|By Matein Khalid| The Federal Reserve could well raise its overnight borrowing rate at the next FOMC monetary policy conclave on September 17. Though contagion from China’s 40% stock market meltdown has triggered bear markets from Hong Kong to Frankfurt and plunged Asian/emerging markets equities into ta ghastly replay of 1998’s epic meltdown (General Suharto’s overthrow, the Russian rouble default, Malaysia’s capital controls, the run on the Thai baht, the IMF’s $57 billion South Korea bailout, $10 crude oil). The smoke signals from the central bank suggest the $17 trillion US economic colossus (25% of global GDP) exhibits strength, with 3.7% second quarter GDP growth, 1.1 million housing starts, 17 million unit vehicle sales, a 5.1% unemployment rates, record corporate profits and accelerating bank loan growth. US economic data unquestionably argues for “monetary normalization”, Fedspeak for higher US interest rates seven years after the failure of Lehman Brothers plunged the world into capital markets/banking Armageddon and the deepest economic slump since the Great Depression of the 1930’s.
It did not surprise me that Fed vice-chairman Stan Fischer chose CNBC to signal that the US economy’s data momentum is strong enough to threaten the central bank’s 2% inflation target. After all, the Federal Reserve operates under a dual mandate, to maximize employment growth consistent with an inflation target below 2%. The Presidents of the Dallas, Atlanta and Richmond regional Feds all echoed Dr. Fischer’s hawkish views.
However, the Yellen Fed cannot and will not ignore the global economy and the $10.4 trillion Chinese economy’s financial carnage in its deliberations. The managing director of the IMF and the governor of India’s Reserve Bank (a former IMF chief economist and University of Chicago monetarist!) have publicly asked the Fed not to raise interest rates during a time of financial market turbulence and deflation risk in emerging markets. Former Treasury Secretary and Harvard President Larry Summers even called on the Fed to ease, not raise, interest rates to fulfil its role as the world’s de facto lender of the last resort.
After all, the Greenspan Fed responded to the Asian flu with three successive rate cuts in 1998-99. The Bernanke Fed responded to Lehman/Wall Street banking crises in 2008 via history’s most epic experiment in unorthodox monetary easing and expanded the Fed’s balance sheet from $900 billion to $4 trillion in the past seven years.
The 5.1% unemployment rate and 173,000 payrolls growth data in August does not negate a September rate hike as average hourly earnings rose 0.3% and aggregate hours worked rose 0.4%. This led to steep equities losses on Wall Street and a fall in the ten year US treasury note to 2.11%, thus flattening the US dollar yield curve. The ECB’s Dr. Draghi downgraded Eurozone growth/inflation, raised limits on singe bond purchase and explicitly pointed to the China/commodities crash as a source of deflation risk. This raises the odds of a “shock and awe” ECB QE in October and a fall in Euro/dollar to parity or lower by early 2016. This is exactly the scenario I had outlined in a column I published six weeks ago. A hawkish Fed, a dovish ECB and the Chinese Politburo in panic means King Dollar, risk aversion spasms in global markets and unwinding of the crude oil short covering trade.
I doubt if China chaos will offset the Yellen Fed’s tightening bias. Unlike September 2008, there is no sign of systemic stress in the wholesale bank funding, loan syndication, commercial paper or bond new issue markets. The Chicago Volatility Index (VIX) has more than doubled to 27 but I cannot see the Fed “ease” unless the VIX spikes to 45, not on the eve of a US Presidential election.
However, Wall Street has priced out the scenario for aggressive Fed tightening (the Chicago futures markets predict the Fed Funds rate will be 1.25% in September 2017). This is the reason Citigroup, Morgan Stanley, Goldman Sachs and J.P. Morgan shares have fallen 15-20% from their recent peaks. As the yield curve flattens, bank interest rate margins compress. Dr. Copper is at $5000 per metric ton on the LME and Uncle Carl’s Freeport Stake did squat for commodities stocks. If the Fed only considered US data strength, it is ‘behind the curve” on inflation risk. Yet the Fed is de facto lender of the last resort for a world in deep financial distress. China/Asia now joins subprime mortgages and Greek sovereign debt as the third global shock in the past decade and bank stocks have paid the price on Wall Street.
