My Diary 611 --- Look beyond 2009; Watching out Rates; Hunting for Revenues; Counting down USD
October 11, 2009/>
“The Anniversary of Global Crisis vs. The Dollar’s RC Status” --- One year after the peak of the crisis, I am now comfortable to say “good bye” to the global dollar-funding shortage as most of LIBOR-OIS spreads have normalised so much that they are no longer a focus point. In US, this spread is now close to ‘normal’ levels (12bps), as it is in UK/>/> (15bps) and in EU (28bps). Overall, the channels of global inter-bank funding have been reopened. Moreover, the price of risk as measured by the implied volatility on options has contracted sharply on almost all underlying assets. VIX index for equity prices is close to its Aug2007 level, FX volatilities have contracted, and volatility on WTI futures is also down. The most noticeable exception is rate volatility, i.e. swaption volatility on 10Y rates or Eurodollar, which remains high. It seemed that the unprecedented levels of base rates, policy innovations, flight-to-quality and flight-to-liquidity have combined to create conditions for a persistently high level of rate volatility. But, in general there have been a normalization from extreme risk aversion to a more realistic risk/return profiles. That being said, although the Armageddon has been avoided, the crisis has evolved rather than been resolved – 1) massive govt and CB intervention has shifted liabilities from private to public sector in DMs; 2) and the consequences of expansionary fiscal policies in DMs could end up depressing global growth and crowding out financial access for EMs that don't have Chinese-style savings ratios. Thus, even if there is a smooth and successful transition of net demand from deficit to surplus regions, the post-crisis world is likely to be characterized by slower growth. Ultimately, the world will need to find a new equilibrium and that is a global challenge. For now, the world is back in a dollar-recycling loop similar to the pre-crisis period.
Obviously, the new world requires a new currency complex in order to rebalance growth and capital flows. Over the week, several developments caught the market off guard and the net result has set USD a new 12-month low. The key catalysts in my observations are 1) growth differentials are moving against USD; 2) implicit official tolerance for a weaker USD after G7 failed to shore up USD sentiment; 3) and the concern over USD's role in global economy. In particular, a UK/>/> paper implied that the USD may be phased out as the currency for pricing oil. In my own view, EUR is the only alternative reserve currency. The latest IMF data shows EUR's share of global reserves rising to 27.5% in 2Q09 from 25.9% in 1Q09, alongside further slippage in USD holdings to 62.8% from 65.0%. But that does not explain to me how weak USD is, particularly against JPY…Could it be the outstanding economic fundamentals in Japan (such as -30% in exports, -20% in IP, UNE >10%, plunging savings rates and aging demographics) propelling JPY?...To complicate the issue a bit more is that BoE has been boring -- rates and QE unchanged, while ECB was also a non-event. The only excitement is RBA became the second central bank to begin normalizing policy rates, hiking 25bp to 3.25%. At this stage, the question is how these dynamics play out for FX market. Understandably, the momentum against the USD looks formidable and there are renewed expectations of USD's further decline, if traditional FX market drivers come back into play. Without that, the overall backdrop of high global liquidity suggests that risk assets should continue to perform well, and such a trend will continue at the expense of USD, as I saw in the past 6 months. Another implication is that gold looks more like the ultimate short USD trade.
X-asset Market Thoughts
On the weekly basis, global equities jumped 4.2% with +4.6% in US, +3.9% in EM, +3.7% in EU and +2.9% in Japan/>/>. Elsewhere, after hitting 4mo low (3.18% and 0.86%) earlier this week, UST yields rose considerably with 10yr jumped 21bp to 3.39% and 2yr popped 11bp to 0.97%. 1MWTI rose $1.82 wow to $71.77/bbl. Gold closed > 4% wow and > 9% over the past 2 months. On the TW basis, USD has declined 1.7% over the past month, while EUR and JPY have risen 0.7% (1.473) and 1.4% (89.8), respectively. Looking across asset markets, the risk-on, pro-cyclical theme returned with cyclicals outperformed defensives on the back of stronger commodities and a weaker USD. I think USD is driving all assets’ performance these days. In fact, the correlations of intra-asset returns have been noteworthy escalated, following the collapse of LEH as risks were sold across the board and funds were repatriated. Interestingly, these correlations have remained close to historical highs even as markets have stabilized in recent months, as synchronized monetary expansion boosted global liquidity and risk appetite. With talk of exit strategies likely to gain traction in 2010 and credit conditions likely to remain tight relative to previous years, I think t investors to differentiate more across risky assets.
