Japan - A decade of lost glory!

Japan pioneered technology - be it cars, music or televisions and earned heavy royalty through exports. Also a strong tariff policy protected home market from imports which pumped up the yen and led to a massive buildup of new found wealth among consumers & government. Liquidity was high, which spawned an era of easy money, and that fueled a frenzy of stock-and-real estate speculation unrivaled since the U.S. Great Depression. Clearly the market manias were ignited by ridiculously loose credit policies.
Almost overnight, the newly wealthy Japanese were viewed with fear. Japanese cars filled American roadways and Japanese-owned companies started buying out US companies overnight – remember Universal, Columbia pictures…
At the peak of the frenzy, a piece of land at Imperial Palace in Tokyo was more than the value of the entire state of California - which defied all wisdom & senses, but which was mathematically correct as prime office space was going for $139,000 a square foot in Tokyo’s Ginza district, way back in 1989!

But “Irrational Exuberance” is “Irrational” after all. Japanese financial system, especially banks tumbled & Japan couldn’t even overcome 10 years of stagflation. 10 years of lost glory!
In Dec 1989, Nikkei 225 Index topped out at around 39,000. By September 1990, it had nearly been halved. Nikkei ultimately bottomed at 7,830 in April 2003. It hangs around 12,700, still down 67% from its trading high 19 years ago).
The fallout from that meltdown was incredible. By early 2004, houses were selling at 1/10th their peak value, and commercial real estate was selling for less than 1/100th of its peak-market value. All told, an estimated $20 trillion in stock market and real-estate wealth had been vanished!

Oil's Risk Premium

Oil is a difficult commodity. The position that oil commands, no other commodity can ever have.

The dual status of oil as an important commodity and proxy for global macroeconomic risk dates back to 1973-74 oil crisis, when OPEC waged an economic war against the West with crude as its weapon in support of the Arab attack on Israel. This elevated the commodity's profile to unprecedented heights on global stage. Since then, oil's price has reflected the forces of both supply and demand, and GLOBAL RISK PERCEPTIONS.

Nobody can determine how much risk premium does Oil command on any given day, but yes it does command increasingly more. Nearest to Oil as a significant global commodity was Gold. Yes, gold too is influenced by global risk, but gold has no strategic economic use. Jewelry and industrial demand are pricing factors for gold, but those applications are hardly critical in the global economy. Even if world sees Gold supply shortage, people simply can stop wearing & storing more gold. The only question is price, which is largely driven by sentiment and the vague memories that the metal was once used as legal tender.

At the moment, there's no shortage of risk fears. The challenge for the world is separating the Oil's risk-premium from the pure economic factors. This is inherently a speculative task and so no one can be confident that they understand how much of oil's price is affected by risk considerations vs. supply and demand analytics. Nonetheless, the biggest risk is underestimating, or ignoring the potential for an oil risk premium-which can and does fluctuate widely over time.

No lesson learnt from LTCM

Everyone remembers the high profile blowup of LTCM 10 years ago, but nobody learnt the lesson. The basic reasons of LTCM blowup was:

1. Very high levels of leveraged used to generate huge profits from minuscule arbitrage opportunities,
2. Expectation that liquidity will always remain high in the markets,
3. Financial models are the pennecia of all risk management needed.

Current scenario looks no different, other than the scale of this crisis. Its no more "one hedge-fund" problem now, it spans globe. Its the most biggest banks & financial institutions that are core to global financial system, are facing the heat. LTCM nearly single handedly brought the financial system to near collapse, but then a bailout package was available. Just no bailout is possible this time, the crisis is huge. Nearly $800 billions have been written down till now & few wall street veterans believe that another $400 billion is still to come. Can you imagine that the wealth worth a whole Hedge Fund industry size (of nearly $1.5 trillion) will be eroded by the time this subprime crisis ends.

Probably its the imperfections of global financial markets, assets were so much overvalued which were never worth that much. So they came down! But this reminds us of LTCM, and we have hardly learnt anything. Still Banks & Hedge Funds are highly levered (Carlyle disclosed 32x leverage, LTCM was 30x when it got bust). Risk mamagement measures is far from efficient. yes, trading/ financial models can churn numbers & predict well, but only when economic conditions & markets are stable. In case of "irrational exuberance", nothing works but greed and fear!

Where is the Oil top?

Though nothing to conclude, but an interesting pattern to see-

Look at the chart below, it simply shows the relationship of the current oil bubble to the last 2 big bubbles - tech stocks and then the housing market. Now the rise in oil eclipsed the mammoth rise in tech stocks in the late 90s. Interesting - where is the top?

