My Diary 654 --- The Mixed Economy Data; The Decade-long Love Affair; Turning Bullish on China; BOJs Next Three Moves
September 18, 2010
“The Weekly Headlines: Bank, Bank and Bank” --- Global central banks and foreign exchange policies were under the spotlight over the week. In Asia, BOJ is likely to be successful near-term in further weakening the JPY. In India, policy tightened more aggressively than anticipated (boosting INR), while dovish statements from New Zealand and Swiss central bankers hit their currencies. Meanwhile, against a backdrop of slower global growth, an increasing number of central banks that were tightening have gone on hold (i.e. Australia, Norway and Brazil). New Zealand’s central bank followed suit. Similarly, SNB left rates unchanged, removed its implicit tightening bias and cut its inflation forecast (below zero in next 6 months). However, we did get a surprise rate hike in India. That being said, in contrast to Fed and BOE (with the anticipation of the resumption of large-scale asset purchases), ECB is still making moves toward an exit from its nonstandard measures. This exit journey began at the start of the year, but was interrupted by the sovereign crisis in the spring. In May, the ECB not only reintroduced some liquidity measures that it had earlier canceled, but also initiated a program to purchase the debt of those sovereigns whose solvency is in question. Since June, however, the sense of an exit journey has returned, albeit very gradually. The ECB’s behavior over the past six months suggests two key things – 1) To the extent that bank funding and financial market stress impede the transmission mechanism of conventional monetary policy, the ECB is ready and willing to act, and it will allow its B/S to evolve accordingly; 2) ECB is still a long way away from thinking of its nonstandard measures as an extension.
In addition, the Basel Committee published the new Basel 3 rules in the past week. Tier-1 go up to 9.5% with 7% of that being common equity (current Tier-1=4% with 2% common equity). Banks that fail to meet the requirements will not be allowed to pay dividends though they won't be forced to raise equity. Banks have less than 5yrs to get to 6% Tier-1 and 4.5% common equity and they have until 1 Jan 2019 to get to 9.5% Tier-1 and 7% common equity. Of the 24 US banks on the KBW Bank Index, 7 (including BoA and Citi) would fall short of the new ratios. European banks are less capitalized than US counterparts and would likely be worse hit. Deutsche Bank has already announced plans to raise EUR9.8bn of equity over the weekend. The Association of German Banks estimated that Germany's 10 biggest banks may need about EUR105bn in fresh capital because of the new requirements. In my own view, this new bank capital rule is negative for growth as no doubt that the more stringent capital requirements will reinforce the credit contraction that is already in motion.
That being discussed, I still remain concerned over the potential policy options left for global central banks and policymakers in front of the current after-mess scenarios of the world economy and financial markets. For many years, western policymakers have told us that they knew how to avoid Japan's mistakes. Yet, after having slashed interest rates, borrowed heavily and adopted unconventional approaches, their earlier claims now look decidedly suspect. With inflation still excessively low and with growth stalling, DM economies are beginning to show economic symptoms previously assumed to be uniquely Japanese. Looking forward, with huge private-sector debts, the risk of falling into a debt-deflation trap is on the rise. Admittedly, activity in Europe has rebounded even as US economy has stalled. Yet the overall level of activity in DMs is still incredibly depressed. The desire to atone for the sins of the credit boom has hampered the pace of recovery. In particular, the latest US consumer sentiment survey (66.6 vs. cons =70), retail sales (0.4%) and small business (NFIB) survey (88.8) are consistent with the view that US growth will be below-trend @ 2-2.5% for at least the near term. Sub-trend performance is a dismal prospect given the massive policy stimulus administered in this cycle. In comparison, the FOMC’s economic forecasts (published in July) looked optimistic at the time and now appear hopelessly out of reach. The central tendency forecast was for real GDP to grow by 3-3.5% in 2010 Q4, followed by 3.5-4.2% in 2011. Growth is not even likely to reach 2.5% this year, and the projection for 2011 looks to be 1-1.5% too high. Such modest growth would not be enough to bring down UNE rate or avoid a period of mild deflation, given the amount of economic slack in the system. The FOMC projected core inflation rates near 1% this year and next in its July forecast. If growth is revised lower, then the FOMC should also reduce its inflation outlook. That would leave an uncomfortably small cushion against the risk of deflation. The FOMC will also have to revise up its forecast for the UNE rate and revise down inflation.
