My Diary 653 --- Another Bad Christmas Orders; Three Messages from Bonds; Good Earnings vs. Bad Rumors; A Review over Dollar
Sunday, August 29, 2010
“Are we at a turning point? “ --- Time is supposed to be a great healer, but this does not appear to be the case with US economy. Over the week, the combined effects of continued sluggishness in key macro data, downbeat assessments from global policy makers and increasing perceptions of being difficult to engineer economic recovery are encouraging a further contraction in risk appetite. As a result, I saw 10yr UST tested as low as 2.42%, Dow tested 10000; crude tested $70/bbl and JPY held the 84 level. That said, evidence has been accumulating recently of an even more pronounced slowdown in 2H10 economic activities than the street economists have been forecasting. In US, LEIs and business surveys have softened, housing activities has fallen back to close its lows, and UNE claims have drifted higher. In addition, the CBO estimates that the real GDP was still more than 6% below its full-employment level in the 2Q10, one of the largest negative output gaps in the history. These indicators highlighted that downside risks have increased and according to Professor Martin Feldstein, “…there’s still a significant risk, maybe one chance in three, that there will be a double dip.”
Policy front, in the highly-anticipated Jackson Hole speech, Chairman Bernanke expressed a willingness to provide further monetary accommodation, if necessary, saying that "the FOMC will do all that it can …" , but did not signal that any such decision was a done deal. Bernanke walked a fine line both on the economy and on policy -- conveying optimism on the outlook while noting the downside risks to the forecast, and highlighting a readiness to act but attaching conditions and costs to those actions. After the speech, I remain of the view that Fed still sticks to "an easing bias" but at the same time think Fed may need more bad data before undertaking additional asset purchases. However, the move from a neutral bias at Humphrey-Hawkins in July to an easing bias at Jackson Hole in August is a testament to the rapid deterioration in the economic data. In my own views, it is troubling to see US economy slow so soon in what has been a very tepid recovery. The 2Q GDP was revised down from 2.4% to 1.6%, with contribution from net exports revised down from -2.78% to -3.37% and inventories from 1.05% to 0.63%. And for final sales (GDP excluding the change in inventories), it increased by a meager 1.2%. Part of this slowing down can be attributed to the unfinished deleveraging by US consumers. However, Part of the slowing I just can't explain, which is worrisome, and which is the increased caution by US companies as their B/S are in good condition
Looking ahead, even if an outright recession is avoided, slower growth at this point implies higher unemployment and further downward pressure on inflation. Considering the positives, monetary policy actions have not being as effective as expected, but setting remain generally simulative, with real interest rates are negative and the size of Fed B/S is still significantly expanded. Meanwhile DXY is at its lower historical range. For the negatives, 1) Fiscal policy has become more a drag. According to CBO’s estimate, the winding down of the stimulus program will lower real US growth by 1.25-1.5% in 3Q10 and by 1.25-2.5% in 4Q10. As far as FY11 concerned, the key issue is the expiring Bush tax cuts. If the tax cuts are not extended, it could reduce growth by 1% for 2011; 2) The transmission mechanism of monetary policy is clearly broken. Interest rate at zero and a much expanded Fed B/S have done little to trigger an upturn in money multiplier. In addition, there is still little indication that business and consumers are keen to borrow as DEBT is still a bad word and the deleveraging has a long way to go; 3) The fragile business and consumer sentiment can be added to the list. In fact there is not much to be cheerful – wage growth (0.2%) is extremely low, job market is weak, large fiscal deficits point to future tax hikes, equity return has been flat over the past 10 year, housing price is still under downward pressure with many in negative equity.
Yes, the world is not a beautiful place. Even Fed policymakers are more worried about the outlook. The question is what can they do? Obviously, they have stopped talking about exit strategies and even decided to reinvest the proceeds from maturing MBS into long-term USTs. However, when it comes to further easing, I think policymakers have limited room to maneuver --- 1) A vigorous fiscal policy response is unlikely. The political will for sizeable increases in the federal deficit is lacking. That puts the policy burden squarely on the Federal Reserve. However, the FOMC is divided about the need for additional policy action and even about how to conduct monetary policy with FFTR effectively at zero. That means it may take a sizable rise in UNE rate before a majority of the FOMC would support a significant move toward a 2nd QE; 2) even if the Fed could go for another asset purchase program, with 10yr USTs already down to 2.6% and 30yr mortgage rate at close to 60-years low, it’s not clear how much more the Fed can achieve. Indeed, QE can drive down USD, but such a “beggar-thy-neighbor” policy could lead to a response by other central banks. Japan is already considering actions to curb the rise in Yen. Another consequence is more asset purchases could complicate the eventual exit, or more precisely, the public's confidence that the Fed could accomplish a smooth exit. As a result, I think 3) the most effective policy response at this stage is to suspend the payroll tax for a year, along with the Fed monetizing the increased UST issuance (900bn) as this will give the incentive for corporate to hire.
