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David Hamilton Executive Director (61) 411 886 155 (61) 3 9863 8559 david.hamilton@falconcap.net Simon Selimaj Executive Director/Chief Investment Officer (61) 3 9863 - 8558 (61) 417 880 688 simon.selimaj@falconcap.net
Question No.1
1/ USA
The US 10-year Treasury bond yield has now broken out of a 26-year trend line (see Fig 1) If the move is sustained that will inevitability, be negative for US Equities as well as loan credit spreads. Inflation pressures are rising due to rising energy and food prices and this is now clearly being factored into the bond market with rising yields. The US import index grew 0.9% month on month in May 2007 which was one of the fastest monthly rise since 2003. For many years the volume of Chinese exports have risen but the price of Chinese exports continued to fall. Each year the retail price of a Chinese TV or DVD player fell in price and we in the West scratched our heads and wondered how the Chinese could produce such products at such low prices. The net result was that for years Chinese manufacturers were exporting deflation to the Western world. This is now no longer the case as the prices of Chinese goods to the USA rose into positive territory for the first time on a year-on-year basis by 0.1% (see Fig 2). From July 1 2007 the Chinese government will cut or eliminate export tax rebates for more than 2,800 export items. China is now exporting inflation!
An overlay of the NASDAQ (tech bubble and bust) of the 1990s and the Shanghai A shares (see fig 3) highlights the speculation in the Chinese equity market. Based on price-to-earnings multiples, Yuan- denominated shares in Shanghai are three times more expensive now than they were two years ago! A short term bust is brewing.
3/ Australia
Australia is highly dependant on exports to both the USA & China and any crisis will have major repercussions on commodity producers. Our stock market is currently facing a troubling situation due to: slowing earnings growth from approx 20% to circa 9.5%. However, the danger is that the pace of earnings upgrades is now starting to ease resources are driving earnings growth while industrials are deteriorating. The strong returns in Australia have been almost entirely driven by P/E expansion against moderate growth. The result is a very stretched market in terms of valuation not seen since 2000.
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Apr-61 Feb-65 Dec-68 Oct-72 Aug-76 Jun-80 Apr-84 Feb-88 Dec-91 Oct-95 Aug-99 Jun-03
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Apr-07
Page 2.
Monthly Report
Economic Outlook U.S.A: We expect the US economy to be in recession before the end of this year (negative growth in Q3 and Q4), but the scale of the unwind in the credit markets has been greater than we expected and has caused us to move the anticipated timing of recovery into 2009. Oil price rises together with a weak base mean that CPI inflation will finish this year around 4.5% well above what most central banks would deem acceptable. The Fed will not have to wait long for inflation to fall back however as GDP growth weakens. We expect CPI inflation to average 1.5% in 2008. Irrespective of near-term inflation pressures the deflation in credit markets means that rate cuts should be expected at each of the three FOMC meetings this year. We expect the funds rate to be 4.5% on 31 December. Aggressive cuts will continue through 2008. This years moves are discounted, even so flight from the credit markets will push 10-year government yields to 4% by end-2007 and through this level in 2008.
We at Falcon Capital highlighted the problems of the US housing sector in our Ominous Omens Report dated 4th July 2007. Less than a month later this provided the trigger for a large sell off in world stockmarkets. Ben Bernanke and the Fed came to the rescue with an immediate 0.50% cut in rates and the world stockmarkets rebounded. Dont TH CA be seduced by the recent rally as the structural flaws in the subordinated debt market are so profound that it is almost a certainty that the US growth will slow dramatically. For historical reasons that we will highlight below the months of September and October 2007 are particularly vulnerable. Use the current reflex rally to sell into the market and lighten position that were not lightened prior to the credit crunch. Call this a second chance!
We are here
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While Treasury yields have fallen asset-backed commercial paper yields have soared. Banks have tightened credit controls and are less inclined to lend. A contraction in credit due to the sub-prime lending crisis will in all probability lead to a dramatic slowdown in the real economy. The U.S consumer is exhausted. Falling home prices not seen since the 1930s will affect consumption.