In my own views, the major shortcoming with the current policy framework is not fully acknowledged by these policy makers. In 1H10, as the initial signs of economic recovery came through, all the focus was on exit strategies. This was a major mistake, placing too much emphasis on the real economy when, all the while, inflation was excessively low in US and in much of Europe. The reality is that no longer is the real economy affecting inflation. Under ZIRP, it's the other way around. The more inflation declines, the higher real interest rates become. People then repay debt with even greater enthusiasm, preventing any initial economic recovery from being sustained. In fact, there have been strong arguments for abandoning inflation targets altogether and replacing them with price-level targets. Central bankers claim this reform would make little difference but, I believe, at least this would force them to maintain zero rates well into the recovery, avoiding the exit strategy confusion seen in the first half of 2010. In a world of excessively low inflation, it is important to persuade the public that interest rates won't rise until the nightmare of deflation is completely eradicated.
Of course, the best friend to global central banks is faster economy growth. According to a latest macro research done by Standard Charter Bank, there is a select group of countries that have achieved GDP growth of 7% pa or more for an extended period. At 7% pa growth, an economy doubles in size every decade and more than quadruples in a generation. After three decades an economy growing at 7% pa will be twice as large as one achieving 5%. In the last half century, countries grown at 7% or more for 25 years include China, Hong Kong, Indonesia, Japan, Korea, Malaysia, Thailand and Singapore --- All in Asia!!! This “Asia growth model” relies on industrialization oriented to manufacturing exports, along with several key policies for achieving strong sustained growth – 1) a stable macroeconomic environment, including low inflation and low budget deficits, and 2) continuing efforts of deregulation. From this regard, the mid-to-long term implications that US and European companies are about to hit a brick wall as the final phase of technology transfer becomes more advanced. Five years ago, China needed Alstrom to build trains, it needed Siemens and ABB to help it with its grid, and it needed Bekaert to help it make radial tires. In a very short while, if not already, these companies will not be needed and in fact will face competition from indigenous Chinese companies, just like a re-run of Ericsson vs. Huawei. The key driver for the European and US economies since 2006 is going to become a negative as their MNCs start to feel the brunt of Chinese competition. Korea is in a similar boat. This is why the USD and the Euro will fall against the Asian currencies. It is the root reason that US lawmakers are debating again and again to take action on China’s FX policies.
X-asset Market Thoughts
On the weekly basis, global equity markets rose 1.51%, with +1.51% in US, -0.72% in EU, +2.36% in Japan and -0.39% in EMs. Elsewhere, USTs posted small gains with 2yrs yield down 10bp to 0.46%, tying the all-time low set in late August, and 10yr fell 5bp to 2.74%. Since 2s initially set their record low on August 24, yields have risen 25bps on 10yr. The 10yr Greek-German spread stayed wide at 913bp. the Irish-German spread increased more dramatically, widening 45bps to 387bps, a new 2010 high. 1MWTI oil dropped $3.69 or 2.79% to USD73.66/bbl. EUR strengthened 2.91% to 1.305USD, while JPY fell about 3.43% to 85.86USD, since Wednesday after the announcement of the MoF intervention.
MTD, we have seen MSCI World up 6.8% in Sep and MSCI Far East ex-Japan is up 6.3% on the back of a "risk-on" week of flows. Money has been flowed into high yield bonds and equities (esp. EM) at the expense of MMF (USD22.0bn outflow). Investors built their bets on the hopes of impending QEII and Japan policy-ease, and I think on 21 September, the Fed’s statement will be scrutinized for hints that “QE-2” is approaching. However, market seems not fully committed as all inflows (USD7.9bn) to equity funds this week are via ETFs, while, LO funds saw outflows. In contrast, fixed-income funds continue to see strong inflows (USD5.2bn). Looking forward, my question to further market upside potential is -- how much cash calls can the market endure? In China, Bank of China just firmed up its RMB60bn (USD8.9bn) rights issue. Just last week, Vodafone sucked over USD6bn out of the system by selling its 3.2% stake in China Mobile and much of that is going to pay the Indian government in taxes, hence not coming back to the markets. Over the week, the new Basel capital rules means that banks need to raise a zillion dollars in capital with Deutsche taking the lead (EUR10bn). Even in Singapore, local government is looking to raise USD3bn through an IPO of GIC Real Estate unit GLP! In HK, local brokers have been telling me that there are >50 HK/China IPOs (some even say close to 100) in the pipeline and most of them are ready for tapping the market before year end. Assuming average offer size of USD300mn, 3/4 to be listed in HK and plus the USD15-20bn AIA deal, IPO alone will draw more than USD30bn of liquidity, not to mention any further ad-hoc cash calls. In the face of this deluge of cash calls, equities have held up well but I really need to see a reverse in fund flows from bonds to equities to enable HSI to test higher. Given such an backdrop, many fund managers are running out of time to recoup the losses made earlier in this year, as the macro/policy uncertainties YTD have stopped them from committing full bets. The biggest risks to many of these funds maybe that none of the risks materialized and there is a sustained rally into year-end similar to the one seen from March to July last year. This was characterized by shallow dips in low volumes, where markets never corrected enough to present obvious buying opportunities and investors were left chasing the market.
