My Diary 616 --- Diagnose the US and Asia/>; Find the Neutral and Value; Watch the PBOC and CPI; Asses the Dollar and Oil
October 25, 2009/>
“The Headache of Global Central Bankers: Second Dip vs. Next Bubble” --- I was in Taiwan/>/> over the weekend. By talking to the taxi drivers and local residents, I come to a general impression that the KMT’s Ma Administration is trying to play the game between “political independence” and “economic reliance”. However, both sides have considerable risk and resistance in the eyes of both Green and Blue politicians. Similarly, while global central bankers are somewhat relieved after the world economy avoided the worst recession since 1930s, they are facing an even troublesome dilemma--- if tightening monetary policy, then it is highly likely to see a second-dip in the economy vs. if maintaining loose policy, then another asset bubble is coming soon. Ironically, calling the money back is tougher than pouring money into the economy. That being said, the recent rise in global bong yields is largely explained by expectations of higher policy rates. In China/>/>, a robust 3Q growth, a falling USD and a recovery in global demand have induced the government to broaden its focus from growth to inflation risk. One thing for sure to happen in 2010 is that rates are going up. But how far do they need to go to make a real difference? Neutral interest rate is always tricky to estimate and we are a long way from neutral. So much is clear.
Back to the capital markets and economy, recent US/>/> earnings reflected asset markets (like GS & MS) have been going gangbusters, while the real economy (like GE, JPM, and BoA) remains in the doldrums. Moreover, corporate earnings and the equity performance remain a central focus for the FX market. Indeed, EUR was in focus last week after breaking 1.50 levels. In my own view, FX will become another source of market volatility, given that --- 1) a further decline in USD (particularly vs. EM currencies) is exactly what is needed to promote global rebalancing, by which means a rotation in demand away from US consumer; 2) but the problem is a weaker USD leads to the hikes in oil prices which have begun to threaten the sustainability of economic recovery; 3) and there is considerable resistance to Dollar depreciation in a world in which exports have been decimated. Although earlier and more aggressive policy normalization outside G3 is undergoing, a continued FX appreciation could become an important tempering force. That being said, currency stress is not limited to EMs/>. Last week, BoC said that "heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures.” Later, ECB officials also emphasized the importance of a stable USD. In short, I still think, in the near term, USD remains downwards as excess reserves on the Fed’s B/S increased 22% during the last month, and I expect the FX market stress will filter into the policy arena sooner or later.
X-asset Market Thoughts
On the weekly basis, global equity edged down 0.2%, mainly led lower on Friday’s movements with -1.3% in US, -0.6% in EU and flat in Japan/>/>. Elsewhere, UST 2yr ended up at 1.00% and 10yr at 3.49%. Both are at their highest level since late August. 1MWTI closed at $80.50/bbl, down from its 12M-high of $81.19. The oil price is up $9.89 MTD. USD strengthened 0.2% wow on a TW basis, with JPY92.1 (weakest in a month) and EUR ebbed 0.2% to 1.501…Looking across asset markets, the inverse D/E correlation persists. With respect to yield curve, the front end was in line with a Barron's article suggesting Fed to raise rates to 2% now to prevent a liquidity bubble from building and to the collapsing USD's future inflationary effects. Energy space sees oil finally broke $80 as a result of a weak USD and a surprise in EIA inventory data, showing another surprising draw by gasoline products (but crude inventories rose 1.3mn bbl to 339mn bbl).
Looking forward, given the 55% rebound in global equities since March, there are concerns that the rally may soon run out of steam and lead to a broader-based correction for cyclical assets. In my own view, as long as the current backdrop of strengthening growth and low rates stay in put, the global corporate earnings cycle could continue to support equity performance. Technical wise, as the equity market is approaching the end of Oct and the traditional Oct sell-off does not seem to be happening, it seems that the 1999 scene, where investors saw a crazy "melt-up" over the final 2 months of the year, could replay. But investors should continue to watch out HK IPOs, many of which are still trading below listing price, i.e. Glorious Property (30% below). Risk side, with recovery under way, investors appear sceptical to how long the policy honeymoon period could last. I think the November rate decisions should be paid closer attention as the market will focus more on the speed and unpredictability of exit strategies, which may cause increased volatilities in the asset markets. That said, in the short-term, -VE output gap buys time for Asian CBs to delay rate hikes till 2010, though RBA’s hike may pressure central banks to be more pre-emptive. I think Asia CBs will likely take more liquidity management measures before rate hikes.
