What to Expect from the FOMC

The short rate is close to zero and the Fed's balance sheet has expanded exponentially. What else can the Fed do? Long treasury yields have risen significantly over the last one month. The Fed could announce a program to buy long bonds. This would help in an environment where risk spreads are slow to normalize. There is also talk in some quarters that the Fed could announce an explicit inflation target. This I think is unlikely for now. When nominal rates hit the zero bound, the only way to bring real yields down is by stoking inflation expectations. This would be achieved by a credible inflation target. I am planning to play the meeting by buying TLT (20+ year Treasury ETF) with a tight stop. Buying TIP seems a safer bet given that 5-year 5-year break-evens are still well below 2%.

RBI: Moral Suasion For Now

The Reserve Bank refrained from tinkering policy tools, but urged banks to reduce rates on loans. With fiscal flexibility limited and a weak transmission mechanism of monetary policy, reduction in base rates and flushing the system with liquidity is the only course of action going forward. Expect further easing. I am long bonds and PSU bank stocks.

India’s Tendulkar Wants Central Bank to Lower Rates (Bloomberg)

"Jan. 23 (Bloomberg) -- Indian Prime Minister Manmohan Singh’s top economic adviser Suresh Tendulkar wants the central bank to reduce interest rates further in its Jan. 27 policy statement to stimulate a slowing economy.

“My own preference would be to see some rate cuts there in next week’s policy,” Tendulkar told Bloomberg News in a phone interview today. “That call will be taken by the Reserve Bank.”"

My Comments: More rate cuts on the way. Remain long bonds. Supply concerns seem overblown given the magnitude of the slowdown that lies ahead.

U.S. High-Yield Cheap Versus U.S. Equities

Source: Wall Street Journal


The credit spread on Merrill's U.S. high-yield index was 1674bp on January 16, 2009. There has been significant contraction from the all the high of 2178bp in late 2008. The question is whether the asset class is a buy at current valuations. To answer that question we need to figure out the likely default and recovery rates going forward.

There is a negative correlation between recovery and default rates.

Recovery Rate = 0.52 - 6.9 * Default Rate (Moody's)

This equation suggests that recovery is going to be very low given the 10% plus default rates that we are likely to witness.

Speculative Grade Default Rates
YEAR**Default Rate
1929**1.29
1930**2.13
1931**2.13
1932**7.85
1933**10.81
1934**15.39
1935**5.93
1936**6.09

Source: Moody's

This data indicates that there is a lot of value in the HY asset class even if an economic scenario akin to the Great Depression were to materialize.

One caveat is that the speculative grade market in those days comprised fallen angels. It is important to understand how this segment differs from original issue high-yield bonds. As per Moody's research: "In comparison to other speculative-grade issuers with the same ratings, fallen angels are more risky (more likely to default and less likely to rise to investment grade) for the first two years after being downgraded to speculative grade, but they become relatively less risky than other speculative-grade issuers as time progresses."

Another issue could be whether the current high-yield universe is worse than the previous vintages.

All said, it seems that current spreads discount a pretty bad economic scenario and provide considerable margin of safety. That is certainly not true for U.S. equities.


Source: Default and Recovery Rates of Corporate Bond Issuers, 1920-2004; Moody's Investors Service
http://www.moodys.com.br/brasil/pdf/default2005.pdf
Source:What Happens To Fallen Angels? A Statistical Review 1982—2003;Moody's Investors Service
http://v2.moodys.com/cust/content/content.ashx?source=StaticContent/Free%20pages/Credit%20Policy%20Research/documents/current/2002000000425343.pdf

Japan doing the heavy lifting?!

Japan November current account surplus shrinks 65.9%

(MarketWatch) -- Japan's current account surplus shrank as much as 65.9% in November from the year-ago period because of a sharp fall in the country's exports, official data showed Tuesday. Current account surplus fell to 581.2 billion yen ($6.46 billion) from 1.71 trillion yen in November 2007. Monthly trade balance was a negative 93.4 billion yen, as exports shrank 26.5% amid tough global economic conditions, compared with a 13.7% decline in imports.

U.S. Economy: Trade Deficit Narrows Most in 12 Years

(Bloomberg) -- The U.S. trade deficit narrowed in November by the most in 12 years as tumbling oil prices and slumping consumer spending cut imports.

The gap shrank 29 percent, more than forecast, to $40.4 billion, the Commerce Department said today in Washington. A record 12 percent drop in imports propelled the improvement. Exports fell for a fourth straight month.

My Comments: This is not good news. One of the weakest link in the global economy has been called upon to do the heavy lifting. This data implies another leg down for the global economy.

Thankfully, one big countervailing force will be the huge public dis-saving unveiled by Obama. This should help the world as the U.S. consumer rebuilds savings.

