My Diary 663--- The Powerhouse of Technical Innovation; A Modest Outlook for Asian Bonds; Some Topics on China Markets; Hold on USD and Gold
Sunday, January 23, 2011
“Inflation: a screaming factor or a scaring one” --- During my latest marketing tour in Southeast Asia, it is obvious that inflation is a key risk factor for markets this year and volatility likely will rise in line with monthly fluctuations in the inflation data. There is an interesting question during the trip, that is, what is the fundamental way to fight the inflation? In my own understanding, this is a very board question related to macro economy and macro-policy. I believe what investors concerned nowadays is how would the Asian central banks deal with such a situation? Well, then the answer is pretty simple. Asian central banks cannot successfully handle inflation as long as local governments continue to have a policy of active FX intervention to slowdown domestic currency strength vs. USD. Put it into another perspective, inflation is always and everywhere a monetary phenomenon. In Asia or US, a more fundamental generalization is that inflation is always and everywhere a political phenomenon. Government is the monopoly issuer of base money and therefore it ultimately determines the value of paper money, a denominator of inflation or the purchasing power. If my judgment is right, the Asian FX will continue its steady march higher vs. USD. Commodities prices will continue to trend higher. Equities will perform well in nominal terms, but real returns will suffer. China will continue to "fight" inflation with various administrative measures, but inflation will nevertheless continue to trend higher as long as USD is weak and authorities continue to accumulate excess FX reserves.
That said, inflation is now a global theme, witnessed by the recent policy responses adopt by the major central banks over the past few weeks --- 1) ECB President Trichet was unexpectedly hawkish about inflation in his press conference on Thursday; 2) Bank of Korea unexpectedly hiked rates (25bp) in an effort to combat inflation; 3) Bank of Thailand recently hiked rates (25bp) to combat inflation; 4) China once again hiked RRR (50bp) in an effort to control inflation; 5) India wholesale prices were reported above expectations (8.43%); 6) Bank of England is facing political pressure to tighten policy in order to offset unacceptably high inflation (3.7%). At the end of day, the Fed's aggressive expansion of its balance sheet is the source of inflation for countries around the world whose governments choose to import US monetary policy through their interventions in the FX markets. Meanwhile, Fed remains committed to QE2 and it is unclear whether there will be a QE3 or other itineration. Furthermore, once the process starts, it is not easy to control inflation. True, central banks can withdraw supplies of money, which is the Fed's major "strategy" of how they will supposedly control inflation, but they have no direct influence over the Demand for money. As result, the main macroeconomic concern for EM Asia this year is inflation and its management by policymakers. EM Asia will grow 7.4% in 2011 based on street forecast. While it is true that regional growth will be lower by 1.5% compared to 2010, this is due to the base effects created by the much stronger-than-expected recovery last year. The regional inflation will average 4.8% yoy in 2011 (cons= 4.4%), up from 4.2% last year. Inflation of asset prices, in particular real estate prices, has been a concern for quite some time. More recently, goods price inflation has accelerated, driven primarily by the food and energy prices that make up a relatively large portion of regional CPI baskets. But it would be a mistake to dismiss the recent rise in headline inflation in Asia as a temporary phenomenon, driven primarily by non-core prices. While this is still true for the current data, it is the future path of inflation and inflation expectations that is the concern. It is worth noting that even though headline inflation in Asia remains below the peak seen during the 2008 inflation scare, it has already risen in this cycle by more than it did three years ago. The implication to financial markets are the fears of policy being “behind the curve” and of a sharper tightening in the future will be an overhang on Asian markets, at least at 1H11. Moreover, the combination of strong GDP growth, solid fiscal and sovereign debt positions, and generally large CA surpluses, is expected to attract continued capital inflows to EM Asia. As a result, regional policymakers, who wrestled in 2010 with the challenge of liquidity management, will again face similar problems this year.