Diagnose the US/>/> and Asia/>
The Fed's Beige Book continued to indicate that weakness in consumer spending and the labour market persisted, while there were slight improvements or stabilization in manufacturing activity and the housing market. In addition, Fed district banks observed "little or no" price pressures and demand for loans was "weak or declining” with a "further erosion of credit quality". Such mixed economic picture is supported by the mixed macro data. US consumer confidence remains subdued and the US savings ratio is still climbing, but BTB increases in US retail sales in Aug (2.2%) and Sep (-1.5%), for the first time this year, bode well for 3Q consumption. US/>/> IP rose for the third consecutive month in Sep, by 0.7% (> 0.2% cons.), but CAPU came in at 70.5% from the 69.6% reported for August, well below the historical norm of ~80%. Housing starts (590K), PPI (-0.6%) and job claims disappointed, but existing home sales is unexpectedly strong (+9.4%). But that does not mean that American are buying more homes as weekend stories highlighted 10% of homeowners who have suffered through a foreclosure this year have ended up in homeless shelters. The US/>/> consumers are now super savers, not super spenders.
In Asia/>, 3Q09 growth likely ended on a strong note as major export-oriented economies (CN, TW, KR, SP and TL) have reported +VE surprise in Sep data. In particular, TW export orders increased 9.0% mom (-3.0%yoy) is much BTE, suggesting that tech exports could continue to lead an export recovery in coming months. Singapore/>/> also offers a good yardstick for trends in global trade. Its 3.0% mom (Saar/>) rise in Sep exports, the third consecutive increase, is particularly encouraging. However, though exports could continue to recover, production could ease where the recovery in IP has run ahead of export demand…Keep in mind that Asia is by no means out of the woods as US UNE is still rising and wages are likely to remain subdued for a protracted period.
To sum up, recent data and surveys continue to suggest that most major economies have returned to +VE growth in Q3 this year. Worldwide, after the initial inventory-driven rebound, the recovery will be uneven across regions, with the strongest upturn in AxJ, followed by US, while EU/>, UK/>/> and Japan/>/> are lagged behind. Policy wise, rate hikes have begun in a few countries (i.e. Israel/>/>, Australia/>/> and Norway/>/>), and strengthening growth will probably prompt several EM countries to hike in early 2010. However, the base case for investors remains that major central banks will not be quick to tighten monetary policy until 2Q2010.
Find the Neutral and Value
Having discussed the above economy picture, I noticed that BoE’s October minutes confirmed a 9-0 vote to leave its asset purchase program unchanged. Moreover, there is an interesting contrast between comments from RBNZ and from BoC, of which both central banks have plans to leave rates on hold for a specified period, with RBNZ targeting late 2010 vs. mid-2010 for BoC. My question is how much do they know about neutral rates. My instinct is they DONOT. So does the market. To calculate neutral interest rates, the biggest trouble is to estimate what the real rate actually is. Theory tells us that real rates are a ƒx (inflation expectations). Since inflation expectations cannot be observed directly, analysts commonly deduct the current inflation rate from the nominal variable in question (here the policy rate) to arrive at real numbers. Popular as this approach is, it is clearly nonsense since the measured inflation rate is highly volatile and not necessarily tightly associate with the expected rate of inflation.
That problem is left for economists. Market wise, the direction of the rates complex will be interesting as we will have UST auctions of USD116bn in 2yr (USD44bn), 5yr (USD41bn), and 7yr (USD31bn). If stocks hold up, where yields head up, this will be most telling uptrend as the market is grappling with the classic bull/bear debate. Ultimately a move through 3.6% would be bearish and conversely below 3.30% would be bullish. Back to corporate credit market, with the rally throughout 3Q09, Asian bonds have been among the best-performing asset classes as yields across the board have fallen to the mid-to-high single-digit range. Valuation wise, investors looking for equity-type returns are currently finding that it is impossible to obtain similar returns in either the primary or the secondary bond markets.
In comparison, US HY is still attractive at 390bp spread. The market in general has reduced the default rate outlook over the next year on growing confidence in the recovery and declining downward migration activity out of BB and B spaces. The 12M trailing default rate is now estimated to be 7% in Sep10 vs. 7.7% last month. Supply front, the number of HY debt issuers has significantly increased with a pipeline around USD2.6bn, exceeding the 2007 levels. On the back of new issues, Asia/> credit markets showed some weakness recently (JACI +5bp =284) although strong earnings numbers did provide some support. Nonetheless, fund flows towards HY continue to be strong as EPFR reported monthly inflows of USD477mn into EM hard currency debt funds.
