The Perfect Storm - RS - Calamander Issue VI -03Nov08

Presented by: Mr Roman Scott
British Chamber of Commerce Singapore’s
Economic Spokesperson
Managing Director, Calamander Capital

www.britcham.org.sg

CONTENTS

1 Forward by HE Paul Madden,
British High Commissioner, British High Commission Singapore

2 British Chamber of Commerce Singapore Economic Briefing, Q4 2008
Key points and slides for the briefing on 6 November 2008

3 The Calamander Group/Calamander Capital
A brief description

PAT R O N F O R E W O R D

HE Paul Madden

BRITISH HIGH COMMISSIONER

BRITISH HIGH COMMISSION SINGAPORE

With the fast moving developments in the global and regional economy, it is vital for British
Chamber of Commerce members to have access to good sources of economic information and
intelligent analysis. This helps to inform their own thinking and their strategic plans for the
future in these uncertain times.

The Chamber has a very valuable asset in its economic expert, Roman Scott. His opinion
pieces in the Chamber's quot;Orientquot; magazine are eagerly awaited and his regular briefing
sessions are some of the Chamber's best attended events.

Q4 2008
Economic
Briefing
The Perfect Storm

Roman Scott
Economic Spokesperson
British Chamber of
Commerce Singapore

Managing Director
Calamander Capital
(Singapore) Pte Ltd

Economic Briefing Q4, 2008

The Perfect Storm
Global markets

I traditionally start our semi-annual economic review with a cursory look at global equities market
performance. Markets are, in themselves, merely a derivative of underlying economic activity and only of
interest to economists because they are one of the few leading indicators, given that economic statistics
are always lagging indicators. However in times of severe distress markets can impact real economic
activity, not just anticipate and follow it. A major crash can lead to such large losses that both businesses
and consumers constrain spending as they rebuild cash-a behaviour called the negative wealth effect. It
appears that 2008 will be one of those years the tail wags the dog. One year ago, when we first advised
members that ‘things would get far worse before they got better’, I took equities allocation to zero. I don’t
believe in the nonsense of overweight and underweight. As it turned out, October 2007 was the final peak
for equities. By March 2008, my last economic review, the markets were already down around 20% for the
Dow and emerging markets, with less than 10% losses for the euro zone (see Fig. 1).

March 2008 - Global markets at a glance

world
(MSCI) (SET)
(FTSE (SMI)
(DJIA) (CAC 40) (Kospi)
(BSE) (JSX)
(Bovespa) (All Ord.)
Euro 100)

world bond
(KLSE)
(Citigroup)
% YTD (TAIEX)
(FTSE 100)
(SPTSX) (RTS) (SSEA)
(DAX) (STI)
(Nikkei
225)
5.0
2.4

0.0
-2.5
-2.8 -4.1
-4.7
-8.4 -9.4
-5.0
-11.4 -11.8
-13.2
-13.8
-16.0
-18.1 -17.3
-17.4
-17.5 -17.6
-19.3 -19.3
-10.0 -20.0
-22.7

-15.0

-20.0

-25.0

Source: EIU (23 Oct 2008) Barbarra, Smith Barney (Citi)
Source: Bloomberg; MSCI

Fig. 1: The global stock market, March 2008

At the time this was a necessary and healthy correction: the sub-prime crisis, which had started way back in
early 2007, continued to exact its toll on financial stocks. Analysts and the US government, however,
continued to believe that this would pass, and that the effects on the real economy would merely result in
a slow-down and a short period of low growth. Recession remained off the table officially, and data
continued to show positive if weaker growth.

03 November 2008 1


November 2008 - Global markets at a glance

world
(MSCI) (SET)
(FTSE (SMI)
(DJIA) (CAC 40) (Kospi)
(BSE) (JSX)
(Bovespa) (All Ord.)
Euro 100)

world bond
(KLSE)
(Citigroup)
% YTD (TAIEX)
(FTSE 100)
(SPTSX) (RTS) (SSEA)
(DAX) (STI)
(Nikkei
225)
10.0
1.1
0.0

-10.0
-31.0
-32.2
-38.5
-20.0
-43.9 -44.9 -46.2 -46.7 -47.6 -47.0 -49.5
-51.2 -53.7 -56.7
-54.4 -54.7
-30.0
-64.6 -65.1 -66.5 -64.7
-71.9
-40.0

-50.0

-60.0

-70.0

-80.0

Source: EIU (23(30 Oct 2008)
Source: EIU Oct 2008)

Fig. 2: The global stock market, November 2008

Markets since have made up for lost time. Equities have paid dearly for the long state of denial and
avoidance by both analysts and the US government, which only finally dared to broach the R word two
months ago. Analysts appear to have finally accepted that the US had already entered a recession, even
though the data continues to show positive numbers. Prices, in all sectors and in all markets globally, have
been in freefall as sentiment moved from late-to-wake up correction, through overshooting bear market, to
irrational fear and finally blind panic. The Dow is down over 35%, most European and emerging markets
have halved, and in extreme cases losses go beyond 70%. I have consistently maintained that the US
market was grossly overvalued and avoided it for half a decade, but genuine value is appearing in the US for
the first time in eight years in some sectors. Emerging markets offer even more value. Although I cherish
my role as a long-time bear, even I believe that the severity of the correction has been overdone, and
market behaviour has bordered on the insane.

