Opening Letter
I will try not to spend too much time on the subject of my past two letters, the mushrooming subprime debacle. However, a few new data have emerged which deserve at least an honorable mention.
Braddock Investments' Galena subprime fund liquidated after losing $100 million out of $300 million, and the fund apparently wasn't even leveraged.
A distribution of loss rates to the economy of the subprime crash comes up with a mean estimate of about $200 billion, +/- $50 billion. Nothing to sneeze at, but not exactly apocalyptic either: after all, the US economy is about $13 trillion. It will severely crimp this year's GDP growth, but not much more than that, right? “Sort of, but not really.”
Sincerely,
Alex Forshaw, Editor
The Subprime Contagion, Redux... Redux
The real impact of the subprime meltdown will not be felt in the erosion of $200 billion of assets. That will hurt, but it won't be ruinous, either. The real problem will be an economy-wide de-levering and permanent loss of liquidity. Bear Stearns' two funds, for example, had about $5 billion in capital with a leverage factor in double digits, meaning that over $50 billion will be taken out of circulation by those two funds alone. Therefore, $200 billion of losses in the most heavily levered sector of the American economy adds up to a stupendous amount of economic damage.
Now, all the leverage originating from subprime loans has been spread all over the world. American household assets alone are incalculably higher than the total levered cost of subprime damage. However, it will be somewhat of a shock.
Other liquidity spigots are being turned off. Although Japan's political class is fighting potential BoJ rate hikes tooth and nail, central bank rate hikes are a matter of Japanese economic necessity. (Friday saw Japan's Senior Vice Minister of Economy, Trade and Industry Kozo Yamamoto howling against an already-once-postponed from July to August rate hike ... to .75%.) However, Japan's hand is being forced by Japanese “desperate housewives” who, having finally discovered what a great cash cow the carry trade has been for Western hedge funds, are now borrowing yen themselves, in order to lend it in other countries at global market rates. All of which means that Japan is exporting more inflation, and suffering from more internal deflation and even lower investment than before. Japan faces a Hobson's choice of higher interest rates for more deflation now, or keeping interest rates artificially low in exchange for more deflation later.
The SWF Factor
However, all is not lost in terms of global liquidity. Many financiers, Morgan Stanley's Stephen Jen being only the latest, have suggested that the Japanese throw $600-700 billion of their FX reserves at the global asset markets to obtain moderate returns, arguing that Japan only needs $250-300 billion to guarantee currency stability. (Japan's central bank is sitting on approximately $900 billion of cold, hard cash from decades of trade surpluses. ... Nice.) China's central bank is also looking for asset classes in which it can park a trillion dollars' accumulated trade surpluses. Their $3 billion bite out of Blackstone was only the beginning. In a sense, then, these looming governmental “sovereign wealth funds” (SWFs) function as a built-in liquidity spigot, once asset values have been somewhat depressed as private liquidity dries up.
The newsletter believes that all global asset classes are in for a beating as the subprime contagion spreads, before it is contained. However, all asset returns are relative. Bond money is stampeding out the door, and while $200 billion-plus will evaporate, some surviving bond money will go into equities. Ironically, then, equities could actually benefit in the longer medium term from the bond blowup. A large component of the phony equities bull market has originated from private equity, of course, and as that demand pump dries up with a significant rise in interest rates, overall demand for shares (in the form of private equity LBOs) will drop. Relative to bonds, however, equities will probably perform quite well (although by “quite well” we mean “not as badly.”)
Currencies
In terms of currencies, we are still somewhat bearish on the yen. The weak yen lobby in Japan still has some fire in its belly, and every investment by a Western hedge fund in the yen (eagerly anticipating some adult supervision of the yen from the BoJ) only encourages the BoJ and the Japanese political class to allow the yen to remain weak. We are dollar-neutral.
Commodities
In terms of commodities, we are decidedly bearish on all of them. (More on that later.) Most of all, however, we are very bearish from oil, which was driven up to $76 thanks to some Nigerian political theatrics over the secession of Biafra, Nigeria's oil-rich southern province (which already seceded once in the 1960's, and in which the leading secessionist still holds substantial political sway himself). However, much as Alberta occasionally threatens to secede in order to wrangle better central-government treatment, so does Biafra. The oil market has proven time and time again that it is incapable of properly pricing geopolitical risk, and this most definitely is one of those times.
We think the Chinese boom (the main driver of commodity prices in the past decade) has been an artificial demand inflator, and we see China as on the cusp of the same 20-year stagflationary hangover that gripped Japan from 1991 onwards.
Because we are very bearish on commodities as a general asset class, we are also bearish on all commodity-driven currencies, e.g., the ruble and the CAD. (Keep in mind that these are medium-term trends.) This is bullish for the JPY (which can be thought of as driven opposite to commodity currencies/prices), but the JPY is still mostly contingent on what the BoJ will do in the next few months in terms of interest rates. So far, the Japanese do not appear to have mustered the political will to apply the necessary squeeze to the yen, so we are still somewhat bearish on JPY overall.
The Bottom Line
USD: The US dollar will continue to weaken against most European currencies. In addition, as Alex mentioned above, it is time for gold and oil to drop. Commodity driven currency pairs such as the CAD and AUD will begin to weaken against the dollar later on in the week. The most important event traders should watch this week is the statement to be released by Bernake on the topic of inflation. This statement will determine the dollar’s outlook over the next couple of weeks. A positive statement would result maximum highs for the EUR/USD and GBP/USD pairs. Traders should look for high activity for the dollar throughout the week.
EURO: With very little economic data being released for the Euro next week, expect the EUR/USD pair to be bullish depending on the statement by Bernake.
Pound: The rates were increased to 5.75%, resulting in a further uptrend for the GBP/USD pair. The week should begin with a bullish GBP/USD pair until Thursday. With positive PPI numbers being release, look for the GBP to begin retracing towards 2.009-95 towards the end of the week. Levels of Resistance are: 2.024, 2.03, 2.05, 2.075, and 2.092.
CAD: The Bank of Canada is expected to raise rates despite a decrease in CPI. Some estimates forecast the Bank of Canada to raise rates by .75% by the end of 2007. This has resulted in the major strengthening of the CAD over the past week. Look for the CAD to keep strengthening early in the week followed by a trend reversal to as high as 1.06. In addition, the RSI is pointing extremely levels; lower than 20 in more than one occasion. This might indication the USD/CAD might be oversold. Look for a reversal later in the week.
NZD: With no strong NZD being released this week, look for the NZD/USD to begin retracing towards .7734, 50.0% level. RSI levels also indicator high overbought levels, over 80 over the last week. Trend reversal is in the near future.
Yen: On Thursday, the Bank of Japan will announce their decision on rates, however, traders will pay closer attention to the publication of the monthly report which includes economical prospects and indications of a rate hike. The technicals look extremely weak for the Yen this week. Current status is Neutral on the currency.
Overall Outlook for the Week:
USD: Outlook based on Bernake’s Statements
EURO: Bullish to Neutral
CAD: Bullish then Bearish
NZD: Very Bearish
Yen: Neutral
--Alex Forshaw & Sumant Yerramilly,
http://www.bestwaytoinvest.com
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