|By Matein Khalid| A month ago, I published a column predicting history’s first Made in China global recession. Wall Street finally agreed with me last week after we witnessed the most brutal crash in global equities since October 2008. I have predicated a 20% fall in US equities several times in the last three months and the 1000 point drop in the Dow last week only reinforces my conviction. The German DAX and Hong Kong’s Hang Seng index are down 20% plus from their peak. The S&P 500 and NASDAQ could well be next. Why?
One, the commodities markets flashes a deflation SOS from Dr. Copper below 5000 per metric ton on the LME to West Texas below $40 on NYMEX. Long term crude oil futures and US Treasury TIPS break evens have begun to fall. This is deflation.
Two, Janet Yellen fiddles while Wall Street burns. Yet King Dollar’s 18% rise since April 2014 has triggered the mother of monetary tightening at a time when world trade is shrinking, as the plunge in Asian exports attest.
Three, the S&P 500 valuation at 17 times earnings made no sense once energy/mining was in free fall, market breadth had begun to decay and 2Q revenue guidance/EPS growth proved mediocre. Even safe haven markets must justify valuation metrics.
Four, as the Chicago Volatility Index rose 100% in a week, every carry trade funded by the Euro was in danger and leverage ratios were slashed overnight. Lord Keynes’s words ring so true. In the long run, we are all dead. In the short run, we get margin calls. When the world runs amok (Malay word, ringgit at 4.18!), you sell not what you must, you sell what you can.
Five, “our currency, your problem”. Nixon’s Treasury Secretary warned the world after Tricky Dick broke the Bretton Woods gold dollar link and devalued the US dollar, the world’s reserve currency. China’s Vice Premier should have said the same thing to the world’s chancelleries after he devalued the yuan in a shock currency regime change. The Beijing put was impotent to stabilize Shanghai. The Politburo and PBOC have opted for beggar thy neighbor devaluations. This is 1998 all over Asia, only worse.
Six, the $17 trillion US economic colossus still cannot manage 3% GDP growth with strong capex/productivity and wage growth six years after the end of the last recession – and the Fed needs to raise rates lest the Weimer Republic be resurrected on the Potomac. Surreal!
Seven, the emerging markets currency meltdown has become a nightmare. This will decimate Corporate America’s global earnings this winter. The pendulum has swung from greed to fear.
Eight, China’s hard landing and the commodities bust means recession in dozens of countries around the world, including oil exporters in the Gulf with pegged currency regimes where King Dollar is a deflationary double whammy to local shares and property markets. Santayana had it right. Those who refuse to learn the lessons of history are doomed to repeat it with bank leverage.
Nine, equity flows and market technical all screamed sell, even for US money centre banks and Old Tech with minimal earnings risk. Once industrials tanked in the index, all bets were off and the longs were destined to be skinned alive.
Ten, correlations between Wall Street, crude oil, EM currencies and Shanghai become all too real. Appetite for speculative IPO’s and fantasy concept stocks (Tesla, Amazon, Facebook, small cap biotechs) began to sag. The VIX rose 46% to 28 on Friday alone. This is not just fear. It is panic.
At 1970 as I write, the S&P 500 is 7.6% below its May peak while NASDAQ/Dow are down 10%. Welcome to history’s first “made in China” stock market crash, Adieu to the bull market? Yes, for now, in wide swathes of global equities. The Fed cannot ignore the tightest labour market since the 1970’s. $1 trillion in market cap vanished into money heaven last week. The world changed for me on Friday, as did investor psychology. This was a liquidation trade and I am not eager to buy “dead cat bounces” as the index rolls over to 1840 or lower. Time to sell put options on deep value megacap US centric shares to earn premium. Time to hoard cash and ignore the hoofbeats of the herd and the screams of the doomed perma-bulls in property and structured products!
Macro Ideas – Terror, the Thai baht and Bangkok equities
The tragic news from Bangkok hit me hard. I have fond memories of the Grand Hyatt hotel on Sukhumvit road and the bomb blast is a traumatic blow to tourism, estimated as 20% of the Thai GDP. The Thai baht has depreciated to post Lehman lows at 3.6 against the US dollar. The military government of General Prayuth has not resolved the Red Shirt-Yellow Shirt schism that has paralyzed Thai politics since populist former Prime Minister Thaksin Shinwatra’s Thai Rak Thai government was overthrown in a military coup in September 2006. The Erawan shrine, ironically, stood at the epicenter of the precise area in downtown Bangkok where “red shirt” protestors clashed with troops that led to the loss of 90 lives in 2010. The revered King Bhumibol, an octogenarian and the world’s longest serving sovereign, is in poor health. There is not much to smile about in Southeast Asia’s Kingdom of Smiles in 2015.
Thailand is no stranger to political violence, coup d’etat, rigged elections, class warfare and provincial secessionism. The Thai tourist season begins in October, as winter starts in Europe, Russia and China and the Erawan shrine/Central mall area is usually crowded with foreign tourists, the reason half the bomb blast victims were not Thai citizens. This means the big chill in consumption spending and capex will continue China’s yuan devaluation has increased pressure on Thai exports, already struggling since late spring. This is particularly true of cars, electronics and even rice exports to Europe and China.
Both General Prayuth and Yingluck Shinwatra did their best to offset awful consumer/capex metrics with ambitious, public infrastructure programs. Yet Keynesian economics has not worked on the Chao Phraya River and public spending is barely 50% of planned capex. I doubt if Thailand will even manage 2% GDP growth in the next six months. No less than $9 billion of offshore money has exited the Thai stock market since 2012, discouraged by the grim realities of military coups, floods, street protests, political violence, FDI ice age, government (and governance) failures, loss of export competitiveness to Vietnam, Cambodia and China.
