My Diary 693 --- Why EMs in lockstep with DMs? The Outshining UST is Overdone; Hot- to-be Negative in China; No Alternative Safe Haven Exists
Sunday, October 02, 2011
“It’s not about Fundamentals, but Risk Premium” --- Tomorrow will start a huge month for global financial markets with several critical events to be closely watched --- 1) EFSF decisions; 2) Bernanke’s Economic testimony in US Congress; 3) US budget super-committee proposals and 4) a G4 central bank easing cycle. That said, commodities have underperformed lately, given the widespread fears of another global recession, dragged by the seemly never-ending European sovereign debt crisis. Certainly a stronger USD (DXY +6% mom to 78.6) didn't help as well. Copper had its worst month since 05Dec2008 with a -24.33% fall while Gold saw its biggest decline since 1983 after a -11.24% move on the month. The CRB index fell 13% on the month as well. Moreover, it is interesting to observe that foreign investors suddenly focus on 5yr China CDS, of which it is closed at 198bps (+15% wow and +84% mom), implying ~16% probability of default in the next 5yrs. Indeed a Bloomberg poll showed that 59% of respondents expect China's GDP to fall to less than 5% annually by 2016. 12% of respondents expect such a move within a year and 47% expect it will unfold over 2-5 years.
For the latest bearish views to China, I personally quite agree with Mr. Minggao Shen (Citigroup’s China Economist) that” …It's always cheap to talk about China collapsing because you don't need to prove it. You can easily argue that the property sector is collapsing, local government debt and shadow banking blowing up, and SMEs bankrupting, and so China is collapsing as it would in many other countries…” However, all these extreme bears ignore several basic facts -- 1) Unlike EU, Chinese policymakers can react swiftly in crisis periods, supported by its much healthier public B/S; 2) Chinese model can adjust itself and evolve through learning from the lessons set-up by other countries; 3) China will not see a banking crisis before a economic crisis as the underlying collateral of banking sector is China economy and 4) China’s economic fundamentals remain healthy, with RMB still appreciating, PMI better than expected and labor market held tight. That being said, with stronger balance sheet, higher growth, and much better policy maneuverability, China has done poorly in the past weeks. I think that isn't about fundamentals, but risk premium. Unfortunately risk premiums are driven by policies. In the past 2.5 years, with massive stimulus and implicitly promises protection against tail events, risk premiums declined along all asset classes. But now US has an issue of ability when QE2 proven ineffective and UST yield curve already twisted, while in EU it is willingness. US policies can no longer warrant growth while EU policies have shown little signs of preventing tail events. So the investors will question who else can self-rescue? The only one with that power is China. But China has an issue on both ability (the entire unpleasant legacy from the RMB 4trn program) and willingness (with strong growth and all domestic issues such as inflation, NPLs, income inequity and property bubble etc). So we will have to live with the elevated risk premiums for some times.
Back to Europe, investors continue to be transfixed by the slow-motion developments in Europe, where the focus has moved from the virtual certainty of a Greek default to the possibility of wider contagion effects on 1) the major Euro-area sovereigns and Spain and Italy, and 2) the European banking system as a whole. The hope in Europe is that things are getting potentially so bad that the chances of seeing something much more substantial from the authorities over the next few weeks have surely increased. Europe has been given a deadline of 6-weeks before the next G20 meeting in Cannes (France). If not then we will really have to think about a financial disaster in the continent. Indeed, the latest development is that Slovenia, Finland and Germany have ratified the EFSF amendments followed other 8 member states (Belgium, France, Greece, Ireland, Italy, Luxembourg, Portugal and Spain). The remaining four is expected to vote in October (Slovakia, Netherlands, Malta and Estonia). Investors have generally think that the biggest form of a firewall is to get the EFSF upsized to EUR440bn and then to leverage this with the use of ECB balance sheet to deliver a size (~EUR2.2trn) that would be truly large enough to get ahead (not necessarily solve) the crisis. However it needs to have the full blessing of the Germans, the ECB and the rating agencies. The political resistance now against using ECB liquidity to leverage up the EFSF is found in Germany, Netherlands, Finland and Slovakia. In Germany, Chancellor Merkel’s junior coalition partner, the FDP, is opposing the monetary leverage of the EFSF, forcing the Finance Minister to ‘guarantee’ that the EFSF would not be leveraged. As a result, some are looking for other ways to use the EFSF efficiently. One is to use EFSF funds to prop up the EIB and creating a SPV fund does not create leverage within EFSF or in my words, it is a leverage outsourcing. The reality is EIB is certainly not a bailout institution for the Euro zone due to several constraints -- 1) EIB's charter currently does not allow sovereign or bank bond buying; 2) EIB has a 2.5x leverage limit (EFSF+ECB=8X leverage) to underpin its AAA rating; and 3) The political issues could be even greater as it may involve all 27 EU member states.
