My Diary 657--- Has Economy Found its Feet? Divergence Won’t Last Long; Why Sell Into The Rally? A Firm Belief in EM Currency
Saturday, October 02, 2010
“China: What? Why? How? When? Really! ” --- The rest of world lacks some basic understanding toward China and Chinese economy. This is my general impression after I spent 6 days in Europe and talked to +70 different investors. As I repeatedly shared with each of them (some in my distribution list now), 1) please pay a visit to China and your eyes will tell what is true and what is not; 2) please help find a solution to various challenges in today’s Chinese economy and do not just point fingers to a problem of which most “clever” economists have raised a thousand times. If you can find a way to improve the living standard for the 1.5bn population in China, one will surely have his or her name in the history book of our next generation! So, people, you get your chance to become a great person in the history! Do not let it go away……
That being said, overnight Chinese PMI disappointed the bears and came out BTE, which proved a point evident in commodities since early-summer. Namely, base metals prices (CRY +14.74%) have been trending higher since early-June, which was a contrary indicator of the bearish commentary in the western media and the bearish trends in equities and credit at that time. In particular, Copper has risen by 31% since late-May and it now trading at post-financial crisis highs. As of Friday, Copper price (8100USD/MT) is less than 10% away from the all-time highs (8722USD/MT) that were hit in 2006 - 2008. Market wise, the main theme latterly across all asset markets was USD weakness, as the markets continues to price in a second found of quantitative easing by Fed as early as the Nov 2-3 FOMC meeting. In fact, the past month has turned out to be the best September for US equities since 1939 (S&P +9.1% / Nasdaq +12.4%), even though we continue to see negative headlines which keep warning us that the sky is about to fall. Just go to CNBC.com and you will see what I mean. From "currency war" to "trade war", the concern continues to mount that the world economy would implode just around the corner. Regardless of what was said in CNBC, many Asian equity markets are hitting cyclical highs, including Indonesia (+40%) Philippine (+35%) and Thailand (+33%)…However, it is not just EQUITIES. It is everything else (IPAD vs. AUD vs. MXCI AxJ vs. Silver) as the seemingly uncorrelated assets start to correlate. Everything is moving based on the Fed’s QE program and the markets do not care about other economic or company specific factors anymore – This is a classic example of something being wrong ……
All come to the anticipation of QE-2. Central banks in US, Japan and the UK have shown willingness to return to QE to prop up their economies. The only exception is ECB which does not appear to share the same view given the different challenges it faces. Backup is being provided by the European Financial Stability Facility (EFSF), although it is unlikely that the facility will be used this year as the smaller peripheral countries are almost close to their issuance targets for 2010. In contrast, the key issue facing EM central banks is how to deal with the “low for longer” scenario for rates in DMs which prevents them from raising interest rates in the face of inflation without appreciating their currencies. Over the past few days, almost half the members of the FOMC have given speeches, each of which discussed the relative merits of further policy accommodation. Friday morning's speech by NY Fed President Dudley was the most notable, not only because of the directness of the message but also because the NY Fed President, as Vice Chair of the FOMC, forms part of the policymaking leadership on the committee. The conclusion of his remarks was transparent"…We have the tools that can provide additional stimulus at costs that do not appear prohibitive. Thus, I conclude that further action is likely to be warranted unless the economic outlook evolves in a way that makes me confident that we will see better outcomes for both employment and inflation before too long…”Dudley also mentioned that USD500bn of purchases corresponds to a FFTR cut of around 50-75bps. The USD500bn figure may have been by way of example, though now that it's out there it seems likely to become a focal point in thinking about the size of further b/s expansion. In my own view that Dudley’s remarks are one of the clearest signs that the Fed will start a second round of unconventional monetary easing as soon as the FOMC’s next meeting Nov. 2-3.
