your guard after a long upward move of four to five years
- Investing is generally for 3 years plus

Eric Tan,
London

US non-farm payrolls: Employers cut 467,000 jobs in Jun

So, given the government stimulus so far, it looks like employment is still weakening and consumer deleveraging, crimping demand.
Reflation efforts by governments worldwide helped boost risky assets such as commodities and equities in the last 3 months and in the process trashed treasuries and bonds.
10-year US benchmark rates rose from 2% at the start of 2009 to a peak of 4% last month, despite the Fed announcing plans to maintain its purchase plans.
Popular belief has it that the negative sentiment is drawn from the potential indigestion of a trillion more dollars of issuances bound for the doorsteps of willing investors in the coming year.

Scenario:
Say Bernanke's "green-shoots" of recovery was stunned by the high oil prices and the economic recovery widely expected by the end of this year doesn't materialise, we could once again face the swings of the oil price cycle and see bond yields revisit the 2% levels.

Eric Tan, London

Impact of China's rise on the world economy.

Impact of China's rise on world economy
1) huge increase in global current account imbalances
2) global decline in nominal and real yields on all forms of debt
3) increase in equity risk premium (gap between earning yield on equities over bonds)
4) increase in global returns on physical capital

1 and 2 can be explained by the global saving glut, loose monetary policies, but a massive increase in global labour supply and extreme risk aversion of creditors from emerging economies explains 3 and 4.

We have seen that the accumulation of net overseas assets are entirely accounted for by public sector acquisitions and channeled principally into reserves.

The global balance of trade and economic power has been tilted by the resurgence of the Chinese economy, and this will have a large impact on global trade and growth in the future. China has already started acquiring raw materials directly by buying into companies with large reserves and will continue to do so in a larger way to secure its vast needs for growth.

We will continue to see the expansion of their growth and there will be opportunities for investors who manage to identify targets that are aligned with the Chinese interests for raw marerials.

Eric Tan,
London

Dr. Friedman VS. Dr. Keynes

This is not a boxing match within the scientific arena nor is it an episode from the popular British science fiction television series.

The Federal Reserve seemed to think that prescribing massive injections of liquidity to avert the kind of banking crisis that caused the Great Depression of the early 1930s (Friedman-style) and coupled with another course of running of massive fiscal deficits in excess of 12 percent of gross domestic product this year, and the issuance therefore of vast quantities of freshly minted bonds (Keynesian-style) will give the economy a double dosage of drugs to pull the patient out of E.R.

But there is a clear contradiction between these two approaches and the central bank is trying to have it both ways.
Question is : can we be a monetarist and a Keynesian simultaneously?

The aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy is to drive interest rates up.
However, both of them have the same objective of trying to stimulate demand:
A) Monetary easing increase the money supply and flows to a liquidity constrained economy and reduces the cost of borrowing, leading also to restoration of credit.
B) Fiscal stimulus from the government replaces the components of our economy that are falling sharply such as consumption, investment, construction, capital spending, inventories, exports etc. when economy is suffering not just from a lack of liquidity but also problems of solvency and a lack of credit.

Real concern is that lenders may start to grow dubious about the financial solvency of governments and that would lead to a fresh push for the interest rates to head north as we have observed in government bond yields this week. After all, $1.75 trillion is an awful lot of freshly minted treasuries to land on the bond market at a time of recession, and we don’t quite know who is going to buy them. It's certainly not going to be the Chinese. Maybe only the Fed can buy these freshly minted treasuries, and there is going to be, in the weeks and months ahead, a very painful tug-of-war between our monetary policy and our fiscal policy as the markets realize just what a vast quantity of bonds are going to have to be absorbed by the financial system this year. That will tend to drive the price of the bonds down, and drive up interest rates, which will also have an effect on mortgage rates, which is precisely what the central banks have been trying to avert.

Bottom-line: lock in your 2.5% mortgage rates for the next 10 years!

Eric Tan, London

Shift in Chinese Economics

With a sharp slowdown in global growth projected by the International Monetary Fund (IMF) for 2009 and 2010, the chinese economy is undergoing a fundamental shift in design. No longer is it expecting the export driven growth to support its economy, but evidence is showing that China is now looking inwards to drive the country's huge capacity that was once known as "the world's factory floor".

The world's most populous country is leveraging its internal demand to propel it's economy. Indicators showing year on year increases in domestically bound cargo is driving corporates to make a rush to capture the spending power of inland consumers in sectors. Retail sales number have held up and property transactions are surging across the country. China's plan to implement a healthcare reform of $125bn will raise disposable income and reduce need for high saving levels.

