My Diary 686 --- The Stresses Getting Bigger; Why Not Buy Italian and Spanish; China Inflation & Market Outlook; Stay Overweight with Gold
Sunday, August 07, 2011
“Can we get rid of Debt and Death?” --- On the Friday lunch, a friend of mine asked the question after seeing the worst trading session YTD. My answer is NO and the ultimate way to get rid of DEBT is DEATH, though it sounds a bit tough. That being said, investors just experienced the free-fall Thursday with 1M US T-bills in negative territory, crude down USD6/bbl, and many global bourses suffering their largest one day decline in 2 years. The ~5% plunge in S&P500 was larger than that seen on the day after Lehman collapsed. The VIX also saw the biggest jump (35.4%) since Feb2007 and is now trading at its highest level since July 2010. In Asia, Nikkei, Hangseng, and Kospi fell -3.5%, -4.7% and -3.3%, respectively. In credit space, Asia iTraxx was 13bp wider at 137bp while The European iTraxx Financial Senior index closed at the wides of 205bp to find itself testing its the post-Lehman highs of 209bp (Mar2009) and Jan2011 wides of 210bp when the bail-in clauses for European banks were first introduced in an European white paper. Even gold was closed 0.71% lower at USD 1654.75/oz on that terrifying night. To put it mildly, risk is off and systemic fears are spiraling.
Fund flow wise, capitulation out of equities & MMF was accompanied by the record inflows to commodities and gold. Money markets funds saw massive USD70bn redemptions, the biggest 1-week outflow since Lehman bankruptcy. Indeed, Lehman MMF outflow was driven entirely by CP, plus other non-government security outflows reflecting extreme corporate credit crunch. In contrast this week’s MF outflows also caused by redemptions of very ST government securities which accounted for almost half outflow. Equities suffered USD11.2bn outflows with Long-Only USD6.5bn redemptions from Los, THE largest since May 2010. Commodities have record inflows of USD2.8bn, with mostly into gold. Bonds had the first outflow in 6 weeks of USD1.2bn, but relatively subdued compared with other asset classes.
The street was attributed the irreversible destruction of risk market on Thursday to ECB. That night, the "heavy use of ECB deposit facility is mark of tension" did drastic damage to confidence winding fears that systemic risk is a real possibility - the fear is that European banks may see the same run on them that US banks did in 2008-09. But some are speculated that Wall Street investors are noticed ahead of Asian peers the downgrade of US sovereign rating. I have no clue of this kind of conspiracy guesswork. However, history will mark down the date -- August 05, 2011, the day that US had its AAA for the first time by Standard & Poor’s. The rating agency also kept the outlook at “negative.” The downgrade reflects S&P’s opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics, S&P said in a statement. In the same token, Moody’s and Fitch Ratings affirmed their AAA credit ratings on Aug. 2, the day President Barack Obama signed a bill that ended the debt-ceiling debate. Moody’s and Fitch also said that downgrades were possible if lawmakers fail to enact debt reduction measures and the economy weakens. In short, the rating downgrade is not a big surprise to the market. Standard & Poor’s warned on July 14 that it would reduce the rating in the absence of a “credible” plan to lower deficits even if the nation’s USD14.3trn debt limit was lifted. The agency also assigned a 50% probability of 1-notch, 20% probability more than 1-notch, 30% on hold. Even with the specter of a downgrade, investors’ demand for USTs has surged as investors saw few alternatives to the traditional refuge during times of risk as concern increased global growth is slowing and Europe’s sovereign debt crisis is spreading. Over the past 5 days, 2yr UST yield dropped 7bps to 0.288% and 10 yr down 24bp to 2.558%. Historically, UST yields on average are 70bp less than the rest of the world’s sovereign debt markets. In the medium term, the US credit-rating cut would likely raise the nation’s borrowing costs by increasing UST yields by 60-70bp. No doubt, the rating cut will hurt USD‘s status as the only reserve currency. As of Friday, DXY has lost 13.36% annualized since the beginning of this year. According to IMF, the USD’s portion of global FX reserves dropped to 60.7% in the period ended March 31, from a peak of 72.7% percent in 2001.