All being discussed, with asset prices moving higher, there is an interesting question --- whether Fed will still engage in QE2 if stocks keep rallying and the economy slowly improves. Based on my own observation, I believe that the Fed will almost certainly find ways to ease again as the term premium for UST yield curve has dropped to zero, which predicts that additional QE is almost a certainty. But on a more fundamental basis, the Fed will probably engage in QE2 for several reasons --- 1) the transmission mechanism for monetary policy is different from how it was in the past. With rates at zero, the Fed can only exert an impact on the overall economy via asset values and the dollar’s FX rate; 2) US consumers’ saving behavior is strongly influenced by the rise and fall of net worth. Any action to increase home values or equity prices could boost consumer confidence and vice versa; 3) similarly, it is extremely important to stabilize the housing market and reflate asset prices. The Fed’s purchase of additional MBS is an important step in helping indebted consumers; 4) lastly; a weakening USD could boost American exports, raise corporate profits and introduce a reflationary impact into the US economy. This is why S&P has been negatively correlated with USD. But, there are only two problems in this new world of zero rates and QE --- 1) No central bank knows in advance what adequate amount of QE is needed, and the only way to find out is through stock market performance and economic data, which by nature is always late. Therefore, policymakers have to rely on a process best described as “progressive approximation”, or trial and error. Remember, all of us, including the Fed, thought that the one-off, + USD1.3trn Fed b/s expansion in 2008 would be enough to put the economy back on track. Today, it seems that more QE is needed. We will find out whether QE2 will be sufficient or overkill sometime next year; 2) another problem is policy backlash and passive reactions. QE impacts the currency market, but a foreign exchange rate is a relative concept. This often creates policy backlash and inadvertent tightening. The USD has been falling against EUR since Jun2010 in response to possible Fed QE2, but a strong EUR will sooner or later create problems for EU economy. Already, the sovereign spreads of Ireland and Portugal have blown out anew and I suspect that the strengthening euro has not only added deflationary pressure to the weak economies but has also begun crushing European equities.
X-Asset Market Thoughts
On a monthly basis, global equities were up 9.11%, with +8.92% in U, +3.23% in EU, +3.25% in Japan and +10.87% in EMs. Elsewhere, UST yield curve stayed at around 208bp (2y/10y), with 2yr down 5bp to 0.42% and 10yr up 5bp to 2.51%. In Europe, sovereign yield spreads narrowed, with 10-year Greek debt closed in 107bp on Bunds, while Irish debt widened 73bp on the back of the EUR50bn costs of bailing out the country’s banks. The USD was down against most currencies (DXY -5.39%). EUR is now at $1.38, +8.7% above its Aug-end value. JPY traded relatively flat at 83.4USD despite the BoJ intervention. Commodity currencies were all gained with NZD +5.33% and AUD +8.53%. 1MWTI oil jumped +13.4% to $81.58/bbl since the end of August. Precious metals continued their run (Gold +4.73%), while agriculture prices tumbled again bringing the weekly decline to 7%.
Looking forward, the end of 3Q10 implies that the large global funds would have to think about their asset allocation for Q4 and more importantly for 2011. With bond yields at such abysmal levels, I won't be surprised to see a shift in allocation from bonds to equities. With FCFs and dividend yields at decade wide relative to bond yields, we are paid to take the equity risk. The world's largest bond fund manager, Bill Gross, has already said that his PIMCO is going to move into equities! That being said, there are two points I want to raise here --- 1) I have talked to the investment community here over the past 6 months that EM share prices are set to enter a mania phase and the prices are to surge dramatically. The rationale has been that the low interest-rate environment in DMs and strong growth in EMs are a powerful combination at work to produce an exponential rally in equities. However, EM equities have been in a narrow trading range so far this year (870-1000 measured by MXEF) despite massive inflows of foreign capital. It is until the late September, EM equities broke the range and traded above 1000, due to QE-2 talks and regained confidence to Chinese economy; 2) Both global and EM equities are failing to outperform gold, even though gold has a zero carry while global and EM stocks have dividend yields of 2.7% and 2.3%, respectively, and enjoy the tailwinds of expanding profits. I think there are really only two explanations behind gold’s outperformance over stocks --- Either gold is bubbly or global stocks are a pure liquidity play without much support from future revenue/profit growth. Drilling down, I think that EM equities would attract more attention than DM equities as valuations remain reasonable and growth outlook is superior. Hence, looking into 2011, I think it is likely that we get a repeat of Asian Bubble II.