The Mixed Economy Data
The week saw mixed macro signs from major economies. In the US, UoM consumer sentiment declined in September from 68.9 to 66.6, mostly due to expectations (dropped 3.8ppts to 59.1). This is the lowest level of sentiment in this survey since August 2009. In comparison, initial jobless claims held near 450K for a second straight week. MBA’s mortgage applications series has increased about 7% so far in Sep vs. Aug, hinting at a gradual pickup in home sales. In Euro area, employment increased in Germany, France, Belgium and Austria, offset by losses in Italy, Spain, Portugal and Greece. Meanwhile, the signs continue to point to a slowing in UK economy. The business surveys are trending lower, housing is weakening, and the labor market has begun to soften. The UK core retail sales tumbled 0.4% mom in August points in the same direction, although it should be noted that the QoQ trend in sales remains strong and that sales have not given good guidance to GDP-based consumer spending.
In Asia, Japan’s Tankan survey was mixed in September, with offsetting moves in business confidence in the manufacturing (down) and nonmanufacturing (up) sectors. With that said, survey respondents expect a meaningful deterioration in the economy in 4Q. This latter finding is consistent with the view of a slow-down in Japan, reflecting a combination of payback for transitory strength in 3Q consumption, slower export growth, and the impact of tighter domestic financial conditions on spending. In India, RBI raises repo rate 25bps to 6% and reverse repo 50bps to 5% surprised the markets. RBI claims policy rates are now close to neutral, but strikes a hawkish tone on “unacceptably high levels” of inflation RBI confident on growth prospects, but legitimate questions remain If inflation continues to be sticky, another 25bps rate hike likely at the November.
Looking ahead, the next week is data heavy with, in US, NAHB housing market s index is likely to remain low during 2010, while housing starts , building permits and pending home sales are likely to continue to suffer pay-back from the homebuyer’s tax credit and weak labor market conditions. Existing home sales and new home sales are likely to edge up, but remain severely depressed. Durable goods are expected to decline, reflecting the rise in American business caution. The Euro area and Germany will release a raft of forward-looking indicators in the coming week with European Commission consumer confidence survey, PMI data and IFO for Germany serving to form a narrative on how activity fared in Q310, and will give an idea of the outlook for Q4.
The Decade-long Love Affair
After a lull in the summer, sovereign stress has returned to the Euro area, with sharply wider yield spreads in Portugal and Ireland. Based on bond market price, the extra premium Portugal and Ireland have had to pay over Germany has surged to record levels above 3%, while Greece has to pay an extra 9%. There has been some slippage in the monthly fiscal data in Portugal, even though GDP growth this year has held up remarkably well, and in Ireland there are concerns about the cost of supporting the banks and the likely need for greater fiscal consolidation than the government has acknowledged thus far. As we saw with Greece earlier in the year, concerns can build about whether domestic taxpayers are able to bear the burden being put upon them. If this happens, external liquidity support is needed. Fortunately, the Euro area is well positioned to provide liquidity support – 1) to banks via the unlimited tenders at ECB, and 2) to sovereigns via the European Stabilization Mechanism (EUR60bn European Financial Stabilization Mechanism and EUR440bin European Financial Stability Facility). Moreover, ECB is willing to support secondary markets via debt purchases. Over the week, ECB bought EUR237mn of government bonds last week – the biggest amount since the middle of August. However, none of these address the real fiscal burden created by prior excesses. Thus, they do not necessarily prevent a high likelihood of a debt restructuring being priced into the government bond market. Whether or not any sovereign sees its banks significantly increasing their reliance on the central bank, experiences greater bond purchases by the central bank and accesses the ESM, remains to be seen. Thus, from now on, essentially market pressure will be the key driver.