Across the pond, the recent improvement in peripheral bond markets (Spain/German -28bps wow vs. Irish/German +8bp) has given Euro area policymakers the impression that they have time to take decisions regarding changes to the size and scope of the EFSF. However, the actual "news" out of Europe is not necessarily improving, as comments from various officials indicate there are still material disagreements on when, how and even if to expand the size and scope of the EFSF. Separately, the prospect of additional sovereign downgrades to the periphery countries is still very much alive, even if it is not an imminent threat. Portugal, Spain and Belgium are all on review for possible downgrade, although decisions there are not expected until February/March. In addition, WSJ reports that the Spanish government is considering a plan to provide additional capital (EUR30bn) to the country's savings banks (cajas). If true, that could further weaken Spain's already-stressed fiscal position in a manner that could not only impact the above-mentioned ratings decisions, but could also set off a chain reaction of events that would eventually require "outside" support, either through standard debt auctions (good), via Eurozone assistance programs (bad), or via outside sovereign wealth funds (which is probably good).
In any event, it looks as if the announcement regarding the EFSF will not take place until March, unless financial market pressure intensifies significantly in the meantime. According to Luxembourg Prime Minister Juncker, President of the Eurogroup, there is a discussion underway of a comprehensive response to the sovereign crisis, with recommendations likely to be presented to the European Council in March. This comprehensive response will have five elements --- 1) A commitment to ongoing fiscal consolidation and structural reform; 2) an improvement in the current crisis management regime. This will almost certainly encompass an increase in the size and a broadening of the scope of the EFSF, and may include changes to the terms and conditions of EFSF loans; 3) An agreement on the details of how the permanent crisis resolution mechanism will work; 4) A new round of more rigorous stress tests to guide the restructuring of the banking sector; 5) An agreement on reforms to economic governance (a strengthening of the Stability and Growth Pact and a new mechanism of macroeconomic surveillance). One advantage of delaying any announcement on the EFSF to March is that it can coincide with the original timetable of the agreement on the details of the functioning of the permanent crisis resolution mechanism. On the one hand, policymakers are saying that sovereign debt restructurings are not an attractive way of exiting the current crisis. The difficulty is caused by the fact that the permanent crisis resolution mechanism will come into force in the middle of 2013, well before the region has exited the current crisis. It is not clear whether policymakers simply want to delay debt restructurings until 2013, or whether they would like to exit the current crisis completely without debt restructurings. It is possible that in the comprehensive package in March we will get more clarity around this issue.One more potential risk factor laid its root in US Muni bonds. Muni bonds are insured and tax free, but still are breaking down because the financials of so many municipalities and States are so poor and doubts exist over the ability of insurers to cover the risk. Even after the cuts of FY2011, for example, California's projected starting deficit for FY12 is US$28 billion through June 2012 (about 25% of revenue). Municipal bond funds saw record outflows of USD3.6bn this week. This is a significant acceleration of outflows from the 4WAVG outflow of USD1.7bn. Not only retail investors are selling their bonds, the latest CDS position data also saw increased protection buying through the CDS market. The current net notional outstanding on Muni issuers of USD7bn is 11% higher than the level seen at the start of December (measured by the sum of positions on the MCDX index and all single-name Muni issuers reported by DTCC (8 issuers in total)). So far, there is seeing no improvement in sentiment from retail investors. And if the situation continues to worsen, then more QE will be needed as the US works through this crisis.
X-asset Market Thoughts
On the weekly basis, global equities saw a week of two-halves with stocks selling off on the back of China's policy tightening concerns but recovering into US bell probably on some encouraging data. As of Friday, MXWO closed down 49bp with -0.81% % in US, -0.84% in Europe, -2.1% in Japan and -2.02% in EMs. Elsewhere, USTs yield climbed with 2yr -4bps to 0.61%, 10yr +9bp to 3.41%, and 30yr +4bp to 4.56%. In the European space, the 10yr yields of Portugal, Irish, Greek and Spain government bonds moved -8bp, +8bp, +11bp and -28bp, respectively. 1MWTI oil lost 2.65% to $89.11/bbl, while CRB index stay flat.. In the currency metrics, EUR (1.3621USD) has strengthened 1.74%, and JPY (82.57USD) has gained 0%, while Dollar Index was down another 1.2% to 78.21.
