My Diary 687 --- EMs Pausing Lies Ahead; What else could Fed do? China Takes Different Approach; Don’t Be Too Bearish on Oil
Sunday, August 14, 2011
“Turning Japanese, I think I'm turning Japanese, I really think so" --- This is the most popular song released by the English band “The Vapors” from their album “New Clear Days”, and the song for which they are known best. The songwriter, David Fenton, was co-producer of the “No Nukes” concerts in New York City, 1979. Well, regarding youth in the context of history the US is young, there is angst and American is afraid of US turning into something no one expected – Japan. Nowadays, this nightmare is coming back. That being said, market mood is bleak, and the problems are mounting on all sides. In addition to the S&Ps D/G of US and the ongoing problems in Europe, misgivings over China were further fuelled when inflation printed HTE (6.5% in July vs. 6.4% in June), adding to fears that a rate hike there is imminent. Such backdrops explained well the hyper volatility embedded in the global risk markets, witnessed by the VIX index, which rose to 48, its highest level since Mar09, and recorded its biggest ever daily gain since 2007, on the back of a weekly op & down of SPX (-6.66%,+4.74%, -4.42%, +4.63% and +0.53%). ML’s MOVE index, which measure price swings in USTS (based on prices of OTC options maturing in 2 to 30yrs) touched 117.8bp on 08 Aug. compared with 89.4 on average since the start of 2010. As a general statement, the UST market will not calm down until stocks calm down.
This volatility in stocks is not a good sign for the economy. Stocks were crazy volatile in Sept and October of 2008, and we all know where that got us. As expected, I saw ECB's statement was later followed up by a joint statement by the G7 Finance Ministers and central Bank Governors. In the statement, the authorities confirmed their commitment to addressing the tensions stemming from the current challenges on the fiscal deficits, debt and growth, and welcome the decisive actions taken in the US (the Budget Control Act 2011) and Europe (the EU/IIF announcements on 21st July). That being said, these policy statements failed to hold the risk markets and the "new and improved" EFSF remains in limbo. The much hoped for extension in its size is looking less likely amidst staunch German opposition. An increase in the EFSF is seen by markets as a precondition for any significant intervention in the Italian and Spanish markets. RBS have estimated that purchases of Italian and Spanish debt may have to reach EUR850bn (compared to EUR80bn of bonds the ECB bought). As a result, there is only scope for spreads to come down on a more permanent basis if the EFSF is appropriately expanded. Without it, the risk is that markets will conclude that the current round of intervention is doomed to fail.
With the abovementioned, it is not surprised to watch the intra-week collapse of European bourses with spotlight on French banks - Soc Gen was in the bear's laser swamped with over a 20% loss at one point. Investors were concerned that France could suffer a rating D/G, even though S&P has rightly argued that the French outlook is better than US. But an expanded EFSF would be a major new contingent liability. This suggests that the fiscal union ‘solution’ to Euro crisis is unattainable on technical, as well as political grounds. In S&P's statement on Friday and in trying to show the divergence between the US and its key peers (Canada, France, Germany and the UK), the agency projects that by 2015, their net debt to GDP ratios will range between 30% (lowest, Canada) and 83% (highest, France) with the US at 79%. However, in contrast with US, S&P expects the ratio of these other AAA sovereigns to start to fall either before or by 2015. So it is not hard to see that while the base case for France's AAA is stable for now it crucially hinges on future growth and deficits. As a result, I expect the Euro-area crisis remains a threat to the world upswing. In fact, the week saw European X-over closed +304bp above the tights for the year back on May 3rd and is 243bps wider since July 22nd just after the major EU summit. Crossover's average rating (Ba3-B1) should lead to 20.15% defaulting over 5 years. At the peak of +656bp, market is pricing in 42.1% defaulting assuming 40% recovery and 33.6% assuming 20% recovery. The worse 5 year cohort for Single-B defaults since 1970 is 41.1%.
