 |
China Outlook in 2008
This year will be a very challenging time for Beijing policy makers, considering headline consumer price inflation is now topping 6 percent, domestic stock and property markets have shown clear signs of a bubble, and both credit and investment activity are growing excessively. An aggressive, tightening monetary policy is the obvious choice to slow things down, but that road is lined with potential potholes no one wants to drive over.
The official wording of the 2008 monetary policy from the People's Bank of China (PBoC) was recently changed from the previous "prudent" to "tight," but top political leaders have also made it perfectly clear that the government's main economic goal continues to be focused on the mantra: "Maintain steady and fast economic growth." Accomplishing this mandate will be far more difficult to implement this year than any other time in the previous five years, which is now considered to be the goldilocks phase of the business cycle in China. With exports accounting for nearly 40 percent of GDP, and the U.S. still a top destination for Chinese exports, the possibility of a U.S. recession would cause a major disruption to the local economy and PBoC policies. While last week's 75 bp Fed ease (interest rate reduction) has helped to stem the immediate decline in global equity markets (including Hang Seng and H-shares) and softened the possibility of a "hard landing" recession in the U.S., the ripple effect of widening interest-rate differentials between the U.S. and China might lead to a new round of investment and its associated inflationary pressures.
It's been estimated that even a slowdown to zero growth in the U.S. could cut China's exports by half — to below 10 percent this year. Under this scenario, an aggressive tightening policy could kill domestic growth and result in millions of workers losing their jobs, which isn't the outcome political leaders want to see when the world's attention will be on China at this summer's Olympic games.
Last week Q4 2007 real GDP growth and the December CPI figures were announced. As expected, GDP moderated to 11.2 percent year-over-year from 11.5 percent year-over-year in Q3 2007. The softening was mainly driven by slower growth in trade surpluses, which decelerated to 12.2 percent year-over-year in Q4. The headline CPI inflation number also moderated to 6.5 percent year-over-year in December (from 6.9 percent in November) and was mainly due to high base effects and sequentially moderated growth in Q4. The underlying inflationary pressures remain significant and risks remain high that CPI inflation will rebound in the coming months, and could be exaggerated if the Fed continues to ease and China continues to tighten the reserve requirement ratio (RRR).
Despite the moderation in activity growth in Q4 and lower year-over-year inflation in December, the government is likely to maintain its tightening stance until they see clear signs of a softening in the inflationary pressures. The expected monetary package currently in place includes strict orders from the PBoC for commercial banks to abide by the lending targets (Rmb 3.6 trillion in new CNY loans for the whole year and no more than 35 percent of the annual target in Q12008), moderate appreciation of the CNY (an expected 10 percent appreciation in 2008), further withdrawals of liquidity via open market operations, and regular hikes to the RRR (currently at 15 percent). There is already evidence that at least some commercial banks have already extended significant amounts of loans in the first few weeks of the year. This could pose further upward inflationary risks and further policy tightening.
Again, given the importance of maintaining a prosperous economic picture this year, the leadership is likely to want to make reducing the risk of killing growth its top priority. The perception of tough talk about policy tightening, and any radical action, such as a currency shake-up, still seems unlikely in 2008. Even moderate tightening measures mentioned above (new loan curbs and rate hikes) are likely to be implemented carefully so as not to slow growth too much. Overheating and inflation are a real concern, but some policy makers seem to believe that supply-side policies (so far the major driver for rising headline consumer price inflation in China) can help check food inflation, which traditionally is considered the domestic consumer's top concern.
Although considered a bit of a macro-economic solution to China's current financial strains, a long-held view has been to encourage capital outflows out of China in order to resolve the problems of excess liquidity and overheating. Although Beijing continues to deregulate capital controls on outflows, authorities also continue to encourage domestic enterprises to expand overseas through easy access to credit and foreign currency funds. With developed economies slowing, Chinese manufactures will have to increase their penetration of global emerging markets to fully utilize their capacities, which will also require further investment in local distribution networks. High energy and resource prices should also encourage Chinese corporations to increase their outward investment to secure the supply, leading to a new wave of outbound investment in these areas. The additional ongoing subprime crisis presents opportunities for Chinese financial institutions to acquire much needed global expertise and market footholds as well.
