CLSA CLSA Capital Partners
GREED & fear - 27 Oct 2006

Tribute     Christopher Wood (852) 2600 8516


On the point of publishing GREED & fear last night came the sad news of the death of CLSA chairman and founder Gary Coull. Gary was a man who commanded deep respect both as a no-nonsense boss and in terms of his total lack of self pity in his struggles with his health.

Commercially, his career has been a resounding success, proving that it is possible still to make money from "old fashioned" institutional stockbroking even though for the past 25 years GREED & fear has been hearing the precise opposite. But the success of CLSA is also due to Gary's talent for identifying and driving themes for its all important research product. GREED & fear has seen many examples of this during a comparatively short period at the company. "Billion Boomers" is one big idea that originated from Gary. More recently, "Capital Links" is another. GREED & fear is convinced that both these themes will be vindicated in the full passage of time.

On a more personal note, Gary, as another ex-journalist who GREED & fear once replaced at the Far Eastern Economic Review 24 years ago, was the most inspiring of bosses to work for. What would take hours of conference calls to resolve at other anonymous institutions was dealt with in a two-minute conversation and a brisk decision. For stockbroking is fundamentally a simple business. With a journalistic hunger for news and new ideas, Gary was always on the look out for new themes to drive the product, be they in the fields of business, technology or politics. And what more exciting context to function in than the human drama posed by modern Asia.

Viewed from the wilderness, financial markets continue to exhibit a lack of concern despite the latest US housing data continuing to show a slowing trend. Thus, existing home sales fell for the sixth consecutive month in September, down by 1.9% MoM and 14.2% YoY to an annualised rate of 6.18m. More importantly, the median existing-home price fell by 2.2% YoY in September, the biggest decline since the series began in 1968 (see Figure 1). This is the first time since late 1990 that the median home price has declined for two consecutive months on a year-on-year basis.

Figure 1

US median existing-home price growth

Source: National Association of Realtors

But with most market participants assuming an orderly clearing at lower prices, it is going to take time to prove the bulls or bears right or wrong on US housing. GREED & fear is still concerned about the implications for growth stemming from a housing slowdown but not quite as concerned as prior to this month's visit to America. This is because there appears to be some initial evidence of market clearing at lower prices (or at least such is what GREED & fear heard in the specific, and probably untypical, case of Manhattan). In this respect inventories have fallen in the past two months. US total existing-home inventories fell by 3% from a record 3.86m in July to 3.75m in September (see Figure 2). It is also the case that the revolutionary application of information technology in terms of selling real estate over the internet should help price discovery and therefore market clearing.

Figure 2

US existing home inventory

Source: National Association of Realtors

Figure 3

US average hourly earnings growth

Source: Bureau of Labour Statistics

Still time is the only issue which will solve the great US housing debate and, in the meantime, the chart of the median existing-home price looks scary. It must also look a little scary to Ben Bernanke which is why it is no surprise that the Federal Reserve has decided to remain on hold. GREED & fear agrees with the official statement, namely that inflation pressures are likely to "moderate over time" but that some nearer team inflation risks remain. In this respect the most important statistic is the steady rise in recent months in the growth rate of US nominal hourly earnings. Thus, US average hourly earnings of private production/non-supervisory workers rose by 4.0% YoY in September, up from a 1.6% YoY increase in February 2004 (see Figure 3). This looks like a big rise on the chart but the bet here would be that this series is likely to peak out at around the 4-4.5% level, which is the top end of the range for the past 20 years.

But with nominal hourly earnings still rising, the tactical inflation scare risk cannot be dismissed out of hand. Significantly higher short-term and long-term interest rates are not GREED & fear's base case. But such a development is what is likely to turn the housing market much uglier than what is currently discounted. Remember that US housing is more a home financing bubble than a house price bubble. In this respect recent data shows that foreign investors have a growing share of the US mortgage-backed securities market. According to a recent study by Inside MBS & ABS, foreign investors held an estimated US$850bn or 15.6% of US mortgage-related securities as at the end of 1H06, up from 6.6% at the end of 2002. Meanwhile, American banks and thrifts have taken over from Fannie Mae and Freddie Mac as the biggest owners of US mortgage-backed securities. American banks and thrifts held an estimated US$1.21tn of MBS at the end of June or 22% of total MBS outstanding, while Fannie and Freddie together held US$1.15tn or 21% of the market (see Figure 4). So, securitisation has not disintermediated the credit risk to the extent that many suppose.