Still, a tangible sense of urgency has finally developed among European policymakers --- there are no more comments that “we won’t be pushed around by the financial markets”. If the meltdown in financial stock prices and soaring periphery borrowing rates did not prod the authorities into seeking a solution, then amounting economic damage and an incipient bank run now seem to have caught their attention. Aside from fears that a banking collapse might occur, one likely reason is that the economic pain has now spread to the healthy German economy, witnessed by the country’s economic activity has slowed, and LEIs have dropped sharply in recent months. While German voters are still in no mood to bail out the “sinners”, they care about their economy (and their banks) and, to some extent, the Euro. Ergo, Chancellor Merkel and other German politicians will have to spend more of their political capital and lend the German B/S, in order to halt the contagion. Elsewhere in Europe, I also saw European Commission rejected a push for a greater haircut on Greece's PSI. Italian, French and Spanish financial market regulators extended their temporary short selling ban on financial stocks. On the micro front, Credit Agricole became the latest bank to join the deleveraging train after announcing plans to reduce its debt funding requirements by EUR50bn by Dece2012. Whilst its perhaps prudent for one entity to delever, my concern is that if numerous entities embark on such a strategy it can create near-term macro damage to the economy out-weighing the micro benefits.
Ultimately, relief of Euro area stress will require concrete decisions that address Greek restructuring, leveraging EFSF firepower, and the recapitalization of European banks. Investors are likely to see some incremental progress on a range of issues in coming weeks, with the risk of continued financial market stress until decisions are announced. In particular, there is still considerable uncertainty about the near-term outlook for Greece. The decision on the sixth disbursement of the original bailout package is likely to be delayed until mid-to-late October, pushing things close to the wire in terms of outright default. Meanwhile, the July agreement is unraveling. Due to slippage in both the Greek fiscal deficit and asset sales, and a higher cost of the credit enhancement in the debt exchange, the need for official financing could exceed EUR109bn by as much as EUR30bn. It is likely that the private sector will be asked to contribute more to debt restructuring.
With respect to global macro, the signs are mounting that significant damage was done to the Euro area by the intensification of the debt crisis in recent months. Euro area economic sentiment plunged by 3.4pts to 95.0 in September following an even larger drop in August. In terms of levels, both the composite PMI and the EC sentiment indicator are signaling broadly stagnant GDP growth at the end of 3Q11. Street economists expect the Euro area to slide into recession in 4Q11. The contraction is expected to last through 1H12 and to involve a peak to trough decline in the level of GDP of just under 1%. This looks like a pretty mild, as in the recessions of the mid-70s, early-80s and early-90s, the Euro area saw peak to trough declines in the level of GDP of 2.5%, 0.5% and 1.9% respectively. And in the 2008/09 recession, GDP fell by a staggering 5.5%. Across the ocean, US Q2 GDP growth was revised up to 1.3%. The growth of consumption (0.7%) and net exports were revised up, whereas capital equipment spending (6.3%) was marked down. Separately, the index of pending home sales fell 1.2% in August after a similar-sized drop in July, suggesting September existing home sales could decline about 3.5%. US initial jobless claims tumbled to 391K in the latest week but the Labor Department cautioned the decline may reflect faulty seasonal factors. Most of the data out this week point to an economy that is not materially accelerating or decelerating. The outlook continues to anticipate 1.0% growth in Q4.The data next week should give important hints regarding the momentum of the economy at the end of 3Q11, including regional factory surveys, the national ISM survey and September employment report. Also up on the calendar is Chairman Bernanke’s assessment of the economy to Congress on Tuesday morning.