In summary, the most important macro question in 2008 for China will be the behavior of inflation and if the policy responses work as intended. The 5-year business cycle with fast growth and low inflation is clearly behind us, leaving rising capacity utilization, increased labor costs, and escalating inflation pressures. An evolving global picture will most likely dictate PBoC policy choices; but in the end, pointing to a double digit growth number will be the top government priority.
— Mark Noble, Senior Advisor, SVB Silicon Valley Bank's Global Financial Services
|
 |
SaaS: The New ASP
Although corporations may reduce IT spending in this slow economy, Software-as-a-service (SaaS) companies may be recession proof. SaaS companies offer corporations low-cost Internet-based business process software and have also been successful selling to the growing small- and medium-sized business market (SME). Experts believe companies that specialize in software for specific business processes will see steady demand. During downturns, businesses typically cut large-scale capital expenses, but they don't do away with services that manage vital functions, such as payroll, travel, communications, and sales. (Forbes)
Rx Plays Tag
A new California law will make the state the first in the country to require electronic tracking for prescription drugs as part of an effort to combat the $40 billion global counterfeit drug trafficking trade. The law, scheduled to take effect in 2009, may be delayed until 2011 to allow the drug industry time to get the necessary systems in place. Each bottle of prescription drugs will be assigned a unique serial number, so that each entity (manufacturer, wholesaler, pharmacy) who transfers the drug would record that transfer with an addition to the drug's electronic record, or e-pedigree. Suspect drugs would be embargoed. (San Francisco Chronicle)
Disrupt This
Among the many promising innovations, Forbes has identified likely candidates for breakthrough or disruptive technologies. GPS chipsets targeting third-generation (3G) cellular networks will probably see significant advances over the next 12 months. Convergence of molecular biology, nanotechnology and genetics presages some notable breakthroughs in medical diagnostics and treatment. Personalized medicine is enabling drugs to more precisely deliver to target sites, thereby increasing net potency and reducing toxicity. Honda's release of 500 hydrogen fuel-cell powered FCX Clarity and corresponding release of its Home Energy Station Unit provides the first alternative energy vehicle with fueling infrastructure that may kick start the alternative fuel industry. (Forbes)
Biotech Healthy, Faces Fed Scrutiny
California's biotechnology industry is growing steadily, but the possibility of increased government oversight could stifle new drug development, according to a report from The California Healthcare Institute. California biotech businesses and research generated $73 billion in revenue in 2006, up almost 20 percent from 2005. Biotech firms, including medical device and diagnostics companies, garnered over 40 percent of the $7.4 billion in biotech venture capital and the National Institutes of Health granted $3.3 billion to California researchers. However, the industry faces challenges from market saturation of top drugs, an overly crowded startup pool that is difficult to sustain, and the proposed expansion of the government's role in determining which drugs are cost-effective. (AP)
VC Investment at 6-Year High
Venture capital investments in U.S. companies continued a steady climb in 2007, reaching $29.4 billion , an 11 percent increase over 2006 and a six-year high according to the National Venture Capital Association and PricewaterhouseCoopers MoneyTree report. The money went into 3,813 deals, representing the busiest year for venture investing since 2001. Venture firms reported raising $34.7 billion in 2007 for future investments, up 9 percent from 2006. (San Jose Mercury News)
PE Litigation Growing
The private equity industry faces the threat of increasing litigation. Several recent cases have been filed over proposed buyouts, by both shareholders and competing bidders, relating to the mechanics of the transaction at issue or whether the directors obtained the highest price and made full disclosures to shareholders. Other cases involve industry practices and allegations of fraud, including antitrust investigations, disputes between private equity firms, disputes between bankruptcy trustees and private equity firms, and a dispute between a private equity firm and a law firm. These cases are typical of a maturing industry where competition is heated, business risks are high, and returns are pressured. (VentureWire)
|
 |
Do you enjoy the ISO each week? Share it with colleagues or peers. Invite them to sign up using the link below.
|
|
 |
|
January 28, 2008
Zut, Alors!