Figure 4

Share of US mortgage-related security holdings by investors

Source: Inside MBS & ABS

Figure 5

Japan nominal average monthly cash earnings per regular employee

Source: Ministry of Health, Labour and Welfare

If America is enjoying rising nominal incomes, the data continues to be much more patchy for Japan. Thus, Japan nominal average monthly cash earnings per regular employee rose by only 0.4% YoY in the first eight months of this year (see Figure 5). So far Japanese statistics suggest that the income growth is confined primarily to those working for large companies, who have seen the biggest pick up in earnings in recent years. Thus, personnel expenses per employee at large manufacturing companies with capital over ¢D1bn rose by 9.6% over the past six years to an annualised ¢D8.7m in 2Q06, according to the Ministry of Finance's quarterly Financial Statements Statistics of Japanese non-financial corporations. While personnel expenses per worker at small firms with capital of ¢D10m-100m fell by 8.2% over the same period to ¢D3.9m (see Figure 6).

Figure 6

Personnel expenses per employee of Japanese corporations

Note: Large corporations with capital over Y1bn, small companies with capital of Y10m-100m

Source: Ministry of Finance - Quarterly Financial Statements Statistics of Corporations

This lack of income growth highlights Japan's vulnerability to a renewed phoney deflation scare. One source of such a scare could be a further fall in the oil price given the role played by oil in causing Japan's core CPI to move into positive territory last year. Another deflationary force in the CPI, mentioned in a Nikkei report this week, is the potential impact of intensifying competition among cellular telephone service providers. Communications account for 3.64% of Japan's CPI basket, compared with 3.55% for petroleum products. Apparently, the Bank of Japan is aware of this, as it is also aware that ongoing deregulation of utilities is imposing another downward pressure on CPI excluding food and energy, which has yet to rise convincingly above zero. Thus, CPI excluding food and energy fell by 0.4% YoY in August (see Figure 7).

Figure 7

Japan core CPI inflation

Source: Statistics Bureau

GREED & fear mentions all of the above to highlight the fact that the Bank of Japan is in no hurry to raise interest rates again, even if it becomes more sanguine about US housing. Fundamentally, such a phoney deflation scare will represent a buying opportunity since cheaper utility rates or cellular phone rates represent "good" deflation stemming from deregulation not the "bad" credit deflation stemming from the banking industry's old bad debt problems. Still in the short term it will impact stock market sentiment negatively.

Figure 8

Japan capital and financial account balance

Source: Bank of Japan, Ministry of Finance, CEIC Data

Meanwhile, the longer the BoJ remains cautious the longer it will take for Japanese interest rates to normalise. The continued presence of microscopic yields in Japan means there is no evidence of a slowdown in the capital outflows from Japan. Japan recorded capital outflows of ¢D4.2tn in the first five months of this fiscal year beginning April, and ¢D32.4tn since April 2004 (see Figure 8). The result of this growing search for more exciting returns overseas can be seen in the huge increase in recent years in the share of foreign currency assets in Japan's investment trust company industry. Thus, foreign currency assets accounted for 39.5% of Japan's total investment trust assets at the end of September, up from 6.2% at the end of 2000 (see Figure 9). This, along with yen-carry trade borrowing, have been the main reasons behind the yen's persistent weakness which has, apparently, caused many macro hedge funds to lose money this year on the popular long yen-short euro trade.

Figure 9

Assets of Japanese investment trusts invested in foreign currency assets

Source: Investment Trusts Association, Japan

As has been argued by CLSA's head of Japan research, Stefan Rheinwald, there is a real chance that the yen depreciates further on the back of continued capital outflows, accelerated by post office privatisation. GREED & fear's view on this is that so long as yen interest rates fail to normalise, the yen is vulnerable to depreciation. This keeps Japanese exporters very competitive. But it also creates an opportunity to buy yen assets cheaply for a long-term investor. For the yen will become a long-term buy when yen interest rates become "normal" and when risk appetite returns to Japan. The timing of these events has as much to do with psychology as economics. But it has to happen sometime, which is why it is potentially risky to extrapolate ongoing capital outflows forever.

Figure 10

Thai Industries Sentiment Index and Consumer Confidence Index

Source: The Federation of Thai Industries, CEIC Data

There is some encouraging data from Thailand in the past two weeks with both consumer and business confidence up, albeit the latter more sharply. Thus, Thai consumer confidence index rose by 3 points in September to 82.1, after falling for eight consecutive months to a four-year low of 79.1 in August. Likewise, the Thai Industries Sentiment Index went up sharply by 11.2 points in September to a six-month high of 96.8 (see Figure 10). This is good news as is Thailand's outperformance so far this month. The MSCI Thailand index has risen by 10% in US dollar terms since 3 October, compared with a 1.9% gain in the MSCI AC Asia ex-Japan index over the same period (see Figure 11). GREED & fear will retain the modest Overweight in the relative return portfolio. But the real driver for improved consumer confidence should be lower interest rates. There is certainly plenty of room to cut rates even if the cautious Bank of Thailand does not yet appear to think so.

Figure 11

MSCI Thailand relative to MSCI AC Asia ex-Japan Index


Source: Datastream, CLSA Asia-Pacific Markets


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