Has Economy Found its Feet?
A rotation in regional growth continues to be an important global theme over the past few weeks. In the US, macro numbers were in general positive with BTE GDP annualized (1.7%), personal consumption (2.2%), Chicago PMI (60.4) and lower initial jobless claims (453K) while the only notable negative was the below expectation consumer confidence number which hit a 7m low AT 48.5 with most decline from expectations, which dropped 6.9 ppts to 65.4. Meanwhile, I saw another batch of soft data in housing (S&P Case-Shiller -0.13% MoM) and regional Fed Survey which extended UST gains and gave the QE2 camp more encouragement. With regard to the regional surveys, the Dallas Fed Manuf. Index saw its fourth consecutive negative print with the Sep's reading (-17.7) coming below August (-13.5) and consensus (-6.0). The Chicago Fed Activity Index was broadly in line with consensus (-0.53 vs. -0.50 expected). Following last week's NY Fed (4.14 vs. 8.00 expected) and Philly Fed (-0.7 vs 0.5 expected), the regional surveys for September so far have been disappointing, in line with a softer ISM (54.4 vs. 56.3 in August). Overnight, US equity market movement (+0.44%) indicated that it has already priced in the marginal slowing of growth, along with Core PCE at 1%, slightly below market expectation at 1.1%.
With that said, Euro area business and consumer confidence surprised on the upside in September. The overall sentiment index reached a new recovery high, rising 1pt to 103.2 (from an upwardly revised August reading). This is a positive outcome. The next week will see PMI, Retail sales and GDP, which are important gauges to the continent economy health status. That said, for G3 economies, this week’s main focus is Japan, where growth recently has received a boost from government stimulus and unusually warm weather. With these supports now fading, consumption is expected to fall into year’s end, even as the stronger JPY and weaker external demand depress export growth. Already, this week’s reports on exports (15.8% vs. 23.5% in Aug and consensus =19%) and the Shoko Chukin small business survey (47.3) signaled a likely shift in momentum. The BoJ Tankan reinforced this message. The survey made impressive gains in September, with the headline large manufacturers’ index rising to the highest level (8 vs. Q2=1) since Mar2008. At the same time, however, the business outlook indexes point to a much weaker economy in 4Q10 (-1 vs. consensus =+3).
In China, after having slowed sharply in 2Q, incoming reports continue to show that China’s growth rate has stabilized at a pace that is modestly below trend. Friday saw the manufacturing PMI posted a second straight gain in Sep to 52.9. Encouragingly, the PMI orders/inventory continued to recover, heralding further gains in the PMI—and a strengthening in IP growth—just ahead. Most street economists agreed that manufacturing growth is picking up amid a combination of continued strength in final domestic demand and the end of a sharp domestic inventory adjustment. These positives are outweighing a slowdown in export growth…It looks like the global economy has found its feet, but what is the next tipping point? One case to be noted here is that Goldman released the most bearish 2011 outlook last week, saying S&P In 725-800 Range in QE2 Case, with US GDP to grow 1.5-2.5% in 2011 (down from 2.5-3.0%) and long-term rates forecast to 3.0-3.75% by end 2011 (from 3.75-4.25%).
Divergence Won’t Last Long
The major government bond markets have partly unwound the selloff that occurred early this month. The 10yr UST yield is trading close to the year’s lows at about 2.5% and the 10yr JGB yield is back below 1%. Financial markets are clearly equating soft economic data with additional QEs in several countries, a weaker USD and lower bond yields across the major countries.