Unfortunately, that is not to say that I think it safe to go back into the waters yet. This is a day traders
market, not an investors market, and it will stay that way (high volatility in sideways trading with extreme
movements on each side). Our ‘dead cat’ comment still has life (excuse the pun), and the cat, bouncing up
and down after its fall from the 70th storey, is still very much dead. Severe market crashes create their own
legacy of value destruction. Because markets have over corrected, they have encouraged panic selling into
an already falling market from amateur investors and forced selling from those facing margin calls. Prices
may be irrational, but the conditions necessary for stability and then recovery are not yet in sight: willing
buyers, with liquidity, outnumbering sellers. Active buyers are few; those that can buy are sitting on the
sidelines. Liquidity is short, because credit has dried up and everyone is using cash to pay down debt. And
sellers remain despite fire-sale prices because they have to sell. Hedge funds in particular are facing a wave
of redemptions and are responsible for the extraordinary recent market declines. Hedge funds remain the
next train wreck, unfolding in slow motion.

03 November 2008 2


That said, it is not long now. The over-optimistic earnings forecasts that analysts continue to put out will
catch up with reality by year end to first quarter next year. Markets can finally resume looking forward,
rather than backward at the debris. Those with cash should be starting their research. For regular investors
‘dollar cost averaging’ monthly investments is a simple and effective route into standard funds. Emerging
markets offer particular value, massacred by the flight to safety of the world’s largest investors back to the
US, Japan and the Europe. Most Asian markets are already oversold, Korea and Russia has been mauled
beyond fundamentals, Brazil is reasonable, and Singapore offers a safe haven of good value. This is in the
context that underlying economic performance in all these countries next year will be absolutely dismal,
and that I still believe that analysts remain, as ever, behind the curve on earnings forecasts where risks
remain to the downside. Some of those dirt cheap P/E ratios will be less cheap with lower earnings, but
some stocks have fallen enough to reflect that.

The global banking system

March 2008: total sub-prime writedowns ~ USD 195Bn and counting…

Premier League Division Players
Championship
3.7
24.5 9.4
3.4
22.4 8.9
3.3
18.1 7.9 3.2
3
12.4 * European banks (<1Bn) 7.7
2.8
2.7
2.6
*** Canadian banks 2.6

6.5 2.4
2.4
5.8
2.3
4.9
1.9
** Asian banks (<1Bn) 4.8 1.7
1.7
1.5
1.5
1.4
4.7
1.3
4.2 1.2
1
3.8
source: bloomberg (25 Mar 08) Gulf International 1

Fig. 3: The global bank league table’s credit losses, March 2008

This will be the last appearance of our quarterly league table of bank losses and write-downs from CDOs,
which has served its purpose. Sadly, our forecast a year ago of 500 billion in losses (double the prevailing
view at the time) has been met and exceeded already. The premier league, once composed only of the ‘big
four’: Citi, UBS, Merrill, and HSBC, has tripled in size as many stalwarts from the championship division
jump above the 10 billion in write-downs required for premiership. This is an outstanding performance, led
by Wachovia and Washington Mutual, who were well down the tables before, and have piled on enough
credit losses since to beat HSBC (the equivalent of Plymouth FC beating Arsenal).

03 November 2008 3


November 2008: total sub-prime writedowns/losses ~ USD 591 Bn and counting…
Premier League Championship Division players

60.8 Other Asian banks 9.1 4.9

52.7 8.8 4.9

52.2 7.6 4.7

45.6 7.2 4.7

44.2 7.1 4.6

27.4 6.9 ~3-4

21.2 6.8

18.8 6.7

15.7 6.6
~2-3
14.8 6.1

14.1 Other Asian banks 5.5 Other US banks

13.8 5.5 ~0-2

10.4 5.4

10.4

10

source: bloomberg (29 Sep 08) Other Canadian banks

Fig. 4: The bank’s credit loss table, November 2008

Due to the opacity of CDOs, the market prices necessary to establish a real estimate of losses could never
be established, because nobody could unravel what lay behind these instruments. Sometime in the middle
of the year, however, Merrill Lynch took the action that is necessary to establish a market clearing price-
they auctioned of the toxic book of CDO’s to clear their balance sheet. That price was merely 22 cents to
the dollar. Of course that means that the actual value of these assets is closer to 35-45 cents/dollar, as
distressed debt houses require the balance for guessing the true value (the only way to price a black box),
the risks they take and the margins they require to take them. But the message is clear. Even a 40%
recovery rate applied to the CDO portfolios of the major banks would mean a lot more capital destruction
still lies ahead.

Why is this so important? I have often argued that bank crises are different, the economic impact is more
destructive, and the time to recovery is much longer than normal recessions- a fact that does not seem to
sink in to most observers and investors even today. Even for the US, this will take at a minimum two years,
and more likely three, and this is generous- the risks are all to the downside. I have repeatedly warned
about the dangers of buying in too early to the banks in the mistaken belief you are bottom fishing because
they are so cheap relative to the past. A cheap bank can very quickly become a worthless bank. Banks will
offer value only when you can fully trust and understand their balance sheet, when all bad assets are
removed, and recapitalisation has been completed. Quite why investors, and many of our readers, have
continued to buy bank stocks of the majors on this league table I fail to understand. Again, there will be a
time to buy, and that is not yet. Of the major UK banks, HSBC and Standard Chartered will remain those
with the best fundamentals when the dust settles, as will Asian banks untainted by CDO’s, particularly in
Singapore. Note also the relative strength of the Canadian banks in our sub-prime loss table. Despite their
proximity, it appears they did not fall for the hubris of their American cousins this time round. Perhaps
memories of the telecom/dotcom bubble remain fresh.

