My Diary 604 --- The Causes of Concern; Bonds Tell You More; Ten-Baggers in China ; Gold Don’t Go Higher
September 13, 2009
“Should the world celebrate the 1st anniversary of LEH collapse?” --- Some people may challenge my rationales behind this very question. But as we approach the first anniversary of the collapse of Lehman Brothers, arguably the proxy cause of global economic and financial crises that followed, most risk assets have come full circle. Asset markets in general, and credit markets in particular, have recovered much of their lost ground... Champaign or Red Wine here?... That being said, the past 7-day is a macro week with upside surprises from Asian, EU and US data. Judged by the momentum, the risk of a “double dip” looks likely to happen until 1H10. Market wise, it seemed that both fundamental and technical factors are pointing to a better risk tolerance of higher-beta assets, and USD is likely to break to new lows. Technically, investors reduced risk in EM over the summer months and increased cash levels. Given G20 stressed that there are no immediate plans for “exit strategies” and emphasized to maintain easy policy, these should reduce the incentive for investors to hold cash any longer.
Back to macro, over the week US initial claims fell 26K to 550K, along with a lower continuing claims and insured UNE rate (from 4.7% to 4.6%). In addition, the US foreign trade showed the both export and import volume are surging with real exports rose 2.4% while import increased 3.7%, implying a bigger drag from net trade to 3Q GDP. Against the “stabilizing” job data, the takeaway from Beige Book is that US economy is just "stable" at a very depressed level as most districts reported that shoppers focused on the bare-bones essentials and stayed away from discretionary and big-ticket items. This is inline with the latest SSS data. In addition, labour market remains weak, although outlook is improving. Wage pressures remain minimal, thus I think Fed will remain on hold for at least another 6 months or more. The Beige book also noted that "manufacturers were cautiously optimistic”, suggesting the current ISM level may be sustainable.
However, as I repeated several times before, the major risk factors are still laid on consumer spending and commercial real estate. Over the week, I saw US consumer credit plunged >5X as much as July forecast as banks restricted lending terms and job losses made Americans reluctant to borrow, leaving many wondering how the US growth will be sustainable. In addition, the move up in oil also put doubt over the ugly problem of recovery as energy costs go to a level where they affect company returns and lead again to a cost savings push through employment and less capital spending. Beyond labour and energy, CRE in US deteriorates further. The Beige book noted that "demand for space remained weak and that construction continued to decline in all districts." This could well be the next shoe to drop, since US banks’ potential exposure to CRE NPLs is quite high. According to New York Times ( 02Sep2009 ), US banks had USD1.3tn in commercial mortgages and USD536bn in commercial loans, citing figures from Real Estate Economics. Currently, 10% of such loans are already in distressed status.
X-asset Market Thoughts
On the weekly basis, global equity prices (+3%) reached an YTD high with +2.3% in September. Regionally, equity added 0.5% in EU, +0.6% in EMs, -0.1% in US and -0.7% in Japan . Elsewhere, 1MWTI oil decreased $2.65 to $69.29/bbl, down 1% since 11August. 2yr UST firmed 2bp to 0.90% and 10yr flat at 3.35%. JPY closed at 90.7, its strongest level in 6mos, while EUR also stood at 1.457 high…Looking back, the weekly BTE jobless claims is good for risk asset, while the disappointed US trade deficit and 15bp wow decline of 30yr UST are bad for USD. I think the market needs to watch the nervous FX market as FX is usually the tail of market movement as it is the medium for global transactions. However, it is quite striking that the move lower on interest rates has taken place despite a persistently +VE news flow on the economic front, especially from the manufacturing sector. Interestingly, oil prices – a powerful signal of global recovery – have contracted ~7% from the end of August. Copper prices, another robust cyclical indicator, have similarly fallen. I think these are signals that the global recovery is no longer surprises to the upside.