In my own view, the potential threat still lies in Europe with a stronger EUR undermining peripheral European government bond markets. The blowout in Irish spreads mainly reflected worries about the government’s tab for bailing out the banking sector. Last week’s announcement that the cost would be EUR50 n at most has been taken positively by the markets so far. Nonetheless, the strong EUR Is making matters worse for the periphery by dimming the growth outlook. The prospect of additional QE in the US is a bearish factor for European sovereign spreads because it is pushing EUR higher, and the ECB is unwilling to do much about it. Indeed, the ECB has been a very reluctant supporter of the peripheral bond markets. It has largely stood by and watched the Irish train wreck. In particular, a ECB’s executive board member Jurgen Stark even warned that a number of the ECB’s unconventional liquidity measures would expire later this year. This comment is breathtaking in the context of soaring sovereign bond yields.
Interestingly, the Barclays index of bank bond spreads has not risen along with sovereign spreads for the weaker EUR bond markets. Bank spreads were highly correlated with peripheral bond markets during the first wave of European turmoil in 2Q10. The problems facing peripheral governments and European banks were thought to be the same because of the latter’s’ elevated sovereign debt exposure. As a result, some strategists claimed that the divergence in bank bond spreads in the recent flare-up is perhaps a good sign that the European Financial Stability Fund (EFSF) and the bank stress tests have succeeded in reducing the systemic risk posed by Ireland and the Med-4 countries. Nonetheless, I am not fully agreed with the judgment. The vulnerability of European banks to a debt rescheduling has not really changed much since the spring. It is worrying that CDS spreads on European financials, which tend to lead spreads in the cash bank bond market, have widened a little. In addition, the deterioration in sovereign bond markets and the lack of aggressive ECB action to support these markets are also worrisome. The risks are escalating because European growth is clearly slowing, the EUR is trending higher and the ECB is much less willing to provide additional support than its fellow central bankers in Japan and US. Global risk assets have ignored the European spread blowout so far, but this divergence may not last long.
Why Sell Into The Rally?
The European trip saw a lot of investors are very concerned about Chinese property bubble. It is a valid concern as domestic property market appears to be heating up again after a temporary “summer lull”, prompting renewed fears that the government will intensify its efforts of cracking down on housing speculation. Indeed, Chinese govt reiterated its tough stance on property over the week but most of the measures were repetitions of what has already been announced earlier. However, there are 2 new measures: 1) all first time homebuyers would now need to pay 30% down payment for flats >90sqm as opposed to 20% before; and 2) developers hoarding land will not be able to issue shares, bonds or even take bank loans. They will also not be allowed to participate in new land auctions! As with everything in China, implementation is an issue but it does show Premier Wen’s resolve in dealing with the property bubble. Transaction volumes in property have already returned to the peak levels pre-tightening so they do need to be tough to re-establish credibility. Meanwhile, the Chinese central authorities issued new orders to local governments to increase land supply for affordable housing. According to the People’s Daily, investment in economic housing this year has reached RMB47bn, and that only 60% of the investment budget for the 2010 has been spent. In other words, investments in economic housing will be ~RMB 800bn this year, significantly higher than the government’s guidance of roughly RMB 300 bn. With the actual investment in economic housing this year will be more than doubled, investors are likely to revise up their estimate of FAI growth. Moreover, I saw NDRC's Chief Economist said China can consider raising its annual inflation target to 5% from 2011~2015. The 12th five-year-plan may target lower GDP growth, and tolerate higher CPI.
That said, HK major indices are at the top of their mid-cycle trading ranges. The 14-day RSI has just peaked with RSI for HSCEI at 65 and fro ‘HSI @ 70.5. I can clearly see that local investors are struggling between positives and negatives. From the negative side, China growth is slowing with IP likely slowing to 7-8% yoy by November and GDP growth will likely slow to 7% by 1Q11. Meanwhile, a mountain of supply will hit the market between now and year end. Mini QFII product will likely redirect retail liquidity away from the HK market in coming months. I have heard that up to HKD20bn of mini QFII product will be launched in October alone. On the flip side, the market does have some positives – 1) Fed and BoE is talking about expanding its QE program. If Fed pumps more liquidity into the system, the USD will drop and some of the increased liquidity may well feed into the equity market; and 2) if the Fed is effectively going to cap long term interest rates then equities do look cheap in relation to bonds; 3) historically, overbought markets often do result in blow-off rallies. These rallies end badly but are painful to miss because one tends to get dragged into them at the last moment.