03 November 2008 4


Global economic growth

Global growth forecasts, including our IMF reference standard, are finally beginning to catch up with
reality. The IMF, consistently over optimistic in downturns and pessimistic in upturns (a lag effect I could
explain but won’t!) reduced global growth forecasts to a still healthy 3.9% early this year to reflect the
necessary slowing from the heady 5% plus growth the world had been enjoying since 2003. Their latest
revision has taken this down to 3%, reflecting the US and EU problems but remaining firm in the belief that
a full recession will be avoided and that Asian growth will remain strong.

Let me repeat what I stated in my April paper for the chamber. ‘Sadly, I continue to believe that there is far
worse to come. If it were just the sub-prime crisis, then recovery could indeed be swift with sufficient
monetary easing, write-downs, and fresh capital injections into the banks. But other fundamental problems
in the US economy have been allowed to go unchecked for years. If sub-prime proves to be the trigger for
these ticking time bombs, I believe the US economy has the makings of a ‘perfect storm’ ahead, and faces a
recession deeper and longer than expected. Asian decoupling will prove to be limited and the world
economy will also slip to recessionary growth levels of around 2%.’

03 November 2008 5


Global GDP growth
% (y-o-y)
6 4.1% for 2008
3.9% for 2009
(IMF, Feb’08)
5

4

2.7% for 2008
3 (WB, Jun’08)
3.9% for 2008 (IMF, Apr’08)
Global
3% for 2009 (IMF, Sep’08)
2
Recession

1

0
1983
1984

1991
1992

1999
2000
2001

2007
1980
1981
1982

1985
1986
1987
1988
1989
1990

1993
1994
1995
1996
1997
1998

2002
2003
2004
2005
2006

2008F
2009F
Source: Bloomberg, IMF, WB, and Strait Times

Fig. 5: Global economic growth

Rather than get more cheery, I now simply hold that this is the best case scenario, and risks are to the
downside. Once earnings start to flow in and economists accept that the real economy has been taken
down by the financial economy, consumer and business activity is proven to be falling fast, banking systems
continue to show severe stress and curtail access to credit, and Asian decoupling is proven to be mainly a
myth, we will see forecast growth go below the magic 2% number. The only question that remains is for
how long this will last. Given my comments above on why systemic banking crises leave the fires burning
far longer than the standard cyclical recession, a two year period is a minimum, not a maximum, and that
would be lucky. Three is more likely, and in a worst case scenario, we could go back to the familiar (to
Asians) long march of five years to full recovery from the 1997/8 start of the Asian financial crisis. For
business planning purposes I would take the middle option and stress test the two extremes.

03 November 2008 6


The US economy

My earlier extreme bearishness on the key US economy was, and remains, based on a view that banking
crises are very different from normal cyclical recessions, and that most policy makers, analysts, and
investors do not completely understand the full implications of a full blown financial crisis (although they
have been learning fast in the last couple of months). This is a heart attack, not a fall, and hearts are
difficult to get started again, even with the triple bypass surgery that the world’s central bankers have been
working on. Investors have, and will continue to, lose money; people will lose jobs, more banks will
collapse, businesses will struggle, and consumers’ will stop spending. This is what happens when the trust
that underpins the system disappears, and credit is severely restricted. The signs are already appearing in
the official US data, after a long lag, although growth somehow officially remains positive at 0.3%
annualised (see Fig. 6). Note in particular the very low levels of the NY Fed economic index and the
Conference Board Index, both indicating deep recession; the severe decline in unemployment (the US
economy has shed over three –quarters of a million jobs this year to date); and indications that for the first
time consumers who have never stopped spending in recent recessions have this time round (October
consumption down 3.3% y-o-y).

What I have said before is worth repeating, because although many bankers dislike the statement there is
ample evidence that it is true: ‘Bank crises invariably lead to a severe, and prolonged, withdrawal of credit,
which in turns leads to a dramatic restriction in business investment, consumer spending, and widespread
de-leveraging on both sides. Risk is avoided and capital is preserved and used to pay back debt and rebuild
balance sheets. This is devastating for an economy, as Asians recall from their experience of the Asian

03 November 2008 7


Financial Crisis. The Fed cannot force the banks to extend fresh loans to borrowers, however much liquidity
they provide them at low rates. Bankers move from ‘irrational exuberance’ in a credit bubble (i.e. stupid
lending in large amounts), to a state of shock when it bursts and equally irrational credit restriction to even
the best borrowers. As a result, there is always contagion as otherwise good borrowers in other portfolios
get infected: business loans, credit cards, and prime consumer debt. The US will be no exception to this,
and we have not yet seen the start of the non-mortgage credit bomb in the US, particularly credit cards. ‘

US economic indicators Q4, 2008
-24.6 (Oct’08) –
+2.6%
general economic
(2Q,08) from
index from Fed.
38 pts (1Q, 08)
-31.42% to 41.9
Res. Bank of NY.
+0.8%
<50 pts, the
-4.5%
-9.9%
<0 contraction pts (Oct’08)
(Aug ‘08)
min positive pt.
(Sep’08)
(1Q, 08)

Investment Corporate Business Conference
Production Inventories Manufacturing
Spending Earnings Confidence Board

Payrolls:
+4.9% y-o-y
-760,000 (first 9
(Sep’08)
0.3% (Q3’08) mths of ’08).
-3.1% y-o-y -18% to 57.6 Unemployment
-1.2% (Sep’08),
(Oct’08) pts (Oct’08) rate: 6.1% (Sep’08)
most since Aug’05