Cheap Chines Goods - End of an Era?

Why American consumers are about to start paying more for clothes, electronics, toys, and just about everything else.

For years, China fed the consumption hunger of Americans through its cheap exoprts. But it seems that $2 t-shirts era will soon end as china is witnessing an increase in cost of production across industries. Deceds ago when large Chinese population wanted jobs desperately, bulk manufacturing for cheap wages looked viable. As a result, labor & environmental laws were violated, people worked for 7 days a week, working environments were just pathetic & there were no respect for intellectual property rights. But economic evolution cycle goes on, wages increased. Also the effect of 1970's one-child-law led to a dwindling demographics in China. Those born then, now-workforce, demand better labor laws, medical insurance & a good working environment. These rising middle class in India & China will ensure that the cost of raw materials continue to increase throughout the world. Inflation grows more rapidly & chinese remibi appreciates against US. All this indicates one thing - era of cheap Chinese goods is coming to an end!

Now US is looking for alternatives - Vietnam, India, Indonesia, Mexico, or Malaysia?

Vietnam - American importers are now looking at Vietnam, for its lower wages. But Vietnam, how hard it tries, has only 85 million people—the size of one Chinese province. Moreover, prices are rising faster in Vietnam than anywhere else in Asia. Also the rising incidence of strikes and labor disputes, and Vietnam looks increasingly like a short-term alternative.

India - India has not yet managed to get its act together to take advantage of China's rising export prices. Importers say India is good at certain things—embroidery, for instance—but not at the volume production. India's road and port infrastructure, while improving, is nowhere near as efficient as China's.

So US importers are looking back to countries they once rejected in favor of China— Indonesia, Mexico, and Malaysia. But none can offers the one-stop shop appeal as China can, where factories make everything under the sun. For the time being, US consumers will still be buying a lot of "Made in China" products—and paying ever more for them - until......!

Mezzanine Debt - Balancing your Capital Structure

Capital Structures - While there are no hard and fast rules for optimizing a company’s capital structure, companies that areahead of the curve use an efficient combination of senior debt, mezzanine debt, and equity capital to minimize their true cost of capital.

Mezzanine debt capital generally refers to that layer of financing between a company's senior debt and equity - filling the gap between the two. It is subordinate in priority of payment to seniordebt, but senior in rank to equity. Thus using mezz capital has positive side: the owners face little dilution and maintain their control of the business; the companies total cost of capital is reduced; and the mezzanine debt has a flexible payment term that is structured as “self liquidating” and is paid off over time. On the negative side, this is a debt structure that requires interest payments over time.

India vs. other Asian Economies

There are few significant differences between Indian Economy and other major Asian economies, lets analyze few:

a). Current account deficit - India has a current account deficit. As oil and fertilizer prices go up, the deficit increases further. Other Asian economies (like China, Japan, Korea, Taiwan, Singapore, Vietnam etc) have a massive current account surplus which they can use to finance growth, India relies on capital flows - FDI and FII. During 1990s, the East Asian crisis emerged as those countries financed their growth through capital flows, not from any forex reserves (as they did not have much in their kitty then), they were devastrated as world pulled back their money out of Asia. India survived then and is not that worse even today - forex reserves are high and FDI flow remains strong. But still, its a concern.

Benefit of having current account surplus is that forex can be used to contain domestic inflation. So China can led yuan appreciate to control inflation because there is a massive current account surplus, India can't.

b). Fiscal deficit - With increasing wages of govt employees (6th pay commission) and subsidies on oil and fertilizer, the fiscal position of India can become very bad soon. If this continues longer, govt will need to cut down on its spending. Whether that will be subsidies or investments is anybody's guess. Most likely, it will be a mix of both.

Surviving a possible recission is important for an economy. But any recession requires multiple shocks. In 2001, there was tech meltdown, Corporate bankruptcies like Enron-Worldcom, junk bond blowup and Sept 11. This time, we had subprime blowup and the credit crunch. This time may be we are on the verge of an oil shock. Only time will tell how these mighty economies steer away from testing times.

China - High A-Share/H-Share Premiums

For those unfamiliar with China's markets, Chinese companies may have Shanghai listed trading as well as Hong Kong listed trading. A-shares are listed on Shanghai exchanges and are largely available only to domestic investors. H-shares are listed on the Hong Kong Stock Exchange; they are available mainly to non-chinese investors (like QDII, International investors). But in both case, the origion of business should be in mainland China.