If China suceeds in unlocking their domestic demand and coupled with a Rmb4tn fiscal stimulus, it is increasing positive that they have seen the worst of the financial crisis.

Eric Tan, London

Can spending hold up?

Overview of the the current state of the US economy

The American economy is contracting at its steepest pace in 50 years, the government reported on Wednesday, but an unanticipated rise in consumer spending since January suggested to many economists that the worst of the recession might have passed

Output fell at a 6.1 percent annual rate in the January-through-March quarter after falling at a rate of 6.3 percent in last year’s fourth quar
Analysts are expecting that as tax breaks and government stimulus spending kick in, the decline in the gross domestic product could be cut in half by summer by federal spending and on various small windfalls for consumers

The looming question remains the severity of job losses. More than five million jobs have disappeared since the recession began in December 2007. As their wages disappear, households spend less, and business, in response, reduces the output of goods and services, cutting more jobs in the process.

Eric Tan

Thoughts on being "cautiously optimistic" on the economy.

Key question to ask: Can an inventory-driven recovery in output, alongside aggressively expansionary monetary and fiscal policy, generate enough optimism among consumers, producers, and lenders to make the recovery sustainable for more than a few months?

any thoughts ?

PPIP: A Stampede on Thin Ice. Markets for the week ending 27-Mar

The S&P 500 Index rose more than 6% this week as hope mounted that the worst might be over for the banking system and a turn of the broader global economy is on the way.

As US released more details of its Public Private Investment Plan (PPIP), the US stock market surged 7% overnight but fears on the viability of the plan and likelihood of participation from banks were the main concerns.

My take on the new release is that the US is taking on a "do-everything-it-takes" attitude to rescue the economy and that should set the right tone for investors and stabilise the markets but ultimately it is not the pricing of the legacy assets and loans that will turn around the lack of confidence, but the greater transparency that is attached to this move that will allow the big banks to raise sufficient capital from private markets (in the range of hundreds of billions more) that will call an end to the crisis.

A couple of issues need also to be addressed to stop the economy from spiralling down further:

a) Distressed home sales: Without a clear sign of the bottom of falling house prices, risk appetite will not return. Hence, finance for viable borrowers with sound leverage need to be earmarked to help establish a floor for home valuations

b) Deleveraging of consumer : UK household savings rate jumped from 1.7% in the third quarter of 08 to 4.8% in the fourth quarter. Although rebuilding and repairs of the household balance sheet will bring balance back to the debt-fueled decades of 90's and early 2000's, the governments also need to ensure consumer credit is freed up to improve liquidty for the people. This is not to fuel another debt spending spree, but to inject consumption back into the economy and pull it out of a longer than expected recession.

Final words, Stabilisation is still not equal to Recovery.

Eric Tan, London

How is Gold a play on quantitative easing and debasing of currencies ?

Gold in itself is a relatively smaller market, and say if the market starts to have doubts that Obama will not be able to halve the US deficit by the end of his first term, investors may start to shift their reserves into gold. So let's expand this exponetially to say China or the Middle Eastern states start to do the same with their reserves, we will certainly see new levels of gold prices.

Hence a bet on gold is essentially a bet against all paper currencies and against all central banks, and that seems to be a bet put on by several hedge funds including Paulson's now.

If the Fed is forced to debase the USD because of increasing prospects of deflation or inflation, UBS's forecast of $2500 per ounce gold prices, may not look impossible..

Eric Tan, London

Are we witnessing a possible turn? Markets for the week ending 13-Mar

So it's true. After I commented last week about equities appearing to look cheap, the market has gained several more percentage points. The thought on most investors mind is whether this is another bear market rally or does it signal the possible turn of the bull market.

Anthony Bolton, President of Investments at Fidelity, has called for a bottom in stock, although he did make the same call late last year. My personal opinion is that the economy is not out of the woods yets and this is highly probable to be a bear market rally that may fade in investor memory in time to come.

Bear market rallies are often short and explosive in nature and it's not uncommon to see bounces in excess of 10 percentage points on the stock market indices. I believe that last month's low will mark a temporary floor for global benchmarks and indices may trade sideways, hence it might not be a bad idea to start making some investments in the Equity market although it is most likely moving too early.