The recent reaction of broad asset classes suggests that the market is beginning to be used to a more subdued economic recovery and benign inflation. Looking forward, I think the bigger near-term drivers for risk markets will be – 1) Q3 earnings which kicks off this week (Pepsi, Yum Brands, Monsanto, Alcoa) but picks up steam next week with releases by the large US banks; 2) the considerable issue of "cost cutting" boosts to earnings vs. "top line" growth, which will be necessary for an eighth consecutive monthly rally in major indices? Obviously, Dr. Doom, Nouriel Roubini, certainly does not believe there will be much growth in revenues saying that stocks have risen "too much, too soon". He sees risk of a correction when the markets realize that "recovery is not rapid and V- shaped, but more like U- shaped". 3) If anything else, the upcoming anniversary of the Oct1987 stock market crash may prove to be a bigger hurdle for equities in the coming weeks…Well, it is always impossible to predict market movement. I still remain Neutral to Cautious view in near term, despite the past week’s strong performance in S&P, mainly due to 1) the potential disappointment from US corporate top lines and macro data as most manufacturing data should have normalized after restocking since June and too much expectation built in retail sales data; 2) after RBA raised 25bp, market will soon start speculating global tightening again; and 3) this round of correction is way too small to be called as a correction.
Look Beyond 2009
Macro data were mixed during the past few weeks as August data had been strong, but September data were clearly less supportive. In US, both investment and employment will need to bounce before I can see a BTE recovery on hold. Elsewhere, data were weak in UK/>/> (Sep IP -2.5% mom vs. cons +0.2%), but BTE in Europe/>. Asia/>'s growth is levelling off from its high levels, while LTA is accelerating. On the back of this growth picture, I expect monetary policy to differ significantly across countries, with inflation targeters are likely to be the first to hike. That being discussed, the most important data of the week probably is US jobless claims which fell to a new low of 521K. But Sep payrolls -263K (cons. -175K) heightened concerns about the trajectory of US/>/> employment. In fact, headline UNE rate was in-line at 9.8%,but this was only because 571K people left labour force and participation rate plunged to 65.2% from 65.5% (lowest since 1986).Without that, the UNE rate would have leaped to 10.3%.
Putting together, the combined impact of soaring oil prices, the housing market slump and the global credit crisis have hit the US/>/> consumer hard, resulting in the deepest US/>/> recession in decades. Although market expects a +VE 2HGDP of 3% QoQ, there is likely followed by a renewed slowdown in 2010 to the 1-2% yoy range. That said, there are still many concerns over US consumers. In 2Q09, US/>/> personal consumption actually contracted by 1.0% QoQ after expanding by 0.6% in 1Q09 and contracting by 3.1% in 3Q08. Meanwhile, the three main sources of support, namely the government stimulus package, the turn in the inventory cycle and the “Cash for Clunkers’ program, are all temporary. Final demand is likely to pick up only very sluggishly given poor B/S and rising unemployment. Moreover, many analysts expect house prices to fall by another 20% over the next year, given rising UNE, foreclosures and the inventory overhang. With reduced wealth, reduced access to credit, and the highest UNE rate in 25 years, I expect savings rate to rise further. In short, unlike previous recessions, this one is led by consumer rather than corporate deleveraging. With consumer debt/GDP at record levels, any US/>/> recovery is likely to be extremely weak relative to previous cycles.
Back to Asia/>, things are looking good. Fiscal support has been a significant contributor to Asian economies in 2009, helping the region through its worst recession since 1998-99 AFC. The question in the coming months will be whether Asian authorities should start to rein in their fiscal stimulus packages in order to achieve mid-term fiscal balance, or to continue to provide support. Having said so, HSBC economist team has raised FY10 GDP forecast for AxJ to 7.6% from 6.9%. Major upgrades come from China/>/> (9.5 from 8.5), HK (3.8 from 2.4), Korea/>/> (4.6 from 3.6) and Singapore/>/> (6.5 from 5.3). Besides continued strength in consumption and investment, HSBC expects export to rebound, driven by restocking in West and inter-EM markets trade.
Watching Out Rates
Talking about rates, I still think the G3 central banks, where large -VE output gaps driving down core inflation, should keep rates on hold. Consistent with this view, NY Fed Chairman Dudley said last week that “… In summary, I believe the current balance of risks around the inflation outlook lie to the downside due to the very low level of resource utilization and the fact that long-run inflation expectations remain stable. This balance of risks is problematic because the current level of inflation is already so low—the core PCE deflator has increased only 1.3 percent over the past 12 months. Thus, we would not need much of a decline in inflation to run the risk of an outright deflation.” But I think this does not mean that Fed will not withdraw liquidity.