In addition, the previous week’s easing in Fed policy is set to be reinforced by moves by ECB and BOE next week. In UK, recent commentary from MPC has been overt in suggesting a rising likelihood of further policy ease. I think that a majority on the committee have already seen enough to vote for GBP50bn of additional gilt purchases next week. That said, JPMorgan economists think ECB officials will take the bold step of cutting the policy rate 50bp to 1.0% by arguing that the inflation risks had shifted to balanced, and that ECB appeared to respond very strongly to the signs of slower growth. Second, the sovereign crisis has entered a more dangerous and systemic phase and this is prompting a number of surprising U-turns from the ECB. For example, it restarted its government bond purchases and now appears willing to reintroduce one-year tenders, even though it did not feel comfortable with them in 2009 and was very keen to phase them out. Third, Trichet may be inclined to deliver a rate cut in his final meeting to save his Italian successor from having to act at his first meeting. At the margin, the broader context of the meeting could make larger policy actions more likely. But I think the call on interest rates is a difficult one. Latest Euro area inflation increased to 3.0% yoy (cons=2.5) in September and reached a 3-year high, although this was anticipated.
X-asset Market Thoughts
On the weekly basis, global stocks finally climbed +1.01%, with -0.6% in US, +4.5% in EU, +1.81% in Japan and +2.6% in EMs. In Asia, MXASJ added 1.40% and MSCI China -0.28%, while CSI300 -3.3%. MXCN’s valuation is now at the 2008 trough level of 7.3X PE12. Elsewhere, 2yr USTs rise 3bp to 0.24% while 10yr +8bp to 1.83%. Yields dropped across the Euro area periphery with Greek, Irish, and Portuguese 2yr yields -587bp, -184bp and -41bp, respectively. The 3M Euribor-OIS shrank 8bp to 81bp. Brent crude dropped 2.23% to $104.26/bbl. The USD gained 0.84% to 1.3387EUR and 0.6% to 77.1JPY. CRB dropped 1.23% to 298.15, while Gold price was down 1.38% to $1628/oz.
Looking forward, it seems that 2011 is following a similar trajectory as the run-up to 2008-09 financial crises. The readings for August are identical for both years --- new export orders are also pointing south, as well as the all important new order/inventory ratio, a good LEI of industrial production. The question is what happens next? While I think much more money printing is to come, it is getting more difficult to be proactive with inflation still elevated. Thus policymakers will have to wait to be reactive when problems are more center stage and inflation is perhaps plummeting. For now, while we are in a near liquidity trap and twisting the yield curve is only going to have marginal benefits to the economy, not all trends are gloomy. The correction in commodity prices will eventually provide support to the global economy. Investors also need to watch for China to soon respond to both the easing in the inflation threat and escalation in economic risks. Also, even the sluggish US economy has not (yet) slid into recession. The corporate sector is far healthier than in 2007-2008, and is willing to invest, albeit not robustly, and hiring plans have not turned negative. Surveys show a sharp drop in consumer and business sentiment, but this has not translated into a parallel plunge in consumption, hiring and capital spending. However, most of the risks are on the downside and a recession could still develop if the European fiasco drags on much longer and the business sector decides to retreat.
As an optimist, I tend to see the latest market movement as setting the stage for positive surprises. Talking to some seasoned industry friends, most believe EM assets offer a lot of value following the recent sell-off that has hit EM equities, currencies and most recently, bonds. However, the fear of a re-run of 2008 keeps everyone on the sidelines and high cash positions remain the preferred defensive strategy. Nobody had a clear sense of where we go from here. However, investors said their bearishness would abate if we were to see an orderly resolution of the debt crisis in Greece, containment for European banks and ring-fencing of the other sovereigns. In short, patience is still warranted given repeated disappointments.