Looking ahead, the world is recovering from a severe shock led out of the hole by a restocking of inventories. Whether this leads to a sustainable recovery in 2010 remains the question and FED speakers last week were on cue about that being enough of a worry to justify keeping rates low. One thing seems clear as global bankers discuss the exit trade – the velocity of future rate hikes is an open debate as the Greenspan gradualism has garnered so much criticism as to create doubt about whether that was the cause of the latest bubble & present mess. Interventionism was never the policy of choice in the last 20 years of the great moderation of inflation but post this great recession the theme may have shifted to a need to re-regulate markets so as to prevent future crisis. I think this change may lead to the great moderation of returns going forward. However, the expectation of equity market seems disagreed with this slow recovery/low return pattern, even though economists view -- the sub-par growth and deflation risks under the feet of UNE – that we may be in for a much different 2010 than the stock market prices now. But when investors mix low rates, a weak USD, big government spending and an industrial recovery, they are hard to be bearish…In my own views, all these “good & bad” and “bullish vs. bearish” make investment a fun job.
The Causes of Concern
Still the big picture is recovery is underway but the global economy is not back to normal, as big structural adjustments are still needed. In short, growth in the West cannot be driven by debt, while growth in Asia cannot be driven by exports alone. From the market perspective, I believe that at current levels, markets have priced in the all-too-evident improvement in economic trends, whether it be IP, PMI, or slower MoM job losses. But, I think we should not ignore the continued deterioration in other macro data, including 1) the continued deterioration in US CRE; 2) the increase in home loan foreclosures; 3) the plunging of US tax receipts and 4) the renewed fall in BDIY.
In particular, US consumer credit fell by a record $21.6bn (10% yoy, -$15.5bn in June) to $2.5trn, according to Fed. Credit fell for a sixth month, the longest series of declines since 1991. Meanwhile, US banks tightened standards on all types of loans in 2Q09 and said they expect to maintain strict criteria on lending until 2H10 because of “a more uncertain economic outlook”, according to the SLOS. More importantly, the Beige Book noted that home prices were falling across most of the country, standing in contrast to the latest Case-Shiller home price data, but along with the deterioration in foreclosures. This suggests that the worsening trend could continue. Clearly, a sustained increase in US consumer spending is unlikely to occur until delinquencies and foreclosures abate. These are causes of concern.
In Asian, there were two +VE signals on consumer spending – 1) China ’s car sales rose 700K (saar) to yet another series high of 12.1mn units. In Japan , the Cabinet Office’s index of real consumer spending rose 0.5% MoM in July. However, I think the most newsworthy was in Korea as the officials signalled a more upbeat view on growth and a bit more discomfort with its current policy stance. More broadly, the BOK is representative of a number of central banks further out on the periphery of the global meltdown, with smaller output gaps and little damage to domestic financial markets, which are signalling an early move to tighten.
Bonds Tell You More
As discussed, though equity had fully priced in a robust recovery, interest rates’ markets have reverted to pessimism. 10yr USSW is almost back to their low level of the beginning of July and 10yr EUR & UK swap rates are even lower. With 10yr USSWs broken lower to the 3.80-4.00% range, I would maintain a short-duration bias. Meanwhile, the downward re-pricing on the LE swap curve has not come this time from a sharp re-pricing of SE rates -- in particular the back end of OIS curve. Between June and July, the OIS-derived forward rate for the June 2010 FOMC meeting was revised downwards by close to 50bp. Between July and August it was revised upwards by 30bp, then downwards again by 45bp.
In the credit space, story was more exciting. In US, IG spreads have tightened back into pre-Lehman levels (161bp), after widening out 300bps in the days immediately following the Lehman collapse. The story is similar in US HY space(721bp), where spreads widened out to ~1800bps, before contracting all the way back in to 800bps. In fact, HY bonds across the world have been among the best-performing asset classes globally, delivering total returns of 40-60% on a YTD basis. This is especially surprising given that default rates have begun to rise significantly and, by Moody’s estimates, have yet to peak. On this regard, I think the HY bonds are trading relatively rich.
It has been a similar story in our home market, where the iTraxx AxJ IG and HY indices initially widened out quite sharply, underperforming US and EU, before staging an impressive rebound and recouping all of their post-Lehman losses. I think, given better relative fundamentals, Asian credit outperformance is to continue in the short term as IG Asia is trading wider (15bp)than the NA & EU (85bp) IG CDX index.