X-asset Market Thoughts
After a relief rally on Friday, global equities still closed down 0.4% wow, with -0.65% in US, -0.3% in EU, -1.4% in Japan and -1.84% in EMs. USTs got with 2yr moved up 7bps to 0.56% and 10yr up 3bps to 2.64%, and 30yr also up 3bps to 3.69%. Despite the price movement, 10yr and 30yr yields are equal or lower to their levels on August 18th. In Europe, 10yr Greek-to-German bond spreads closed at 925bps, the first time since EU and IMF created a EUR750bn bailout fund in May.1MWTI oil rose $2.37 to $74.29/bbl. EUR strengthened 0.4% to 1.273USD, while USD also weakened 0.5% to JPY at 85.22.
In short, the market’s movements in the past two weeks point to a lack of investor conviction in the remaining months of the year. This is not being helped by the weak economic data out of US – which is raising concerns over a potential double-dip. The downside risks to growth are compounded by the realization that policy makers are running out of ammunition. With bond yields near historic lows, more QE buying of government bonds will not accomplish much. And fiscal easing is unlikely with most major governments heading the other way. At some point, policy makers will be tempted to abandon caution, moving QE to a new level, or cutting taxes again, but this is likely more a risk for next year. For the rest of 2010, lower growth poses a clear danger for risky assets. Most at risk are commodities, followed by equities, with credit least affected. Commodities are most at risk as they offer no yield, are more sensitive to the industrial cycle, and are a clear short for those starting to position for deflation. Equities require growth more than does credit, which just needs downside protection. As long as investors see only slower growth without recession, then credit risk is a better place than equities.
An interesting observation is the global investors are combating to grab whatever piece of US Treasury is floating around. However, equities are just so ignored the fund flows with almost USD200bn inflow into bond funds this year vs. USD30bn outflow from equity funds. Thus, the logic question is why are equities not selling off more badly? In my own view, what really matters for equities is earnings and not GDP growth. US GDP growth projections are being cut, but earnings projections have been little affected so far. Investors and analysts are hoping that, to the extent the soft patch in US GDP growth lasts for only a few quarters and does not spill over to the rest of the world. So far, the corporate sector’s performance has been one of the few brightest stars in an otherwise dull economy sky. Companies have done great job in protecting margins and building B/S as costs are being contained by improving productivity and lower wage growth. A key issue is whether this could be sustained. One thing for sure is the nominal GDP (
Another Bad Christmas Orders
This week’s activity reports amounted to a continuation of recent themes. US economic reports were strikingly weak and EM Asia growth was moderating. In sharp contrast, reports continue to highlight surprising strength and resilience in Euro area. Next week’s data calendar is critical for US, especially ISM and labor market reports. China will start to announce August economic data from Wednesday, and market may pay close attention to PMI and trade data.
Regionally, I saw another set of bad US data. July durable goods orders only rose 0.3% mom (cons +3.0%). The weakness was fairly broad-based, with the most notable drop in machinery orders (-15%). ISM could fall towards or even below 50 (reported on 1 Sep). New home sales fell 12.4% in July (276k vs. cons 330k) and is at the lowest level since 1960. The data underscores the fact that underlying demand for housing remains very weak. Meanwhile I overheard that Roubini said he expects a large downward revision to Q2 US GDP and that Q3 GDP would decline "well below" 1%. Cross the pond, data continues to be positive in Euro area. German IFO came in BTE at 106.7 (cons 105.7). BNB (Belgium) also registered a gain in August.
