My Diary 407 --- Trickiest Times to Fed; Doubt on Chinese Inflation; Feedbacks from Bonds; Wild Card on Equities; Chocking Point of EUR
June 29, 2008
Another bad Friday and another bad week ... I learned a few interesting “talks”, like “OPEC + Goldman” is the “O, God” prevailing in investors’ lips, a Chinese stock proverb – “Dead May, Depressed June and Rebounce July”, and Queen Elizabeth II hit by Inflation … With the combination of surging oil, inflation fear, threat of higher rates and the brokers new game on downgrading each other have reminded investors that credit crisis may be in the full bloom mood, sending market risk premium higher, despite equity sentiment at 10 years low. As a result, USD, yields and stocks were dumped due to scared investors.
Looking back into the past week, 1MWTI ended at a new all-time high of $140.21/bbl, while global equities moved further down, dropping 2% in Japan and 0.3% in EU and US on Friday. Global stock prices have now fallen more than 11% from their May peak and sit just 2% above their mid-March low. Elsewhere, UST yields slid, with the 2yr slipping 3bp to 2.62% and 10- receding 7bp to 3.97%. Over the past two weeks, 2yr and 10yr yields moved down 41bp and 29bp, respectively. Accordingly, USD lost 2.7% to EUR (1.5794) and 1.9% YEN (106.135) respectively.
Clearly, it seemed that policy markers have failed to boost USD, extending oil prices. Why? The collective thought of market views Fed as it is scared about inflation and both risk premium for bond yields and equities soared. Going forward, if oil price rises more, the -ve correlation between oil and stocks will intensify, while correlation to bond yields will return to deflationary bust, which should be a warning signal to whom only see inflation risk. As we are heading into the 3Q08, I think we should remain cautious on equities, given the intensifying oil crisis and renewed recession fears. On bonds, given the less possibility of Fed hiking, bond may see a rally, while I think USD is going to its bottom, EUR may reach a top after ECB one-off hike. In additional, as market volatility/inflation return, gold is reignite. To the global economy, growth is my top concern, while today I would like to spend some ink on inflation…
The Trickiest Times to Fed
Over the week, although news on US economy (-0.9% ex.Tran durable orders, 1% GDP, 2% Existing home sales, 1.1% Personal spending, 1.9% personal income, 0.1% PCE and 56.4 Michigan Confidence) were largely positive or in-line with expectation, the tension between slowing growth and rising inflation in the DMs is increasing. Outside the US, EU and Japan economies are skewed to the downside, underscored by the below 50 Composite PMI and Shoko Chukin small biz survey. At the same time, inflation is pressing new highs in the G3, with the 3Q headline rate set to reach 4% yoy. Thus, how central banks will manage such a tricky condition in the next few months remains to be seen and the Fed is on my top watch.
Reading last week’s FOMC statement, we can see somewhat dovish on the baseline assumptions for future growth and inflation, but with some hawkish tone on the upside risk to inflation. On the growth side, the US outlook may get boosted by the fiscal stimulus, but given consumer long-run inflation expectations is edging up to the highest level in 13 years and headline inflation is likely to climb higher in the short run, it may not be a bad time for the Fed to begin gradual rate hikes. On the other hand, consumer expectations are at a 35-year low, unemployment is still rising and high oil price has so far not produced a wage-price spiral, so that higher energy prices may be more of a danger for killing growth than stoking up core inflation. Moreover, financial markets and credit conditions remain stressed; even some negatives may have eased a bit ... Thus, the trickiest time for the Fed is on 2H08... On the economy side, although the downside risk to growth may have diminished, the laundry list of factors cited in the FOMC statement (soft labor, housing decline, high energy prices, and stressed financial markets) is a pretty heavy note to the growth outlook. In addition, regarding the timing of FOMC meeting, it remains skeptical for the Fed to raise rates on 16 Sep (Disc. Window to be closed), 29 Oct (6 days before Presidential election), and 16 Dec.( tax rebate to be over). So the August meeting looks likely the best time to hike, but it appears too early.
Overall, I think the deteriorating growth/inflation tradeoff is a clear negative for financial asset prices and most markets has seen their turning points in May. This includes the emerging markets, where growth prospects are much stronger, but core inflation pressures are also more intense. Given many market interest rates are higher than before the Fed started to ease, and the credit system is not yet functioning properly, I think an early tightening by the Fed is less likely as underlying inflation is better than headline data suggested, given no wage price-spiral and anchored inflation expectations.