That said, the decade long love affair with bonds continued in Aug as retail investors continued to yank money out of equity funds and into bond funds. In Aug, another USD14.3bn was pulled out of US equity funds (YTD outflow =USD42.2bn) and USD24.6bn was put into bond funds (YTD inflow =USD168.4bn). Free cash flow yields in excess of bond yields and earnings yield gaps at multi-decade highs did nothing to stem the flow. Looking back, UST 10yrs have returned +25% over the past 10 years while S&P has returned -22%. It seems that investors are more concerned about the “return of capital” rather than “return on capital”. As a result, though G7 bond yields have backed up from the lows reached in late August on hopes that China will have a soft economic landing and that US economy is not falling back into recession, the bond selloff is being limited by the nagging worry that the US economic recovery is still struggling to gain traction and that the Fed will jump into action. Bernanke clearly is predisposed to erring on the side of doing too much rather than too little. I do think that additional Fed asset purchases would be concentrated in the Treasury market. It is estimated that an announcement of an USD1tn program could cut the 10yr UST yields by as much as 50bp almost immediately.
Given the dismissing concern the economy will go back into recession and trigger a rise in corporate defaults, junk bonds investors are wagering they’ll be fully repaid for the first time since June 2007. Average prices on HY debt rose above 100cts on the dollar as of Friday after falling as low as 55cts in December 2008, according to Merrill Lynch index data. Bonds due in 2031 from Ford Motor, which fell 22 months ago to 12 cents on concern that the automaker would fail, trade above par for the first time in more than five years. As of this week, HY bonds on average generate 6.25% more than USTs. That’s helped sales of junk bonds reach USD172.2bn in 2010, exceeding the annual record set in 2009 with more than three months left in the year, according to Bloomberg. In addition, UGs on HY US companies are outpacing DGs, with 171 rating increases compared with 111 reductions in the first 8M10, S&P said Sept. 14 in a statement. The global HY default rate will fall to 2.7% by year-end and 2% in September 2011, from 5% last month, Moody’s said Sept. 8. The rate has declined from 12.3% a year ago.
Turning Bullish on China
The week also sat firmly on the Chinese data dump for August. In summary, CPI and FAI were in-line at +3.5% and +24.8% respectively, while PPI (+4.3% vs. cons +4.5%) was lower. Retail sales (+18.4% vs. cons +18.0%) and IP (+13.9% vs. cons +13.0%) were stronger. In addition, money supply data was positive with M2 +19.2% yoy (cons +17.5%), M1 +21.9% (cons +22.2%) and new RMB loans at RMB545.2bn (cons RMB500bn). Trade data showed that export growth slowed to 34.4% yoy from 38.1% in July while imports accelerated to 35.2% yoy from 22.7%. The BTE data flow suggests the economy is making a soft landing. But the government needs to maintain the stability of policy since CPI will likely soon peak and external uncertainties linger. As a result, global investors turn sharply bullish on China growth prospects. A net 11% of respondents now expect stronger economic growth in China over the next year, compared with a net 19% who expected it to weaken last month and a net 39% who were bearish in July, according to Merrill Lynch FMS. The 30% swing from Aug to Sep is the survey’s largest positive change since May2009. Global emerging market investors raced back into Chinese equities, with a net 22% O/W in September, contrasting to a net 22% U/W in August.
Looking forward, several economists estimated China could lose 2~4% of GDP per year as it tries to clean up the environment after 30 years of industrial waste buildup. We should see that effect start to be reflected in Sept's IP figure, as many provinces shut down productions in highly polluted sectors. The cleanup action will continue till year end as the govt strives to reach the emission target that could mean slower growth for 4Q. So slower growth in 4Q10 could relieve some of the upward pricing pressure on raw materials and the surge in food prices should also be tamed as weather conditions improve. Another key event to watch for is the forthcoming 12th 5-Year Plan. DB’s economist, Dr Ma Jun, expects reforms in the next five years to be significant in the following areas: 1) income distribution, 2) consumption upgrade, 3) promoting a green economy, 4) manufacturing upgrade, 5) developing a consumer-driven housing market, 6) development of second- and third-tier cities, and 7) financial sector reform.
