My Diary 415 --- Winners and Losers; The Cost of Turning Around; Long Government Duration; Olympic Long Is Wrong
August 13, 2008 (On Vacation)
“A Summer Financial Olympic vs. The Beijing Olympic”…One of the most respectful gold medals was granted yesterday after China’s Men Gymnastics team had a nearly perfect show in front of hundreds of million of fans. I was so touched by their tears as over the past 8 years, these world Champions of year 2000 suffered the biggest defeat in 2004 Athens and now they reborn like a phoenix…What I learned from this medal is – sometimes in our lives, taking a step back may gain yourself more … Another Olympic medal should go for USD as the Dollar’s positioning has changed materially in the past few days based on large futures flows and technical breaks in EUR and DXY…The 3rd gold medal is always ready for global financials which have potential to record over $1trn losses. In fact, the credit crisis reared its ugly head again after a global survey of 146 US and EU institutional investors indicated that nearly 60% of them believe that there will be another big collapse within the next six months…
Looking back, big changes have taken place since the price of oil diving below $115 and gold sinking below $815 courtesy of USD which is now below 1.49EUR as opposed to the near 1.58 level for the pair on June 26th. Helped by the strong USD, commodity prices declined sharply with metals and agricultures prices down 10-15% MTD. Partly in response to commodities, S&P reached a milestone on Monday, climbing back above 1300 for the first time since June 26, the day when Dow dumped almost 400pts while S&P purged almost 40 handles. That was the day that the FOMC further promulgated label of the "gang that couldn't communicate straight" and in process pushed 1MWTI through $140/bbl for the first time while gold was a stunning $37 hitting $920. Elsewhere, we saw USTs bumped around with 2yr trading at 2.44% and 10yr at 3.90%.
Going forward, big picture is that the acknowledgement of slowing global growth and expectations of rate easing in Australia and Europe have eroded support for commodities, leading to a sharp break lower in commodities. In turn, this is now giving hope to a sooner rather later recovery in the US economy (seen via rising equities). However, inflation is still spiking throughout EMs and their monetary policy will continue to be tightened as global growth slows. I think the asset markets are now re-pricing lower growth all over the place, including USD, oil, gold, banks and growth equities which have experienced rapid reversals lately for two main reasons, aside from summer volumes -- 1) fundamental growth de-rating and 2) crowded positions unwinding. Of course, lower oil prices will have impact on the macro-equity views due to potential earning and inflation relief. My interpretation to these observations is that the equity market viewed higher commodity prices as a constraint to growth, and that the expected demand destruction is now damaging both the commodities themselves as well as cyclically sensitive stocks…Well, enough growth talk and let us start from the winners and losers…
The Winners and Losers
The rise in commodity prices over the past two years, dominated by energy, has had a profound effect on world economies and markets. It has been the primary driver of the increased inflationary pressures that have caused numerous central banks to tighten policy despite the credit crunch, has weakened growth in many economies, and has seen a massive income transfer from consumers to producers. To FX world, the major beneficiaries of higher commodity prices have been CAD, AUD and NOK, and the main loser has been USD. EUR seems to benefit from higher commodity prices, though through their impact on inflationary expectations and ECB policy. But given commodity prices have fallen back quite sharply over the past few weeks, the question now is whether or not this trend will continue and what will be its effects?
I think the rally in oil - one of the most important global economic prices - over the last few years has clearly been due to excessive demand relative to supply. Speculation can only exacerbate trends, but it cannot create them per se. Fundamentally, S&D dynamics can not changed so massively in two weeks as at a macro level, global growth is slowing, but it is not collapsing. Whatever price we see in oil in the coming weeks, what seems certain is that inflation has not gone away and that significant pipeline pressures still exist, particularly in EM - the source of much of the excess demand. But the large correction in the recent speculative (or at least financial) positioning in oil since last August is to suggest that a further downward correction is likely. For example, ST technical of oil price has been bearish given the downside break of the 55D MAVG ($114/bbl) with potentially targeting the 200D MAVG at 109. The latest NYMEX Commitments of Traders data show that speculators were net short oil in the last two weeks, the first net shorts since 16 Feb 2007. Such a change may be linked to exchange rules and investigations.
On the back of this oil market correction, the main winner in the FX market will be USD and the biggest losers are likely to be CAD, AUD and NOK. EUR will also likely suffer a reversal in these circumstances as ECB policy focus shifts from upward inflation pressures due to commodity prices towards downward pressures from weakening economic activity. Moreover, EM currencies that had been under pressure due to high oil have staged notable recoveries. In short, fundamentally the result of all this is that is the market’s attention has switched from inflation to growth. Given the commodity market is starting to aggressively price a global slowdown, it could be bullish for HK/China equities due to rebalancing of GEM portfolios and lower pressure to China’s headline inflations.