Consumer
GDP
Price Index

Consumer Consumer Employment
Retail Sales
Expenditure Confidence Rate
11
Source: U.S. BEA; Census Bureau; Conference Board & Bloomberg

Fig. 6: US economy, Q4 2008

Finally, the latest housing data continues to indicate a prolonged period of weakness and a slow recovery.
Price adjustments will help restore activity, and there is already evidence that foreclosure sales at deep
discounts are starting to gain momentum. But building permits and new home starts, which have been
falling for three years, have plummeted to lows never experienced before, and new home sales are at a
similar level of distress. Monthly building permits in September dropped to merely 68.8k compared to a 45
year average of 122k, the lowest since January 1975. New home sales are at levels (35k) last witnessed in
December 1991. I cannot emphasise enough just how important the housing market is in the developed
market economies, typically accounting for at least 25% or more of GDP. Housing goes beyond the
development, construction and house sales and financing sectors. A ‘housing related’ eco-system spreads
into a huge range of industries: materials, fixtures and fittings, lighting, carpets, paint, plumbing and
sanitary ware, kitchens, furniture, linens, garden related, home improvement and DIY, pools and
maintenance, cooling and heating, legal and accounting services… the list goes on. For the US, this
accounts for over a third of GDP, with a heavy dependence on low cost sourcing from Asian factories for
many segments.

03 November 2008 8


US housing market
250

200
Unadjusted Monthly Number of Housing Units
(in thousands)

150
Housing Starts
71.6 < 128 (avg.)

Building Permit
100 68.8 < 121 (avg.)

New Home Sales
50 36 < 58 (avg.)

Jan-82: 47.2
Jan-75: 43.5
Dec-66: 23
0
Sep-66

Sep-79

Sep-93

Sep-06
Sep-63
Sep-64
Sep-65
Sep-67
Sep-68
Sep-69
Sep-70
Sep-71
Sep-72
Sep-73
Sep-74
Sep-75
Sep-76
Sep-77
Sep-78
Sep-80
Sep-81
Sep-82
Sep-83
Sep-84
Sep-85
Sep-86
Sep-87
Sep-88
Sep-89
Sep-90
Sep-91
Sep-92
Sep-94
Sep-95
Sep-96
Sep-97
Sep-98
Sep-99
Sep-00
Sep-01
Sep-02
Sep-03
Sep-04
Sep-05
Sep-07
Sep-08
12
Source: US Census Bureau

Fig. 7: US housing market

The Euro zone

If the two remaining engines of the G3 were in a much better shape, there would be hope. But the Euro
area, already struggling over the last three years with energy and food driven inflation and its negative
impact on consumption, does not have sufficient growth potential to make up for the US in global growth.
Consumption has stalled and will decline; manufacturing and business confidence have been falling since
mid year; over 600k jobs have been shed in system that was already under-employed; GDP growth is barely
above water; and inflation remains an issue giving negative real growth rates across the board. European
banks have always been followers of Wall Street, willing to jump into the latest new, new thing or at least
buy the paper, and suffer the consequences a few years later-remember the one trillion dollar losses on the
telecoms and dot.com bubble largely taken by European banks. The derivatives gravy train, structured
products, and CDO’s have proven no exception. EU governments, already over-budget, are devoting
billions to supporting their banking systems, leaving limited room for fiscal pump priming. As is usual in the
EU, the rigidity of the labour markets will not help businesses adjust easily to reduced demand, and the
Euro remains expensive relative to most currencies constricting exports. In the long run however, I believe
that the structural adjustments in the global economy that are now underway will benefit continental
Europe, particularly Germany and France, and the Euro will continue its rise as a fiat currency and a larger
component of global trade and reserves.

03 November 2008 9


Fig. 8: EU economy, Q4 2008

The biggest problems are with the UK, which has pursued the US economic model of services, real estate
and finance the most aggressively. The financial services sector has grown to be as large a proportion of
GDP in the UK as in the US. Where goes Wall Street, goes London. Unfortunately if that is down the toilet,
the chain remains. Perhaps the UK will relook at the strengths of the ‘old-fashioned’ models of the
Germans and the French, which still believe in having factories, making stuff, and even exporting a lot of it.
The best thing that can be said about the UK is that the government has, at least, done by far the best job in
pursuing the right policies for rescuing the banking system, and without any further damaging delay. This
contrasts to the inconsistent, slow, and half-hearted attempts by the US administration, admittedly lame
duck in their last few months in power. Brown has understood that there is no substitute for active, across
the board intervention by the state in a systemic banking crisis; else the ‘system’ simply fails to operate, as
it did. Nationalisation in whole or in part was the way forward for Asia ten years ago, and is the way
forward now. Whether Mr. Brown will reap the political rewards from his efforts remains to be seen (there
is a lot of water to pass under the bridge before election time), but his efforts should be applauded, and his
policy prescriptions are one hundred percent correct. There is no other path.