Adding to the sour is that in US the political turmoil continues. The FSOC led by Treasury Secretary Geithner held an emergency meeting to discuss the recent market volatility. It is not known what was concluded there. Elsewhere, FOMC meeting did not provide additional stimulus options (i.e. QE3), left market speculating that more dramatic actions will likely put off until Jackson Hole later this month. I do think those gunning for QE3 are disappointed, after seeing FOMC's efforts as falling short of what is necessary to turn the economy around. Their disappointment will most likely be felt via another equity market rout. In short, it is politics that remains the issue both in Europe and the US. As distinct from 2008, when it was a financial crisis, currently we have a political crisis. After all, The S&P downgrade is a reflection of politician's inability to deal with the problem, and to take the steps needed, rather than a reflection of the US' ability to repay its debt. In fact, 10yr UST auction did well last week with the highest customer takedown since Feb2011. The direct bid takedown was 31.7% and customers bidding direct are not little guys. PIMCO as Total Return has been adding USTs to their lowest level ever. Its fund assets increased by USD3.4bn that month, with USTs holdings increased by USD35.4bn from 36% to 51%. Effective duration rose from 4.71 to 5.35, and effective maturity rose from 6.92 to 8.08. This suggests that PIMCO may have taken profits in other sectors – Europe, Emerging Markets etc.
The difficulty policy makers in Europe and the US now face is the deteriorating credibility of their arsenal of policy tools. The S&P500 has given up all gains since the start of QE2, and is almost back to last year’s low just before Bernanke’s Jackson Hole speech. Fed Chairman must feel like the mythical Sisyphus, pushing the monetary boulder up the hill only to see it slide all the way back down again. The S&P downgrade added to this burden, but even without it there is no perceived credible policy left. There is concern, as QE3 is contemplated, that the unwanted hitchhiker in QE2 was higher commodity prices. Europe appears to be in even weaker shape, with European bank concerns contributing to higher USD funding costs globally. Significant emphasis has been placed on the size of the EFSF, relative to funding needs for the periphery countries. If compared with a typical deposit insurance model to prevent bank runs, this does not need to cover such a large figure, provided there is a credible fiscal authority behind the insurance that will step in. but in Europe, this does not appear to be the case.
Moreover, market participants are rightly concerned about increased downside risks to global economic growth, and what appears to be the very limited ability of policy makers to address those risks in a coordinated and, more importantly, effective manner. A glaring example of the limits of policy effectiveness is seen in USDJPY, where the currency pair has already retraced over half of the 77.00-80.20 rally driven by the extraordinary BoJ intervention on Thursday, given that intervention totaled JPY4trn (USD50bn). Now it is certainly true that markets are bigger than central banks. The 2010 BIS FX turnover survey showed daily JPY turnover at USD300bn and in truth, USD50bn worth of USDJPY buying in one day can be expected to have a considerable impact, which it did against that type of daily volume. But without follow through buying from either BoJ or somewhere else, the effects of the intervention cannot be expected to be sustained, at least not in the current environment of low risk appetite and where the convergence of global yields towards those in Japan keep investment biased inward. Similarly, CHF has also remained strong, and actually strengthened further against EUR, following SNB's policy ease on Wednesday. But there again, ultra accommodative monetary policy combined with aggressive FX intervention in the past ultimately proved ineffective in halting CHF strength previously, and I cannot help but be sceptical that further monetary easing this week will prove to be any more effective in weakening the CHF on a sustained basis.
As I discussed above, in a week where volatility has taken us back to 2008-09, another reminder of those days came with the late announcement that France, Spain, Italy and Belgium impose short-selling ban on certain financial stocks to stabilize markets. This adds to short-selling restrictions that are already in place in Greece and South Korea. In any case, short selling bans have a proven track record of failure, and did not prevent Greece, Portugal, or Ireland from succumbing to the need for Euro assistance. The US, too, imposed a short selling ban back on Sept. 19, 2008. While prompting a quick rally which was unwound a few days later and, by the time the ban was removed on Oct. 02, S&P had lost 11% in value; by November 10, 28% had been wiped off.
What concerns me more is that current market turmoil is a new blow to US consumers, who are already reeling from a series of shocks this year, on top of the damage from the housing bust and high unemployment. Market turmoil is also a threat to the recovery in Europe and potentially Asia, though Asia is in a stronger position. My base case is that in the coming weeks data will show the US economy picking up as the shocks from oil prices and the Japanese supply chain dissipate. The two biggest threats to this view are that markets slump much lower and that the European crisis boils over. The sell-off in US stocks to date (SP500=1170) has been similar in scale to the 2Q10 decline, though more violent. By wiping about USD2.5trn from market cap, this month’s decline could take about 1% off consumer spending over time, if the normal wealth effect applies. But offsetting this is lower oil prices, assuming they stay down, and lower bond yields, helped by Fed’s indication that it will keep rates low until 2013. For the world as a whole, stock market cap is down about USD6trn from Q2 levels, but outside of US, wealth effects are less important. What matters more is business confidence. If business confidence begins to be affected, we could see hitherto fairly solid domestic demand beginning to weaken. However, unlike DMs, EMs have room for a strong policy response.