Looking forward, the dawn of a New Year typically does see a new perspective on the financial market landscape, but 2011 is flooded with uncertainty given the debate over return to normal vs. new normal. I think at this moment real money investors demonstrate a current lack of conviction, leaving big fast money/hedge funds flailing away creating/breaking their own trends - result, extreme choppiness. That said, from macro perspective, global recovery is proceeding at a somewhat faster pace than market anticipated, although risks remain elevated. Private demand in US has picked up and will be reinforced by recently announced monetary and fiscal stimulus. European growth has also been slightly stronger than anticipated. Ongoing challenges associated with sovereign and bank B/S will limit the pace of the European recovery and are a significant source of uncertainty to the global outlook. In response to overheating, some EM countries have begun to implement more restrictive policy measures. Their effectiveness will influence the path of commodity prices.
That said, the key positive drivers (valuation, earnings and liquidity) of global equity markets remain in place heading into 2011. On all three backdrops, the equity market outlook still looks favorable as equity prices are reasonably valued. For the global index, both PE and PB are at the low end of their historical range, while DY compares favorably to bond yields. Meanwhile, if the economic recovery persists, then earnings should eke out further gains, albeit with growth below the past year’s level. Finally, there is little chance of an early tightening in monetary policy in the major regions. In contrast, bonds are confronted with a mix of stretched valuations, rising rates and a front-loaded inflation expectation on the one hand, and positive investor sentiment, fund flows into risky assets and a very benign macroeconomic environment on the other. Given this mix of offsetting factors, returns on bonds in 2011 will be modestly positive.
I think for 2011, USD is a key indicator to watch as the sentiment has swung significantly with the consensus bullish on USD and US equities. The US growth outlook has improved with the extension of Bush tax cuts and an additional boost in the form of a reduction in the payrolls tax that will put an extra USD100-150bn into consumers' wallets. Thus, analysts are racing to raise their US GDP forecasts (some forecasting 5%). Further support for USD has been driven by a movement in interest rate differentials in favor of the USD as the growth outlook improves and inflationary expectations have risen to 2%. Indeed, the entire US yield curve has shifted upward since the beginning of October. In contrast, I think the adjustment process for the macro imbalance in Europe would continue with more deflation pressure in PIGS (more inflation in Germany) and a weaker EUR over time. On the back of this view, it is worth to remind the historical inverse relationship between USD and Asian equity markets. The logic is fairly straightforward: USD strength is usually associated with the US economy performing relatively better than its G-20 counterparts and this raises expectations of an imminent Fed tightening cycle. Moreover, a stronger US$ reduces the purchasing power of the non-dollar economies and thus reduces demand for imports. Given its export orientation and $ pegs, this makes Asia's earnings cycles vulnerable to the US$ upcycle. US$ also does well during times of global stress, serving as safe haven for the protection of the value of investor assets. The Asian Crisis and the tech wreck are 2 episodes during which the USD has strengthened, not to mention the Great Recession which started in the US and went global. What might be different this time is the structural shifts in economic activity and investment behavior in the aftermath of the Great Recession as well as trends underway before it will loosen the link between the USD and Asian equity markets. When taken as a whole, there are factors could allow Asian markets to move in a manner not anticipated by past relationships. These include: 1) a structural shift in investor preferences toward EM assets; 2) growing economic weight of Asia and EM countries; and 3) still accommodative policy in the developed countries despite their growth is picking up. These factors are likely to slow the pace of a USD rally.
The Powerhouse of Technical Innovation
A ton of data released last week but the main focus was on China's Dec data dump so let's start there. China's activity data were very strong in December, capping off a robust gain in 4Q GDP. Based on seasonal adjustment, GDP rose 12.7% QoQ, the strongest advance since 2Q09 (9.8% on yoy basis). Inflation eased to 4.6% yoy due to lower food inflation, whereas non-food inflation climbed to 2.1% yoy, matching the previous cyclical high set in mid-2008. Some street economists have raised their 2011 inflation forecast and now see inflation peaking near 5.5% yoy in 1H11. In my own views, Chinese policymakers are not expected to respond aggressively to this inflation outcome. Officials already have raised their inflation forecast to 4%, yet their rhetoric remains balanced and growth supportive. Economists look for headline inflation to fall below 4% during 2H11 as food inflation fades and non-food inflation stays with a 2.5%-3% range. Elsewhere in Asia, Taiwan export orders (19.1%) and HK CPI (3.1%) were both higher than expected. Japan’s Reuters Tankan survey rose for the first time in three months in January, led by the service sector. The result supports our view that the economy will grow this quarter after a temporary dip in 4Q10. Next week’s reports (January surveys, December activity indicators) will give more information.