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The yen carry trade is one of the largest sources of excess capital in the global system today. It has been instrumental in supplying leveraged funds for bets on high yield currencies, commodities, emerging market debt and fashionable stock markets.
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The 2008 Investment Outlook: The Year of the Rat will be a challenging one for Global equities. Entering 2008, we see the key themes for Asian equities as: i) a US-led G7 downturn; ii) Earnings downgrades; iii/ resilient domestic Asia; & iv) structural fund inflows into Asia. Theme 1: The US Downturn The US economy is rapidly decelerating. Some measures (such as housing) suggest the US may already be in recession. This will lead to a significant slowdown in Europe and Japan. Industrial World growth is expected to slow from 2.4% in 2007 to 1.4% in 2008. Theme 2: Earnings cuts Top-down macro matters at inflection points The defining event of early 2008 will be the massive cuts to earnings estimates. Since mid 2007 we have emphasized the disturbing scenario that was unfolding due to the sub prime crisis. However, the Street was emphasizing that earnings were still strong and would continue to be. Indeed, for the past four years top-down strategists have been too cautious in their profit forecasts and bottom-up indicators were more accurate. But top-down strategy shines at economic inflection points when investors need perspective. A disconnect now exists between bottom-up corporate profit forecasts of 14% in 2008 and 11% in 2009 and many top-down EPS forecasts of -3% in 2008 and 5% in 2009. We expect analysts to cut EPS estimates sharply during 1H.
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Conclusion: Rather than seeing signs that the worst is behind us, we think the clouds are intensifying again. The markets across Asia and Australia are seeing; 1/ disturbing technical patterns such as very narrow breadth i.e. only a handful of stocks driving the indices, 2/ the valuation tailwind is fading quickly on our metrics, the market is back out of cheap territory. Overall fundamentals are deteriorating, and whilst still our market timing indicators are in neutral territory, markets are not far away from heading back towards sell levels. The euphoria surrounding the relief rally is fading, and we are now approaching the danger zone of bear market rallies i.e. when they typically finish. Finally, there is caution in the US, Europe and China.
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From: David Hamilton [mailto:david.hamilton@falconcap.net] Sent: Friday, 6 June 2008 3:06 PM Subject: FW: commodities to tumble SUMMARY A near perfect storm of a rolling commodity market, hoarding suppliers, slowing demand, and rapacious US regulators with a slew of proposed regulation who will stop at nothing to end the commodity speculation which has stopped traditional hedgers in those commodities from being able to hedge their positions. In formal chart terms, the global commodity complex bubble officially popped last week. This bubble had been steadily inflating since 2002 (since the last peak in the USD) and finally popped from Tuesday to Friday with oil (CL1) attempting a last run at 132 on Thursday evening and then coming off to close at 127. This is a monumental WATERSHED occurrence and marks a major shift in market mentality from inflationary/stagflationary to a period of disinflation at the margin for the foreseeable future.
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b c x a b c
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For these reasons we recommend a zero weighting in Australian banks. For like New Zealand, there has been a consumer debt-driven bubble of massive excesses in Australia further fuelled by the following wind from the commodity boom. The domestic economy is now unwinding just as the oil led commodity index is showing growing evidence of cracking. Macro investors should bet aggressively on falling interest rates and a weakening currency in Australia. But both trends will not be bullish for Australian banks which absolute-return investors should remain short. As for relativereturn investors in Asia Pacific the increasing likelihood of significant Australian dollar weakness over the next 12 months or more is another reason to run a massive underweight in Australia. This should be funded by an overweight in Japanese domestic stocks, including Japanese Banks. The financial excesses of the credit bubble were not just confined to America. Rather this is a global phenomenon where the greatest excesses have been where the Western free market model has been most vigorously practised. The model has been fatally compromised by the only too evident view of the relevant financial service sectors that the relevant governments and central banks will always bail them out of a problem. Investment flows into Aussie and Kiwi dollar instruments from the Japanese have already begun to slow (see below).