Another risk remains on Europe. While the ECB’s extension of its Securities and Markets Program this week has had a dramatic impact on sovereign bond markets, the central bank is intervening with reluctance, and is keen to hand over the task of stabilizing markets to the fiscal authorities. Similar to the situation in Japan and Switzerland, that does not represent a LT solution to the problem. And lacking that, the stresses on those bond markets and downward pressure on EUR will resume. It is only a matter of timing. If market pressure continues to haunt Italy and Spain, however, the EFSF is not currently equipped to deal with an enlarged crisis. Assuming European parliaments ratify the decision taken by Euro area finance ministers in June to extend the EFSF’s effective lending capacity from EUR255bn to EUR 440bn, total EU-IMF liquidity support to Euro area sovereigns will amount to EUR 750bn, short of the cumulative funding needs in excess of EUR 1tr that Greece, Portugal, Ireland, Spain and Italy have by mid 2014. To be credibly equipped to deal with a liquidity shortage in such a group of countries, the EFSF would need to be at least doubled, if not tripled. But, while this may seem like the next logical step in the resolution of the crisis, it is far from clear how this can be done without compromising the financial solidity of the sovereigns providing liquidity, or making significant changes to governance in the region. Added to this, there are concerns regarding the resulting incentives for sovereigns to make fiscal adjustments, and questions on the governance structure of the EFSF itself. Back from his holidays, Dutch Finance Minister wrote in a letter to lawmakers that the EFSF is "no panacea" to solve the mounting troubles in the euro zone and "any significant increase of the EFSF can...have consequences on the creditworthiness of guarantor nations". The launch of EFSF 2.0 is clearly a top priority when politicians return from summer holidays and continues to be a space that will probably bring us more volatility along the way. We still think that the current problems will prove beyond the EFSF and to ensure stability the ECB will need to keep very active in the weeks, months, quarters and even years ahead. The problem is that they think their interventions are temporary.
To sum up, the latest policy markers’ reactions highlight the lack of global policy coordination. That should not be the least bit surprising given the national priorities of each government/institution involved. But these unilateral actions can sometimes conflict with each other in a manner that makes them untenable over time. Indeed, it is mathematically impossible for all countries to keep their currencies weak at the same time. More immediately, markets will view the lack of policy coordination as another indication that the resources policy makers can call upon in these conditions are extremely limited, and that the effectiveness of the few they can employ is questionable, at best.
X-asset Market Thoughts
On the weekly basis, global stocks dropped 1.11%, with -1.58% in US, -0.53% in Europe, -4.52% in Japan and -0.97% in EMs. MTD, global equities are down more than 10%. Elsewhere, 2yr USTs yield dropped 10bps to 0.19%, 10yr down 30bp to 2.26% and 30yr declined 12bp to 3.73%. 5yr France CDS once reached 174bps in Wednesday and closed at 151bp on Friday, +8bp wow. While 5yr CDS of Italy and Spain retreated 33bp and 55bp from last from last Friday’s 387Bp and 407bp, respectively. Elsewhere, Brent oil lost 1.23% to $108/bbl. CRB index stayed flat to 326.5; while spot gold climbed another 4.97% to $1739/oz. EUR softened 0.25% to 1.4248USD and JPY strengthened 2.14% to 776.72USD. DXY barely moved to end @74.61.
Looking forward, I expect the market recovery is likely to be slow. US growth prospects appear to be dim, with the labor markets stagnant. The housing market remains in the doldrums, while the recent equity rout pressures personal (household) B/S. On top of these, European debt issues have arisen once again. The expanded EFSF still requires ratification from EU member states in September, with German politics then likely to dominate. The ECB has restarted its SMP but not on a large scale yet, either in absolute terms or relative to the total amount it could execute. The above should continue to underpin sentiment, encouraging more flows into safe haven assets while keeping USTs yields at rock-bottom. However, various stimulus measures, such as the Fed’s undertaking to keep rates low until 2Q13 could prop up markets but such moves would be short-lived, as negative sentiment and profit-taking would limit any upward moves until momentum can be built. Market technicals also suggest that recovery from such drastic falls has usually been slow, with high volatility as the market swings on an almost daily basis. Using SP500 as a proxy, it can be seen that in four of the previous big sell-offs – Black Monday in 1987, the bursting of the dot com bubble in 2001-02, the Lehman bankruptcy in 2008 and the Greece crisis in May 2010 – recovery has been shaky and slow.