Nothing significant in Europe so I move on to the US. Initial jobless claims fell much more than expected to 404K (cons=420K), lowering the 4WAVG ~4K lower. Continuing claims fell by 26k to 3861k, the third consecutive weekly decline which also brings the series to the lowest since October 2008. The housing data was also quite positive. Existing home sales rose 12.3% mom in December, the highest level of existing sales since the homebuyer tax credit expired in June 2010. The Conference Board LEIs were up by 1.0% (cons= 0.6%) helped by some technical adjustments but it was still a good report. On the Philly Fed, despite the disappointing headline, the underlying details of the survey were actually quite robust. The headline fell to 19.3 (vs. 20.8 expected) but new orders (23.6 v 10.6), shipments (13.4 v 5.2), and employment (17.6 v 4.3) all rose. Indeed the employment component saw the largest monthly increase in 7 years. The Chicago PMI out the day before the crucial ISM manufacturing release on the 1st of Feb is the next key survey to watch.
From the global context, I think the China story is not over and nor is it fully priced. The recent launch of the secret 5th generation fleet – J-20 Stealth Fighter is a good example of China’s capacity and potential as the powerhouse of global technical innovation. More data are supportive to my observation – 1) In 2010 China surpassed US as the world's largest value added manufacturer, ending 100 years of US dominance; 2) Trademark applications in China each year surpass those in the G7 combined; 3) The number of utility model patents filed in Chine each year exceeds that in the rest of the world combined; 4) In 2011 China will likely surpass the US in patent applications. The acceleration in China's technical innovation is unlike anything seen before. In 1968, when Japan surpassed US in patent applications, "Made in Japan" was still a popular joke. Japanese manufacturers obliterated the world in the ensuing decade. Based on current trends, China will achieve a 35-40% of global manufacturing value add by 2025 (triple the US, double the G7, and hence also dominating services to manufacturing). Value-added manufacturers represent 30.5% for Japan and 35% for Korean markets. If China follows the Korean and Japanese model, China's manufacturing sector will be the hottest sector in the index for the next 10-15 years.
A Modest Outlook for Asian Bonds
Both total returns and risk-adjusted returns will be lower in 2011 for Asian bonds and credits, given a mix of stretched valuations, rising rates and a busy issuance calendar. Fundamentally, As 2011 got underway, there was increasing evidence that US recovery continues to gain traction, even as Europe’s fiscal woes hit sentiment on that continent. With the ECRI’s Weekly LEI in US continuing to post solid gains, this bellwether indicator turned positive in December, and its growth rate currently stands at 3.7%, a multi-month high. Thus, the market seems to be gradually coming around to the view that not only will there not be a double-dip, there will be no growth slowdown either. Some houses have revised up 2011 US GDP growth forecast to 3.5% from 2%. As a consequence, risk assets got off to a strong start in 2011 as a whole host of asset classes – ranging from DM/EM equity to EM and HY bonds – all rallied hard. One clear sign that the global economic cycle is taking a turn for the better is surging Treasury yields, which widened out sharply in 4Q2010.