03 November 2008 10


Japan

Japan economic indicators Q4, 2008
GDP: -3% in Q2, 2008
I: 0.5%
FX Reserves: USD 996Bn
CPI: 2.3% (Sep’08)
C/A balance: 3.9%

-0.4%
-3.5% -55% from
-4% (Sep’08), -3.68% y-o-y y-o-y
+2.8% to
(Aug’08), 11 pts (Mar
most since (Sep08) from (Jun ’08) to
140.5
fastest pace ‘08) to 5 pts
-0.5% from
+4% (Sep’08)
Sep’06 32.6 (Jun’08) US$ 102Bn
(Jun’08)
in 5 years (Jun ‘08)
1Q’08

Un -
Business
Investment Corporate Consumer Consumer
Inventories
Production Retail Sales employment
Confidence
Spending Earnings Expenditure Confidence
Rate

Public debt: 180% of GDP, biggest in industrialized world

Source: BOJ & Bloomberg

Fig. 9: Japan economy, Q4 2008

That leaves Japan. But why bother. Regular readers will know that there is no love lost between the
Japanese economy and myself. Japan remains in its permanent state of long, slow, and graceful decline.
Don’t get me wrong. I love the place, the people, their design, the food-and four memorable years. But I
have two major problems with their economy. Firstly, their own huge ‘easy credit and real estate inflation’
bubble of the late 1980’s, which lead to the world’s largest and most destructive banking crisis before the
US decided to go one better, was so mishandled it left a level of economic destruction that remains to this
day. In short, poor policy prescriptions allowed the banking system to limp along unreconstructed, which in
turn infected the real economy, lead to such a long period of stagnation that Japan has never really
recovered from the resulting demand destruction. It is not called the ‘lost decade’ for nothing, and reminds
us all why the Gordon Brown policy actions for a systemic bank crisis require such strong endorsement.
Japan has crawled out of its shell in the last couple of years to post some respectable growth rates and
consumer demand, but the scar tissues remain and this environment will simply put the consumer back
into their cave for another year or two. It looks like the latest data support exactly that (see fig 9). Latest
GDP numbers are shocking. To produce -3% growth in the second quarter, in a country where money is
already almost free, and inflation is running at 2.3%, is a disaster.

Secondly, I simply not believe that the Japanese will ever overcome the huge obstacle of poor
demographics. It is virtually impossible to grow and economy without growth in the population, and if that

03 November 2008 11


population is shrinking, well good luck. Now is not the time the Japanese will start to consider having more
babies, or overcoming their opposition to immigration. Put these two factors together and all you are left
with is the world’s largest shrinking economy, which occasionally in the last few years demonstrates
sufficient improvement to shrink at a slightly slower rate. I have to confess that I have spent over a decade
trying to work out why anyone with any sense would ever invest in the Nikkei, which investors, even some
sophisticated ones, regularly do. A bottle of Bolly for anyone that can enlighten me. Please don’t bother
with the ‘it’s fundamentally cheap’ line. Remember that everything in life that is cheap is cheap for a
reason.

Monetary conditions & the dollar

Given it looks like we really do have a problem, their remains all the usual policy tools governments have to
prop-up growth. One of the most extraordinary events in an extraordinary year was witnessing Alan
Greenspan admit that he might, just might, have got it wrong and believed too much in the invincibility of
the ‘invisible hand’ and his brand of laissez-faire market economics, doped up with occasional stimulants in
the form of easy money. But in the post-Greenspan world, it appears that easing money remains the US
monetarists’ tools of choice. The Fed has taken their official interest rates, the Fed Funds Rate, down to
1.0% in one of the fast rate drops in history-don’t forget that only 12 months ago we were still agonising
over inflation pressures. It of course may well go lower still, Japan style. Through this monetary easing
mechanism, the US exported its problems around the world, particularly to dollar linked countries, given
that the rest of the world continued to battle inflation (which requires higher rates not lower) and had
been tightening. This would have been a bigger headache had not the US also exported their economic
crisis as well, so that the rest of the world is also now slowing down very fast, and may need the stimulants
of cheaper money. Almost all key economies are reducing rates in sympathy, even Japan.

Money, money, money

Benchmark official rates (%)

% % %
6 6 6
Euribor (3mths): 4.66%
5 5 5

4 4 4
MFOR:
3 3
3 3.75%
2 2
2
USD Libor(3 mths)
Yen Libor (3mths): 0.79%
2.71%
1 1
1
Repo: 0.3%
Fed Fund: 1.0%
0 0
0
Nov-01

Nov-02

Nov-03

Nov-04

Nov-05

Nov-06

Nov-07

Nov-08

Nov-01

Nov-02

Nov-03

Nov-04

Nov-05

Nov-06

Nov-07

Nov-08
Nov-01

Nov-02

Nov-03

Nov-04

Nov-05

Nov-06

Nov-07

Nov-08

Source: US Fed Reserve; ECB; BOJ

Fig. 10: Money market

03 November 2008 12


There remains a problem. Lower official rates from your friendly central bank are only beneficial if your
local bank follows through and reduces the cost of credit that they charge your business or consumers.
And bankers have proven to be a lot less-than-friendly on the pass through. Rather than credit getting
cheaper it’s been getting more expensive. How does that work? Well credit depends on the interest rate
that banks charge each other that happen to be set in London, hence the term London interbank offered
rate or Libor. In normal circumstances Libor follows pretty closely the official rates from the central banks
for that currency (see Fig. 10). It is a measure of just how bad things have got that biggest and best known
banks in the world trust each other so little now that they don’t really want to lend to each other, so when
they do they charge more for it, despite official rates going down. The spread between the official rate and
interbank (since investment bankers like daft acronyms, it is called the ‘TED’ spread) is a useful measure of
risk in the financial system. A month or so ago it got to ‘TEOTWIN’ levels (my own daft acronym for The-
End-Of-The-World-Is-Nigh. Like it?). Central banks have since intervened enough to provide some measure
of rationality and trust, but the only way they were able to do this was to effectively provide a government
guarantee for the market, and take ownership in whole or in part of many banks. In the meantime, the
interest margins charged for ‘Joe the Plumber’ and Bob the Builder’s construction business remains high,
and is getting higher. That is, if the banks will lend at all. So will easing solve the problem? Unfortunately
not, even though it is the right thing to do (it is a necessary but not sufficient condition to restore the flow
of credit). Easing has to be accompanied by coercing the banks to lend again, and at lower rates, to reverse
the deadly ‘credit crunch’ that chokes off growth. And there is no legislation in the world that enables a
government to do that with private sector banks in a free market economy. The only alternative system
that does work on that front is called forced nationalisation of banks (Venezuela anyone?), or communism.