Why EMs in lockstep with DMs?
The recent loss in global growth momentum has been broad-based. In Euro area, Italy and possibly Spain have joined Portugal and Greece in recession this quarter. A sharp drop in Euro area business confidence and in the September PMI composite --- where the new orders index fell to 44.8 --- suggests that a region-wide recession is taking hold. In comparison, US growth remains subpar but readings for August and September do not yet point to a recession. This message should be reinforced by next week’s key September releases expected to show a stable ISM manuf index (50), rising auto sales (12.8mn), and a modest rise in NFP (90K). The risk is on consumer side as the CB consumer confidence barely rose from 45.2 to 45.4 in September following the 14pt drop in August. The index of current conditions fell from 34.3 to 32.5 in September, while the index of expectations rose from 52.4 to 54. Consumer confidence remains stagnant and may lead to spending restraint by households in the remainder of this year. Poor labor market conditions are weighing heavily on sentiment. The index is 13.5pts below its 12M average, still right on the threshold that historically has signaled recession. 50% of respondents said that jobs were "hard to get," the largest proportion since May 1983. This is evidence that slowing momentum in the labor market is having a knock-on effect on sentiment.
Although Euro area weakness has not, by itself, been a reliable forward indicator of global growth. Indeed, it is common for the region to significantly underperform, and we have witnessed periods of Euro area contraction (1992-93) and stagnation (2002-03) in the early stages of otherwise solid global expansions. here are, however, good reasons to fear the spillovers from Euro area financial stress. Europe’s sovereign debt crisis threatens regional banking sector stability and building stress on banks is fueling a generalized reduction in global risk appetite. The record USD3.2bn outflow from EM dedicated debt funds this week is an indication that financial spillovers can be quite powerful even for countries far removed from Europe. Despite its solid domestic demand growth and strong public sector balance sheets, EM is in the midst of a credit boom with a significant rise in foreign participation in its sovereign and corporate debt markets. Through this linkage, an abrupt tightening in developed world financial conditions will materially weaken EM growth.
With the Euro area expected to enter a mild recession and US GDP growth expected at near 1% through mid-2012, EM exporters are facing a sustained period of weak export demand. Exports to US and Euro area still account for more than 40% of EM GDP. This share has declined from 57% in 2006, but exports to the two big DM markets continue to make up a huge portion of EM output. A good data example is from Singapore where its electronics manufacturing output continued to plummet in August, when it dropped 2.6% mom. The % 3M/3M annualized rate of decline reached 55%, approaching the severe rate of descent recorded at the height of the 2008/09 recession. In fact, over the past decade US and Euro area domestic spending has correlated fairly well with EM export volume (ex China due to data unavailability), yielding RQ of 0.41. This simple regression indicates that a 1%-pt decline in US and Euro area spending growth leads to a 2.7% slowdown in EM export growth. With this in mind, EM export growth is expected to slow to 6% yoy in 4Q11 and just 4% yoy in 1H12. This pace is weaker than at any point in the 2000s expansion save during the SARS scare. However, it falls far short of the collapse experienced during the devasting 2008/09 recession, when EM exports plummeted in excess of 20% annualized in 4Q08 and 1Q09.
As a larger point, I think the base case is that we should not anticipate widespread, aggressive monetary easing in EMs. With DM growth forecast to remain modestly positive (despite a mild recession in Euro area), and with inflation still a high priority for EM policymakers, the majority of EM central banks will leave rates on hold while letting a bit of steam out of the economy. Recent EM currency depreciation adds to official caution on rates. To be sure, policymakers would ease decisively should US and Europe slide into a more serious recession or if there was a major financial event. EM central banks slashed rates about 300bp in late 2008 and 2009 but, as now, inflation concerns kept them from acting in preemptive fashion, so growth in the EM fell almost in lockstep with the DM.
