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MONEY MATTERS – Time to get domestic

Recession in the US used to be the kiss of death for emerging economies, but that may no longer be the case


THERE was something inevitable about the worst US job reports in four years. They suggest that the American economy has now ‘officially’ slipped into recession and will ensure that the Bernanke Fed cuts the overnight borrowing rate at the next three open market committee meetings, starting Sept 18. Net-net, a 4 per cent Fed Funds rate is the last antidote to the liquidity squeeze and credit shock that has delivered a deflationary blow to Wall Street and the international banking system. Global stock markets are on edge, amid fear that the correction in equities could morph into something far nastier.

The risk is that the US stock market could re-test its August lows, because even a Fed rate cut cannot magically end the distress of millions of bankrupt homeowners and the financial bomb that has hit the mortgage-backed securities and credit derivatives markets. Main Street is going down and Ben Bernanke and his merry men at the Fed must act fast or risk economic disaster.

Fear cannot be captured in any economic model but it is the one human emotion more powerful than greed during a psychological U-turn.

Not even the most soothing words from Mr Bernanke can change the fact that as long as US house prices continue to fall, the leverage-embedded mortgage-backed securities and collateralised debt obligation markets – and investors in these markets – are in deep trouble.

The meltdown in sub-prime mortgages is not the real malaise affecting the capital markets. The real time bomb is the coming end of the structured finance business, in which financial innovation has often been nothing more than collusion between investment banks and ratings agencies to disguise highly risky mortgage and corporate debt as AAA securities.

When even the Bush White House is compelled to fulminate against Wall Street, a Congressional witch-hunt and more restrictive regulatory protocols are inevitable.

The Day After

The macro-economic impact of ‘The Day After’ on Wall Street will be a deflationary shock as broker-dealers and institutional investors de-leverage their exposure to mortgage-backed securities and structured finance. This means that new issues of corporate bonds and leveraged buyout loans will plummet because investment banks can no longer underwrite or syndicate credit risk, even though it has been re-priced higher since August.

Asset-backed commercial paper liquidity lines have come back to haunt the world’s largest banks, which must now necessarily cut bank credit growth. The markets are witnessing the dark side of securitisation as international banks are caught with untold billions of off-balance-sheet exposure. This is the real reason that central banks are desperate to pump huge amounts of liquidity into money markets frozen with fear.

Emerging markets have not escaped unscathed from the trauma in the world financial markets since August. Apart from China’s Shanghai A shares, market indices as diverse as Brazil’s Bovespa, South Korea’s Kospi, India’s Sensex and Russia’s RTS plunged 10-20 per cent in just four weeks as the Japanese yen carry trade unwound with a vengeance in the foreign exchange market and triggered a global scramble to sell risk.

This meant that billions of dollars fled emerging market equities, that spreads on emerging market sovereign debt widened above 200 basis points on US Treasuries and that the Chicago Volatility Index doubled in a month.

But what will be the end-result of the US credit bust on emerging markets?

In my view it will be a strong de-coupling from the now outdated and wrong assumption that the US dollar and US rates are the global benchmark and the so-called risk-free rate.

Emerging market spreads recently have been the narrowest in history. Does this mean that all emerging markets are over-valued? Or that the underlying assumption that US-dollar rates are the ‘risk-free-rate’ needs to be rethought?

Do the lessons of 1998 have any relevance in the months ahead? I believe so.

As US economic growth decelerates, the Fed will do its best to reduce the real cost of borrowing to zero – a prerequisite to avoid recession and re-liquify the banking system. This means the Fed Funds rate can well fall below 4 per cent some time next summer.

While this will most probably help the US equity market, it will mean a much lower value for the US dollar in the foreign exchange markets.

Ordinarily and in the past, a US recession is or was the kiss of death for emerging markets.

But this may not be the case now, particularly if the Fed, at the expense of a much weaker US dollar, cuts rates aggressively to pre-empt recession and global GDP growth, led by China, India, Brazil and Russia, anchors domestic demand and export growth in emerging markets.

As the US Treasury bond yield falls to 4.25 per cent, emerging market equities will be the biggest beneficiaries, as more and more global investors realise that the real victim of the sub-prime mess is the US dollar.

However, I recommend buying domestic demand, not export, plays in emerging markets in order to insulate a portfolio from the very real risk of a US slowdown.

Russian banks and telecom shares such as Sberbank, Vimplecom, MTS and Comstar provide exposure to one of the world’s highest-growth consumer stories in a petro-dollar state with 160 million citizens and US$400 billion of reserves.

The credit crunch may actually prove beneficial to the Russian stock market because it will force the postponement of many London floats, which cannot take place amid a mood of risk aversion.

The Singapore market was also victim of the stockmarket sell-off on Wall Street and the Asian bourses. In fact, Singapore property shares fell far more than even the Straits Times Index, as much as 20-30 per cent in some cases.

The Singapore Reit sector’s cost of capital has risen, but its growth prospects are tied to South-east Asia’s most compelling asset reflation story.

After all, the forward yield on the sector is now 5.2 per cent – a compelling value metric for long-term exposure. It is imperative to seek Reits that offer long lease contracts, high-quality assets and acquisition strategies, proven business models and attractive discounts to net asset value.

It is ironic that the largest, most liquid Singapore Reits have been hit the hardest, proving once again that during moments of panic, emerging market managers do not sell what they must, they sell what they can.

So CapitaCommercial Trust, CapitaMall Trust, Ascendas and Mapletree are all down 20 per cent from their August highs. The spread between the Singapore Reit forward dividend yield and the island’s bellwether 10-year government bond rate is now the highest since at least May 2006.

Singapore Reit shares will be the natural beneficiaries of central bank easing in the US and Europe, somewhat akin to Nasdaq stocks after the Greenspan Fed bailed out Long Term Capital Management in 1998.

Asian property in local currency could be the next big thing in emerging markets, especially as the US dollar takes a tumble when the Fed cuts rates aggressively.

Michael Preiss is a chartered wealth manager and can be reached at Michael@michaelpreiss.net

Source: Business Times 12 Sept 07

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