Whereas Euro area lags the global manufacturing cycle, US and EM Asia lead. Export growth has been slowing sharply across Asia. Based on the recent talk to local exporters, I found that Christmas 2010 orders from the West are another sign of a weak world economy. Many of the corporate management said that 2010 is similar to 2008 - 2009. Buyers are still leaving orders until very late, perhaps Sept. or even Oct., and the size of shipments remains small, mainly due to uncertain demand in US and Europe. The clouded outlook beyond the 3Mos horizon implies that Asian businesses, especially SMEs, will be reluctant to invest in capacity expansion, while facing higher costs and higher needs of WC. Thus, business sentiment indicators in Asia, such as PMIs, could correct further in months ahead, suggesting but the pace of growth in Asian is likely to moderate considerably. Recent data out of Taiwan and Singapore echoed the theme. Taiwan reported July IP of +20.7%, in- line, but on a 3month saar basis, IP growth contracted materially for the 1st time since Mar09 and is also the 2nd consecutive month of below-trend growth. In Singapore, electronics output declined 5.6% mom in July or -7.4% QoQ. Such a clear downshift of manufacturing activities in Asia will likely weigh on Japan's export and IP in coming months, along with ongoing yen appreciation. The street only expects Japan GDP growth rate to stagnate at 1.0% in 4Q 2010 and 1Q 2011,
Three Messages from Bonds
There are several important messages from rates markets over the past few weeks, which I think investors should keep a close eye on them. Firstly, until two weeks ago, both Fed and ECB had a natural exit strategy from extraordinary stimulus built into their monetary policy. The Fed halted its move to the exit at its last policy meeting and is actively debating whether further quantitative easing, will be required. The question is whether ECB (meeting next week) will follow suit by reinstating its six-month liquidity operations or simply stay the course. While ECB Governing Council member Axel Weber has indicated discussions over monetary normalization will resume in 1Q 2011, the fact is that this natural exit will still be at work and put upward pressure on EONIA O/N rates. The expiry of the 1yr operation in July has already seen the level of excess liquidity decline from >EUR300bn to ~100 bn. The critical thing to asset markets is that if US to expand QE and for Europe to join in, then it becomes a flow of money argument to see much of liquidity created will "leak" to higher growth economies like Asia. Here in Home town, most local authorities are already bust in fighting against asst bubbles like Hong Kong and China.
Secondly, through the TIPS market, one can decompose the fall in UST yields in order to understand the market implied growth risk. Since April, real yields have tumbled an all-time low of sub-1%, accounting for 70bp of UST’s 140bp decline, suggesting that dwindling growth expectations have played a dominant role in driving yields lower. Meanwhile, inflation expectation has dropped sharply with 10yr BE falling to 1.62%, the bottom of its historic range. The Fed will inevitably be watching these measures closely. Such a collapse in interest rates is a classic double-edged sword for the Fed. While the accelerated compression of the economy's nominal framework is clearly a cause for concern particularly if further declines are driven by falling inflation expectations, lower rates nonetheless provide the economy with a much needed fresh round of stimulus. Given historic relationships, the decline in 10yr bond yields of 30bp over the last month is equivalent to 1% off the FFTR, helping make up a considerable portion of the so-called policy 'shortfall' that standard estimates of the appropriate policy rate for US economy usually imply.
The last question is whether bonds are in a bubble? 10yr USTs this week fell briefly below 2.5% and much debate in the market centers on whether govt bonds are in a bubble or whether, in an environment of slowing growth, they are the only prudent investment. The answer to that depends on whether you believe the US over the next decade will be like Japan in the 1990s. In retrospect, when JGB yields first fell to 2.5% in 1995, investors should have bought them because the yield subsequently fell to 0.7% in 1998 and 0.4% in 2003. In my own view, it is NOT a bubble scenario now. Historically, three conditions signal the presence of a bubble -- excessive optimism, leverage, and huge mis-valuation against fundamentals. These conditions are not clearly in place. Long duration positions are subdued, despite massive Japanese buying (USD163bn over past 3 months). Bond yields have been falling for 20 years and have been below average for at least 10. Most importantly, the fundamentals against which to value bond are not clear. If growth and inflation return to normal, then bonds are massively overvalued. But there is a serious risk now that we have entered a decade of low growth, with deflation around the corner.
However, relative valuation indeed favors equity over bonds. The US earnings yield is now 8%, more than 3X 10yr bond yield. The dividend yield on MSCI World is also higher than the global risk-free rate. While these phenomena may reflect just the poor prospects for growth, JPMorgan’s DDM model suggests that US stocks are now implying an equity risk premium of as high as 8.5% (vs. 3.5% historically) or, alternatively, zero growth for a decade and then only 3% in perpetuity. To me, that makes equities look cheap as an asset class. In addition, it is not only government bond yields that have fallen, with credit spreads for IG bonds holding steady, the yield on a 5yr A-rated US corporate has fallen to 2.8%. Thus, it means many companies now pay significantly higher dividends than the coupons on their bonds.