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New Zealand 0.5 Norway 0.8 UK 1.2 Italy 1.2 France 1.4
USA 5.6
At present there has yet to be a panicky withdrawal of funds by the Japanese , but the stampede for the exit will inevitably come.
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07 July 2008
Falcon Capital Group 2008. All rights reserved. This publication is intended to provide general information only and has been prepared by Falcon Capital Pty Ltd (ACN 119 204 554) (AFS License No. 302538), the issuer of the Fund, without taking into account any particular person's objectives, financial situation or needs. Investors should before acting on this information, consider the appropriateness of this information having regard to their personal objectives, financial situation or needs. Offers of interests in the Fund are contained in the Falcon Capital Information Memorandum (IM). A copy of the IM is available from our website: www.falconcap.net or contact Client Services on 0411886155 or email david.hamilton@falconcap.net You should consider that IM and seek professional advice before making any decision about whether to acquire or continue to hold an investment in the Fund.
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Top-down strategy shines at economic inflection points when investors need perspective discrepancy lies between topdown estimates and bottom-up estimates do not rely on analysts... especially at major inflexion points and also at the C wave decline (or economic deterioration phase).
Anxiety Denial
a b
Fear FUDD
c
Desperation
x
Panic Capitulation
Despondency
Bear market will continue until ~mid 2009. Markets (as opposed to earnings growth) will bottom first, while sectors (as opposed to country allocation) are the key to create alpha in a bear market focus on sector rotation.
Economic deterioration stagflation Earnings decline Margins compression Market continues to de-rate Trust and confidence continue to fade Technical, Risk (Debt, cash flow)
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Style rewarded:
Anticipation
b x
Confirmation
b c
EPS down grades to continue FY09 sticky and just starting... Domestically growth rolling over under the weight of de-leveraging. Expect asset deflation and product inflation risks to become apparent. Rolling over phase of the business cycle: Rising inflation & domestic economic slowing down. Capacity constraints remain. The effect of the EARNINGS BUBBLE & the inflection point of the earnings cycle remains the key risk for equity market FY09 EPSg...
Substantial earnings downgrades follow over 2 years with slowing economic growth and then rising inflation... Higher B&DD drive Bank downgrades but FY09 EPSg still at risk... Style rewarded: Growth, Momentum, Buyout, Earnings revisions Macro, Value, Contrarian
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b a
c
Risk aversion continually rises Credit contraction intensifies
Crisis has now moved to the next, more damaging phase. This phase is about real economic slowdown & losses in regular banking business. Financial sector problems will rumble on.
x a
b c
Cost of capital increases investments shelved Lack of confidence curtails spending & discretionary spending power fails Export order cancellations increase Weak earnings intensifies, especially for manufactured exports Central Banks tighten policy and then orchestrate loosening
C wave: phase where the real economy is being impacted negatively expect ongoing earnings deterioration.
Bad debts in banking system rise Confidence falters and recession hits Commodity prices crash as Asian demand collapses
Chinese buying spree stokes inflation, but is mismatched with productive capacity of eco
Top-down strategy shines at economic inflection points when investors need perspective discrepancy lies between top-down estimates and bottom-up estimates do not rely on analysts... especially at major inflexion points and also at the C wave decline (or economic deterioration phase).
Complacency
Lynchpin: trust is failing.
Denial
b
Fear FUDD
x
Desperation
c
Relief
a
Panic
Anticipation shifting to confirmation
Bear truncation
Despondency Capitulation
WORST OF BEAR MARKET Wash out - Prices decline relentlessly. Selling breadth, nowhere to hide. Volatility high. Fundamentals ultimately collapse in response. White candles in sequence signal reflex rally is due. "C" waves Declining "C" waves are usually devastating in their destruction. They are third waves and have most of the properties of third waves. It is during this decline that there is virtually no place to hide except cash. The illusions held throughout waves A and B tend to evaporate and fear takes over. "C" waves are persistent and broad. BOTTOM OR POINT OF OPPORTUNITY Large degrees: financial crisis, question of existence, survival. Intermediate degrees: recession, panic and FUDD. Minor degrees: accompanied by bad news and market immune.