but not the dollar

against USD
2.2

2

GBP
1.8

1.6

1.4
EURO
1.2

1

0.8
Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08

Source: Oanda

Fig. 11: Currency market

03 November 2008 13


What of the dollar? I am sure there will be many sniggers in the audience given my extreme dollar
bearishness for so long. Other than against the yen, the dollar has rocketed against virtually every major,
and minor, currency in the last 3 months. The Euro has given up two years of gain, and sterling five, against
the dollar. The Asian currencies that I regard as the best long term bets have all weakened. Does this
mean that I was wrong, and that the dollar is back from the dead? In my view, not at all. I care nothing for
short term movements. I personally believe currency trading is a speculative zero sum game at best, but if
you are a trader, then sure, betting against the dollar has been bad news and may continue to be so for a
few more months. But recent dollar strength is really the result of a process; it has nothing to do with the
fundamentals. In fact, the fundamentals (current account and trade deficits, government and personal
sector debt levels) have just got dramatically worse. Add massive easing, which has left the dollar paying
only 1% against such a backdrop of weak fundamentals, and the stage is set for the dollar to revert to a
steady decline.

The strengthening was simply a process, and all processes come to an end when their purpose is done.
Market panic led major US and other dollar investors to rapidly unwind positions in any non-dollar
investments and repatriate the money, in dollars, back home to settle debts, margin calls and redemptions.
In the last couple of months absolutely any investments that had the word ‘foreign’ or ‘emerging’ attached
to them have been dumped, leading to sell those foreign currencies and buy back dollars. Ditto with
Japanese investors for the Yen, which has strengthen so much so fast that this alone will ensure Japan goes
into recession as the new super yen kills Japan’s export lifeblood. The Koreans, with a Won that has sunk
as fast as the Yen has strengthened, must be grinning. The rush for the exit has been so rapid that the IMF
has been forced to provide a standby dollar swap facility for dollar strapped developing economies. The
rising dollar is not a sign of strength; it’s a sign of weakness. What the US needs right now is a weak
currency, not a strong one, so that they can boost exports and start steps to reverse the trade deficits that
have been one underlying cause of the rot in their economy. And they will get it, soon enough. I can only
hope that the Japanese manage to get the Yen down to do the same.

Asian economies & decoupling

When America sneezes, the saying used to go, Asia gets a cold. If that’s the case, what happens when
America crashes at full speed into a concrete barrier? If that logic still holds, we all know the answer. But
that was then, and in today’s new world order the future belongs to Asia and 2.5 billion people, particularly
those in China and India, are now up with the world’s largest economies and are the fastest growing. We all
know that, and it’s true. As a result, Asia the argument goes, has a new resilience, and will be the engine
that keeps the world economy going.

I have written extensively before on why I am no fan of ‘Asian decoupling’ in this crisis. That is not to say I
don’t believe in the theory-Asia has been, and will continue-to decouple from the US and the other G3
economies. I remain a die-hard, long term, Asian bull, convinced of the secular transformation of the
region. Asian consumers are on the rise, and intra regional trade will continue to grow. But the rise of Asia
remains work in process. Asia is rising, it is not yet fully risen. At least not to where it needs to be to cut its
dependence on the G3, and be immune from US economic cycles. In the ‘Chindia’ excitement we have
forgotten how far there is still to go. 2008 is too early; perhaps by 2028 we can all truly speak of
decoupling. Asia is more, not less dependent on exports to the G3 economies (about 65% of Asia’s total
exports), and for all the talk of the rising Asian middle class, their consumption remains about a quarter of
that of US consumers. Growth rates in Asia are yet to be hit hard by the fall out (see Fig. 12), but these are
mainly Q2 numbers. The earnings impact of rapidly slowing G3 growth will hit exporters hard, particularly in

03 November 2008 14


China, Korea, and Taiwan and to a lesser extent Malaysia. Expect to see the problems from Q3, as we have
done in Singapore, and very unpleasant numbers by Q4. Neither is Asia immune from the financial crisis
and the severe credit market restrictions. Asian banks may hold very little of the sub-prime toxic debt, but
the resultant damage to the interbank market and those human things-trust and credibility-that are
essential ingredients of the banking system, has affected Asia equally. Many smartly dressed; highly paid
investment and private bankers in HK and Singapore are rediscovering the reason ‘global financial markets’
are called global. They are. The Asian financial centres that became part of the global club will feel the
fallout.