Watching the turning point of this rate cycle is particularly important. In a normal rate hike cycle, moving from 2% to 2.5% would normally be viewed as +VE as it would indicate economic recovery, with a change in discount rate more than offset by the higher revenues. However, when we have rates this low, the same 50bps change in rates (from 0.25% to 0.75%) has a disproportionate effect on the denominator of asset valuation models so my guess is that markets this time will peak when rate hikes start, not when they end as is usually the case in any other cycle. This is why Fed desires to minimise ambiguity and the surprise factor associated with articulating monetary policy, as this means investors can better assess general risk-taking.
In our home market, there was a strong rally in EM SOV with Indonesia/>/> bonds rally by 2-5pts. Such a constructive tone is partially underpinned by both global and regional macroeconomic data, which continue to surprise on the upside. In the near-term, current spreads present a decent entry opportunity. From mid-August to early October, IG spreads ex. Korea, widened 18bp on average in AAs, 27bp in As and 48bp in BBBs. Looking forward, strong demand and more limited issuance in 2010 will provide technical support for Asian IGs, given the peak issuance in 2009 of USD16.2bn ytd, a limited redemption profile seen for IG credits in 2010, and a general unwillingness by companies to hold large amounts of liquidity given the negative carry on cash holdings in a low rate environment.
Hunting for Revenues
US retailers were strong last week with many beating sales expectations -- Macy's +5.06%, Target +1.71% and Abercrombie & Fitch +5.51%, while homebuilders also rallied after the avg rate on a 30yr mtg dropped to 4.87% from 4.94% -- Lennar +9.18% and KB Home +5.66%. Looking ahead, market will focus on revenues to see if firms can generate bottom-line growth through more than just cost cutting. During 1Q and 2Q09, S&P 500 rallied 11% and 15% due to BTE EPS. However, sales results disappointed. Stocks are unlikely to rally this Q without +VE revenue surprises. The reason for me to focus on sales is because 2nd derivative EPS improvement fades. Bottom-up consensus expects -23% yoy growths in 3Q as in 2Q and EPS growth for S&P constituents bottomed in 4Q08 at -64% and has yet to turn +VE.
Back to regional market, in 3Q09 MXAxJ rose 16.5% QoQ vs. MXWO 15.2%. In fact, EM markets were on fire for much of the decade that followed the Russian crisis at the end of the 1990s, attracting a greater amount of “money inflows”. But the global credit crisis was a rude awakening, exposing an underlying dependence on net external demand. That being said, the "wall of money" was apparently not involved in HK IPOs as I saw CRC struggling at the unchanged mark despite being 83X oversubscribed! Certainly, later IPOs hit the momentum with China Vanadium, Ausnutria Dairy, Yingde Gases all shined in the first day.
Policy maker side, Liu Mingkang, Chairman of CBRC, said that new loans in September were likely to be in the range of RMB300-400bn, and expected more sustainable and stable new loans in 2H09. But, the market is unsure what "sustainable and stable" mean? Here is my number crunching, 1H09 new loans were RMB7.4tn, averaging RMB1.2tn per month, but RMB356bn, Aug RMB410bn and in Sept RMB300-400bn. For 2010, assuming 15% loan growth (RMB6tn new loans), it should translates into about RMB500bn of new loans per month next year. For Chinese banks, after NIM fallen by 100bps from the peak, it should be bottoming in 3Q09…Lastly, valuation wise, MSCI China is now traded at 16.5XPE09 and 13.9% EPSG, CSI 300 at 23.1 XPE09 and 18.9% EPSG, and Hang Seng at 17.1XPE09 and -5.9% EPSG, while AxJ region is traded at 17.7XPE09 and +13.5% EPSG.
Counting down USD
There is likely that FX will shift to growth and interest rate fundamentals, along with stabilization in economy growth and a further normalization in financial markets, and with the need of risk trade. But this is not going to change overnight. That said, G7 shows no firmly support or intervention over USD weakness, as 1) Japanese FM said that "…we will take appropriate action if FX rates become too one-sided"; 2) separately, ECB President Trichet also say that he trusts US authorities when they say they support a strong USD, and that global rebalancing does not imply a change in the EUR/USD exchange rate. All this seems talk-talk and the current down-trend of USD resembles the period in 2002-2004. If history has any reference value, given the extent of USD decline in 2002-04, the Dollar has room to fall further and it should not recover before US monetary policy normalizes.
In sum, I think 1) USD remains in a multi-decade downtrend; 2) USD will see a further multi-year period of gradual weakness until US/>/> inflation expectations spike; 3) there are strong arguments for expecting EM currencies to lead the rally against USD. That said, technically, there is a risk of a temporary correction higher in 1H10 in USD on valuation and interest rate considerations. On the other front, several houses have raised metals price forecasts significantly on --1) the boost in demand from government infrastructure projects; 2) increased interest in inflation hedge; 3) and strong Chinese FAI growth.
Good night, my dear friends!