The fall in Chinese auto sales are a disaster for Japanese owned auto plants in Asia’s self styled Detroit. I expect political risk in Thailand will rise this autumn and the Bank of Thailand will cut its policy rate for the third time. This means a fall in the baht to 37 against the US dollar in the next six months is my base macro scenario. In fact, Thai corporate debt is 100% of GDP and a Thai recession could well devastate banking NPL ratios.
Friends ask me if Thai equities are cheap. Absolutely not. At 1350, the SET index trades at 14 times forward consensus EPS growth estimates that I am certain will be cut this autumn. This means Bangkok trades at almost two sigma (standard deviations) above its valuation range since Thaksin first became Prime Minister. The optimal strategy is to remain short Thailand, since SET index earnings have fallen by 30% since 2013. The SET index is down 10% in 2015. I expect another 20% fall in the next twelve months, possibly to as low as 1150. World trade in Asia is shrinking. Ex banks and oil companies, Thai equities trade a surreal 20 times earnings. The 12% EPS growth consensus in Thai equities is a cruel joke only those who have never traded Siam equities can believe. Positioning is also negative since many Asian equity funds are overweight Thailand. So I see absolutely no reason for Gulf investors to bottom fish in the Thai stock market.
China’s PBOC and State Council have failed to stabilize the Shanghai stock market and Asian markets now face a liquidity shock that could well mean recession in 2016. Apart from India, Pakistan and Japan, Asian equities are in deep distress. So it is time to short Nifty at 8450 and the TOPIX at 1670. I will not short Pakistan at 8 times earnings and the massive inflows from Hundi Offshore Capital AG./Ltd/SA/LLC. Asian debt markets will fail to act as shock absorbers, while global hot money flees as in 1998. Stay short Indonesian, Malaysian, Thai and Chinese country index funds in New York.
Stock Pick – The bullish case for Bank of America shares
Bank of America has fallen to 16 as Wall Street slumps. The company interests me as the US money centre bank most leveraged to a steeper US Treasury bond yield curve and most sensitive to a stable US housing market. I was also impressed by the bank’s 2Q 2015 earnings beat, thanks to momentum in investment banking, credit cards, mortgage banking and cost control. The resignation of CFO Bruce Thompson is a negative as it raises succession issues, but the bank will manage to deliver $1.40 in EPS in 2015 and $106 in EPS in 2016. Therefore, my strategic entry point for the bank would be 10 times forward earnings or $16 a share. As volatility spikes on Wall Street, put selling strategies are ideal to generate a 20% annual profit.
Ever since its shotgun marriage with the Thundering Herd and Countrywide Financial in 2008, Bank of America has been crippled by lawsuits related to its toxic CDO’s and misselling risky mortgages to consumers. The Federal Reserve approved the bank’s “stress test” capital plan with some caveats and allowed it to maintain both its 0.20 dividend $4 billion stock repurchase program.
Bank shares are the obvious long term winners from a steeper US dollar yield curve while utilities/REIT’s will suffer. Operating earnings for Bank of America, Citigroup, Wells Fargo and J.P. Morgan have all been on a roll, the major reason why I wrote successive columns in late 2014/early 2015 picking US bank stocks as a sector to outperform the S&P 500 index.
I am also impressed by the rise in the bank’s asset quality metrics. The Fed has greatly derisked the US money centre bank business model by forcing them to boost capital by $600 billion in the post Lehman era as well as boost liquid assets on their balance sheet, now $2.6 trillion. This means, as loan growth and fee income rises, it boosts returns on equity, dividend payouts, free cash flow and stock buybacks. BankAm has also slashed its payroll by 40,000. This is an argument for a valuation rerating.
Amazingly, even my friends in New York diss Bank of America as a boring meat and potato domestic retail and commercial bank based in Charlotte, Nowhereville. Not true. Since its acquisition of Merrill Lynch after Lehman’s failure, Bank of America is also one of the world’s great investment banks, wealth managers and loan syndicators.
It is America’s second largest money centre bank after J.P. Morgan and its $2.1 trillion assets exceed Citigroup’s 1.9 trillion. The bank is not undercapitalized. After all, its Basel Tier One is 12.5%, slightly below J.P. Morgan’s 12.8. Jamie Dimon’s fabled Fortress balance sheet enraptures Wall Street. Bank of America shares have underperformed the KBW Bank Index in 2015. This will change in the next twelve months as Street fears over mortgage litigation risks, CEO succession, asset quality and capital adequacy fade. The stock market discounts the future while its human ecosystem obsesses about the past, which admittedly included reckless lending, botched acquisitions, a $4 billion accounting error and motgage misselling. Scott Fitzgerald the chronicler of the Jazz Age, was so right. Life is lived forward but only understood backward.
The 0.8 price/book value metric in the shares grossly undervalues the bank’s long term earnings power. The $16.7 billion negotiated settlement with the Justice Department over fraudulent mortgage misselling has removed a dark shadow from its balance sheet and CEO Brian Moynihan.
Bank of America has now paid $70 billion in legacy mortgage litigation, more than Citi, J.P. Morgan and Wells Fargo combined. This litigation expenses crippled the bank’s profit potential, as did ultra-low US interest rates. However the bank used its “lost half decade” to slash its payrolls, shed sad sack business units in the quest for operating leverage. This is a bank that now has the potential to earn $24 billion a year in the next two years and achieve management’s 12-14% ROE target. No other major bank in the world generates $1.5 trillion in cheap US retail deposits, the reason Warren Buffett became a shareholder in 2011.
It seems perverse to rhapsodize about a steeper US Treasury yield curve in the midst of a deflation scare when the world scrambles to bid up Uncle Sam debt. Yet contrarian thinking defines my DNA as an investor and strategist. Remember the big money is made when things go from Godawful to just plain awful.