It isn't hard to picture some Inspecteur Clouseau type poring over the books at Société Générale on January 19, jumping up, hitting his head and screaming the exclamation above. As the trading world now knows, that was the date they discovered the shenanigans of one Jérôme Kerviel. Monsieur Kerviel was an earnest-but-misguided junior trader in their equities department who had not only mastered the execute key on his terminal but had intimate knowledge of the inner workings of the bank's back-office compliance and risk management systems. For reasons yet to be fully explained, he combined these two skills to amass a €50 billion long position in euro-equities that was briefly a winner but fell badly in the red with the early January market sell-off. The odd bit is that apparently young Jérôme had no financial motivation to perpetrate the alleged fraud. (We reserve judgment on that one until his profit-making counterparties are identified.) According to early reports, total losses exceed €4.9 billion ($7.1 billion), with €2 billion coming from the rogue trading and the remaining €2.9 billion resulting from the ham-handed way this French banking icon sold its way out of the fix.
The heavy selling by the French coincided with weak markets in Asia on Monday and drove the early Tuesday euro indexes off a cliff. With the DJIA and S&P futures indicating a calamitous opening, Chairman Bernanke announced his historic 75 basis point inter-meeting easing. The perception was that the Fed was attempting to offset those turbulent markets before the disease spread to the U.S. It's difficult to overstate what a dramatic shift that was for the Fed. In the past, the Fed would intervene if markets stopped working, prices become discontinuous, and liquidity vanished. Their intervention in the '87 crash and after 9/11 were classic. In this case, markets were trading normally (granted, investors were losing trillions — $5 trillion globally to be exact since January 1), but it's not a central banker's responsibility to reverse losses in the equity markets. In an op-ed this week The Economist noted, "the Fed seems to have been spooked." Is it possible that the central bank of the world's largest economy was battling the ghost of a low-level rogue trader in Paris? Think of it as the ultimate butterfly effect.
The brief rebound after the initial slump in New York quickly faded. It was the actions of a little-known insurance regulator that finally brought stability by working to shore up the monoline insurance companies that guarantee municipal debt. Notably, the other central banks looked askance at the Fed's action. Jean-Claude Trichet, another Frenchman and head of the European Central Bank, asserted that, "Particularly in demanding times of significant market correction, it is the responsibility of the central bank to solidly anchor inflation expectations." Indeed.
Now the Fed has a daunting problem — to recover its credibility and stature in the financial markets. Whether the assertion about a "spooked Fed" is accurate or not, it is the perception. And in times like these, perceptions quickly become the operative reality. At an annual economic forecasting dinner in San Francisco last week involving 150 money managers and financial analysts, the disdain heaped upon the Fed during the cocktail hour was embarrassing. One of the featured speakers noted that in his 30 years experience, he had never seen such a panicked reaction to activities "in foreign markets." I hadn't heard comments like that since the days of the Great Inflation under Fed Chairman Bill Miller in the late 1970s.
We had often wondered how an academic without street experience would fair at the controls of the Federal Reserve. Readers of these pages will note that we have flip-flopped on this question ourselves. First, we thought that he would be immune from the ebbs and flows (and sometimes stormy seas) of the trading floor resulting in a more stable policy focused on the long term. Now we feel that years of experience in the passive-aggressive world of academia was not the best preparation for the daily billion dollar warfare of the global bond market. We want the central bank to be the source of "sang-froid" as street traders ride their emotional roller coaster. It may take a while, but we trust they will recovery a sense of proportion using economic data and insight as well as intuition in their decision process. This week's FOMC session will be another difficult test.
Anything Can Happen Now
The Bloomberg survey of economists is predicting another 50 bps cut in rates this at this Wednesday's FOMC meeting. That makes it 1.25 percent in eight days. The Fed Funds futures are aligned as well. So what will it be? We don't have a clue.
Short rates fell fast on the Fed move. The 4-week bill is at 2 percent. The 2-year bond dropped below 2 percent before settling back to 2.23 percent. The rate on the 30-year bond fell to an all time low of 4.10 percent — and they've been trading those bonds since 1977. The move prompted selling by bond mavens, so I guess we have set a floor.
In the real economy, fear and loathing has taken hold. How do we know? The two parties in Washington, who had been squabbling like felines and canines, put together a $150 billion rescue package in record time. Rumor has it that helicopters will be returned from Iraq to speed the distribution of the checks. We worry that this legislation will prove out the theory that the quality of lawmaking is inversely correlated to the time it took to send the bill to the White House.