While the attention of the world has been focused on the US debt ceiling/downgrade and European sovereign headlines, data and economic weakness has also added to financial market volatility. The recent economic data from the US has been weak enough to raise concerns of a cycle turn rather than merely a soft patch. I believe that the slump in risk asset pricing over the last week may not be a blip but a re-pricing to reflect recent economic data. In particular, the US real GDP forecast is revised down and now looks for 1.5% growth in 3Q11 and only 2.0% over the coming year. As a result, the D/G rating action could further hurt the US economy over time by increasing the cost of mortgages and auto loans, of which their interest rates are referred to USTs. JPMorgan estimated that a downgrade would raise the nation’s borrowing costs by USD100bn a year. As a reference, US spent USD414bn on interest expense in fiscal 2010, or 2.7% GDP, according to Treasury Department data. Looking forward, the US expansion will be trapped by an ongoing tension between cyclical lift and structural drags in the aftermath of a damaging financial crisis and deficit cut. Having said so, support for lifts are still present: easy monetary policy (that’s potentially getting easier), easing credit standards (albeit from tight levels), healthy corporate B/S, pent up demand for business Capex spending. Stacked against it is the shift of fiscal policy from a support to a drag, ongoing deleveraging in the household sector, and heightened uncertainty. That said, the Fed is almost surely revising down its growth forecast as well. The Fed will likely respond by altering next Tuesday’s policy statement to indicate that the current policy of reinvesting principal payments will be maintained for an extended period. In addition, the reinvestment policy probably will extend the average maturity of Fed holdings. There is almost no chance that the Fed will begin another round of large-scale asset purchases, however, in my own views.
The string of soft data continues, and is pointing to downside risk to the global GDP outlook for the current quarter. The disappointing manuf. PMIs in the country level suggests that the slowdown in the industrial sector is carrying through midyear. While this partly reflects a lingering of the correction in the pace of stock-building, it also likely reflects continued weakness in final demand growth. While tentative signs suggest consumer spending began lifting in June in parts of Asia (Japan, China and Korea) and in Europe (EMU, Poland and Russia), spending in US was unchanged in June. In particular, real consumer spending growth in US fell 0.03% in June. This decline (albeit small) marks the third straight monthly decrease -- a first outside of a recession in US recorded history back to 1959. The move raises the question of whether there is a behavioral shift underway. As a result, the risk is that businesses become overly cautious, reducing spending and hiring, and this feeds into further declines in final demand growth. In an interview last week with the WSJ, three former Fed officials (Kohn, Madigan, and Reinhart) assigned the risk of a recession at between 20-40%. The former two said the Fed should consider a third round of bond purchases only if inflation slows from recent elevated levels and if the economy continues to underperform but also warned that QE3 would not be the silver bullet.
In Europe, the EU area economic sentiment (ZEW = -7.0 vs. cons.= -5.9) declined at a faster rate in July to a level significantly below LT average. The EC survey reinforces the message from the Euro area PMI (50.4) that region-wide growth is dropping to a below-trend pace. The EC survey also registered a drop in capacity utilization in manufacturing, whose high level has been mentioned by the ECB as a potential source of inflation pressure. The ECB's latest Bank Lending survey, conducted in the second half of June, showed that banks continued to tighten lending standards. In contrast, Asia is the one region of the world in which there is a clear-cut pickup in final demand under way. The new orders index provides the most striking divergence between East and West. In Asia, again with the exception of Taiwan, new orders have held up well, if not accelerated. In the West, by contrast, and therefore for the Global PMI as well, new orders are now in uniformly negative territory. Interestingly, new export orders are showing the opposite trend: rising in the West and declining in Asia. Therefore, both the new order and the new export order series send a consistent message -- local demand in the region is growing robustly, helping to sustain shipments from the West, but exports from Asia to Europe and the US are struggling. The East, in short, now undoubtedly leads the world. Looking ahead into 2H, Japan is bouncing from a demand shock and Chinese domestic indicators are starting to firm. On the heels of a solid gain in June, Chinese retail sales are expected to have accelerated to a robust pace in July. Momentum in FAI should also be building as affordable housing investment ramps up through this quarter. Still downside risks to the EM Asian outlook are building. A weaker projected global growth backdrop in light of recent downward revisions to GDP growth in US and Western Europe, along with soft readings from this week’s July PMIs across the region, suggests a LTE 2H11 bounce in activity. Consequently, downward revisions are likely.