In short, the general views on China are constructive - deliberate tightening is being phased out, CPI should have peaked, 10% GDP growth should be achievable in next year. However, the coming months may be bumpy due to likely policy moves in property and banking, worsening overseas demand, transition issues between five year plans, etc. The tug of war between loosening in certain areas (infrastructure, social housing, Central/Western provinces, etc) and tightening in others may be confusing. Taking about confusion, CBRC denied new 15% CAR requirements by saying that …”the new BASIL III won’t hurt Chinese banks directly, but banks may face mounting pressure to grow their capital with rising loans and strict regulation.” Meanwhile the regulator also said Chinese banks face 3 major risks, namely domestic & global macro uncertainty, LGFV loans, credit risk from property market and economic restructuring.
In the near term, I think there will see a full re-test of the Nov-09, Jan-10 and Apr-10 highs. Assuming we continue to rally for a further week, I would expect Hang Seng Index to challenge the 22500 level. My personal instinct is to start selling as HSI approaches that level, especially if the market continues to favor extremely high beta. Over the week, local market rally is all about beta chasing as the average beta of the ten best performing sectors was 1.31 versus 0.71 for the worst performing sectors. As a general rule, rallies which chase beta will fail when meet resistance because people chase beta for quick gain. I am kind of cautious to see market’s further gain as 1) global growth is slowing and a lot weaker in underlying terms than is presently apparent; 2) we have a mountain of IPOs supply hitting the HK market into the next six weeks; 3) sentiment towards China policy could switch very rapidly; 4) market will be stretched based on the current RSI of HIS (70.29) and HSCEI (62.16)…. Lastly, regional wise, MSCI China is now traded at 13.8XPE10 and 27.7%EG10, CSI 300 at 16XPE10 and 27.5%EG10, and Hang Seng at 14XPE10 and 29.3%EG10, while MXASJ region is traded at 13.5XPE10 and +38.2%EG10.
BOJs Next Three Moves
The BoJ has finally intervened. The poor timing of the intervention effort signifies just how the skill level in that institution has faded over the years. In former times the BoJ would not have intervened more than two weeks after a key market level had been breached (in this case, the 15 year low=82.88). Rather, it would have intervened at the 15 year low. However, fundamentally, JPY is strong because investment opportunities in the principal offshore markets (notably US) are not what they once were for Japanese investors, because USD has become the favorite funding currency for carry trades, and because Japan, while beset with many economic problems, stands to benefit more from China in coming years than most other countries. Japan, right or wrong, is seen as part of Asia and therefore part of from Asia's currency ascent.
That being said, the initial effect of Japan intervention has been quite large, with USDJPY bouncing about 3%. The reasons for Japan’s frustration with yen appreciation are clear – 1) the JPY REER has surged almost 30% over the past two years, exacerbating Japan’s deflation and eroding its international competitiveness. One question is whether the BoJ will signal the intervention be considered monetary easing by leaving the purchases unsterilized. This approach appears likely considering the economic backdrop and the political pressure on the BoJ.
Going forward, whether the intervention will be successful relies on three benchmarks – 1) the most recent example is SNB’s FX intervention from Mar2009 through Jun2010. During that time, SNB is estimated to have spent roughly USD175bn, based on the change in foreign reserves, attempting to curb CHF strength (primarily buying EUR). Of course, the CHF continued to strengthen against both the EUR and USD during that period, so it is reasonable to question how much amount of money was sufficient for BOJ and MOF to keep Yen low. 2) Another case is the BoJ's last intervention efforts from 2002 to 1Q2004, during which the agency has spent USD420bn, an amount that was and remains unprecedented in terms of DM FX intervention in the post Bretton-Woods era. The "success" of those efforts is still the source of some debate. Some argue that USD/JPY remained weak during that period and ended up falling further later in 2004 after the BoJ had stepped away from the market, and as such that rendered their efforts unsuccessful. Others will argue that the BoJ's persistent "absorption" of JPY prevented what would have been a larger and economically-crippling appreciation in the JPY, and therefore it was effective. I am not attempting to settle that debate here, but the amounts and time span of the BoJ's past intervention efforts are useful benchmarks to consider in the current scenario.3) The last important thing to consider is that pressure is growing on Fed Chairman Bernanke to print more Dollars to bolster America’s flagging economy, a policy that contributed to a weaker greenback in 2009, which will counter the effectiveness of BOJ’s efforts
Good night, my dear friends!