The Doubt on Chinese Inflation
While DM central banks are caught in a tricky balance between growth and inflation concerns, EM banker are acting to tighten policy in sweeping fashion, witnessed by the latest 50bp hiking by RBI, following its 25bp increase on June 11. In addition, EMs seem to show some scattered signs of a wage/price acceleration, suggested by Thailand where manufacturing wages shot up 17% yoy in 1Q08, far above the rate of inflation and productivity growth. In Russia, May wages rose 31.8% yoy, more than double the rate of inflation. Furthermore, the inflation news in China is also ugly as steelmakers agreed to a near doubling in iron ore prices with their Australian suppliers, the largest ever annual increase.
Having said so, China now is well-known as one of the largest oil importers in the world and its dependence on import crude oil is close to 50% of its consumption. However, the Chinese economy has been able to handle surging crude oil prices remarkably well, even though there is a lot of debate over the country’s inflation outlook, after recent energy price reform. Indeed, with the total oil consumption jumped to more than 10% of GDP (5% in 2007), I do see energy subsidiaries have become an increasingly heavy economic burden. Moreover, the stronger wage growth (potentially driven by rising food prices) could also become a transmission tunnel to a widespread inflation in China…Thus a critical but interesting question is that will the China’s inflation be kept in Bay or in Doubt? Here I have some observation to show that the overall inflation dynamics in China remains benign --- 1) The big gap between headline CPI and core CPI ( April = 8.5% -1.8%; May = 7.7% -1.7%) suggests that a rising inflation so far has been a relative price shock, not a general inflation and supply increases are pushing down food and meat prices; 2) the avg 19.2% yoy increase in 1Q08 is misleading because the survey sample is dominated by large SOEs with monopoly and strong pricing power and are able to grant faster wage growth than private firms in more competitive industries. In general, as long as corporate earnings growth remains in check, it is unlikely that a wage inflation spiral will develop.
However, we have to admit that inflation expectations are creeping up, albeit slowly. To keep inflation expectations on bay, we have seen PBOC vowed to keep a tight monetary bias witnessed the weekend comments by Governor Zhou XiaoChuan. With RRR now stands at a record high of 17.5% and RMB appreciation IS ineffective in curbing inflation, Mr. Zhou seems only have one option left in hand – IR hikes … I have second guess of Chinese IR hike as this may lead to a greater degree of RMB appreciation/or speculation, and a deflationary shock to the macro economy as well as a move against the policy of developing domestic consumption. To sum up, although the long-term picture of Chinese inflation is on the upward trend, given the aging population and a smaller labor pool, the mid-term inflation outlook remain benign, given 1) a excess labor supply, 2) an increasing business competition; and a accelerating productivity gains…
The Feedbacks from Bonds
With Dow losing 4.2%, the worst June since1930, and concerns higher energy prices will erode corporate profits, USTs regain their strength as plummeting stocks sent investors to find a safe bay. 2yr UST yield touched the lowest level in 3 weeks and I think given pressures are continuing to build in the financial sector, we are going to see a pretty decent rally in bonds in 3Q08. As suggested by the futures, there is a 25% chance the Fed will raise on 05August, compared with 40% odds a week earlier. In addition, Fed does mention the uncertainty of the inflation outlook, citing some inflation expectation indicators are in an "elevated state". But that is not true based on 5y5y BE inflation expectations (2.6%) derived from TIPs.
Having said so, CMBS is set to fall to the lowest level since at least 1996 as investor demand for the debt slumps. According to JPMorgan, CMBS offerings in 1H08 dropped to $12.2bn, from about $137bn in 1H07, such a more than 10-folds decline shows the Feds 7 rate cuts since Sep07 had limited success in reviving the market for securities derived from real estate assets. By the end of last Friday, US 10yr AAA CMBS yields 154bp more than 10yr swap rates, compared with 30bp a year ago, according to Lehman Brothers.
Indeed, the overall credit spreads were wider last week after we heard the CITI writing down another $8.9bn, plus rumors of possible European HF problems. As a result, CDS spread gapped wider with iTraxx XO in EURO area increased 15bp to 523, according to JPMorgan. In Asian, iTraxx Asia HY closed 12bp wider to 558 from 492bps a week ago, while at the mean time, iTraxx Asia IG (156bp), widened 31bps from a week ago, according to Lehman. What drove ITraxx HY was the panic trading in Hopson 5yr CDS (2yr at 1250 and 5yr at 1500) and its spillover to other China property names…Heard Agile and Hopson were downgraded by rating agencies, the Chinese property names seemed having more problems ahead….