With the global economy struggling, eyes are turning to policy yet again. But fiscal policy has reached its limit and is now reversing course. The pace of fiscal tightening is set to pick up. After rising 0.5% of GDP this year, global fiscal net lending is projected to rise by an additional 1.2% of GDP. The coming fiscal crunch puts the onus of supporting the recovery squarely on the shoulders of monetary policy. And central banks are already responding. ECB resumed its bond purchasing program to ease financial stress (although restricted to IRL and PRT). Following a surprise SNB ease to lower CHF, tBoJ bumped up its asset purchases (from JPY40trn to JPY 50trn) to effectively leave unsterilized the MoF’s intervention to weaken JPY. Future markets have also pushed back rate hikes for the Fed (from early 2013 to mid-2013) and for the BoE (from early 2012 to late 2012). This follows on the heels of delays in recent weeks in rate hikes for the RBA, BoC, and Riksbank. Monetary policy easing has not been restricted to the developed markets. As has been a running theme in these pages for the past couple of months, rates hikes across the EM have been delayed until late this year at the earliest. This week, I saw EM economists called Russia to just a single hike in November. Most surprising was the central bank of Turkey’s unexpected 50bp cut in its key policy rate. The CBRT also cut the RRR on FX deposits to provide liquidity to the banking system, while it also began selling USD to support the declining Lira.
X-asset Market Thoughts
On the weekly basis, global stocks dropped 8.57%, with -7.35% in US, -9.91% in Europe, -4.8% in Japan and -9.92% in EMs. Since setting a peak on July 22, global equities are down more than 11%. Elsewhere, USTs held up well with, 2yr yield dropped 7bps to 0.29%, 10 yr down 24bp to 2.56% and 30yr declined 27bp to 3.85%. 2yr Italian sovereign bond yield added 19bp to 4.42% and with the falling 2yr bund yield (-39bp to 0.76%), the spread expanded to 366bps. Spanish and other peripheral yields were down, with the exception of longer dated Greeks. Brent oil lost 6.31% to $109.37/bbl. The 3M Euribor-OIS spread climbed 17bp to 52.5bp. The VIX jumped 27% to 32.0, a more than year-high. CRB index lost 4.47% to 326.8, while spot gold climbed 2.06% to $1657/oz. EUR softened 0.8% to 1.4282USD and JPY weakened 2.12% to 78.4USD. DXY rallied 0.95% to 74.598.
Looking forward, while the triggers differ, the ultimate source of each crisis surrounds debt sustainability. Over the next two years, fiscal policy in US is set to tighten significantly, halving the federal government primary deficit. However, US remains far off a path that stabilizes debt by the middle of this decade. Indeed, based on current projection, the US needs additional adjustment of close to 4% of GDP to keep US general government debt from rising well above 100% of GDP. Even larger adjustments will be needed to offset the effects of rising debt service costs and an aging population into the next decade. That being discussed, the outlook for QE3 is not as good as last year as rising recession fears are now not coinciding with falling inflation expectations. Unlike last August, when the 5y5y FW BE inflation rate fell below 2.2%, this year this rate has risen to just under 3.2%, virtually precluding another QE stimulus program. Thus, given public sector deleveraging and US recession risk, commodities and credit will be less vulnerable than equities.