Google the phrase "recession 2008," and you get 144,000 hits. The debate has shifted from "if" to "when" and "how bad." The housing market continues to dissolve with existing home sales off another notch. The average price trends look positively awful and accelerating. We need to constantly remind ourselves that a median number says almost nothing about a data set as large and complex as the U.S. housing market. Remember that the market for real estate is local and in the last few years builders were creating enough condos for every man, woman, and child to have their own. Today, vast numbers of those properties are now as worthless as a strip mall in Enid, Okla., in 1982, but that fact says little about the value of the house next door.
End Note
Denis Kucinich dropped out of the race to become the presidential nominee for the Democratic Party after his loss in Nevada where he received five votes (26 less than "uncommitted"). He said that he would not endorse any of the remaining contenders. There were audible sighs of relief at Clinton and Obama headquarters.
— Jim Anderson, Editor
Investment Strategy Outlook is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates.
|
|
|
|
New-Home Sales at 12-Year Low
Purchases of new homes in the U.S. unexpectedly fell to a 12-year low in December, ending the worst sales year since records began in 1963 and signaling little prospect for a recovery. Sales decreased 4.7 percent to an annual pace of 604,000, the Commerce Department said today in Washington. The median price dropped 10 percent from December 2006, the most in 37 years. The median price of a new home fell to $219,200 in December from $244,700 a year earlier, today's report showed. For all of 2007, the median price rose 0.2 percent to $246,900. (Bloomberg)
Bernanke Expected to Cut Further & Faster
Fed Chairman Ben Bernanke has decided inflation concerns have faded enough to let him cut interest rates further and faster to keep the U.S. from tipping world economies into recession. "Now they are free to move very aggressively," said New York University professor Mark Gertler. The Fed's emergency rate cut last week signals a dramatic shift by policy makers from inflation to growth concerns. It indicates they now see a risk of lower home and stock values feeding back into tighter credit conditions that threaten to choke off growth, economists said. (Bloomberg)
Global Recession Risk Grows
The U.S. economy may already be in recession; other countries might not be far behind. Japan, Britain, Spain, and Singapore (which together represent about 12 percent of the world economy) are vulnerable as fallout from the U.S. continues. Even emerging markets, including China, are likely to suffer as exports to the U.S. wane. The result: global growth may decelerate close to the 3 percent pace economists deem a worldwide recession, from a 4.7 percent rate in 2007. "Some form" of global recession "is inevitable at some point," former Federal Reserve Chairman Alan Greenspan said in a speech in Vancouver last week. (Bloomberg)
|
|
Auction-Rate Securities Defying Cash Classification
Corporate finance managers are starting to find themselves cash-strapped by one of the very financing tools they use to manage cash flows. Auction-rate securities, touted by sellers as a highly liquid cash management strategy, have been hit by the credit crunch and some are failing to attract enough bidders. For companies, the result is that cash once thought to be readily accessible may be locked up indefinitely. Auction-rate securities are municipal bonds, corporate bonds, and preferred stocks whose rates, or dividend yields, reset through periodic "Dutch auctions," which typically happen every seven, 28, or 30 days. (Reuters)
Emergency Rate Cut Made without Knowledge of SocGen Loss
Federal Reserve policy makers didn't know about a $7.2 billion trading loss at Société Générale prior to last week's decision to sharply cut interest rates, said a Fed official. The Federal Open Market Committee voted to cut the federal funds rate by three quarters of a percentage point, the most since the Fed began using the rate as its main tool of monetary policy in 1990, to 3.5 percent. Chairman Ben S. Bernanke and his colleagues concluded that losses in financial markets may result in reduced credit for companies and consumers, the official said. (Bloomberg)
Investors are Betting on Agencies vs. Treasuries
After the best annual start for treasuries since 1998, investors are now betting the highest-rated mortgage and corporate bonds will outperform as the Federal Reserve cuts interest rates. PIMCo., manager of the world's largest bond fund, and BlackRock Inc., are dumping U.S. debt following a rally that produced $120 billion in gains. The yield on the 30-year Treasury fell as much as 18 basis points to 4.10 percent last week, the lowest since regular sales of the bonds began in 1977. Mortgage bonds guaranteed by Fannie Mae and Freddie Mac yield 97 basis points more than treasuries on average. (Bloomberg)
|
|
|
|
Print Version 