The Wild Card on Equities
One of my observations on the stock markets is that investors were rattled not only by the uncertainty about oil's impact, but discouraging outlooks for the financial, high-tech and automotive industries. As a result, they pushed the Dow (20% from Oct high) to the brink of a bear market, on concern over worsening write downs, record oil prices, and profits warning from companies. S&P 500 also fell 3%, the forth consecutive weeks and the longest losing streak since January. Earning rerating emerged as the top threat to the investors as 2Q08 earnings is probably worse than the market thought. According to BBG, the street forecasts S&P 500 earnings will slump 11%, compared with a projected decline of 8.9% a week ago. Goldman Sachs said that expectations for 2008 and 2009 profits are “too optimistic'' and are likely to be reduced.
It is not surprised with such an expectation, if you see high energy prices, more write-offs at banks and the slowing economy. I think the best business activity proxy also told us the worrisome outlook as FEDEX, the global logistics giant is down 15% MTD after warning about the economy and lowering guidance earlier this week…. Some ppl now forecast major index move could get worse and it is not the time to start scooping up everything with both hands. In fact, VIX did rise 13% to 23.93, leaving it 26% below its high (32.4) reached on March 1…Indeed, if compared with 2001-2002 when dot-com bust, terrorist attacks, recession and corporate wrongdoing combined send stocks plunging, the current market has some similar problems, in particular the troubled economy and a devastated industry -- the financial sector. But there's one wild card today --- oil prices that have more than doubled in a year and show no signs of abating, and this isn't something the Fed can solve on its own.
Back to our regional markets, there is an update on Chinese industrial profits growth, which rebounded to 20.9% in 5M08, up from 16.5%yoy from Jan-Feb, but below the 37% growth in 2007. With widened PPI-CPI gap and a more challenging macro and business environment, we will face the same concerns over S&P --- earnings growth momentum could weaken in 2H08. As suggested by Goldman Analysts based on top-down approach, sectors like coal, oil E&P, infrastructure construction and F&B could deliver upside earnings surprises, while we should stay away from oil refiners and coal-fire utilities…But I think the later one is more on government gesture instead of earnings….
Having talked about earning outlooks, the weekly performance of both H and A share are not decupling from its overseas peer markets. Over the week, MSCI HK dropped 4% (YTD -23.4%) and MSCI CN down 3.8% (YTD -27.9%), while HSCEI is traded at 11,814 (YTD -26.7%) and CSI300 at 2816(YTD -47.2%). Valuation wise, MSCI CN ended 13.9X08PE vs. 23.1% 08EPSG, CSI 300 at 17.5X08PE vs. 26.5% 08EPSG and H shares at 13.4X 08PE vs. 23.5% 08EPSG. The MSCI AxJ is averaged at 12.8X 08EPE vs. 10.9% 08EPSG. The significant changed over the past few weeks is the fast shrink of trade volume and regional liquidity, which has sent HKEx dropped 7.3% wow. Regional flow wise, global funds started to turn negative on AxJ this week, given the poor investment sentiment, although country weights of Korea and China at regional Asian funds increased the most in May, upped 110bps and 80bps Mom, respectively. One of my broker friends’ note is worth to bear in mind that during bear market bounces, it usually sucks in more liquidity and then kills ppl in its 2nd leg down. Indeed, another 10-15% down on ‘HSI now looks likely, given the not-yet bottomed S&P, holding tight you pockets seems to be a good strategy in the next few months …
The Chocking Point of EUR
Following the Fed Chairman Bernanke's surprising verbal support of USD on June 3, it is understandable that we saw a temporary rebounce in USD. But that does not last long as recent FOMC statement has emboldened USD bears due to the reduction in Fed tightening expectations. Well, from the fundamental perspective, I still have more to argue for USD weakness, such as slow growth, low interest rates, and large current account deficit and so on. But taken a step forward, the move on EURUSD is to be constrained by the relative monetary policy view; that is, unchanged FFTR vs the anticipated ECB rate hike next week. Thus, I think although USD is weaker vs. EUR over the week, there does not appear to be much momentum behind EUR, if markets are concerned about the downside risks to EU area growth out of tighter ECB policy. This is the similar logic to think that tighter Fed policy would create similar headwinds for the US economy, sending USD lower.
Over the recent year, there has been a great deal of inks spent on oil price and USD weakness. Some ppl are quite convinced not only of the high negative correlation between oil and the USD, but they are see causality in that relationship, i.e. that the USD's declines are a material driving force behind oil price gains. Such a perception has become more of a political problem among the world leaders, given the politically undesirable/unacceptable level of oil prices, and the notion that the USD and USD policy are contributing factors…This is why we start to see the increased verbal support from US senior officials, even from Fed. But here is a skeptical guess behind of the linkage/correlation/causality between oil and the USD – that is oil prices have risen roughly 43% YTD, while EURUSD has risen just over 6%...Now, I have more reasons to believe in the speculation theory, after the arguments on an unavoidable demand growth in Chindia world.
Good night, my dear friends!