Despite slower US growth and blows to confidence, I think US should see a stronger 2H as the oil shock reverses and supply-chain problems fade. The Fed could turn to QE3 in 2012. China and other Asian countries could ease monetary policy in coming months. That being said, there is no magic cure for the problems in DM economies. I think we are not currently at a temporary equilibrium point, so volatility will remain high. Problems in DMs will drive sustained capital flows to EM economies. Moreover, external factors and the deterioration in risk appetite will be positive for US and EM rates markets. Inflation concerns still lurk in Asia, but I expect external risks to dominate central banks’ policy decisions. Meanwhile USD is now less of a safe haven than it once was, and EM central banks are accelerating diversification. In the absence of a US recession, I remain structurally bullish on AXJ currencies. Furthermore, risk aversion has caused commodities sliding materially downwards from 4-9 August, a good number of investors had been bracing for this correction – safe-haven investment flows have pushed the AUM of precious metals ETFs higher over the past month, in contrast with outflows from oil, agriculture and commodity index ETFs. As prolonged uncertainty leads to higher volatility, I see opportunities to be positive on selected commodities over the medium term, specifically cotton and silver.
EMs Pausing Lies Ahead
US consumer confidence has fallen in recent weeks and could fall further as the surveys react first to the debt-ceiling debate, then the S&P downgrade and the stock market sell-off. Moreover, even though confidence is above the troughs seen in 2008-09, it is still at recession levels by the standards of the last 40 years. Friday saw the UoM confidence (54.9) came in much lower than market expectations (62.0), with both current conditions and consumer expectations plunged. Forward-looking CE fell to 45.7, taking out the Great Recession low of 49.2 in Jun 2008. The level of this important leading indicator was the lowest since May 1980 – and the fifth lowest reading in the history of this survey. More importantly, unemployment expectations spike higher as 12M UNE expectation rose sharply to 46% in Aug from 31% in July.
In contrast, Euro-area consumer confidence is in much better shape – well up from recession levels, although it has not regained typical peak expansion levels. European households, at least outside the weak southern region of Europe and Ireland, do not face high UNE or an imploded housing market. However, market confidence in EU policy-making is fragile. Relatively modest ECB bond purchases have helped pull Italian and Spanish yields sharply down. The ECB’s weekly report, published on Monday, will disclose recent purchases, but the scale will be small relative to the total market. If Italian policy makers can generate more confidence that the budget deficit will come down and the economy can continue to grow, the markets may relax.
As in 2008, Asian countries are watching anxiously to see whether markets stabilize and the US and Europe can keep growing. This is important for export orders, on which many countries heavily rely. It also matters for domestic confidence, which is easily damaged by a weak world economy. In recent weeks, street economists have reduced EM growth by 1% for 2H11. With growth expectations lowered and central banks having ample firepower --- EM policy rates have increased roughly 125bp from the cycle trough and currently stand at 6% --- it would seem that they offer hope for policy stimulus. The market has scaled back expectations for tightening, but is currently not expecting easing by any large EM central bank. This reluctance to ease reflects a combination of three factors – 1) EM forecasts have growth cooling toward trend but not turning into weakness in the region as a whole; 2) the slide in inflation will prove gradual and maintain levels of inflation (and inflation expectations) that are still uncomfortably high for most EM central banks, and 3) EM policymakers have generally been slow in normalizing rates and will likely look at the growth moderation in our forecasts as aligning macro conditions with their current policy stances. This was the signal from the Bank of Korea this week, which recognized downside growth risks while emphasizing that inflationary expectation need to be managed with higher rates.