Financial woes/deterioration
Credit cycle deteriorates rapidly which impacts growth
Economic deterioration Deflation Inflation Earnings decline Margin compression Market continues to de-rate Trust/confidence fade
Technical, Risk (Debt, cash flow) Mean Reversion, Value (P/B)
Style rewarded:
28 ELLIOTT WAVE COUNT: Instead of a b c x a b c and then wave 1 with a wave 2 correction could turn out to be a major A B and now mature C.
12 STEPS TO CAPITULATION
ROUND 1 - The 12 points apply to US asset markets. As the US is the source of the global contagion impacting emerging markets it can be used to asses the position in the stock mark cycle of most markets. Subjective analysis indicates that seven of the 10 signals have been confirmed. The signal from this road map confirms the view that the bear market is not over, we are in the early part of the second half of the cycle.... which is the long drawn out segment of a credit unwind (develeraging cycle)...
1) The worst housing recession in US history. House prices decline 20-30% from their peak. Prices already down 15% and falling. 2) Downgrading of the monoline insurers. Rating agencies cut AMBAC & MBNA AAA ratings. 3) Bankruptcy of a large regional or national bank. . Bear Sterns, Indymac, Fannie Mae, Freddy Mac
4) Liquidity drying up in a range of financial mkts: incl. interbank & money mkts. ACHIEVED LIBOR rose after Fed cut rates on 18 March. 5) Meltdown of the commercial property market. Commercial property from NY to London are seeing declines in capital values. 6) Further collapse in stock prices. S&P500 now in bear market territory. 7) Further losses, beyond the USD250300b now estimated, for subprime mtgs. US write down & credit losses now USD296b.
ROUND 2 - Next phase Actual contraction in GDP neither tax rebates nor lower interest rates nor massive liquidity injection will forestall a severe retrenchment in consumer spending, stem sub prime losses or revive risk appetite.
8) Big losses on unsecured consumer debt: credit cards, auto loans and student loans 9) Big losses on reckless leveraged buy-outs by private equity firms. 10) Meltdown in the shadow financial system hedge funds & special invest. vehicles
Macro Top down Technical Risk (CAPM, Strong Balance sheet and Cash flow) Soon shifting to: Mean reversion Value (P/B) (NB to justify high P/B need high ROE).
Risk aversion: all small, mid and large caps are vulnerable magnitude is more so with the smalls.
These thematics are yet to be confirmed by relative strengthneed to wait for the dust to settle
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Comment
After slipping into recession in the third quarter of 2008, G3 growth resumes in 2009 Q2. This would be in line with an average duration of every recession in the post war period. Probability: 5%
Speedy Recovery
Mild Recession
Long drawn out recovery
U-Shaped
1990
Aggressive central bank easing and a quick resolution to G3 banking sector leads to a recovery taking hold in the second half of 2009. Probability: 15%
Severe Recession
Long drawn out recession
W-Shaped
1981
Banking sector problems lead to a collapse in consumer and business confidence. Economic output contracts for the next 18 months and a recovery only starts to emerge mid 2010 as the process of de-leveraging runs its course. Probability: 45%
Depression
L-Shaped
1929
Banking failures spread around the G7 nations. Equity markets & house prices collapse further. Unemployment rises rapidly & deflation takes hold. World economic activity contracts for the next four years. Probability: 35%
Whichever way the economic path transcends the likely outcome will be one of muted growth for many years to come.
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FALCON CAPITAL PTY LTD ACN 119 204 554 AFS License 302538 Suite 802 1 Queens Road Melbourne VICTORIA 3004 AUSTRALIA Tel: +61 3 9863 8559 www.falconcap.net
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