Some analysts are still reiterating that the CAPE (cyclically adjusted P/Es) ratios of companies, are still expensive and markets may fall further, but it is very dangerous to time the market and if you are planning to invest for the long term, current valuations appear relatively cheap.

My take as I've mentioned in previous posts is that if you agree property values have stabilised, i.e. levels of personal wealth no longer falling, we should start to see a return of risk appetite in the equity markets and that should initiate the turn of the bear to bull market.

Eric Tan, London

Grantham of GMO urges

If you are a fan of Jeremy Grantham's quarterly letter to his investors, you might be interested to know that he is now urging investors to shift cash into the stock markets.

Grantham dubbed a "perma-bear" for having a negative view of the stock market for 10 years, and correctly predicting the end of the dot-com era and foreseeing in 2007 that the credit bubble would lead to collapse of banks and hedge funds. He reversed his decade long bearish stance on stocks and expects it to return 10-13% in the next 7 years. Grantham recommended investing in a few large steps instead of all at once as it would be impossible to catch the bottom of the market. His fair value estimate of the S&P500 index is 900.

My take is that, the S&P500 currently projects 2009 earnings at $48.10. Given the long term (last 20 years) average earnings of 19.4 it traded at, the current fair value can be estimated at 933. However, in the last 20 years, we've been in a bubble for more than half the time, hence maybe an average earning of 15 would be more conservative, and that would estimate fair value of S&p500 index at 721.

As I am writing this, the S&P500 has already risen more than 6% today to 719, but I would still support Jeremy Grantham's urge to start shifting cash to stock in stages and this is definitely a attractive level on valuation grounds to put your money into the stock markets.

Eric Tan, London

Why Go Long Equities? Week ending 6-Mar

It's true, hedge fund redemptions are still going on. A total of $73bn was redeemed from hedge fund managers in Jan 2009. Given the need to meet client redemptions, highly liquid asset classes such as index futures seem to be the obvious choice for hedge fund managers.

But having witnessed the sharp falls in world equity indices in the last 2 weeks, we wonder what the impact would be on hedge fund performance. HFRX reported dismal Feb-09 results for equity strategies.

I believe this can be partially attributed to the high cost of hedging. Put option interest has been declining since Nov 08 due to higher costs - it costs approximately 25% to purchase a 12 month at-the-money put on SX5E. So implicitly it costs the same amount to buy a put as the estimated downside of the position, and if historically bear market rallies provide a 50% upside, the cost of hedging would have consumed 1/2 of the potential profits.

It would be interesting to find out the average level of protection put on by equity-based hedge funds...

Eric Tan, London

Will supervision solve the crisis?

Yesterday's problem: Banks that are too big to fail..
Today's worry: Institutions that are too "interconnected" to fail..

The last 2 decades of financial imagery and innovation, combined with globalisation has created a financial system with entities that are connected in unimaginable ways. This interconnectivity has been raised by Trichet that there is an impending need to extend regulatory and supervision oversight to "systematically important" financial institutions.

In the last century, supervisors and central bankers have conveniently and neatly grouped financial institutions into Banks and Non-banks, but the over-simplistic approach to non-bank financial institutions is now deemed to be obsolete. Hedge funds, credit rating agencies, credit default swaps, structured investment vehicles and offshore centres are areas highlighted by Trichet as requiring more regulation and supervision. The role required is likely to include more monitoring, and analysis of financial stability, developing early warning systems for risks to the financial system, conducting stress testing exercises and advising on financial regulation to improve stability.

Whether how Trichet's proposals will tie in with what the Obama administration has in mind is likely to take months to thresh out. It may ultimately lead to a super agency and the list of headline-screaming reforms will definitely have an impact on both financial markets and investor confidence. But whoever's in charge should keep in mind that the one size fit all approach from policy makers across both sides of the atlantic needs to manage the increased supervision without stifling innovation.

Eric Tan, London

A Eurozone Growth Decline. Markets for the week ending 13-Feb-09

Markets:

- Global equity markets suffered sell-offs as optimism turned to scepticism. Evidence of a deepening recession and doubts on the US stimulus package were the key drivers.

- Government bonds benefited from the shift away from equites this week

- Sterling was among the major losers in the currency markets. Bank of England unveiled a stark assessment of economic outlook and signalled that it would embark on quantitative easing policies. The pound fell 2.6% against the dollar and 1.9% against the euro.

- Commodites-wise, oil (US light crude) tumbled 12% after the International Energy Agency forecasted bleak demand, while gold rose to test the $950/ounce level on investor flight to safety.