In general, I do expect Asian central banks to hold off tightening in coming weeks; some, including China, may begin to move towards easing. Inflation is now peaking in most countries, while growth has slowed. Overall, rates are close to neutral and the next move may be towards easing. Asian economies, including China, also have room for more fiscal stimulus, if necessary. At the other extreme, India is most likely to continue tightening. The global uncertainty over the last few days and the corresponding softening of global commodity prices has raised expectations that the RBI will pause at its September review. A strong rebound in June IP, and continued buoyancy in non-oil imports and indirect tax collections suggests that domestic activity is holding firm. With the latest inflation survey indicating that expectations remain elevated and anecdotal evidence suggesting that producers retain significant pricing power, the RBI will likely raise policy rates by another 25bp next month.
What Else Could Fed do?
The FOMC somewhat shocked markets that were more volatile than gas vapors on Tuesday by not announcing Operation Twist or a version of long end QE. The FOMC pledged to keep rates exceptionally low (into mid-2013) that investors and traders must go out the curve as there is no yield in return-free under 5yr yields. Meanwhile, the 5y5y forward swap rate plunged 27 bps to 3.496%. All eyes now are focused on Jackson Hole in two and a half weeks time and perhaps on any Fed speeches ahead of that. In terms of possible tools, "Operation Twist" (bond portfolio duration extension) seems to be the consensus favorite and most market observers do not expect a full-scale B/S expansion for now. But much of this will depend on whether market and/or economic conditions deteriorate sharply from this point. There is clearly a decent amount of economic data between now and then with July's CPI report next Thursday important for the QE3 debate. If Bernanke can get evidence that inflation is showing any sign of slowing then the hurdle for further QE reduces.
The question is what if QE3 did not work, what are the remaining Fed options. Indeed, the Fed has limited options to stimulate growth when O/N rates are already close to zero. But there are still a few remaining options for Fed policy easing, and we will likely hear more about them at Bernanke’s Jackson Hole speech on August 26. Unless he pulls a rabbit out of the hat, some of the options he will likely talk about include --- 1) B/S communication: One policy choice Bernanke mentioned at his Humphrey-Hawkins testimony was to give forward guidance as to how long the Fed planned to continue with its current policy of reinvesting principal payments of securities on its balance sheet. Similar to providing guidance on the expected path of the funds rate, such communications may further lower interest rates and ease financial conditions; 2) Changing the composition of B/S. The Fed’s large-scale asset purchases were supposed to work by removing longer-duration assets from the market, thereby increasing their price and lowering their yield, with the hoped-for benefit being lower long-term interest rates for private borrowers. It is possible the Fed would alter the composition of its B/S in favor of longer duration assets, with the intended effect of furthering lowering LT rates.
This option—dubbed Operation Twist in reference to a somewhat similar policy in the early 1960s—would leave the size of the B/S unchanged and comes in two varieties: i) Passive Operation Twist --Currently the Fed reinvests about USD20bn per month in principal payments. The Fed could conduct these reinvestments further out the curve, thereby gradually increasing the average duration of its portfolio. Employing this option could exert some added downward pressure on mortgage rates, perhaps up to 10 basis points. This wouldn’t, of course, guarantee a turnaround in the housing market, but every little bit helps. The likelihood of this step being taken is fairly high. ii) Active Operation Twist -- a more aggressive option would be for the Fed to actively sell the shorter-duration assets on its balance sheet and invest the proceeds in longer-duration assets. This would obviously increase the average duration of Fed assets much more quickly than the passive option, though it could raise concerns about causing rates to back up at the front end of the curve. Arguably, the recent change in communications has helped to limit the degree of any potential backup in ST rates due to Fed selling in that part of the curve. While the hurdle to this action may be a little higher than to the passive option, there is a good chance that the Committee employs this policy at the next two meetings.
3) Increasing the size of B/S. This option is probably what most people mean when they say QE3: another round of large-scale asset purchases that increases the size of the Fed balance sheet. Relative to the options discussed earlier, this would represent the biggest step. QE2 was hugely controversial, and it received sharp criticism from several influential lawmakers in the US Congress. Because of this, the Fed would likely need to see good evidence that deflation concerns were reappearing before embarking on QE3. How could QE3 look different from QE2? I can think of at least two ways -- i) unlike QE2, which was of pre-announced size, it could be a program of purchases, contingent on economic conditions. For example, the Fed could commit to purchasing certain amount each quarter until its inflation forecast returns to the rate deemed as consistent with its price stability mandate. This would clearly be a very aggressive move and the evidence of deflation risks would need to be quite high. ii) the reserves created by QE3 could be sterilized. One of the worries created by QE2 was that the increase in monetary base due to the resulting creation of USD600bn of bank reserves would spark runaway inflation or a destabilizing explosion in bank lending. Neither of these happened, of course, but concerns remain. Sterilizing the reserves created from QE3 would help to allay these concerns and would have the added benefit of allowing the Fed to test out its reserve-draining exit tools in a large-scale manner.