Madoff and Raju: May be we are Ignorant

TRUE LIES
(What Raju owned up to)
* Inflated cash and bank balances of Rs 5,040 crore
* Non-existent accrued interest of Rs 376 crore
* Understated liabilities of Rs 1,230 crore on account of funds arranged by Raju
* Overstated debtor position of Rs 490 crore
* Q2 ‘08-09 profit stated as Rs 2,700 crore and operating margin of 24% revenues. Actuals: Rs 2,112 crore profit and 3% of revenues
* Profits inflated over “last several years”; attained unmanageable levels as company grew
* Aborted Maytas deal was “an attempt to fill the fictitious assets with real ones”

Source: Business Standard

Buffet: "Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing."

My Comments: Satyam and Madoff: Both these cases are high profile and one would reckon that investors were privy to extensive information. All major brokers covered Satyam and big institutional investors owned the stock. Henry Kauffman – a Wall Street legend – lost money in Madoff’s Ponzi scheme aside from several other prominent people.

I do not want to sound cynical. But if a company like Satyam could pull-off such a scam, what do we really know about those obscure small caps?

This is a lesson for all of us - "proud stock pickers" - who can rant indefinitely about our ability to read company managements.

Diversification is important because may be we are ignorant.

Why India Won't Rebound Soon (Barron's)

"FOR THOSE TEMPTED TO WADE INTO THE INDIAN STOCK MARKET with a view to making a quick killing after its massive slide, consider the advice that Punch magazine once gave a person who was about to marry: Don't.

Although India's benchmark Sensex has fallen about 55% from its peak a year ago, the market is still not attractive as a short-term investment. November's terror attacks in Mumbai aren't even the half of it: The Indian economy, valuation issues and broad political uncertainty all argue for real caution."

My Comments: Agreed. India is still not an attractive short-term investment. But not because of issues inherent to India. Instead, I do not see a sustained revival in global risk appetite in the near future.

Get Out Now! (Barron's)

"The bubble in Treasuries looks ready to pop, sending prices on government debt sharply lower. But just about every other corner of the bond market beckons -- and could provide competitive returns with stocks, even if the equity markets have a strong 2009."

http://online.barrons.com/article/SB123094029415750267.html?mod=ba_mp_view

My Comments: I agree with the basic thrust of this article. Risk-reward favors shorts in U.S. treasuries. But to reduce the downside risk, I am keen to play it through break-evens. 10-year break-evens imply virtually no inflation. The market’s price escalation outlook seems at variance with the current level of 10-year real yields. If rates decline further, inflation protected securities should keep pace with nominals. More likely, there will be a vicious sell-off in nominal bonds at some stage.

Manufacturers suffer record declines in activity (FT)

"US manufacturing activity contracted at its sharpest pace for nearly 30 years in December, a closely watched survey suggested on Friday, underscoring the downward momentum in the economy at the turn of the year.

The Institute for Supply Managers survey index declined from 36.2 in November to 32.4, much worse than expected, while new orders and production measures hit their lowest level since the survey began in 1948."

My Comments: Economic data continues to worsen. I doubt the sustainability of this January rally in equities. Tactically, I am inclined to reduce risk as markets move higher. I am fairly certain that the Fed will not hike in 2009. Not only that, I think that the Fed's easing bias will remain intact through the year. The RBI cut the Reverse Repo rate by 100bp last week. I think that further easing is likely going forward.

India IPOs Slide 46% as Worst Year for Stock Index Halts Offers (Bloomberg)

"Indian initial share sales slumped 46 percent last year as a record decline in the benchmark index spurred investors to shun stocks and Emaar MGF Ltd. and Jaiprakash Power Ventures Ltd. to cancel offers."

My Comments: IPO volumes are often contrarian indicators. High numbers are generally seen around market tops.

India Exports Fall a Second Month, Adding Pressure to Cut Rates (Bloomberg)

"Overseas shipments dropped 9.9 percent to $11.5 billion from a year earlier after contracting 12.1 percent in October, the first decline in seven years, the government said in New Delhi today."

My Comments:Look for depressed industrial production numbers going forward. I think a 100bp cut in the reverse repo rate is a foregone conclusion.

New Forbes Index Forecasts Economic Recovery (Forbes)

"Our index includes four indicators. The dollar volume of insider buying shows what managers honestly think about their own companies' prospects. Spreads on bond yields give a sense of what investors think of the chances of recovery. Road congestion at peak travel times (as measured by traffic tracker Inrix) tells us whether businesses are buying, workers are commuting and shoppers are shopping. Finally, mentions of the word "recession" in the news media illustrate the degree to which the downturn is on the public's mind.

Testing back over the last five years, we find that the Forbes Chirp Index typically leads economic activity by ten months which brings us to the possible August recovery. More road congestion and insider buying nudged the Chirp Index higher in November, overriding an increase in the number of mentions of the word recession."

My Comments:The bigger question is the contours and the strength of the eventual recovery. Consumption boom of yesteryears seems unlikely. Direct government spending needs to step in to fill the gap. Infrastructure focused investments would be the winners in this scenario.