Snow white and the nine dwarves

GDP 4.2% -0.5%
4.3% 4.8%
9%
I 2.00% 0.38%
3.25% 5.00%
6.66%
FX Reserves 160.6 Bn 169.9 Bn
281.1 Bn 239.7 Bn
1,905.6 Bn
CPI 4.6% 6.7%
3% 5.1%
4.60%
C/A balance 10.8% 18.6%
5.6% -3.3%
8.5%

GDP 6.% 5.3% 4.6% 6.5%
6.3%
I 9.5% 3.75% 6.00% 12%
3.5%
FX Reserves 56.4 Bn 99 Bn 32.8 Bn 21.3 Bn
109. 4 Bn
CPI 12.1% 9.2% 11.2% 28.3%
8.2%
C/A balance 2.8% 1.1% 2.0% -10%
13.7%

Source: Bloomberg, central banks; IMF; EIU
* FX Reserves in USD
Fig. 12: Asian economy, Q4 2008

Singapore in particular is vulnerable. Singapore’s small size, limited domestic market, highly open and
trade orientated economy make it a call option on global trade. It is the proverbial canary in the coalmine
for Asia, the first to fall over when the air gets bad. It will, in return, be the first to pick itself up again when
the fires have died down. Again, nothing has changed, and I remain a long term secular bull on Singapore,
and the Singapore dollar. The remaking of its economy and the returns from investments in new sectors
and technologies, services, wealth management, lifestyle and entertainment-‘Monaco in the East’ as I have
called it- will follow. The model is sound, and they are pretty good at delivery, which is a huge advantage.
But to see the flower fully in bloom is a 2015 story. Early this year I was very cautious on Singapore growth,
but next year I believe will be brutal for Singapore. Does this matter? Not really, assuming your business
can hunker down. Long term investors in the city state that stay the course will still find their patience
rewarded.

03 November 2008 15


Investment risks

The most interesting outcomes of the extraordinary events that have unfolded this year are the
fundamental questions raised about the value and effectiveness of the world’s prevailing investment
model. This model is an Anglo-Saxon invention, with a few core components. Firstly, an almost exclusive
focus on capital markets ‘paper’ assets that are liquid and readily tradable; and that provide the potential
for endless innovative offshoots or derivatives that are model-based plays on yield. Secondly, a strong
belief in the efficiency and supremacy of the market in pricing this paper, and in accurately reflecting all
information in the price. And finally, asset allocations that focus only on paper liquid assets, and pick
markets based on current size, liquidity and depth (hence the weightings for the US for example) over
growth, future potential, arbitrage opportunities, and inefficiencies. The entire industry (analysts, private
bankers, investment advisors, etc.) follow this model. I believe they are wrong, and recent events appear to
support the idea that the model should be questioned.

But having raised the question, I will keep the debate for another time and place. Let’s leave it with the
facts so far: the collapse of the best names in Wall Street; the huge wealth destruction from derivatives;
the inability of those that made and sold them, and those that regulated them, to completely understand
the monster they had created or to even connect the underlying asset to the paper representative; the
humbling of the world’s largest private banks; the millions of angry investors who feel duped having been
sold structured products with risks they didn’t understand; and the complete failure of an entire industry-
hedge funds-that charged a fortune on the promise they were market neutral and could perform as well in
bear markets to generate returns superior to everyone else. Quite why ordinary investors haven’t hit the
streets rioting, and burned down a few investment banks and hedge fund offices, I am not quite sure.
Perhaps the frustration is there, but no-one knows where to direct it. Either way, there will be
repercussions: in new regulations, in modifications to compensation models, and in the loss of business and
investors by the investment industry. I just don’t think the industry has woken up to that yet. Private
bankers, for example, still seem to believe they can continue to sell structured nonsense to gullible
investors. Nero fiddling while Rome burns.

I am often asked were best to invest, to which the reply is always that our job is to provide economic
guidance and strategy, not to be investment advisers. As ever, our core belief in times like this, and at all
times, remains in the value of real assets in relatively esoteric areas-the road less travelled. The advantages
are many: the assurance of fundamental value, transparency, non-correlation with financial markets,
inflation proofing, and real returns in limited markets that often provide serious arbitrage opportunities.
The downside is lack of liquidity and a long time horizon. We are believers, it is all that we do ourselves.
Oh, and there is one other advantage. We actually make money. Other than real assets, cash and
currencies remain a safe bet for now, but one where real returns may be negative. Gold remains an
inflation and risk hedge, but is too speculative to make it an easy call. So in the medium term, beaten down
equities in emerging markets will provide the best liquid returns for balanced investors over the medium
term, taken straight up (i.e. avoid those structured entities). That said, not all emerging markets are
created equal. Many emerging markets are cheap because they are genuinely at risk. Here the things to
look for are poor current account balances, trade deficits, government budget deficits and a track record of
over spending, and worst of all high levels of external debt with a low level of FX reserve protection.
Sounds familiar? Yes, that was Asia a decade ago. Asia’s major advantage this time round is that Asia had
its crisis and so learnt to avoid the same mistakes. Rapidly rising Eastern Europe on the other hand looks
exactly like 1998 Asia. Likewise for Latin America (particularly Argentina), Russia, and South Africa. Iceland
had all the signs, but it has blown up already. Enjoy the tour guide (Fig. 13).

03 November 2008 16


Emerging countries at risk

High
Medium
Low
Based on level of current account/budge deficit, external debt, inflation, economic uncertainty, foreign exchange reserves, and currency value.

