GaveKal Daily Report - Wednesday March 7th 2007

As anyone who has read a financial newspaper over the past two weeks
undoubtedly knows, there has been a lot of focus on the deteriorating
situation facing US sub-prime lenders. And there are indeed signs of
increased stress: delinquency rates on these risky home loans are rising
(see chart), sub-prime lenders are going belly up at an alarming rate, and
US financials have been underperforming significantly (see chart).

Many analysts are now touting this development as the tip of the US
debt-iceberg, and the first step of a major correction in the mortgage
market. In turn, this will then go on to seriously hurt overall US
consumption, prompting a global slowdown. But how big an impact will the
sub-prime story really have on the economy as a whole?

In a Feb. 20 talk to students at Duke University's Fuqua School of Business,
Fed Governor Susan Schmidt Bies explained why the Fed is much less concerned
than most investors and analysts. Bies stressed that sub-prime ARMs
represent only about "seven to eight percent of all outstanding mortgages".
Furthermore, she highlighted that the delinquencies are concentrated mostly
in those issued last year, stating: "If you look at what's happening in
mortgage markets this year, what you see is, in the aggregate, the mortgage
markets are doing very well in terms of credit quality". Yesterday, this
sentiment was backed by US Treasury Secretary Paulson, who downplayed the
rising defaults in the sub-prime sector, saying that loans would not spill
over to banks that make less risky loans. "Credit issues are there, but they
are contained", Paulson said, as he highlighted that the US financial sector
remains healthy.

Overall, as we understand it, US households with ARMs, both prime and
sub-prime, whose interest rates will adjust upward in 2007 and 2008 will
experience about a US$10 billion rise in payments. To put that number in
perspective, overall consumer spending was about US$9 trillion in 2006. In
other words, the rising interest rate cost would only represent about 0.1%
of total consumption. Overall, we doubt that ARMs will have the dramatic
effect that the perma-bears fear, and we expect this to have a very limited
impact on consumer spending and overall growth. After all, despite all the
doom and gloom, consumption rose by a very solid +4.2% in the fourth
quarter, while Wal-Mart and Target have posted strong numbers of late. In
addition, forward-looking housing surveys appear increasingly brighter (see
chart).

Interestingly, yesterday, US financials were the best performing sector of
the S&P 500, gaining +2.1%, the best single day since July of last year,
while Countrywide, the biggest US mortgage lender, jumped +4.7%.... Looking
ahead, we still believe that betting against the US consumer is to likely
offer the same meager rewards it has in the past. In addition, we very much
doubt that the current hopes for a Fed rate cut in the near future will be
fulfilled.

Warm regards,

Louis-Vincent Gave,

GaveKal Research
Suite 801-802,
ChinaChem Hollywood Centre
1-13 Hollywood Road
Central, Hong Kong

Website: http://www.gavekal.com

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