With respect to equity market outlook, it’s probably the right time to review and rethink the overall investment process. So far, SP500 had the second-best performance in 2011 among the world’s 10 biggest stock markets, even after the 12 percent slump since April 29 brought the YTD decline to 4.6%. SHCOMP Index did best with a 4.3% drop. Japan’s Topix lost 7.85%, while the Euro Stoxx 50 dropped 9.4%. Indeed, Europe has big problems, US economy is weak and investors are no longer convinced US govt is all out for growth as fiscal austerity is the new plan. Stocks are cracking technically around the world, leveraged accounts are being forced out of bad bets, and people fear a replay of late 2008. Talking heads on CNBC say this is no 2008, and that is likely true. But with the Fed having thrown its best shot, the change in fiscal attitude, Europe and the weakening global economy, stocks being so much closer to 2007 highs rather than 2009 lows means we can likely still have more of a stock pullback.
The question is what's the right level for equities? Let us start from earnings. According to ML, global earning revision ratio continues to fall. Although forecast earnings growth rates remain healthy, they are being consistently cut all around the world. The latest 1M GRR fell from 0.82 to 0.69, and the 3M GRR fell from 0.82 to 0.80. Meanwhile, downgrades dominate in all regions. The 1M ratio fell significantly in US (from 1.12 to 0.79) and in Europe (from 0.87 to 0.57). The 1M ratio also fell in APxJ from 0.76 to 0.64 and in EMs (from 0.77 to 0.66). Earnings expectations continue to be trimmed in Japan. For the current quarter, with 302 companies of SP500 index having reported so far, the average EPS beat is 3.7, slightly below the average of previous reporting seasons. Revenues are also beating by an average 1.9% so far, suggesting that US companies are able to generate decent top line growth even in a low GDP growth environment. But the reporting season is less encouraging in Europe. So far 40% companies are beating estimates in Europe within the DJ Stoxx 600 index, as compared to 78% in US. The strong earnings in US probably underpins the equity outlook as Wall Street has never been more sure that stocks will rally in 2011, even along with the concern of a renewed recession. Chief strategists at 13 banks from Barclays to UBS see S&P 500 surging 17% through Dec. 31, according to Bloomberg. Their projection that the index will reach 1401 hasn’t budged in four weeks.
Fundamentally, US GDP growth has been adjusted from 3-3.5% to 1-1.5% growth path in 2012. This suggests a 10yr yields at 2.55% and the first Fed hike now priced in August 2013. I believe the ~2% decline can be explained with 3 simple items -- 1) fiscal policy is subtracting -1%, and this is increasing; 2) higher oil prices subtract -0.5% and 3) the Japanese earthquake hurt -0.5% as well. Effects of Japan have diminished, but fiscal restraint is increasing. Given the current 2012EPS forecast for SP500 is USD104 and historically, every 50bp change in GDP growth, SP 500 top-down earnings change by approximately $2, a 1.5% GDP growth means SPX earnings go to the USD96-98 range next year. In August 2010, SP500 bottomed at 12.2X 12MFW PE. Thus, the fair value of SPX is around $97 x 12.2 = 1180. Regarding our regional market, the outlook for earnings growth this year and next remains good, forecasted to grow by 16% this year and 13% next. MXASJ is on 11.6X FWPE and 1.7XPB, history tells us peak to trough we have about 15-20% downside from here implying 1.3XPB. In short, equities stand at historically cheap levels, global PE is at 11X vs. LT average of 16.2X, Asia is at 11X vs. LT average of 14.8x. With earnings growth on track and valuations unlikely to be derated further, I expect stock indices to bounce by 10-15% in the next 12 months, in line with earnings.