As a consequence, 2011 issuance will be front-loaded as issuers seek to take advantage of -- 1) rates/spread levels that are still attractive, and 2) positive investor sentiment, to conclude deals while conditions remain benign. Yet another factor that will weigh heavily in issuer calculations is the crowded calendar of European issuance, both sovereign and financial, that will compete with a range of offerings from other parts of the world (especially Asia) in a European environment that is far from benign. As contagion spreads from peripheral Europe to the core on perceptions that European authorities have not done enough to address the causes of the crisis that began with Greece, refinancing requirements will necessarily force a whole host of European sovereign and financial issuers to get deals done at prices that appear even remotely reasonable (for instance, Portugal priced a 10Y transaction at 6.716% on 12 January, considerably higher than the rate it would have paid six months ago). Given that yields on these issues are higher than that on offer not just for Asian IG issues but for certain sub-IG bonds as well, it is worth noting that Asian issuers face stiff competition for investors’ attention at a time when Asian valuations appear stretched.
On the investor front, appetite still remains high as fund flows into risky assets (particularly HY bond funds) were strong in the first two weeks of 2011. High yield bond funds saw record inflows in excess of USD 1.0bn for each of the weeks ended 5 and 12 January 2011,with flows for the week ended 5 January being the highest since 2003. Also, inflows into EM bond funds have picked up pace after a relatively weak December, when EM bond funds experienced outflows in what had otherwise been a very strong year. On balance, i remain constructive on fixed income securities, given that Asian economic fundamentals also remain favorable as GDP growth rates, current account surpluses and FX reserves are all surging across the region.
Some Topics on China Markets
As discussed, one of the draggers for Chinese equities is inflation outlook. In a media interview last week, Zhou Wangjun, deputy head of NDRC, claimed new administrative measures would be taken if price pressures grow stronger. Other major negative news include --1) vegetable price rose 6.1% in the past week; 2) GD is to raise minimum wage by 18.6% from March 1st; 4) SH and CQ will announce property tax on. Many domestic economists predict 5.5% of Jan CPI, arguing that the bad weather. But in my observation, the Chinese government is not sure whether the inflation is mainly a cyclical or a structural one. Thus, an IR hike should come not early than April after it can come to a conclusion in March. It looks like A share index should have priced in the worst N-T inflation expectation. The solutions for the government are mainly filled into two categories, administrative controls or the RMB appreciation? Last week RMB did break through 6.6USD threshold. That particular move is probably more a Chinese attempt to smooth the way for Hu Jintao's imminent visit to the US than a step-change in economic policy. More RMB appreciation isn't a free lunch for policymakers. Expectations of RMB appreciation raise the risk of hot money and thus excess liquidity. One response is to allow more money to leave, hence last week's rules on outbound investment for residents of Wenzhou, and broader measures to allow domestic firms to use RMB to fund overseas investments. Most importantly, such rules perhaps create the opportunity to hold more foreign currency; they don't really create the incentive to do so. As an example, why would companies want to borrow in RMB to finance overseas investments when domestic rates are above global levels and the RMB rising? Clearly, the PBC doesn't think these changes solve China's problem of excess liquidity, on Friday announcing another 50bp RRR hike, the fourth since November 10th. Even with this series of hikes, which has been even sharper for the bigger banks, liquidity remains abundant, with overnight SHIBOR rates falling from 4.5% at the beginning of the year to just 1.9% on Friday. The challenge facing the PBC isn't just new money coming into China. In addition, rather than soaking up money, the PBC's other tools of sterilization have in recent months been releasing it. Open market operations aren't helping much either. Indeed, instruments maturing exceeded those issued by RMB376bn in recent weeks. Reversing this will be tough as there are +RMB1trn worth of PBC paper is coming up for maturity in 1Q11 alone.
On the other hand, CBRC provided guidance on banks' recognition of off-B/S trust loan products. Banks must transfer at least 25% of trust loans back onto the balance sheet in each quarter of 2011. The measure means that banks will transfer RMB1.7trn of off –B/S loans back onto the balance sheet in 2011. If we lived in a world of a fixed loan quota, this would lower the amount of net new lending in 2011 and would represent a reasonably draconian measure, which is why the banks sold off. In reality, however, no loan quota for 2011 has been officially announced and nor is it likely to be. To be sure, Beijing has been very keen to restrict loan growth in Q1. The banks have been given unofficial guidance of a RMB2trn quota for the quarter. But why has no loan quota announcement been made for the full year? PBOC and CBRC want to appear as tough as possible in 1Q11 because there will be financial deregulation in 2011. In recent weeks we have seen/heard: 1) Comments about the Wenzhou pilot program; 2) Comments about deregulating the capital account; 3) Official comments about the need for higher rates; and 4) More RMB products listed in HK Exchange. If we do see concrete steps towards financial deregulation in 2011, then the risk is that Chinese interest rates could rise a lot more (300-400bps) than the market currently expects over the next 2-3 years. Historically, during the financial deregulation era of the 1980s, financial deregulation had demand for loans far exceed expectations until real interest rates become restrictive. This is positive to Chinese banks’ earnings outlook.