Eurozone's dilemma

-Eurozone's gross domestic product (GDP) fell 1.5% in the fourth quarter of 2008, led by a sharp deterioration of the German economy. The data show the challenging economic circumstances across the whole of Europe
- German GDP contracted 2.1% which was significantly faster than the UK although Germany had no housing bubble.
- The European Central Bank (ECB) is widely anticipated to cut its rate by another 0.5% next month to 1.5%, - its lowest rate ever.


Eric Tan, London

Markets for the week ending 6-Feb-09

Markets

- US markets rallied despite news that the US economy shed almost 600,000 jobs in January. Market assumed that the job losses would strengthen the president's hand and ensure that the stimulus would go through.

- US financial stocks enjoyed spectacular gains on the close of the week as investors looked beyond the bleak economic data and focused on Obama's plan to shore up the strickened sector.

- In Asia, Shanghai composite share index rose almost 10% this week on hopes that China's economy could see an early recovery

- The sterling pound continued recovering against the euro after the markets welcomed Bank of England's interest rates cut of 50bps to 1%, and the ECB left Euro Area interest rates unchanged at 2%.

Comments

European Central Bank made clear on Thursday, (as the Bank of England slashed UK interest rates by another half a percentage point) that zero per cent rate policy would be inappropriate “at the moment”, but his remarks did not rule out the ECB eventually following the US Federal Reserve, which has moved rates close to that level.

Sterling has climbed to a 2 month high against Euro after weeks after coming close to a whisker of being parity with the Euro.

This week, we also witnessed Unilever and GSK announcing that they will not be providing financial guidance for this year. CEO of Unilever is of the opinion that setting a target and subsequently revising them would lead to a decrease in credibility in the company.

Defensive companies had outperformed the market significantly in the last quarter of the 2008, but with them off their recent highs this week, it has given investors a wake up call that there aren't many more places to hide.

As investors continued to flock to the safe haven asset class of gold, Goldman Sachs, Merrill Lynch and UBS have dramatically altered their earlier forecasts and are all now predicting that the gold price will hit at least $1,000 an ounce this year, up from previous estimates of $700.

Interests in dividend swaps have been stirred up recently and it might be interesting to look at my article posted on 22-Jan-09.

Eric, London

Time to Look at Dividend Swaps?

With 2012 and 2013 dividend swaps priced at the 55-65 levels, let's look at some of the main drivers which are pushing dividend swap levels significantly lower than the current stock markets are:

a) Banks are cutting dividends or are in no position to pay dividend post-full or -partial nationalisation by government bailouts.

b) Concerns over macro-economic conditions that might affect many companies' ability to maintain dividend levels at the pre-crisis levels.

c) De-leveraging and unwinding of such trades by hedge funds and proprietary trading desks due to losses from other asset classes and pressure from investor redemptions.



Why it may look attractive:

a) Markets are pricing in zero dividends from the financial sector and construction, auto sectors and almost 30% cut in all other sectors.

b) Implied levels look extremely low compared to historical averages, although there is a risk of a longdrawn/prolonged recession.

c) Potential macroeconomic recovery by 2010

d) Cash dividends may resume to restore investor confidence



Given that the dividend swap levels for are so low in absolute terms, the long term risk reward looks attractive.

Eric Tan, London

How do you shrink the house of cards? Markets for the week ending 16-Jan-08

The FT economists forum was quite interesting this morning and I thought it was quite a good idea to put that in perspective with what the governments are adopting to deal with the current crisis.

Q: With the US official interest rate at close to zero, is monetary policy running out of ammunition?
People are confusing the 'level of interest rates' with the 'rate of change of the interest rates', hence are focusing on America's inability to lower interest rates further.
But cheap money itself provides a strong incentive to borrow and spend and raise discounted cashflow calculations of asset values
However,
1) There is an imperfect linkage between the official interest rates and the actual range of borrowing rates offered in the market
2) Borrowers further out in the yield curve, which hasn’t fallen as much has less to benefit (10-year US Treasury rates has fallen only 2% compared to the Fed fund rates which has fallen 5%)
3) Banks may not be in a position to lend for various reasons such as shortage of capital, dissapearance of commercial credit market

So, can ZIRP (zero interest rate policy) help ?
- Yes:
A) Central banks can push out as much base money (Issuing bonds) as they want to at close to zero rates.
B) Governments can use the money raised to buy longer dated government paper to push down the yield curve to partially address 2) above
C) The money can buy undervalued assets that are clogging illiquid markets from banks and add much needed capital to their balance sheet, addressing 3)
D) The same money can fund expansionary fiscal policies such as improving infrastructure, providing insurance or guarantees to banks and companies

Comments
But the above does not do much to fix the problems happening in the banking sector. The government wants to maintain a flow of lending to help good companies, but how can they distinguish between the good and toxic assets at the micro level.