The Systemic Stresses Getting Bigger
The US economic backdrop seems to be deteriorating further. Following WTE US GDP (1.3%), the July ISM Manufacturing Index fell to 50.9 from 55.3 in June, notably worse than expected, the lowest in two years and leaving the index worryingly close to the breakeven level of 50. Though Friday saw NFP rose by 117K (46K increase in June) and UNE rate slipped to 9.1%, from 9.2%, there are 44% of the unemployed workers in US now have been without a job for 27 weeks or more, near the 45.6% peak in May 2010, the highest of any business cycle in the postwar period. The persistence of high UNE, a concern Bernanke has voiced on several occasions, ripples through the economy. A high jobless rate reinforces low income expectations and can result in an enduring trend of pessimism that makes consumer spending difficult to predict. In fact, real consumer spending declined in April, May, and June. And the slowdown in spending was broad-based, not simply a decline in auto sales reflecting reduced vehicle availability. US CB consumer confidence is now 59.5. Going back to 1970, every time the index has been below the present level, with the exception of 3Q09-to-present (when Fed expanding B/S), the economy has been in recession. Consumer spending decreased 0.2% in June, the biggest drop since Sep2009, compared with a 0.1% increase in May, showing household finances remain strained by lackluster hiring and high unemployment.
In the rest of world, the acceleration in global IP is turning out to be much LTE, with the last set of global manufacturing PMIs even consistent with an outright stall in industrial activity. Regional PMI data worldwide has been poor. Britain's fell to 49.1, Ireland's 48.2, Spain 45.6, Taiwan 46.1 and Australia an incredibly weak 43.4. Even the Chinese HSBC survey which differentiates itself from the government survey with its inclusion of SME's is now below 50 at 49.3. Last month after the US ISM forward looking index of new orders minus inventories, which is now back to levels associated with previous recessions or massive monetary stimulus in 1984 (a 175bp rate cut in 1 meeting followed by another two 50bp rate cuts in the subsequent month) to avoid a recession. For the moment the US has just ended QE2, what does the Thursday leave the markets – calling for QE3 of course and with all the damage done to stocks it may be on the doorstep. I am watch ST BE inflation for clues as to when FOMC may believe deflation is encroaching since CPI will lag too much. So far, a US recession seems a virtual certainty and the respected economists like Martin Feldstein stated the odds were 50-50 and Larry Summers is at 1-in-3.
In response to US markdown and the disappointing July business surveys, further downward revisions are likely in EM Asia. Asian manufacturing is cooling even as accelerating inflation puts pressure on officials to keep tightening monetary policy, adding to headwinds for the global economy after recoveries faltered in US and Europe. Manufacturing in China, Australia and Taiwan weakened in July. Since last June, RMB has appreciated by 5.67% against USD, but has fallen 14.54% against EUR. China is struggling to remain competitive in the outside world which means there is an almighty risk of a capital account unwinds, particularly with QE2 ended and the ECB raising rates. Europe’s debt crisis and a struggling US recovery have cut demand for Asian goods and complicated the task for central banks in a region that’s enacted the world’s steepest interest- rate increases since the start of 2010. Failure to keep tightening would risk exacerbating inflation that’s already breached or is approaching official targets in many Asia nations. South Korea’s inflation (4.7%) quickened to the fastest pace since March, Thailand’s held above 4% for a fourth month and a gauge of Australian prices (3.65) exceeded the central bank’s target ceiling. At the same time while WTI has stalled, Brent is still around USD109/bbl and even worse Asian Mina oil price is now USD117bbl. This 12M MAVG of Asian oil prices is now 37% above the preceding 12 month oil price, and secondly spot price is another 20% higher again. Given the far higher sensitivity to the terms of trade change between oil and other goods in Asia to the rest of the world, Asia is going to struggle very soon.
To sum up, the stresses in the system are clearly getting bigger and bigger. I think investors are starting to price in that for the first time since the financial crisis, there are very few policy options left to further stimulate the economy. Thus, slower growth is ahead of us. It’s my strong view that the Fed is out of options. Everyone wants a weak currency to stimulate exports, as evidenced by the Japanese and Swiss moves this week. Fiscal austerity will also lead to a drag on growth. The European situation adds to market volatility.