There are two main reserve-draining tools: The term deposit facility and reverse repos. The term deposit facility lets banks bid for interest-bearing Fed term deposits—effectively locking up reserves for a specified period and thereby removing them from the monetary base. If the Fed chose to drain the reserves created by QE3 through reverse repos, it would be able to operate through its newly expanded set of counter-parties, including the money funds. This would help to more widely distribute the funding of the expansion of the Fed balance sheet, from not only the banking system but also to the money funds. In addition, by supplying more collateral into the repo market, the Fed would improve demand for longer Treasury securities, arguably at the cost of a modest increase in bill yields.
4) Lowering IOER. The final conventional option for stimulating the economy is lowering the interest on excess reserve (IOER) rate from its current 25 basis points, perhaps down to around 10 basis points. The previous concern that prevented lowering IOER below 25 basis points—that it could cause deleveraging by money funds that could no longer cover operating expenses—may now look less compelling since interest rates in many instruments available to money funds are already below 10bp. Lowering IOER could modestly lower other interest rates, such as Libor, as well as provide a signal of the Fed’s commitment to low rates. In addition, if the Fed were to engage in either active Operation Twist or in draining reserves through large-scale reverse repos, lowering IOER could prevent either of those actions from putting unwanted upward pressure on frontend interest rates.
What else could the Fed do? One point to keep in mind is that much of the Fed’s creativity during the financial crisis was in getting liquidity to cash-strapped borrowers and financial institutions. Stimulating a lethargic economy is an entirely different operation. With that in mind, one set of more radical options includes invoking the Fed’s section 13-3 powers, which allow it to lend to broad classes of nonbank borrowers, provided the Treasury secretary signs off and conditions are deemed exigent and unusual. Its possible that the Fed could create something like a Small Business Lending Facility to help the nonfinancial sectors of the economy. Such a move would probably encounter fierce resistance from Capitol Hill, and its unlikely the benefits would be seen as worth the risk to Fed independence. How about creating a special purpose vehicle that the Fed lends to that buys stocks? Unless Congress changes the Federal Reserve Act, this won’t happen. Section 13-3 lending can only be undertaken if the loans are secured such that there is no risk to the taxpayer. Given the inherent volatility in equity prices, this would appear to rule out this potential scheme. Another outside-the-box option is for the Fed to increase its inflation target. This idea was floated by some Fed officials last fall but was shot down by Chairman Bernanke in no uncertain terms. It would appear that currently the hurdle to this option is extremely high.
China Takes Different Approach
HK’s 2Q11 GDP growth disappoints on external weakness. The economy expanded 5.1% yoy in real terms vs. market forecasts of 6%, down from 7.5% in 1Q11. The biggest shortfall in growth impetus in 2Q11 was in external trade. The softening in external demand stretched the merchandise trade deficit by 30% yoy to 27% of GDP, contributing 4.6% decline in real GDP. In mainland China, latest data showed that M2 growth slowed visibly to 14.7% yoy in July, down from 15.9% in June and significantly lower than consensus of 15.8%. This is the first time since end-2008 that M2 growth fell below 15%. New loans came in at RMB493bn in July, also significantly below market expectation of RMB550bn and slowing from RMB634bn in June. Both figures indicate that monetary conditions remained tight in July, as a result of the strict implementation of credit quotas and the aggressive RRR hikes. Although rates and RRR are tentatively on hold, we do not expect immediate easing in monetary policy, as the government is still worried about CPI.
Moreover, YTD FAI growth came in at 25.4% yoy. China's exports and imports respectively grew BTE at 20.4% and 22.9% yoy in July, with the trade surplus widened to USD31.5bn in July vs. USD7.7bn per month in 1H11. This would force PBOC, via FX intervention, to create new liquidity in the banking system. It therefore makes a cut in RRR unlikely in the near term. Given the rapid deterioration in US/EU growth outlook, it is estimated that China export growth will likely slow to 10-12% yoy in 2H. By Nov-Dec, export growth may fall to single digit levels. China's industrial production (IP) rose 14.0% yoy in July, LTE. I believe this has yet fully reflected the weakening outlook of export demand and commodity prices given that the IP growth of textile, electronics and metal smelting only softened marginally.
