Attacking inflation key to a recovery

Inflation’s poisonous tentacles are strangling the economy

The biggest hope for the month is the probable downtrend in inflation against April’s figure. However, the government’s forecast of 1.8–2.0 per cent means the consumer price index (CPI) will remain high against the same month in previous years. With this forecasted level of inflation, we do not believe any potential short-term changes in the monetary policies will take place. Hence, the cash flows will remain low. Unless interest rates are reduced, any rise in the indices is just a temporary blip.

In this analysis, we plan to comment in depth on the impacts of the excessive ‘margin’ lending (leveraged financing) in 2010 and look at how the probability of a recovery in 2011 is under pressure from high financing costs and a shortage of funds. This is one of the key reasons behind the slower recovery of the equity market this year despite some good news.

In general, the stock market will keep trading at the lower end of the price spectrum. In the medium term, this will probably only change when monthly inflation falls below 0.6 per cent and lending rates drop below 14 per cent. This is forecasted to take a few months, so the market situation is yet ideal for short-term disbursement. Long-term investors might want to refer to companies’ first quarter earnings performances and the 2011 business plans to pick the strong fundamental firms in the shortlist. They can then ready themselves for buy decisions once the outlook brightens.

The stock market in May will be influenced by the following factors:

Inflation eases, yet remains high

The government’s inflation forecast of 1.8–2.0 per cent is, in our view, not entirely positive news. This is almost six times higher than the CPI of 0.27 per cent in the same period last year. An accumulated 12 consecutive month view pushes the inflation rate to approximately 20 per cent. The only positive is that the CPI is lower than April, which implies a downward trend for the rest of the year (under the assumption that there are no further significant price adjustments for electricity and petrol).

Even if May’s CPI turns out to be much lower than forecasted, there is still a risk that the price simply carries over to the following months. In recent years, inflation has only been considered ‘under control’ when it has stayed low within the 0.5–0.6 per cent range for three consecutive months.

Some analysts believe when inflation peaks the market will bottom out. This is not always the case since it depends on how the ‘peak’ is calculated. If we consider each month separately - that is, this current month compared to the previous one - April’s CPI might be the peak unless, of course, there are new big shocks. However, if we compare April to the corresponding period in previous years, or look at the number of 12 consecutive months, the answer might be different. Some calculations and forecasts indicate that the peak will occur in the third quarter. That means the equity market will bottom out in the third quarter and not in May.

Conversely, during the first four months of this year, although the stock market was buffeted by bad news, the VN-Index failed to fall below the 450-point barrier. This means the likelihood of further drops is low. Therefore, we could say the current market traded around the bottom zone while the lowest point is very hard to predict. With the opportunity cost of around 20 per cent per annum, holding shares for too long means investors will see losses. A more suitable investment strategy for short-term traders is probably to wait until the macroeconomic outlook is brighter.

Easing inflation needs to be matched by lower interest rates

Assuming inflation will drop gradually from May as estimated, can the market fully recover? Ignoring the impacts of psychological factors, we can say the equity market needs aggressive changes to the interest rate level. In fact, the interest rate has direct impacts on the opportunity costs for investors, the cash flows into the market and the performance of enterprises, among others. Deposit rates of up to 17 per cent a year including bonuses, borrowing cost for manufacturing firms in the range of 16-20 per cent and securities firms’ financial services rates climbing up to 23-25 per cent are creating strong barriers to market recovery.

High interest rates are pushing up the opportunity costs

Let’s assume the VN-Index starts at the 460-point level. To hit a return of 17 per cent per year, the index needs to rise to 540 points, which is too ambitious at present. This explains why cash isn’t being poured into the equity market as investors opt for bank deposits. The more the interest rate drops, the lower the opportunity costs are. If the deposit rate goes down to 12 per cent per annum, a VN-Index target of 515 points in one year seems more feasible.

High interest rates means low financial gearing

This includes both active and passive impacts. It not only means that investors are cautious about services but securities firms restrict the provision of financial leveraging for clients as well. Once the demand drops, raising funds at the cost over 20 per cent without full utilisation equates to the erosion of profits. If the interest rate level in the market decreases, those active and passive effects will be loosened, enhancing market liquidity. In 2010, short trading cash flows were the main cause of market upturns. Currently, such cash flows are being tightened. Therefore, unless the interest rates go down, we are not optimistic about the prospect of a sustainable market in the short and medium terms.

Potential share supplies from margin trading in 2010 are huge

Since December last year, the market seems to have forgotten the margin trading story and its impacts when the market pulls back. People assume this because securities firms announced they had withdrawn most of the funds or no longer participated in such activities. However, in our view, this is not totally true. Margin trading is going to have further impacts in 2011 whenever indices show sign of weak recovery. This is because:

In 2010, thousands of billions of VND were provided by securities firms for margin trading. Many of these have not shown up fully on balance sheets as the service is not legal. During the spike in the weeks at the end of November and in the beginning of December last year, liquidity was maintained at the range of VND3 - 5 trillion ($153 - $253 million) per trading session. Immediately after that, the market dropped very quickly in terms of both performance and liquidity.

Penny stocks, which make the most of margin trading shed about 30 to 50 per cent in value, and there was minimal liquidity. Securities firms have now placed those penny stocks into the ‘warning’ range and legally they can take most of those assets for the prop-trading portfolio.

For securities firms that used their own funding, the situation is much safer because they can wait for a market recovery before selling down. However, most securities firms raised the funds externally, and the longer the funds are trapped, the riskier it becomes. This is a fundamental difference between the market in 2011 versus 2009, and the equity needs much more supportive factors to repeat the recovery story of that year.

- Financial cost stress: Securities firms still have to pay borrowing costs of around 20 per cent per annum without any revenue compensation. Clients who made losses and had to transfer assets to securities firms have been running out of financial strength.

- Loan call stress: In line with credit limits to the non-manufacturing sectors, margin funding is facing loan call risks. If the average period for those loans is three to six months, the peak for the loan call (if not extended) will fall in the second quarter. The only way to solve the problem is to sell down the portfolio from clients when the chance arises. Hence, the market is still under huge pressure for ‘cheap’ share supplies if demand picks up. The main issue is how to get hold of thousands of billions of VND to absorb those supplies if the interest remains high and credit is tightened.

For investors with financial capabilities to maintain margin trading accounts, the financing costs are very high while most small and mid-cap stocks are seeing falls. The lower the price, the more cash has to be bumped into existing portfolios to avoid bankruptcy. The market is waiting for new investors and new sources of cash, which is a long-term story. Also, this will only happen if the indices see sustainable growth.

May: Liquidity is still a key concern

Since tightened monetary policies are preventing cash flows into the equity market, we believe liquidity is a more important performance indicator than the VN-Index or HNX-Index. At the moment, a big crash together with significant jump in liquidity (over VND2 trillion or $96 million per session) is a better scenario than increases in the VN-Index and HNX-Index with very low liquidity. If liquidity doesn’t exceed VND1,500 billion per session (on the two exchanges), there is no hope for a sustainable recovery. Instead, it implies that:

- Investors are reluctant to transfer cash into the stock investment channel.

- Foreign investors are not disbursing funds aggressively because of what they perceive as macroeconomic risks.

- New sources of funds are not entering the equity market.

Overall, it is too early to expect the short-term recovery of the market as a whole though there are weak signals that this may be case. The reality is that long-term economic problems cannot be solved in one or two months. It is going to take longer, and investors need to get used to the concept of ‘patience’ in waiting for returns.