Why Not Buy Italian and Spanish Debt
While European leaders last month agreed on a second bailout package for Greece that includes PSI and widens the scope of the European rescue fund, investors aren’t convinced the measures will stop the 21-month crisis from spreading. 10yr Italian bond yields are up 76bp since the summit, while Spanish yields have gained 33bp. The 1oyr Italian-Bund spread reached 416bp last week, a record since the adoption of the single currency. The market for Italian and Spanish government bonds offers an indication of how little confidence Europe’s most recent package of rescue measures has inspired.
Investors’ jitters are dangerous, because they can become a self-fulfilling prophecy. As worries about default push up governments’ cost of borrowing, debts that were once manageable can become unsustainable. Consider Italy, which carries Euro area’s 2nd largest debt burden after Greece. At a 5% cost of borrowing, the government must run a budget surplus of EUR29bn a year -- not including interest payments -- to stabilize its gross government debt at its current level of 120% GDP. At a 10% cost of borrowing, the required surplus rises to about EUR125bn, or 1/6 of all government revenue. That’s roughly what the government spends every year on Italy’s largely state-run health system. At some point, default becomes a necessity.
The ECB responded to the escalating sovereign stress by intervening in the government bond market (via its SMP) and by extending its unlimited provision of liquidity to banks until 1Q12. The latter will help to ease bank funding pressures, but the former seemed more and more half-hearted as wires have reported interventions in the Portuguese and Irish bond markets, but none in the Italian and Spanish markets. It is obvious that ECB does not want to carry more periphery debt on its B/S, but this concern can be relieved by assurances that the EFSF will buy those bonds once the program is amended this Autumn, which brings us to the current "crisis." It is partly a crisis of timing because the market may not be able to hold out until Sept/Oct when amendments to the EFSF are expected to be passed into law by the respective parliaments. Trichet also indicated the ECB is reluctant to shelve further rate increases even as investors reduce bets on the central bank adding to its two rate moves in 2011. While acknowledging a “particularly high” level of uncertainty, ECB rates are still “accommodative” and inflation risks “remain on the upside.” However, an official entity that can act immediately is needed to quell the panic. The only entity capable of doing so is the ECB.
In some senses, the decision not to buy Italian and Spanish debt is understandable. Official buying might do more harm than good by confirming that the markets are dysfunctional. Some may have considered buying Italy as a sign of panic, a "last resort", which would have likely accelerating the pace of investor exit. But the ECB decision not to buy also spooked markets - if the ECB is not prepared to take on the risk, why should anyone else - and yields on Spain and Italy ended some 30bps higher in the aftermath. It was really a case of damned if you do, damned if you don"t. Some are also suggesting that ECB didn't get involved in Italy and Spain because the size of their bond markets - estimated at a combined total of EUR2.2trn - is simply too large for the ECB to get involved. Recall that the current total of SMP purchases to Monday this week was 74bn. Perhaps also the decision not to buy Spain and Italy was motivated by a desire to show that, whilst ready to act when financial stability is at risk, it will only do so for those governments have made an effort to get their fiscal house in order.
Fundamentally, investors were counting on Europe’s biggest economy to lead growth the next six months. Economies in Germany, Sweden and Norway may expand by an average of 3.5% in 2011, compared with a 1.4% in UK, France and Spain, according to Bloomberg. Economies around the periphery of the Euro area -- Greece, Ireland, Portugal, Spain, and Italy --- have three distinct problems: large deficits, high debt, and weak growth potential. However, they don’t have these problems in equal measure. Greece and Portugal are clearly in the worst situation, with very wide deficits, elevated debt levels, and very poor growth prospects. Ranking the other countries is more challenging. Ireland has a very high deficit and an elevated level of debt, but probably has the best growth prospects of this group of countries. Spain has a very wide deficit, but only a modest level of debt and a reasonable growth outlook. Italy, meanwhile, doesn’t have a deficit problem, but it has an elevated level of debt and a serious structural growth problem.