There is a huge price difference at which a mainland company trade in both the exchanges, and intrestingly there is no channel to arbitrage. A-shares trade at a huge premium over H-share counterparts (or even what is being quoted in London exchanges). This is due to huge imbalance between supply and demand of high quality stocks in China. High ristrictions/regulations combined with high demand from newfound investible wealth, is pushing premiums up. More possible reason for the price difference is summarized in below graph:

To track this, there is an index called Hang Seng China AH Premium Index" which measures the the spread between the A-shares and H-shares of dual-listed companies domiciled in mainland China. This means that A-shares as a group are currently trading at a premium of about 80% over the H-shares and that at one point they were trading at a premium of more than 100% !!

The spread is going up constantly, some reasons could be that China is a closed market wheres Hong Kong is a fiercly open economy, thus it reacts more sharply to international economic developments. A recent credit crisis left many markets crashing, impacting HK markets as well. Also HK currency being pegged to US dollars, it took a greater hit from investors!

There is something about Germany !!

Germany just increased their labor wages, a weird decision at current economic situation! Once inflation works its way into wage growth, wages propel inflation further upward. So European Union is worried about Germany. And this is not not the only reason, as ECB battles against inflation that results in a strong Euro, this is actually threatning the long term viability of Euro. If any major EU country (such as France) plans to drop Euro (they can do it anytime under the initial Euro treaties), value of Euro will nose-dive in global financial markets. For that matter, Germany - the strongest EU economy, is equally unhappy about having to ‘carry' the Euro and the weaker economies!!

High Inflation - Don't blame U.S. alone!!

World is already bleeding under inflation, if Central banks cut interest rates more (to protect ecenomy drowing under recession), this will push inflation further up. That’s making the global response to inflation more complicated. European Central Banks are convinced of not decreasing rates further as they believe high inflation is a bigger threat than what credit crisis was!

World Bank estimated that global food prices have risen 83% over the past three years. The IMF forecast consumer prices in developing countries will rise 7.4% this year, and 2.6% in rich countries, the highest inflation rate since 1995. The 15 countries that share the euro currently see inflation of 3.5%, a decade high.

Some of the factors driving inflation vary from country to country: union-negotiated wage hikes in Germany, pork shortages in China, an electricity squeeze in South Africa, pay rises for civil servants in India. But the fact that inflation is rising almost everywhere suggests some of its causes are global. As crops are sold for alternative-energy production, food prices have soared: The price of rice is up 147% over the past year. Increasing demand for natural resources from India and China has pushed up prices for raw materials world-wide. Sky rocketing crude oil prices has increased fuel and transportation prices.

The weakening U.S. dollar is another source. Not only is it pushing up prices of American imports, it is transmitting inflation to economies that link their currencies to the U.S. dollar, from Saudi Arabia to Hong Kong. Because of their currency pegs, these economies are forced to track Fed rate cuts even if they aren’t facing recession. If they don’t, investors seeking higher returns would move money to these countries, placing upward pressure on their currencies. Hong Kong has mirrored the Fed’s recent rate cuts, igniting the local property market, that went up 31% from a year earlier in January, thus feeding inflation.

Economists believe that slowing growth in the U.S. and Europe will ease inflationary pressures globally. Also, current commodity prices are higher than what underlying demand can justify, and predict they could fall sharply. And, at some point, the Fed will stop cutting U.S. rates, helping arrest the decline in the dollar and the inflationary side-effects.

High Oil & Commodity Prices - Blame it on Fed Rates!

Crude oil prices is hoovering around $110/barrel - this does not essentially reflects changes in fundamental demand & supply of oil. There are some exiting news about oil supplies - global oil production had stagnated over the last few years, but January 2008 data finally show a new all-time high quantities produced worldwide.

With Energy Information Administration (EIA) also forecasting an increase in global oil production in 2008-09 after a series of dull years in oil production output.

So the million dollar question is - than what is driving the Oil prices so high? The explanation is: we're seeing similar increases in the price of virtually every storable commodity since start of 2008. The 12% increase in oil prices this year closely follows the median increase in other important commodities graphed below. Thus we are looking for a single explanation behind the common behavior, rather individual theories.

We can't attribute all the increase in commodity prices to the decline in dollar. The dollar depreciated only 7% against euro in 2008, which is less than the price increase in nearly all commodities. Also, pretty surely, there is no big surge in demand for commodities which can push prices us, as we have been hearing of global slowdown last 3 months.