The UK government has just announced more help for Royal Bank of Scotland this morning but short of nationalising the banking sector in the UK, the regulators are going to find their hands tied on how to shrink the banking sector to a realistic size while not fully recognising the large amounts of mis(over)-priced illiquid assets still sitting in the banking books of financial institutions that have yet to be marked to market.

Something positive
On hind-side for UK, not being part of the Euro might just turn out to be a blessing this week as the European nations in the EU battle to rescue crumbling credibility of the Euro as the Irish economy worsens and Spain's soverign rating downgrade from AAA to AA+. At the rate this continues, it is not impossible to predict a default of posibly a large European economy. (Other at risks: Greece , Italian Portugal)

Eric Tan, London

The Psychological Profile of a Downturn. Markets for the week ending 9-Jan-09

Economy:
The U.S. Economy Lost 524,000 Jobs in Dec 2008,
Unemployment Jumps to 7.2% Jan 9, 2009
Non Farm Payrolls declined by -524,000 in Dec 2008. Oct and Nov job losses revised up to -584k and -423k.
Unemployment rate rose from 6.8% to 7.2% (15-yr high).
Total 2.6 mn jobs were lost in 2008 (most since World War II).
Households Survey: 806,000 jobs lost in Dec; 3 mn in 2008 (most since 1945)
Continued job losses in manufacturing (-149k), construction (-101k), residential construction (-87k), services (-273k), finance (-14k), retail (-67k), business&professional services (-113k), leisure services (-22k), temporary help (-81k). Job gains in govt. (+7k), education & health (+45k)

Psychological Profile of a Downturn
The massive debt accumulation that drives up prices of assets means, that when the downturn comes, previously optimistic investors are forced to sell assets to raise money. That factor tends to make the downward spiral steeper than the upturn that preceded it. Over the past 60 years, nine of the 10 biggest one-day percentage moves in the S&P 500 were down.


Market participants hoard and protect wealth as they pay down the accumulated debt. This reduces economic transaction velocity, restraining demand for the bubble asset, further increasing the inventory oversupply. And so it goes until the inventories decline near sustainable levels, giving market participants confidence to put their money to work.


Investors look ahead to an improved segment of the economic cycle and begin to adjust asset valuations. More participants enter the fray, seeking higher returns for their cash hoards, and economic activity returns.

2009: Still Underweight Banking? Week ending 02-Jan-09.

Markets

Grim UK economic data drove government bond yields to a fresh low of 0.95 per cent last week.

Ahead of next week's BOE monetary policy committee meeting, the 2-year gilt was affected by an expectation of at least half a percentage point.

a) UK mortgage approvals in Nov hit 27,000 loans, lowest on record

b) Halifax data showed a 2.2 per cent drop in house prices in December 08

c) Bank of England's credit conditions survey showed that banks were cutting the supply of debt to businesses and consumers

Looking back at 2008,

it was easy to claim that the crisis we've tripped ourselves over was largely a crisis of confidence which is unlikely to untangle easily. The spillover into 2009 would most probably be in the form of more business failures (we have seen Zavvi, Woolworth's and Whittards capitulating in the last weeks of 2008) and higher bad debts (credit card loans, mortgages) from recessionary pressures.

Retail banks in the UK and around the world have been used to low levels of bad debt provisions due to a 10-year bull cycle of rising home values and economic growth, but in this new/weaker business environment, banks would have to act fast to raise equity. For those unable to, they will have to resort to balance sheet deleveraging which directly contradicts the UK government's adopted expanionary policy to increase lending.

Many can now claim that investment revenues were actually driven by unsustainable risk taking and dangerous levels of leverage, and with the shift of power from the trading room to corporate and retail banking, we can safely expect less revenues from M&A advisory and proprietary trading. Maybe investment banks can encroach on the business of advising the sale and restructuring of troubled businesses, but that is already a crowded arena with many specialists.

Therefore in 2009, I can safely predict that banking and financial stocks will still underperform the wider "real" economy, but that's something for next week.

Eric Tan, London