Watch the PBOC and CPI
Over the week, I saw a lot of "real economy" companies reporting and thus far, revenues have been light on that front. The degree of cost cutting still taking place is quiet surprising, suggesting that consumer spending may not come back in a big way (high UNE + low wages). Note that in 2000, it was companies missing earnings which eventually brought the markets down once again. Meanwhile, investors continue to enjoy the "fake economy" of financial markets, like the Ostriches…Economy front, China/>/>'s 3Q GDP growth topped 8.9% yoy, the fastest pace since 3Q08. Investment (+33.3% yoy in 3Qs) remains the key driver and effectively lifts demand for industrial goods as IP (40% of GDP) accelerated to the 14mos high of 13.9% yoy in Sep (12.3% in Aug). Meanwhile, electricity consumption growth rose to 9.5% yoy in September from 8.3% in August, with the biggest contribution by industrial sectors. The pick-up in REI has been sustained in Sep (36% vs. 34.6% in August). Consumer spending holds up strongly at 15.5% yoy. Moreover, the decline in CPI and PPI narrowed to -0.8% yoy and -7% yoy, respectively from -1.2% and -7.8% in August. As the base effect gradually phases out, headline CPI is to return to +VE territory and inflation expectation is on the rise.
Thus, not-surprisingly the State Council mentioned inflation for the first time in over a year last week. The rhetoric has changed slightly to say that the recovery has been consolidated (vs. "not solid foundation of recovery") and that policy focus would have to manage inflation expectations. The concerns over inflation are not unfounded as SDRC pointed out that “… CPI inflation pressure will be big next year…Could be difficult to keep it below 3%... probably will exceed 5%...It is cost driven (i.e. commodity), nothing to do with over capacity.” Thus, some economists are thinking that PBOC could hike RRR as early as YE09 before it starts to hike rates moderately in 2Q10. In my own judgement, it is clear that China/>/>’s macro policies will be targeting both growth and containing inflation next year. But the problem is if private investment does not pick up, the country may get into a Chinese style stagflation. Thus I believe that we will see a relaxation of 2nd mortgage policy in early 2010.
Sector wise, domestic steel production hit new record, with production reached 50.7mt (+28.7% yoy) in Sep despite weak prices. It seems nobody is willing to cut production, expecting a robust 4Q09. Thus given the plenty of inventory out there, I expect a minor price rebound only. Banking front, CBRC has formally announced the new regulation on banks’ sub debt. According to the new draft, only inter-bank sub debt came in after July 1st 2009 need to be excluded from core capital calculation. Another closely watched sector driver is NIM. The recent MSB number confirmed that NIM is bottoming out, but CCB NIM was down 3bp QoQ due to lower DB exposure. Overall asset quality surprises on the upside. Looking ahead, capital will be a key differentiating factor for banking stocks…Lastly, valuation wise, MSCI China is now traded at 14.4XPE10 and 20.9%EG10, CSI 300 at 19.8XPE10 and 25.3%EG10, and Hang Seng at 15.2XPE10 and 17.6%EG10, while AxJ region is traded at 14.2XPE10 and +27.1%EG10.
Asses the Dollar and Oil
It is interesting and important to see EURUSD 1.50 threshold is crossed. I think it witnesses the broader trend of USD weakness and in that regard, I hold on the weaker USD bias in the near-term, given the still-decent level of risk appetite and disadvantaged US yields. That said, short-end US/>/> yields have backed up 20-25bp from levels early this month, while long-ends have also moved up a similar amount. But one has to note that EU yields have risen as well, and EU/US 2yr spreads recently pushed above 40bp after averaging ~27bp in the past two months. Thus, the weaker USD is indeed consistent with the low US/>/> rate backdrop, relative rate spreads, and the notion that the Fed will be lagging other central banks (including ECB) in terms of implementing the exiting strategies. Moreover, one other item to highlight for USD bears was US 2008-09 fiscal deficit, which ballooned to $1.42trn from $455bn the previous year. In truth, I don’t believe the fiscal discipline story once the recovery is proven to be more sustainable, and Moody's repeated that US could lose its Aaa rating if it does not reduce its budget deficit to a more manageable level in the next 3-4 years. However, a near-term shock to USD could come from repo rates. The market is expecting US authorities to withdraw liquidity by raising repo rates through reverse repos in the second half of Q4.
Clearly, USD is a driver of all commodities risks, obscuring even more important developments in market fundamentals. Market sentiment and risk appetite continue to improve assisted by a raft of +VE macro data (particularly from China/>/>), especially in oil which was traded convincingly through $80/bbl after the decent DOE stats. Over the week, the break-out from the previous range has consolidated, with prices continuing to test new highs at the front of crude curve, while back-end prices are now close to $100/bbl again. That said, amid pessimism on China's imports in 2H09, recent data from China have been a key source of upside surprise, lending confusion over how these should be interpreted. At the macro level, there are signs that the recovery is already broadening into private spending and inland areas while exports are recovering, driving a discernible shift from concerns over slowing growth to concerns about inflation risks.
Good night, my dear friends!