The Outshining USTs is Overdone
Those investors who were betting on Ben Bernanke should be very happy in this summer as this has been the most profitable trade for govt bond investors in 16 years, defying lawmakers in US and abroad who said Fed chairman’s policies would lead to runaway inflation and USD debasement. USTs with maturity >= 10 years have returned 28% in 2011, exceeding the 24.4% gain in all of 2008 during worst financial crisis since the Great Depression, according Merrill Lynch indexes. Not since 1995, when the securities soared 30.7%, have investors done so well owning LT US government debt. Looking ahead, according to Franklin Templeton, even with the rally, the difference between 10yr and 30yr UST yields, at 107bp, remains wider than its average of 50bp during the past two decades. That suggests the gains in longer-term debt have scope to continue,.
Indeed, investor concern regarding the deteriorating global growth backdrop has led to a stampede into US, UK. and German government bonds at the expense of risk assets (including equities, spread product and periphery European sovereign debt markets). Government debt markets have also benefited from aggressive support from the major central banks and another round of unorthodox policy. In particular, the Fed’s conditional commitment to remain on hold until mid-2013 (if needed) and the introduction of “Operation Twist”, helped drive down the long-end of the curve. Most other central banks have either eased or backed away from their tightening campaigns in response to weakness in the global economy. However, I do think the bond market is now priced for at least a mild recession. The flight to safety and central bank reassurance that interest rates will remain anchored have caused government bonds to become extremely overbought and overvalued relative to their LT fundamentals. Likewise, the selloff in spread product (HY Corp debt) seems overdone, unless the global economy enters a deep or prolonged recession. Nonetheless, a gradual backup in government bond yields and narrowing in both corporate and EM spreads will require some sort of resolution on the European sovereign debt crisis. Until then, risks to the global financial system and economy will escalate and deflationary pressures will intensify.
To sum up, the rally into government bonds is overdone but a reversal will await a policy resolution to the European debt crisis. Even then, the backup in yields will be gradual as policy will lag and disinflationary pressures will linger. Thus, I think the duration strategy should be neutral for now and investors could UW government bonds and OW corporate debt.
Hot- to-be Negative in China
China is becoming a hot topic for markets at the moment and there is increasing chatter/focus on the downside risk. Over the week I saw couple of negative reports is causing heavy selling after more reports on China slowdown ,with focus on 25 Wenzhou SME's default on underground loan sharks, CLSA saying luxury goods and Macau gaming sectors set to fall, and US Justice dept launched a probe into accounting at Chinese internet names listed in US. The property sector also caught attention as a regulatory investigation into Chinese developers' trust transactions has led a few Chinese HY property bonds down as much as 30-40pts from the highs. Put this negative aside for a while, China’s manufacturing PMI actually ticked up modestly again in September, to register at 51.2 (cons=51.1), compared to 50.9 in August and 50.7 in July, suggesting that China’s industrial activity continues to track a steady, moderate growth trend amid growing uncertainty on DM final demand. This echo what PBOC governor, Zhou Xiaochuan, said last week that”…China would maintain monetary policy as govt believe China growth is still strong and inflation concern remains in short term. “
Sector wise, consumer discretionary was sold down badly (avg 20-40% in a month) due to concerns of growth slowdown, YTD outperformance and rich valuation. But I think the sector worth for accumulation in the coming month if we see 1) a meaningful SSG slowdown (Q411); 2) more clarity on the gift card regulations (early 2012) and 3) signs of government policy easing. For property, the recent sell-off has brought the sector’s valuation (60% NAV disc, 6.7x PE11) back to the trough level. Fundamental wise, according to, the total transacted GFA in 20 key cities recorded in Jan-Sep was 92.5mn sqm, down 10.3% yoy from the 103.1mn sqm GFA in the corresponding period of FY10. ASP remains intact in contrast with average 7% yoy gain in 16 cities. Investors generally believe a scenario of “No-Gold-September” based on 1) a skepticism to China economy;2) a very stringent credit environment; and3) a less seasonality pattern after the launching of purchasing limits. The current market environment may provide interesting opportunity for equity investors who can buy CBs with attractive yields through some short-dated safe haven names. I.e. BB/Ba2 rated Agile 2016 (April 2014 put) with 14.3% YTP (129% premium). The company has a land bank of 32mn sqm, focusing on residential development, with a manageable balance sheet liquidity position in the next 18 months.