However, the fact remains that the problems facing the Euro zone are still political in nature. The 21 July summit has not come up with a plan seen by the market as credible. Euro leaders still have to agree to the details, ratify them in national parliaments and then implement them. So by stepping in now, surely the ECB is using its non-standard monetary policy to fix problems that remain largely political. EU leaders continue to squabble over the details of the package. EU"s Barroso called for a rapid reassessment of all elements of the EFSF (including its size), but German FinMin said reopening the debate about the EFSF"s powers would not calm markets. The EMU sovereign debt crisis, has risen to a new, more dangerous level. Until now, the funding crisis affected only three smaller member countries—Greece, Portugal and Ireland. EU authorities have re acted by setting up a central funding mechanism—the EFSF—and have given it steadily more powers and money. But each of its actions has had less and less lasting impact as none has so far solved the core instability of the monetary union, which is the lack of a central fiscal authority. If the Euro area were a single country, it would have no funding problems as it has sufficient savings (no current account deficit) and a low government deficit that is only half that of the US, UK and Japan. The problem is that while it acts as one country on monetary policy, it does not do so in fiscal affairs, and it has only a small central budget.
If political will is lacking, Europe does have some options. Instead of replacing the debt of strapped governments with euro bonds, leaders could push the European Central Bank to step in and buy large quantities of troubled governments’ outstanding debt. But that would risk undermining the ECB’s independence and inflation-fighting mandate, and in any case would be only a temporary solution. Ultimately, like the debt crisis in US, Europe’s challenge in resolving its problems boils down to a fundamental social question: Can Germans and Greeks, rich and poor, find common ground? If they can’t, the advanced world is headed down the path to polarization. History suggests it wouldn’t end well.
China Inflation & Market Outlook
Developed markets, burdened with sovereign leverage, are sensitive to small changes in growth expectations. The debt ceiling crisis is a reminder of the risk of fiscal drag on a weak economy. In this environment EM should thrive. But inflation in EM Asia and China is above the central bank target zone. That said, a recent outpouring of fury on Chinese websites over the Wenzhou high-speed rail crash on July 23 has once again spurred the growth/price stability policy debate in China. The consensus view is still that growth is the priority. China’s 2Q FAI to GDP ratio was 53%. The reacceleration in 2H11 growth is based on affordable housing and FAI projects. The result is FAI to GDP above 60%, this is a concern to me because with wage inflation signaling healthy employment conditions and public concern about the rising cost of living, it is rational that policy makers focus on price stability rather than growth.
China’s July data pack is scheduled to be released Aug 9-10. In short, market expect CPI to be 6.4-6.7% yoy, higher PPI to 7.5% (from 7.1%), softer loans, bigger trade surplus. Domestic economists like SYWG expect July CPI stayed high at 6.7% yoy on higher pork prices. Pork price rose sharply at end June and early July, moderating slightly in 2H July. However, prices of other meat, fish, and eggs also surged. As a result, it is estimates that food inflation have stayed above 14% yoy in July while non-food inflation stayed at about 3% yoy. Upstream price pressure is stabilizing, as reflected in commodity and import prices, but the base effect should push July PPI to about 7.5% yoy. Meanwhile, a latest PBOC survey shows that inflation expectations are further entrenched with 64% of respondents expect inflation to continue to rise in August.