Macro Ideas – Can India’s Sensex fall to 18000?
India, the dream macro trade of 2014 on Modimania, was not immune to the global market angst after China’s shock yuan devaluation. The Sensex has fallen to 25200 and Nifty 7650 as I write. I was stunned to see $1.9 billion flee Dalal Street in a single week in late August, though local funds were buyers. Foreign funds have seen their Indian equities portfolios gutted by the 45% fall in the rupee against the US dollar in August 2011. RBI Governor Subbarao’s monetary mismanagement compelled me to publish a strategy idea to short the Indian rupee at 45 in mid 2011. The Indian rupee tanked 50% to 68 in August 2013.
Despite its sharp correction, India is still expensive at 3 times book value and 16.4 times forward earnings, double its historical 22% ten year premium to the Morgan Stanley Asia ex Japan index. There is no credible valuation case for India in a world where growth is being derated in favour of value. The earnings revision ratio in India has begun to accelerate to the downside, notably in telecoms, autos and infrastructure.
The India macro trade since the May 2014 BJP election landslide is now over. India is the biggest consensus overweight for emerging markets funds by at least 500 basis points. If another $100 billion flees this toxic asset class, the Sensex could well plummet to 18,000. While the fall in crude oil was a $50 billion windfall for the Indian economy in 2014 – 2015 and narrowed its trade deficit/inflation pressures, the oil plunge also coincided with an economic shock in Asia/China that will hit Indian earnings growth.
No sane investor should have been overweight emerging markets since the 2013 Fed “taper tantrum”, though rationality is often an optical illusion east of Suez. As I expect the Chinese yuan to depreciate to at least 7.6 against the US dollar in 2016, the Indian rupee could well fall to 72 or lower, as the RBI cuts rates and offshore money flees Dalal Street as the Indian growth story derates in a world which could well see history’s first Made in China recession. Barclays, CLSA and Nomura Securities have all slashed their Sensex targets. This is only the tip of iceberg. As Indian corporate profits disappoint and US economic data justifies a Federal Reserve rate hike, Bhaluji will maul Dalal Street. This is definitely not the time to book a leveraged passage to India.
I doubt if India’s permabull cheerleaders will find their growth/policy narrative resonate among terrified fund managers in Wall Street and the City, let alone the Bahnhofstrasse or Singapore. Growth shock hits, blows to investor sentiment and retail redemptions take years, not weeks to resolve.
All is not doom and gloom for India in my 2H macro crystal ball. I expect the RBI to cut the repo rate twice this autumn as August CPI data has fallen below 4%. Easy money in India makes me turn to HDFC Bank, ICICI Bank and Axis Bank, though I expect public sector banks will be crippled by a spike in non performing loans to metal producers. While India’s cyclical GDP uptick to 7% and the reform agenda of Modinomics is compelling, India is vulnerable to a hard landing in China and its shock waves across the planet. If the Middle Kingdom’s economic growth rate was really 7% (The Politburo’s target), Chinese August PMI would not be 49, a metric of contraction. Modinomics will also be difficult to implement in a nation with such, complex, diffuse and regional power constellations, as the BJP government has learnt with its blocked Land Acquisition and GST tax bills in the Lok Sabha.
There are dangerous pockets of overvaluation in Indian equities. Why does the midcap index trade at a premium in a world where liquidity and risk appetite is ebbing? What impact will a fall in the rupee to 72-74 have on the unhedged foreign debt of Indian oligarch conglomerates?
Apart from private banks, I like India pharma, given the 40% generic and OTC drug market share commanded by Indian firms in the US. Note the stellar outperformance of Dr. Reddys, Wockhardt and Glenmark Pharma in 2015. Indian IT firm Infosys is also a winner in a world where the rupee depreciates while US economic growth rises and operating margins are robust. Indian capital goods/engineering firms are grossly overvalued. The Indian property market is comically overvalued.
I track RBI interventions in the money markets, FII flows, Nifty put/call ratios and ETF/mutual fund redemptions. These all flashed a sell signal on Nifty since July. Better to be approximately right than precisely wrong in the Indian money bazaar.