The Cost of Turning Around
As indicated by major currency-crosses, markets have repriced the growth picture significantly, a move which is consistent with global leading indicators, including export and global imbalance. What has shifted most dramatically is in the EMs of which I think non-US&OECD area will continue to lead global growth and inflation is trending higher, but global imbalances will be reduced at significant cost.
With respect to export, globally this provides a useful and timely gauge on the underlying thrust of aggregate demand around the world. The recent data flows have undoubtedly pointed to a weakening global demand. For example, exports out of Taiwan in July were weaker than expected, declining 2.3% mom, with both tech and non-tech shipments decelerating. Regionally, ASEAN GDP growth in 2H08 has been marked down from an annualized 4.3% pace to just 2.6% due to a softening global demand, the elevated energy prices and domestic political turmoil. Perhaps most concerning is that exports to China have weakened as a material slowing in China could point to a more pronounced global slowdown. Elsewhere in G3, the deceleration in economic activity has been even steeper –1) the recent deterioration in EU labor market confirm that corporates are just now beginning to retrench; 2) the Fed’s statement signals growing concerns over US demand growth; 3) Japan today reported its 2Q08 GDP dropped at 2.4% yoy, a marked fall from a 4.0% rise in 1Q08. The slowdown of G3 should reinforce concerns among policy-makers in Asia that growth across the region will begin to slow. As a result, I expect export out of Asia should turn down sharply in the coming months, stoking fears over the resilience of growth in the region among both investors and policy-makers.
Moreover, as we all know now that the US external deficit is largely with Asia. The issue is that export-import elasticity suggests a USD decline is not enough per se to reduce the US CA deficit on a sustained basis. Rather, it needs a substantial fall in US import demand. The cost of turning this around will be substantial in terms of global welfare and it will need pro-active economic policies to offset the hit. In terms of macro changes, global consumer B/S will undergo major restructuring and global economy should evolve into a multi-polar growth world, while global inflation will continue to trend higher until global IRs temper demand-pull price growth in EM and cost-push in DM. Overall, as EMs growth is now getting a benign rating down a couple of ticks, and DMs always looked limp, the demand drop has and will translate into more weakness in commodities. This suggests that 1) EM stocks will eventually become oversold and offer significant value relative to DMs; 2) Asian consumption should be favored over exports; 3) USD will see renewed weakness (same as the 1970s) when the global economy stabilizes (2H09?); 4) Growth sensitive sectors, such as resources, cyclicals and industrials are likely bear some pain.
Long Government Duration
Over the past few weeks, global investors are shunning index-linked securities even as global inflation accelerates at the fastest pace in a decade (US CPI @ 5%, EU@ 4.1%, and Japan ex Food@1.9%). In the US, 10yr BE rate fell to 2.19% from the peak this year of 2.6% on July. At the same time, European linkers were also poised for their worst third-quarter performance in almost 10 years, returning 1.1% percent as of last week.
It looks obvious that the biggest story in the bond market in the next 6-12 months is going to be a slowdown in global growth as people finally realize that the housing crisis-led slowdown in the US has led to a credit problem worldwide. This has been reflected by the credit fears raised again after AIG tripled its forecast of possible $8.5bn payments on CDS, in addition to its 16.5bn of collateral as of July 31 demanded by investors. On the earnings side, poor news included AIG reporting a $5bn 2Q08 loss, Barclays stating 1H08 profits had fallen by 33% and Allianz posting a 29% decline in Q2 profit following a fourth consecutive quarterly loss at its Dresdner Bank unit. As a result, we've seen a fundamental re-assessment of risk in this new world of tighter credit as suggested by money markets which are quite clearly still in a pretty bad way and that's not going to change in the foreseeable future. The LIBOR-OIS spread rose to 74bp from 10bp on July 31, 2007. While TED spread declined to 113bp, it averaged 50bp over the previous five years. In addition, defaults on HY bonds in US may soar above 10% in the next year as the economy slows, according to Moody's, while in Europe, 6 -7 % of corporate borrowers may fail to pay debts on time in the next year, a tenfold increase from June, according to Dresdner Kleinwort. In Asia, fears about the economy and the credit crunch have been refreshed with reports on more US major banks' losses stemming from the mortgage crisis. The iTraxx AxJ HY and IG were traded at 550bp and 144bp, respectively, both at 2-3 times wider than they were in early 2007.