Market side, SHCOMP has touched on the previous low at 2683 with bears worrying about inflation and another IR hike before the holiday vs. bulls arguing over-reaction over the near-term inflation pressure. Looking back, there are two periods of time in the history that A-share diverged from the underlying economic fundamentals. One is Jan 2002-Dec2005 when Chinese economy grew at average annual rate of 9.6%, but A-share lost 30% in the four years from 1611 to 1140. A share was agonized by the discussion of the reform of non-tradable shares as well as the correction of extensive market manipulation. Now we are in the second time to see this divergence. In 2010 Chinese real GDP grew more than 10% while A-share lost 15%, making it one of the worst performing markets in the world…...Lastly, regional wise, MSCI China is now traded at 11.9XPE11 and 17.4% EG11, CSI 300 at 13.5XPE11 and 23.4% EG11, and Hang Seng at 12.8XPE11 and 16.5% EG11, while MXASJ region is traded at 12.7XPE11 and +13.2% EG11.
Hold on USD and Gold
From the currency perspective, I expect major themes from the past year will continue to play out over the next twelve months, given the global economy on a recovery path and no exits from the super-simulative policy settings. This is particularly the case for US where a pro-cyclical currency investment stance is still warranted, as the widening US “twin deficits” and ultra-accommodative interest rates will keep the dollar under pressure in 2011. Moreover, suggestions that USD inverse correlation with risky assets will soon falter seems premature. The Fed’s QE program and the widening US CA deficit will continue to funnel USD liquidity into the global economy. Meanwhile, some recovery in EUR is possible. While Portugal could still fall under the EFSF umbrella, Spain and Italy are unlikely to require bailouts. For now, it would appear that most of the “bad” news is already priced into the currency. As for USD/JPY, the yen likely has further to rise. JPY is not overvalued and according to the latest Tankan survey, large businesses have budgeted for a USD-JPY rate of roughly 84 for the remainder of the fiscal year. However, As discussed in the above, the bulk of any dollar adjustment is likely to come relative the Asian currencies. Asian policymakers will increasingly be forced to accept stronger currencies as inflationary pressures mount
For precious metal, gold was the top performer of the main asset classes in 2010, returning nearly 30% amid record investment flows and speculation that after years of selling, central banks would start buying gold. In a complete reversal, so far in 2011, gold is the worst performing major asset and speculation has begun that the major hedge fund gold investors have started selling. Looking at positions, the picture is certainly becoming less positive. CFTC data show that while speculative investors are still net long gold, the number of short positions is increasing and is now at the highest level since July 2010. Furthermore, in the Merrill Lynch FMS for January, a net 33% of respondents thought gold is now overvalued, the highest reading since the question was first asked in May 2008. The flow picture is also looking less supportive than last year. After seeing record flows into gold ETFs in 2010, so far January 2011 has seen around USD1bn of outflows, the heaviest since July.
However, I think the next upleg of gold is driven by the potential inflationary implications of current large fiscal deficits and central banks that are prepared to stop at nothing to prevent deflation. It may be several years before DM real interest rates return to the norms of earlier decades, especially in US. In this environment, gold will continue to be an excellent insurance policy and should continue to fare well when measured against the major currencies. In addition, it is hard to make the case that gold is currently a crowded trade. Many institutional and retail investors agree with the gold bull case but have been slow to act, even as their faith in conventional stocks and bonds has ebbed. Indeed, the average portfolio allocation to gold is around 1%. This suggests that there is plenty of pent-up demand which could still flow into gold and related shares.
Good night, my dear friends!
