FYI | Jul 12 2007
By Greg Peel
There is only so much time of a morning before the bell, so this is the more expanded version of this morning’s Wall Street report.
There is a simple Finance 101 formula which dictates that when the return on bonds exceeds the return on equity then the market will sell stocks and buy bonds. Market watchers in the US suggest this point will be reached in the current US market if 10-year bond yields sustain levels over 5.25%.
US 10-year yields leapt through the psychological 5.00% mark last month and have flirted with levels above 5.20% or below 5.05% on an almost day to day basis ever since. There is a lot of talk about official foreign money being pulled out of US Treasuries, but the reality is the net trend is still up. This largely leaves the reason for increasing bond yields as a concern about global inflation.
This should be a red rag to the bulls. Inflation is the enemy of a rising stock market as it implies tighter monetary policy ahead which brings us back to Finance 101. When bond yields rise, traders sell stocks.
So what on earth has been going on on Wall Street these past two days? On Tuesday night bond yields collapsed from around 5.15% to 5.04% and the Dow fell 142 points while last night yields rebounded to 5.08% and the Dow rallied 76 points. The market is not sticking to the script.
The problem is, of course, the subprime scare, and particularly a subprime scare intensifying right at the start of the quarterly results season. After 67 months of bull market, Wall Street is looking to upcoming earnings results as an indicator of whether it’s safe to keep backing this market or not. But the credit problem has thrown a spanner in the works.
The bulls will tell you that the subprime market represents 25% of the overall US mortgage market and defaults within subprime are running at a mere one in seven. In other words, 3.57% of the world’s largest non-government credit market is in distress. Altogether now – Big Deal!
The bears will tell you that one in seven is just the beginning as housing market woes continue, and that the subprime crisis is a contagious virus. When mortgage bonds are eventually marked to market the money that will flow out will cause a re-rating of all debt instruments across the low quality spectrum, and any other risky credit spreads for that matter. In such circumstances, equities are also a risky asset, particularly when margin lending or other forms of leverage come into play.
So who’s right? Well that’s the problem isn’t it.
Those Wall Street traders who are unsure will tend to run to either camp depending on which way the wind seems to be blowing on the day. Yesterday, as Moody’s and S&P started downgrading mortgage bonds, there was an against-trend flight to quality into US Treasuries. Such a panicky flight to quality is not good news for stock markets because, irrespective of the lower yields it implies, equity actually rates on the bottom of the credit quality scale. Last night, the trend came back into play once more as the sellers came back into the bond market and yields pushed up again. Instead of being concerned about rising yields, equity traders simply said Phew!
Commentators have put part of the bullishness down to what Fed chairman Bernanke said the night before. To cut a long story short, he suggested that the connection between low unemployment and rising inflation was actually tenuous. So bang, just like that, the market need no longer worry about the employment numbers. This takes one reason for a further tightening of monetary policy off the table, and thus reduces the risk the Fed will raise in the foreseeable future. (NB: The RBA counts low unemployment-driven wage inflation as possibly its biggest fear).
Furthermore, the chairman of the Philadelphia Fed was also on the soap box last night and he suggested the financial market is perfectly well equipped to deal with the subprime problem.
The equity traders loved it, and the bond traders clearly ignored it. Now let’s remove bonds from the equation.
Nothing warms the cockles of a bull’s heart like a tantalising bit of M&A. It was all happening again last night as one US steel company announced it was buying another one and Colgate Palmolive suggested it wouldn’t mind having a go at Unilever. But the biggie was the worst kept secret that Alcan had signed an agreement with an unnamed “white knight” which everyone suspects is probably Rio Tinto (RIO) or, less likely, BHP Billiton (BHP).
There weren’t any major profit announcements last night although two came in after the close – both exceeding expectations. The bulls will tell you quarterly profits will again be healthy, and probably above expectations, but the bears will tell you they won’t be as healthy as Q1 – ergo a downward trend.
Private equity is very much still in focus as the bears will tell you it’s game over now that credit is under pressure and leverage is becoming a dirty word. The bulls will tell you private equity has already raised the money it wanted in its funds, and that has to go somewhere. It’s still the excess liquidity argument. What else are you going to do with it?
But maybe, as this column has suggested before, there is a bit of clue lying in what one might call the Blackstone conga line. Blackstone – the world’s biggest private equity firm – partially listed last month at a ridiculous premium. It was ridiculous because (a) current credit concerns suggest private equity will struggle to find “cheap” funds to engage in 80% leveraged buyouts, (b) Blackstone partners themselves suggested the cost of the IPO meant it would be “years” before new shareholders saw any profits and (c) because profits would be further eroded if the Democrats raise the tax rate, as they are attempting to do. So while Blackstone might march merrily on buying out the world the trickle down to equity holders will be minimal, at least until the cycle’s well and truly past.
Did Blackstone subscribers stop to think just why the partners were selling out?
Actually, it’s probably more of a case of did the people paying a 75%-odd premium the next day really think about it as subscribers may well have been simply setting themselves up for a nice stag, and there were largely only partners, staff and existing fund investors allocated stock (outside of the Chinese government). But the Blackstone deal has spurred the rest of the private equity market into action. Kohlberg Kravis Roberts has already announced its intention to list. And reports suggest there are several other funds now queuing up behind KKR. The private equity impresarios are cashing out.
One reason it’s probably a good time for them to crystallise their earnings is because of the Democrats’ war on partnerships. Having already put forward the so-called “Blackstone Bill” (which ends the 15% tax sweetener that the likes of “entrepreneurial” businesses such as private equity, hedge funds and even venture capital funds enjoy, meaning wealthy partners would end up paying the top 35% rate like every other high earner), the Democrats now wish to raise the “carried interest” tax paid by such firms from 15% to 35% as well. Critics suggest this is just a precursor to raising the capital gains tax from 15% to 35% – a move which the capitalists would see as killing the market dead. (The Democrat agenda is the widening income gap, and many Republicans also support the stance).
Were the Democrats to succeed in getting these bills through the senate, it would be a disaster for the stock market in most people’s eyes. Given the democrats have a majority, there’s every chance the bills will pass. However, there was another reason to be bullish on the floor of the stock market last night when the Bush Administration indicated the president’s veto stamp would come out faster than you could say God Bless America.
Either way, the bulls are facing the distinct possibility that 2008 will be the last year of prosperity before Goldilocks is taken out and shot.
But coming back to the subprime situation, let us not forget when this all began – back in February, when the Chinese stock market fell 9% one day.
The Chinese government has been desperate to slow its runaway economic growth in order to avoid an implosion. Many tightening measures have been implemented in the last year or so. So far these measures have proven insufficient.
Yesterday it was announced China’s foreign exchange reserves (the largest in the world) jumped to US$1.33 trillion in the first half of 2007. That represents an increase of US$266.3 billion, which is more than the total reserves accumulated in all of 2006. Forecasters were predicting an economic growth rate in the first half of 10.7%, but it has come out at 11.1%. China is close to overtaking Germany to reach #3 on the world economy scale.
There is now even more pressure on Beijing to raise interest rates and let the renminbi appreciate. Annual loan growth hit 16.25% in June from 16.00% in May while new renminbi loans reached 2.54 trillion renminbi in the first six months versus 3.2 trillion renminbi for the whole of 2006 . The only comforting news is that there are expectations of a slowing in foreign reserve growth in the second half of 2007. The second quarter’s growth was actually lower than the first quarter.
It would not be a good time for the Chinese stock market to take a dive while the US stock market is jittery. The only thing that can be certain as the Wall Street bulls and bears argue it out is that volatility looks like the current winner on the day.