In sum, I remain cautious in the near term as US appears sinking into recession and the continuous woes in the financial sector and I just do not see any meaningful positive catalysts soon. I think many investors are still in the risk reduction rather than risk addition mode. Based on the above discussion, all the indicators of financial stress, commodity prices and economic growth are all aligned in a bullish direction for government bonds, especially the long duration ones.
Olympic Long Is Wrong
Overnight session is another down day in the US, and again led by financials as total Subprime write-downs surpassed $500bn and UBS’ losses led to the split of its major business segments. In the laggers’ list of S&P 500, I saw an exhausted list of financial name, including WB (-12.14%), JPM (-9.48%), BAC (-6.74%), CITI (-6.46%), AIG (-6.62%), GS (-6.01%) and MS (-6.37%). A few observations for the financials are 1) flows are down significantly (- 50%) on FI names from levels a few weeks ago, thus the rallies are likely macro/ETF driven; 2) Analysts can still move markets (S5FINL -5%) as several of them took down their earning estimates, while investors continue to be confused as 88% of hedge funds were down in July; and 3) shorts haven’t capitulated and are riding the storm out with short ratios in US financials is down only 0.5% for the past week, +.5% for the past 2 weeks and +12% for the past month.
Back to China markets, Olympic Longs which speculated that the govt would pump up the A-shares turn out to be LONG and WRONG. Fundamentally, I think market participants are losing faith to the economic momentum of China. Key concern is that weak export growth could lead to a sluggish FAI, even though retail sales are still growing at 23.3% yoy in July. However, several big-item data in July have seen further evidence of China Cooling-Off, including GDP (slowed from 11.2% in 4Q07 to 10.6% in 1Q08 and 10.1% in 2Q08) due mainly to the effects of the tight monetary measures and softening external demand. Here I summarize a few below:
>Export growth is likely slowed further after the sharp dip to 17.6% yoy in June. Remarkably, Guangdong, the largest exporting province, almost halved its exports growth to 13.1% in 1H08 from 25.6% 1H07.
>Property investment will see further down as experience from HK and US suggested that declines in volume usually lead drops in property prices by 4-12 months. Beside this, NDRC also says the government has no intention to put any rescue measures to save the property market. In addition, the market once had expected a 13% yoy RMB appreciation in March, and now expects only 3.5%, according to the offshore RMB NDF market, suggesting weakening overseas demand going forward.
>Electricity shortage will likely result in further slowdown in the economy by their directly negative impact on activities but also through the damages they incur on corporate earnings. For example, Shandong province is reportedly to be experiencing the worst power shortage in a decade.
>Both auto sales and air traffics point to a weakening consumption propensity. China’s July PV sales for top 15 auto makers post very weak figure with only 3% yoy growth. More importantly, all these companies missed their 1H08 sales target and due to high inventory level, market believes 33% of dealers will shut down in 2008. In addition, 1H08 also saw Airline traffic demand only grow by 7.4% with 13.7% in 1Q08 and 1.6% in 2Q08. Looking forward, global economic slowdown, low consumer confidence and high oil price will continue to put pressure on these big-ticket items.
Having said so, moderating commodity prices are overall a positive for regional equity markets. Externally, a weakening US labor market and moderating commodity prices should push the Fed more towards an easing bias as the year progresses. But whether a lower input price decline in inflation P/E stabilization re-rating remains on doubt. This because a weak EUR will further kill Asian export-led models as the hope of Export-to-EU decoupling from Export-to-US waned. Petrified by weak export demand, Asian central banks will continue to keep their currencies down. But with inflation is likely remain elevated into 2009, I expect Asian CBs will less than fully sterilize. Market wise, I saw investors overwhelmingly emphasize defensive names with fat OPM, while stocks with weak headline growth have begun to under-perform significantly, including China Mobile. This is a sign that growth is becoming scarcer than Value. Thus, I feel 2H08 will focus on names with high OPM & ROE and favorable pricing power & potential +ve earnings revisions…Consumer Staples look fit in…Well before returning to Olympic games, we take a look of valuation. MSCI China is now traded at 13.6XPE08 and 21.2% EPSG, CSI 300 at 14.9XPE08 and 25%EPSG, and H-shares at 13.5XPE08 and 20.8%EPSG, while regional market is traded at 12.7XPE08 and 5.8% EPSG.
Good night, my dear friends!