Instead, high oil prices just like all other storable commodities, is primarily a response to the Fed's decision to move 'real' interest rate into negative territory. High commodity prices is merely reflecting an expectation that Fed may further cut fed interest rates to 2% at the meeting at the end of this month. If Fed shocks the market by keeping rates steady at 2.25%, all those commodities will begin to crash within hours of the news.

Corn, Ethanol - Reason for High Global Food Prices?

Global food demand is increasing as significant amounts of food is being diverted to produce biofuels. Half of the increase in global corn consumption in 2007 was related to ethanol production. This has already led to spillovers on prices of other food commodities through higher feed costs, crop substitution, and demand substitution etc; lets see how:

Some statistics regarding US corn in 2007: *19% of corn was used to produce ethanol; *4.1% was used to make high fructose corn syrup; *Over 50% was used as livestock feed (this is decreasing fast & other foodgrains are substuting corn to feed livestock).

According to the Renewable Fuels Association, just US is producing around 375,000 barrels per day. This is almost 2 billion bushels of corn a year (around 25% of the domestic use), and it’s growing. This simply means that 2 billion fewer bushels of corn are going into the food supply for both humans and animals.

We need to identify what effect (if any) does the increased production of ethanol have on the food supply and prices? Analyzing this requires careful study the correlation of corn prices vs ethanol prices.

Yes, we see a strong correlation. Though ethanol was minimally produced in the beginning of this decade, it had minimal affect on corn prices then. In 1999 only 1.5bn gallons of ethanol were produced a year verse over 5bn today. That’s a lot more corn, and this has shown on ever increasing prices of corn. Using food to produce biofuels might further strain already tight supplies of land and water all over the world, thereby pushing food prices up further.

Conclusion: The massive increase in ethanol production due to high energy prices has had an obvious effect on corn prices. Until Oil/Energy prices cools down, we can expect to see the food prices go up further (food prices having jumped 48 percent since 2006). One simple alternative is using switchgrass and jatropa instead of corn. This will not directly impact the food chain, since you can't eat it.

So next time you eat corn - relish it, who knows all the corn might make their way into your car fuel tank soon!! And wondering how much food & energy is contributing to increase in inflation globally ??.... have a look .....

New buble in the making - Alternative Energy.. catch it!!

I found an interesting article in Harper's Magazine featured an article by Eric Janszen. The gist of the article is beautifully sumarized by the chart below where Janszen plotted the (actual and predicted) trajectories of the bubbles of past, present and future, namely the tech bubble, the housing bubble and the coming bubble in alternative energy and infrastructure.

• Author described variuos stages of bubble beautifully namely: normal, formation, hyperinflation, dissipation and overshoot.
• Current housing bubble - forecasted to reach the overshoot stage in 2011-12.
• Next bubble - alternative energy is currently in the formation stage and bound to reach its hyperinflation stage in 2011-2013.

Read full article, its a must-read: http://www.harpers.org/archive/2008/02/0081908

Gold's Correlation with Real Interest Rates

Gold's sharp gain of 60% in the seven months starting August 07 till Mar 08 began with the Fed's first interest rate change in 18 months. The real cost of borrowing Dollars – (rather, the real returns paid to anyone saving money today) clearly impacts the demand for Gold; lets see how:- compare the changing value of real interest rates with the price of gold, and notice that when the real returns paid to cash sink below zero, investors tend to demand Gold more (as atleast gold beats inflation) . That's what happened in the 1970s.

Why choose gold when real interest rates sink? People will seek out reliable stores of value instead, led by hard assets. Unlike real estate, gold remains a highly liquid, easily priced asset that can store huge quantities of wealth in a very small space.

Wide Credit Spreads says - think again, crisis is far from over !!

Credit spread between Baa-rated bonds and treasuries gives a decent idea to measure the investor's willingness to accept risk. Currently the spread is well above 300 basis points, a level rarely seen in last 50 years.

Whats important is when and how quickly this spread will start to narrow down. As long as the spread continues to widen, risky assets will perform poorly. However, the abnormally high risk premia we are currently seeing indicate that longer-term investors will be paid more handsomely for accepting such risks than they have been paid on average in the past.

Latest:

• Credit spreads widened significantly in Q1-08, but have contracted since dec-end levels.
• Low liquidity, concerns of counterparty risk, billions realized and mark-to-market losses, falling home prices & weakning economy contributed to widening credit spreads (mainly in Q4-07).
• Agressive fed fund rate cut restored liquidity lately helped moderated these concerns in Q1-08.

Trend Reversal in the Global Buyout Deals?