Policy wise, I continue to see interest rate policy remaining on hold. The deterioration in the global growth outlook and the latest financial market turmoil are undoubtedly concerns to authorities. But China’s CPI inflation rate reached a new cycle high of 6.5% last month. Even though this move likely represents a peak, the authorities will feel constrained to act to support growth, absent a greater global threat. Some greater currency flexibility may be forthcoming as a tool to tame inflation and support domestic demand. In fact, RMB has appreciated beyond 6.4 per USD for the first time in 17 years. It looks like China has taken up a different approach on currency this time vs. 2008. Looking forward, inflation should peak in August. Thus, there is room for loosening in 4Q as inflation slows. However, market correction has not reached 2008 trough valuations (5.7x PER and 1.2x PBV) which I think this is unlikely as the outlook is not as dire. However selected sectors such as Sportswear, Telecom, banks, utilities, transports and power equipment are at or below their 2008 trough valuations and are overly-discounted.
Lessons from 2008 showed that materials and energy has the most downside risk in a correction. In a rebound, sectors that do the best are those that will benefit from policy response such as materials, consumers and industrials. Internet and consumers do well in up and down markets. China may not need a new stimulus, but there is urgency to generate more domestic growth and accelerate existing policies. Consumer, Internet and Social housing plays should do well. Property and Auto sector could surprise. Macau plays and HK consumer will benefit from RMB internationalization ……Lastly, regional wise, MSCI China is now traded at 9.7XPE11 and 19.5% EG11, CSI 300 at 13XPE11 and 25.2% EG11, and Hang Seng at 10XPE11 and 22.4% EG11, while MXASJ region is traded at 11.1XPE11 and +11% EG11.
Don’t Be Too Bearish on Oil
Market turmoil over these first two weeks of August has led to at times extreme volatility across asset classes and high risk commodities have fully participated in this chaos. Concerns are rising that a slowdown in global growth will negatively impact commodity demand growth lead and lead to lower prices especially at a time of high metal inventory cover and sharply world rising supply. Thus far there is no sign of the traumatic slump in commodity demand and prices that we saw at the time of the 2H08 – 1H09 financial crises. It's worth noting for example, that the key metal consuming automobile manufacturing sector in US and Japan is running hard to catch up on the Japanese earthquake induced supplier disruption. Japanese vehicle production in April at 292K units was the lowest in decades, but output rose 68% in May mom and a further 52% in June to 742K units.
Bulk commodity prices of for example iron ore, coking and thermal coal and alumina have been shielded from the chaos as they have less speculative involvement. Richly priced gold has had a life of its own and is vulnerable to the downside, whilst silver, platinum and palladium have struggled. Industrial metals are all now lower than their end 2010 levels with aluminum the best (-2%) and nickel the worst (-12%). In short, this is a situation where prices are influenced more by macro developments than changes in underlying fundamentals. That said, I doubt that a further deterioration in the economic climate could return oil prices to the lows of 2009. In early 2009, Brent fell to USD40/bbl from nearly USD150/bbl in July 2008 as the global economy contracted sharply, driving down industrial demand. This was exacerbated by the sharp rise in prices during 2008, which caused demand destruction as retail consumers changed their behavior. OPEC did react to the fall in prices, but the speed of the collapse in demand meant it could not react in time.
For oil prices to fall below USD90, we believe OPEC would need to lose control of the market. That would require a multi-year slowdown in demand, in our view. But such events are fairly rare. Over the past forty five years, it has only occurred in 1974-75, 1980-1983 and 2008-9, in each case preceded by a very sharp year-on-year rise in oil prices (quadrupling in 1974 and 1980, doubling in 2008). That ingredient is absent in 2011. Emerging Market growth will likely be the key factor for prices in the near term. EM economies are in much better shape, and they are twice as energy-intensive as the OECD and use oil in more industrial processes than the OECD. We expect them to account for 95% of the rise in global demand for oil in 2012. But even under a global 'pause for-breath' scenario in 2012, we believe OPEC could support prices should they fall below its desired level, which we believe to be USD90/b. Saudi's production has risen by nearly 2mb/d since the beginning of 2010 and we believe the kingdom would be willing to cut production by a similar amount to support prices should the USD90/b level be threatened.
Good night, my dear friends!