Stock Pick – American Express is a credit card Cinderella
My recommendation to stay short the share of Standard Chartered Bank (originally at 1500 pence, latest at 1080p) remains a winner. Stan Chart shares have fallen from their 1800 pence peak in early 2013 to a dismal 715 pence now. The last time I saw these levels in the bank, Rana Talwar was the CEO, albeit soon to be ousted in a boardroom palace coup. Peter Sands has bequeathed a disastrous legacy with his flawed investment banking strategy and reckless loan underwriting culture. As I expect higher provisioning in Asia/China and a dilutive capital raise, I would not be surprised to the bank trade below 650 pence in London. In international banking, the “cockroach theory” is a proven winner!
American Express is another Wall Street Cinderella with its shares down 20% in 2015 alone. Murphy’s Law gutted AmEx from 95 to 74 as I write, as all that could go wrong went wrong in the world’s preeminent global payments and travel related services brand. AmEx lost its lucrative, exclusive credit card deal with Costco Wholesale. AmEx lost US court cases that hit its bargaining power with merchants. Its respected President Edward Gilligan, the potential successor to CEO Ken Chenault, died suddenly from a heart attack. Ultra low US money market rates and King Dollar hit revenue growth. AmEx was forced to boost its marketing budget to compensate for the loss of co-branded relationships, though thankfully Starwood Hotel is safe. AmEx even saw San Fran activist hedge fund Value Asset Capital Management accumulate a $1 billion stake and agitate for a corporate restructuring.
Unlike Visa or Mastercard, American Express provides balance sheet credit to cardholders and manages its merchant relationships worldwide. Yet it trades at an unjustified valuation discount at 12.8 times forward earnings or the lower end of its own 13–17 times earnings valuation trading range since 2012. This is a company that could well deliver 13 – 15% EPS growth next year, especially as it will gain a $1 billion windfall on the sale of its Costco co-branded portfolio to Citicorp. Why do I like AmEx at 68 – 70?
One, the US is 77% of AmEx revenues. Thanks to job growth, low gasoline and the housing wealth effect, the US consumer is on a roll in a dismal global economy. If ever there was a premium credit card brand, AmEx is it.
Two, AmEx has the highest return on assets among any major credit card issuer, higher than Discover, Synovus, Well Fargo, Regions and J.P. Morgan. The current valuation metrics do not reflect this competitive excellence.
Three, the Federal Reserve has approved AmEx’s generous $6.6 billion share buyback and dividend payout proposal in its last capital plan. This is a hugely positive ballast for the shares.
Four, AmEx has vastly expanded its merchant network since my time on Wall Street, when managing directors on the trading desk bragged about their AmEx platinum cards, their Sutton Place condos and their East Hampton/Sag Harbour beach homes.
Five, AmEx’s “closed loop” consumer credit model is superior to Visa or Mastercard, whose valuations are in the 24-26 times earnings range. AmEx is undervalued at barely 13 times current earnings.
Six, AmEx leveraged Big Data analytics on its clients to initiate corporate partnerships and incentive programs. This is the world’s premium credit card brand for merchants and high net worth consumers ever since AmEx was founded in Belle Époque New York in 1890.
Seven, while AmEx valuation was derated as US consumers paid down debt after the 2008-9 financial crisis yet consumer psychology is now changing. In any case, AmEx is far less dependent on loans to cardholders than megabanks like Wells Fargo, Citigroup or Bank of America. In any case, revolving credit card debt has risen 7% since summer 2014, the highest post Lehman metric, even as loss rates fall to historic lows. Even Tina Fey uses an AmEx card to buy zit cream LOL!
Eight, management guidance concedes a dismal 2015 but signals 12 – 15% EPS growth next year. This makes the shares undervalued on the NYSE even if China/“taper tantrum” take the shares below 70. In fact, volatility spikes (Chicago VIX 35, implying a US recession that will just not happen) are an optimal moment to capture excess returns via AmEx put spreads and even naked put option sales. Worst case scenario on the strategy? Delivery of AmEx at 12 times earnings or 65. Ahlan wa sahlan!