Source: Press research

Fig. 13: Emerging countries at risk

Oil prices and inflation

It is nice to see that the old rules on elasticity of demand for oil to appear to be functioning again.
Economic activity slows down, and world-wide demand for oil drops accordingly. The surprise comes only
because for the last four years oil prices essentially tripled, with little discernable effect on demand in the
rich economies, sending economists scrambling to explain why (such as inflation adjusted oil hadn’t got
that expensive, consumers wee richer and could afford it, energy as a percent of household spend had
fallen etc.). The resultant continuous upward spiraling of demand in a world where easy supply has been
dwindling for years caused the dramatic oil price rises we all got used to, leading to a nasty cycle of l
inflation. Oil has since corrected, but that does not mean that oil is cheap. It simply means that it has come
back to earth and is no longer priced beyond the fundamentals. Neither does this mean that oil is about to
fall off a cliff like every other price and return to the $40 level or lower. Yes, demand has dropped and will
continue to drop, as the world goes through the worst recession in decades. But the fundamental
problems of exceptionally tight supply, concentrated in the hands of one key nation (Saudi Arabia), with
continued strong demand from the emerging market giants of China and India, has not gone away. New
sources of supply continue to elude the industry, and the great white hope- the Canadian oil sands, are a
decade away from serious scalable production at a reasonable cost. Deep water finds remain tricky and
very expensive, the industry is a long way from making up for two decades of gross under investment; and
the shortage of experienced labour and deepwater rigs remains. Don’t rely on a return to cheap oil prices
anytime soon.

03 November 2008 17


Oil
World Production Capacity for Oil in Mbbl/day

Russia
Canada
Norway 9.93 9.93 0
2.60 2.60 0
2.84 2.84 0 China

3.77 3.77 0
Middle East USA

8.33 8.33 0
24.4 19.6 4.85
North Africa
Iran
Mexico
4.89 4.89 0
4.16 4.16 0
3.6 3.26 0
Indonesia

1.11 1.11 0
Nigeria Venezuela

3 2.28 0.72 2.8 2.80 0

03 November 2008
Capacity Production Spare capacity
USD 69.10 per barrel

Source: Energy Information Administration; OPEC; Bloomberg

Fig. 14: Oil

Despite the welcome relief for inflation pressures and a weak economy, cheaper oil is not necessarily a
good thing. $150 oil had two major advantages. For the first time, it was encouraging more efficient usage
and alternatives; particularly in gas guzzling America. This is the only long term solution to the current
shortages. Secondly, prices were finally getting an industry famous for under- investing to commit serious
capital to badly needed new exploration and more expensive deepwater operations. There is a real danger
that in reducing dramatically the incentive to rebuild reserves and find new supply, the world economy has
laid the seeds of a second wave of uncontrollable oil price inflation that will see oil back over $150 dollars
and beyond, because the opportunity to invest in new supply aggressively ground to a halt.

03 November 2008 18


Conclusions

The Filey lifeboat: designed to be unsinkable

The risk of depression conditions, not merely recession risks, is real. The world’s three major economies
have always moved in sync, as has the rest of the world. Globalization and trade have supported this. We
do not live in a decoupled world for any country, we have spent the last twenty years getting increasingly
more ‘coupled’. Even if a worst case scenario is avoided, global growth will be slower for the next five years
as the G3 deleverages and repairs bank balance sheets. Bank crises have a devastating effect across the
board for all industries, because all depend in some form or another on the supply of readily available and
reasonably priced credit, distributed from savers to borrowers by those ‘piggy’s in the middle’-the banking
system. Meanwhile, US consumers have equally large problems. They have built up a level of debt equal to
the entire annual GDP of the country, and now have to now pay it back. The effect has been and will be felt
the world over for years to come.

For businesses, the realization of existing business plans under current conditions will prove to be highly
unrealistic. An earnings shock will be the first wave of impact, as businesses feel the impact of demand
contraction from chocolates to cement blocks to excavators to mortgages. Investment will decline,
followed by employment, followed by consumer spend on everything from new homes to goods in that
home, travel and leisure. Businesses plans should be stress tested against 2-3 scenarios, including an
extreme case of depression economics for five years. Smaller enterprises will be particularly vulnerable,
and should plan cash flow to ensure that a year’s requirements for cash is available, and if not it is time to
liquidate assets to get to that point.

03 November 2008 19


Given my usual focus with monetary conditions and debt levels, which are clearly bad at this time, I may
sound overly pessimistic. This is true. I am a banking guy, obsessed with credit cycles, debt levels, money
supply and interest rates (the so-called Austrian school). The reason is that the credit and debt cycle has a
habit of regularly blowing up the real economy, through a bank credit crisis, every five to ten years in some
part of the world. My caution is born from the experience of many years I spent helping clean up the last
banking crisis in South East Asia, and what I saw in Japan before that. What we went through in Asia was
brutal, and a five year process before life really began again. Let’s hope that I am wrong- nothing would
make me happier. In the meantime, I hope that our warnings to date have helped members avoid painful
losses, and prepare their business plans for worse case scenarios that we all desire will not happen.

Global Disclaimer
This research note and/or opinion paper, article, or analysis has been released by Calamander Capital (Singapore) Pte Ltd., or its
parent company or affiliates, to professional investors, clients, and business members of the British Chamber of Commerce for
information only, and its accuracy/completeness is not guaranteed. All opinions may change without notice. The opinions
expressed, unless stated otherwise, are not investment recommendations, or an offer or solicitation to buy/sell any funds,
investments or other services of the Calamander Group, Calamander Capital, or its affiliates. Calamander Capital does not accept
any liability arising from the use of this communication.

Copyright © Calamander Capital 2008. All rights reserved. Intended for recipient only and not for further distribution without the
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03 November 2008 20


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03 November 2008 21

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03 November 2008 22
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Economic briefing Q4, 2008

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03 November 2008 1
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The Perfect Storm - RS - Calamander Issue VI -03Nov08

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