Moreover, finally we got to see the unknown part of private loans sector. In Wenzhou city, media reports that there are 25 cases of biz owners or loan sharks escaping away in Sep alone and a totally of 80 cases since Apr. Among the lenders to the loan sharks, many are actually govt workers, showing the degree of participation and involvement into the private lending business from different social classes. A key reason for explosive growth in underground lending is the massive inflow from the household deposits - benchmark deposit rates are pathetically low in the high inflationary environment, and household sector is now much proactive and keen in managing and protecting their wealth. To really address the issue of underground lending and SMEs' financing problems, government should push forward the interest rate deregulation. Such a phenomenon has caused a 12% markdown of MinSheng Bank in a day (now 0.7xPB12). I think this is a bit too much as MSB is a bank with 15 years of clean track record with no NPL carve-out and for its own LT growth (i.e. price credit risks). Though China has +30mn SMEs and average life cycle is 2.9 years, most of them have very limited access to bank loans. The threat to banks' NPL should be very limited as it has always been difficult for SMEs to borrow, especially so in the past year when credit was tightened. Systemic wide, By July 011, the amount of SME loans is RMN9.85trn or 29% of industry corporate loans. CBRC officials was quoted that it might tolerate NPL ratio of 5% under the current bleak global economic outlook…Lastly, regional wise, MSCI China is now traded at 8.4XPE11 and 18.7% EG11, CSI 300 at 11.9XPE11 and 24.0% EG11, and Hang Seng at 8.9XPE11 and 22.6% EG11, while MXASJ region is traded at 10.5XPE11 and +8.8% EG11.
No Alternative Safe Haven Exists
Last week's gloomy outlook for global growth has caused an exodus from risk assets such as equities and commodities. The main beneficiary of this repositioning has been USD, at the expense of nearly every other currency (-10% for AUD and NZD). This flight to USD has taken place despite the fact that there has been no improvement in the structural position in US. The USD has benefited simply because no alternative safe haven exists. The JPY and CHF have both been taken out of play by official intervention to halt their appreciation; and other countries with the structural characteristics of safe havens do not possess currencies with sufficient liquidity to absorb safe-haven flows.
Looking ahead, the 2011 policy roadmap is eerily similar to the past 24 months, especially after the latest two Fed meetings left markets underwhelmed. But until QE3 is credibly articulated by Bernanke, there could be more downside for risky assets and further upside for USD. Apart from the Fed, efforts by European officials to stem their sovereign debt crisis and an end to Chinese tightening would also go a long way to supporting global growth and stabilizing risky assets. When the outlook for global growth improves, I expect USD to retrace. But for now the reality is that the FX market and financial markets more broadly still face concerns about Euro area bank capitalization, the yet-to-be delivered tranche of EU/IMF/ECB financial aid to Greece, and weakening economic growth on an increasingly global scale.
With the estimate for Euro zone GDP expected to shrink by as much as 1% yoy before resuming growth in 2H12, there is some discussion over global oil demand. In the 2009 recession, when regional GDP contracted by 4.2%, oil demand fell by 700 kbd—a rate consistent with 500 kbd contraction in demand seen in the 1992/93 recession, when GDP shrunk by 3.5%. As such, a European recession by itself is important, but not catastrophic for global oil demand. Of greater concern is the issue of global contagion. A 1% fall in GDP growth in mature economies tends to translate to a 1% drop in global GDP, which in turn feeds through to a 500 kbd reduction in world oil demand growth. Given JPMorgan's recent 0.5% downshift to global GDP, it is likely that global oil demand growth projection for 2012 is to be lowered by 1mbd.
Good night, my dear friends!