In short, there are some basic facts behind the market -- 1) a weakening USD tends to support Asian equity markets; 2) a precondition for a blow-off rally is that the VIX needs to fall under 20 because that will facilitate hedged buying in equity markets; and 3) slowing growth will not impact equity markets until it is visible in the data. That being said, my own instinct is to sell into the rally due to the following considerations. Firstly, why are central banks considering expanding QE? Simply put, because they know a sharp slowing looms and they know DM economies are caput. This is not a sustained bull market environment for equities. Secondly, we have policy risk in China. Investors know that there is a lot of pressure for higher deposit rates. Higher deposit rates alleviate the hidden tax burden on Chinese households and raise the opportunity cost of vacant property investment in China. Though PBOC has denied that it will adopt asymmetric rate hikes, it has argued in favor of interest rate liberalization. There is a risk that we might see some deregulation in coming weeks/months in the form of a raised ceiling on the deposit rates which banks can offer. If such liberalization were to occur, it would signal an end to the 300bp NIM policy that Chinese government has endorsed for the past decade. Chinese bank stocks would come under pressure. The risk of some move on rate deregulation is probably about 30%. This so because the PBOC will need to fight inflation next year, as I pointed out above, and some deregulation in interest rates would help….Lastly, regional wise, MSCI China is now traded at 14XPE10 and 28.1% EG10, CSI 300 at 16.4XPE10 and 28% EG10, and Hang Seng at 14.3XPE10 and 29.4% EG10, while MXASJ region is traded at 13.8XPE10 and +38.8% EG10.
A Firm Belief in EM Currency
The US Congress has passed a bill granting the Commerce Dept. the right to determine whether a currency is undervalued and constitutes a prohibited export subsidy. The bill passed 348-79 and would open the door to extra duties on Chinese goods entering the US. This bill is aimed a pressuring more action from China on the CNY in the run-up to the 2 November US mid-term elections. Now, the US Senate needs to approve its own bill, which is not expected to be voted on until after the mid-term elections. By then, there may be less political appetite for the legislation. Indeed, September has brought a substantial reacceleration in CNY gains against USD. The annualized pace of CNY appreciation since the depeg (on 19 June) is now 7.1% (vs. just 1.1% at the beginning of the month). However, this development comes amid broad-based USD weakness, and the CNY has been losing ground against a basket of currencies. The CNY index against a trade-weighted basket (CNY NEER) is now 2.7% below the level at the time of depeg in mid-June.
That said, the Dollar weakness is now spreading deflationary pressures in the US to some of its main trading partners, forcing government bond yields lower in the process. The intervention in foreign exchange markets, both direct and verbal, has been relentless since the BOJ intervened on September 15th and has accelerated since the FOMC statement which opened the door for QE2. The roster of central banks intervening or discussing alternative measures to stem currency appreciation is large and growing (BOJ, SNB, BOI, MAS, BNM, BACEN, BANREP.. the list goes on and on.). Indeed the challenge for many EM policy makers remains large as the gap between EM and DM growth continues to be wide in many cases. For investors, the tension between the increased likelihood of QE2 and concerns about selected EM FX valuation creates more near-term risk; nonetheless, the rationale for structural trend appreciation of higher EM currencies remains in place. If one is to think of the aftermath of the Japan bubble in the 1990s as a template for current conditions in much of the developed world, money was reallocated into the higher growth South East Asian countries. Thus, there is little reason to expect money not to flow to the higher growth EM markets again. The difference is that EM central banks have learned from that subsequent bust and will continue to absorb but are unlikely to reverse these flows absent unorthodox policy measures.
To sum up, while the debate over currency levels has heated up, the majority of EM central banks are more focused on absorbing flows rather than attempting to influence currency levels. In my own views, the backdrop of "ultra-low” core market rates and large growth differentials between EMs and DMs is one that remains medium term supportive for EM currency appreciation relative to the developed markets.
Good night, my dear friends!
