26 April 2009

Nolan ~ Reflation appears to be working

Fan Gang stated that the Chinese government’s $585bn stimulus package would help support 2009 growth in the range of between 7% and 8%. Goldman Sachs economists this week raised their estimates of China GDP growth to 8.3% from 6.0%. CLSA Asia-Pacific Markets increased their China growth forecast to 7.0% from 5.5%.

Examining stock markets, China is leading exceptional performance by the “Bric” equities markets. Brazil’s Bovespa has posted 2009 gains of 24.6%, Russia’s RTS 31.6%, India’s Sensex 17.4%, and China’s Shanghai Composite 34.5%. Asia’s markets have been especially robust. Taiwan’s major index has posted a 2009 gain of 28.1%, South Korea's 20.4%, Indonesia's 17.4%, Malaysia's 13.2%, and the Philippines' 12.3%. It is also worth noting that Japan’s Nikkei (down 1.7%), Hong Kong’s Hang Seng (up 6.1%), and Australia’s S&P/ASX (down 0.3%) are among the world’s best performing major stock indices.

Currency markets also point toward a reflationary bias. The “commodities” currencies are among the strongest performers so far this year. The South African rand has gained 7.7%, the Norwegian krone 6.1%, the Brazilian real 5.5%, the Mexican peso 3.4%, the Australian dollar 2.4%, and the Canadian dollar 0.4%.

In commodities markets, industrial metals have bounced back meaningfully. Copper has gained about 45% so far this year. Platinum has jumped 25%, with strong gains also for lead and zinc. And let’s not forget silver, with its year-to-date gains of 9.1%. Overall, the CRB commodities index is down 2.9% y-t-d, while the Goldman Sachs Commodities index is up 5.6%. Now, if energy markets get going…

According to Dealogic, year-to-date global M&A activity has jumped to $449bn, a level now only 14% below comparable 2008. With PepsiCo’s acquisition of Pepsi bottling companies and Oracle’s purchase of Sun Microsystems, this past week was one of the strongest for M&A in months. Recall that first quarter “global debt capital issuance” was up 26% year-over-year to $1.53 TN (data from Dealogic). Asia issuance was up 55% year-on-year ($176bn). Here at home, there was record first quarter investment grade debt issuance ($298bn).

Companies are again able to raise finance through the junk bond market. Over the past two weeks, $5.5bn of high yield bonds have been sold. It is worth noting (citing AMG data) that high-yield funds attracted $532 million of inflows this week, up from last week’s $433 million. Notably, six-week inflows now stand at an impressive $3.38bn. Supported by various Washington-based programs, U.S. corporate debt issuance is on record pace.

Taking a look at U.S. debt market risk premiums, junk spreads are at the narrowest level since last October. Investment-grade spreads are at their tightest since February (from Merrill Lynch Credit indices). Corporate bonds have generally performed well for investors so far this year. Agency debt spreads have tightened all the way back to a pre-crises level 48 bps, and MBS spreads are now down to 98 bps. Muni bond yields have dropped to the lowest level since September in what has developed into a mini municipal issuance boom ($9.2bn issued this week inclusive of California’s “Build America Bonds”).

This week, inter-bank lending risk premiums tightened to levels not seen since before the failure of Lehman. According to Bloomberg, the “Libor-OIS” spread has narrowed to 0.87%, down from an October high of 3.64%. We’ll be learning much more about the “stress test” over the next couple weeks. Examining financial CDS prices, there remains extraordinary stress but apparently somewhat less of it as it pertains to bank defaults. JPMorgan CDS prices have dropped to about 170, down from as high as 240 bps last month. Morgan Stanley CDS is down about 120 to 360 bps. At 245 bps, Goldman Sachs CDS is down about 130 bps from March highs. Wells Fargo CDS is down about 60 from highs to 240 bps. The “problem child,” Citigroup, has seen its CDS prices come in a moderate 90 to a still high 575 bps.

This past Monday the U.S. Equities VIX index (expectations for future market volatility/risk) dropped below 34 to the lowest level since before the Lehman collapse. The S&P Homebuilding Index is now up 32% for the year. The Morgan Stanley Retail Index (35 companies) has now posted a 2009 gain of 31%. The Morgan Stanley High Tech index is up 24% y-t-d, and the InteractiveWeek Internet index is 31% higher.

It is worth noting that the Mortgage Bankers Association weekly application index is near the highest level since the summer of 2003. Of course, this boom is being driven by refinancings – which are now running about triple the year ago level. Mortgage rates are these days at historic lows. There are indications that Credit conditions are loosening meaningfully, with even jumbo mortgage rates dropping. As a disciplined analyst, I cannot disregard indicators that have many times in the past proven their worth.

The unfolding refi boom has the potential to significantly impact systemic reflation. For one, millions of households will be reducing their monthly mortgage payments. Many with adjustable-rate, shorter-term, or various “exotic” mortgages now have an opportunity to stretch things out to 30 years at quite favorable rates. While certainly a fraction of previous inflated levels, there will be meaningful equity extraction used to pay down higher cost debt and, perhaps even, buy things (weekly retail sales trends have stabilized). There is also the dynamic where holders of millions of old mortgages will receive early repayment in a process that works to reliquefy segments of the MBS marketplace. And I’ll assume that the GSE’s will increase their holdings of new MBS, perhaps creating a significant impetus for system reflation. At the minimum, Fannie, Freddie, and the FHA will be stamping their (I mean the taxpayers’) guarantee on hundreds of billions of MBS, creating more “money-like” debt instruments out of Wall Street’s previous “private-label” variety of (discredited) mortgage securities.

It’s my view that the markets generally lead the economy – not vice-versa. If this stock market rally is sustained, I would expect the summer home selling season to surprise on the upside in many locations. When some semblance of confidence returns to housing markets, I would not be surprised to see some pent up demand positively impact auto sales. Anecdotally, it appears consumer Credit conditions are beginning to loosen – even in auto finance.

If we step back and ponder the unprecedented scope of today’s global fiscal and monetary stimulus, we shouldn’t be all that surprised by the fledgling reflationary forces observable both at home and abroad. I have labeled emerging dynamics the “Government Finance Bubble.” There is mounting evidence that this Bubble is developing critical mass and should be taken seriously.


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