Some global buyout deal trends-

• Deal Volumes currently declining to 2003-04 levels




• Premiums have increased, especially due to increase in high-premium unsolicited offers
  
  
• Amount of cash considerations in the open deal value decreased from its peak of 90% in Q3-07 to 78% in Q1-08.
  
• Deals involving private acquirers (primarily LBO) continued to decline from a peak of 60% in Q3-07 to 40% in Q1-08.
  

* Source - Lehman Brothers report

IMF Predicts Slower World Growth, a Possible Recession

The International Monetary Fund cut its forecast for global growth this year and said there's a 25 percent chance of a world recession, citing the worst financial crisis in the US since the Great Depression.

Global growth will decelerate in 2008, led by a sharp slowdown in the United States, amid a housing correction and a financial crisis that has quickly spread from the U.S. subprime sector to core parts of the financial system, the IMF says in its latest World Economic Outlook.

• World growth will slow to 3.7 percent in 2008, in wake of financial crisis
• United States, other advanced economies lead slowdown. US economic growth forecasted at 0.5 percent in 2008 and 0.6 percent in 2009.
• Emerging economies are likely to weather storm better, but not insulated

Was Greenspan justified in cutting the Fed Interest Rate that much?

Greenspan's main defense is that the long-term interest rates were falling in the early 2000s due to "global factors beyond his control". But even if the decline in long rates were beyond his control, did he have to cut the fed funds rate that much - an interest rate he did control - and hold it at the low level for that long (see Chart below)?

Starting in 2001, Greenspan held the fed funds rate below the y-o-y percent change in the median price of an existing single-family home, holding it below house-price appreciation through 2005 (see Chart below). Thus, the real fed rate in terms of house-price appreciation was negative from 2001 through 2005, bringing to a record low real fed funds rate of minus 9.6% in 2005. Never since late 1970s had the Fed allowed fed rate to consistently trade below the rate of house-price appreciation.

Interestingly, mortgage borrowers are not restricted to 15- or 30-year fixed rate loans. If shorter maturity rates are attractive, they can opt for those adjustable rate loans Greenspan was actually pushing for in 2004. Chart below shows that mortgage borrowers did increasingly opted for adjustable rate mortgages (ARM) because Greenspan held down short-term interest rates.

Although bond yields do move in somewhat different directions than the fed rates, they still are affected by it. That is, if the Fed sends a strong signal to the markets that it intends to slash the level of the federal rate and hold it at a low level for an extended period of time, these fed funds rate expectations will be factored into the level of bond yields - not 100 %, but not 0% either. So, Greenspan's argument that he had no control over bond yields is not entirely correct!

Collateralized Debt Obligations (CDO) - Complex products!!!

CDO (Collateralized Debt Obligations) is backed by a pool of other debt obligations (business loans, asset-backed securities etc. and can even another CDO). These assets are divided into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Some of these CDO’s are backed by Mortgage Backed Security (MSB) also.....

These CDO's are traded between institutions, usually further bundled in other CDO basket, making it impossible to understand the true underlying.... the interesting thing here is that credit rating agencies like Moodys & Fitch still graded (before sub-prime crisis) those CDO basket as investible securities with A & A+ etc... probably some good credit or corporate loans bundled in those baskets kept the ratings high even if the basket had lot of MBS (subprime housing loans) that were about to start defaulting!!!

Today, the world is blaming complex CDO products for the financial woes of the 2007 credit crunch. Credit rating agencies failed to value these products using their risk and recovery models. Some institutions buying CDOs even lacked the understanding to monitor credit performance and estimate its expected cash flows. As many CDO products are held on a mark to market basis, the steep fall in the credit markets and declining liquidity in CDOs led to substantial write-downs in 2007-08.

Gold glitters

Gold prices tend to move in the opposite direction of the U.S. dollar, as investors use it to hedge against inflation. Dollar and gold are inversly correlated by 70% (approx). As the greenback makes record lows, upward pressure on gold prices has intensified.

Food and Oil are putting extreme pressures on Global Inflation. Central banks are facing dilemma - if they cut rates, inflation rages. If they don't, there is a serious risk of economic slowdown. 'Economic stagnation' combined with 'Inflation stagflation', is a combination gold just loves. World could be in its first stages when gold prices goes up for years together. Real prices of gold (inflation adjusted) is still cheap if we compare with 1980's when it spiked to $870. Generel prices have risen 3 times since then, thus gold at sub $1000 is still really cheap related to everything else. Imagine gold at $2610 in a few years!!