Ten-Baggers in China
Back to China , one important news line is in the World Economic Forum last week; Premier Wen said that “ China would not withdraw stimulus policies at an inappropriate time”. And he also warns that “we need to be ware of and guard against the inflation risk”. My own interpretation is although the government is not changing the official policy tone but we need to prepare for the exit. The key to watch is GDP and CPI. Data wise, August releases show that FAI led recovery is accelerating as IP growth (12.3%) hits a 12M high. Rmb loan growth (33% yoy vs. YTD 27.3%) was Rmb410bn (vs. Rmb356bn in June), ahead of media reports earlier suggesting Rmb320bn-370bn but in line with market suggestions later. This brings YTD loan growth to Rmb8.15trn. At the current pace, FY09 loan growth would reach ~Rmb10trn. Loan mix improvement is most positive as DBs fell Rmb276bn (July -Rmb198bn), while medium/long term loans grew Rmb368bn (July Rmb351bn). YTD discounted bills account for 15% of new lending, down sharply from 32% in 1Q09.
In the other hand, CPI (-1.2%) seems to be bottoming out, yet it is too early to worry about inflation risk. Given strong food price hikes in August, there is a risk that deflation may ease faster than expected as the yoy falls in prices are largely due to base effects. More over, consumer spending remained robust with 15.4% yoy growth in August retail sales. Sector wise, property prices in 70 large and mid sized cities rose 2% in August, the third consecutive monthly yoy increase after 7 month decline. NSB latest data showed that ppty development investment was +34.3% yoy or +6.4% mom, and NSP + 23.8% yoy or 14.3% mom. This is inline with my expectation that private investment is the key source of growth engine, if export not coming back in 2H10, while stimulus impact wanes.
Over the week, JPM published a “ten-bagger” report, which is interesting to note here. In general, China ’s past ten-baggers mostly in the manufacturing space, such as China Mobile, Anhui Conch and Lenovo. Most of these companies are growing fast against the backdrop of China seizing the opportunity from WTO accession to develop itself into a global manufacturing giant over the past 15 years. Looking forward, the future ten-baggers are most likely to be in the consumer space, on the backdrop of China ’s mission of shifting its growth model from FAI and manufacturing-dominated exports to domestic consumption. In particular sectors with low penetration rate and strong secular growth, like internet and natural gas, are very attractive…Lastly, valuation wise, MSCI China is now traded at 16.4XPE09 and 13.3% EPSG, CSI 300 at 24.1XPE09 and 18.2% EPSG, and Hang Seng at 16.9XPE09 and -6.6% EPSG, while AxJ region is traded at 17.7XPE09 and +12.5% EPSG.
Gold Don’t Go Higher
Much of attention was on gold over the week. In my own view, gold will not rise anywhere near its previous high in 1980. Looking back, US economy suffered from stagflation during 1970s and early 1980s due to two oil crises. The first crisis in 1973 occurred when OPEC implemented an oil export embargo, while the second one occurred during 1979-1980 in the wake of Iranian revolution and the Iran-Iraq war. As a result, US inflation levels peaked at 14.8% yoy and Paul Volker addressed inflationary pressures by interest rates hikes (+20% FDTR). Subsequently, UNE surged from 6% in 1979 to 10.8% by the end of 1982. This combination of high inflation and high unemployment, coupled with the tumultuous geopolitical backdrop, provided the catalysts for gold’s all-time inflation-adjusted high of +USD 2100/oz in Jan1980. However, in current environment, the highs in UNE and the rapid drop in CAPU means we are unlikely to see inflation returning in a significant way in US, at least in the near term. Market wise, 10yr US BE inflation rates is around 1.7% pa, well below pre-Lehman levels. Moreover, with expectation of rate hikes in major economies in 2010, a high real rate is generally bearish for gold. The only supportive element is resumed USD weakness, as discussed in last diary.
With respect to USD, it is obviously that the current movement is not a fundamentally based but is instead based on positioning, technicals and risk appetite. The reality is that the fundamental backdrop, while evolving, is not necessarily doing so in dramatic fashion for USD. The fact of its most recent new lows against EUR is that USD has fallen
Good night, my dear friends!