Good Earnings vs. Bad Rumors
We are in the late sessions of earnings season. Over the month, APxJ ERR improved from 0.78 to 0.97, according to Merrill Lynch. Nevertheless, the 3Mos ERR continued its fall and is now back to the level of 2005-06. Sector wise, the highest ratio of UG-to-DG are Retailing (1.83) and Industrials (1.81), while Materials (0.59) and Telecom (0.65) are both at the bottom, providing a mixed signal. In China, 94 out of 118 MSCI China constituents and 34 out of 40 HSCEI constituents have reported 1H/2Q results, representing 87% and 90% of market cap respectively. 1H10 cumulative earnings are tracking at 52% of FY10 estimates for both MSCI China and HSCEI (vs. 48% and 50% in 1H09 respectively). For A-share market, according to disclosed 1H10 results of 1439 listco, average earnings growth of 93 GEB listco is only 26% yoy, while those of SME and main board listco are 42%! Despite the weak market, companies were never too hesitated to raise funds. For the week, as much as USD683mn was raised via IPO or placement from Greentown, Hengdeli, Intime, PCCW, Ruinian and West China. The market was dominated by interim results and my impression was that most took that as an opportunity to sell down the market
In mainland, CSI 300 fell by 1.37% on the back of concerns over slowing global economy, the talks on continuous property measures together with the rumor on the restriction on banks to lend to property developers (though not confirmed) also acted to weigh on the index. The most eye catching action was the intra-week rally of the B-shares market on rumor that the A & B markets will soon merge. However such rumor was proven to be a translation mistake from a broker report and the B-share gave back some of its gains while managed to post a 2.27% return. According to the NBS, China’s Industrial profits from Jan-July recorded revenue growth of 34.7% while profits were up 61.1%. Such numbers highlighted the still strong growth and continuous margin expansion, but the market was more worried about the future and the question on the return of top line growth and the policy direction. For the latter point increasingly more are talking about the next Five Year Plan.
Macro wise, several senior government officers has voiced high latterly. Mr. Zhang Ping, the head of NDRC, said it’s challenging to manage the expectation in 2H10 due to high agricultural prices, imported inflation and speculation. Deputy Premier LI Keqiang vowed to crack down property speculation and increase subsidized housing supply, the 2nd time over the past 8 days. Followed his message, there are rumors in the market that some domestic banks might suspend lending to property developers in the rest of 2010. But Chinese developers seemed to have expected a tightening domestic credit environment in 2H10. A number of China developers, including Sino-ocean Land, Shimao, Country Garden and Poly (HK), have been active in the capital market since July, raising over USd2.5b in total…Lastly, regional wise, MSCI China is now traded at 13.1XPE10 and 26.2%EG10, CSI 300 at 16XPE10 and 28%EG10, and Hang Seng at 13.1XPE10 and 29.2%EG10, while MXASJ region is traded at 12.8XPE10 and +40%EG10.
A Review over Dollar
My latest diaries called for the Dollar's broad sell-off in July would narrow in August as earnings season excitement gave way to dismal US data. This judgment turns out to be largely right, except for EUR, which is weakening more on declining stock markets and recurring sovereign stress than it is benefiting from Fed actions. The USD's decline from June to early-August did much to price in a weaker US growth outlook. The rebound in USD has actually followed the Fed's acknowledgement of the downside risks to growth and its policy response at the August 10 FOMC meeting (via its asset reinvestment program), and newer concerns about contagion from the US troubles on the rest of the world have become important in the FX market.
The original path oF USD looked like a typical correction, but now that jobless claims are signaling a material downshift in US growth, the odds favors a further rise in volatility and a more substantial carry unwind. Indeed, every 1% D/G in US growth tends to be worth about 3% on TW Dollar. A key question now is whether this newer dynamic of global growth concerns and contracting risk appetite will remain the more dominant driver in the FX market, or whether US data can be expected to exert its more traditional impact on the USD. The latest USD selloff following the weak housing data suggests the answer is not clear cut. The only comfort comes from positions, which generally are much smaller than in May. Still, carry unwinds have become such familiar events over the past two years that they have established a pattern: they move exposures from long to almost flat and take currencies from expensive to cheap. In addition, Nikkei newspaper reported that Japanese MoF may consider unilateral JPY-selling intervention if speculators drive JPY up by several yens against USD in a day. However, it looks like the typical mantra used by the MoF officials repeatedly.
Last point, the aggressive sell-off in crude oil has reached a short-term exhaustion point, with Brent rebounding by nearly USD5/bbl in the past three days. The move down was fundamentally driven by the trimming of US refinery runs, the end of peak summer demand, weaker Chinese apparent demand and a slew of bearish US economic data. With global manufacturing growth set to halve over the coming months and projections of EM growth being ratcheted down, it is hard to argue that this will be any more than a temporary bounce. I think Investors should use the bounce as a selling opportunity, looking for the market to move into the mid $60s before OPEC meets in October.
Good night, my dear friends!