Overall, a recession looks not a bad scenario for China. CAO recently estimated total LGFV about RMB10.7 trn (USD1.66trn), or about 27% of 2010 GDP. But China is hardly Greece and a full-blown debt crisis is unlikely. Economists peg total government debt at somewhere between 60- 90% of GDP. But because of how the local debt is structured, only 25- 30% of China's public debt has to be serviced with public revenues, according to GaveKal-Dragonomics, a research firm. That, combined with strong growth and significant assets on the other side of the balance sheet, means the chances of default on a national scale are low. In the near-term, the implications of the US/EU market sell-off and the likely downward revisions to OECD growth forecasts for China’s equity markets are obviously negative. Accordinh to DB economist, assuming US/EU GDP growth is revised down 1%, it would tend to reduce Chinese export growth by 7% and reduce Chinese GDP growth by 1%. This result is based on historical correlation. Meanwhile though China is a major source of demand (about 10% of global crude oil demand and 30-40% for major industrial metals), the US/EU combined account for 40% of global demand for oil and 20-30% for metals. Therefore, even if Chinese demand remains constant, a slowdown in US/EU growth could put significant downward pressure on these commodity prices, thereby reducing the profitability of Chinese producers in these sectors. As a result, investors are adviced to UW container shipping, exporters, ports, base materials, while OW consumer, IPPs and Telco operators ……Lastly, regional wise, MSCI China is now traded at 10.4XPE11 and 19.5% EG11, CSI 300 at 13.1XPE11 and 25.2% EG11, and Hang Seng at 10.6XPE11 and 22.3% EG11, while MXASJ region is traded at 11.6XPE11 and +11.7% EG11.
Stay Overweight on Gold
The BoJ eased the policy last week by increasing APP by JPY10tn to JPY50tn from the current JPY40tn. While this was just in line with market forecast, surprise was the timing and the 1-day MPM meeting statement indicating that BoJ wanted to impress the market participants by emphasizing the close cooperation with MoF, which conducted USDJPY supporting intervention. In short, the main purpose of last week’s easing was not simply to support USDJPY, but also to push up USDJPY (from 76.77 to 78.4), and this also reflects the change in the BoJ's policy response function. In the past, the BoJ has never eased its policy because of JPY, except in the late 1980s. Since 1990s, the BoJ eased the policy, only when strong JPY did hurt or was expected to hurt the economy.
That said, the rating downgrade by S&P over US government it should keep USD under pressure, while the beneficiaries will be the remaining triple-A-rated economies. Since US loses its top credit rating, six Euro-area economies will form the largest bloc of triple-A sovereign debt. In light of the continuing debt problems in the periphery, EUR may not benefit from a US downgrade as much as it would have otherwise. The biggest winners will be the smaller currencies: The dollar-bloc commodity currencies, the Scandis and the Swiss franc. It is impossible for these currencies to dominate global investors’ portfolios since they are just too small. But even a marginal shift in the allocation to these currencies could lead to significant overshoots. This process is already underway in the case of the Swiss franc.
With respect to commodities, all fell in tandem with other risky assets this week, with losses largely driven by energy. Gold managed to maintain its winning streak with another 2% gain. Gold continues to see strong demand via ETFs with a further USD1.2bn inflow this week as investors look for an alternative to the usual safe haven of USTs. Precious metals, especially gold, have benefited from a “perfect storm” in recent months -- falling real interest rates, a weak dollar, fears of US recession and/or debt default, and European stress. These concerns will be recurring themes in the coming years. Bottom line is to stay overweight as the deleterious fiscal situation in both the US and Europe coupled with weaker economic data keep investors bullish gold. That said, there has been talk about BoK buying gold as reserves. This week the Bank of Korea announced that it had bought 25 ton of gold in the past two months, taking its holding to 39 ton. This was the first time the country had bought gold since the Asian crisis in 1997-98, and was in response to worries about the outlook for reserve currencies such as EUR and USD. Korea still has a modest amount of its reserves in gold compared with the region’s other central banks, so there is scope for continued opportunistic buying, especially if gold prices fall back. China currently has 1054 ton of gold (1.6% of reserves), India has 558 ton of gold (8.7% of reserves), while South Korea’s is now 0.5% of reserves. The global average for central banks is 12%. According to the World Gold Council, the official sector became a net buyer of gold last year for the first time in 20 years and bought 155t in the first five months of this year.
Good night, my dear friends!
