My Diary 704 --- Global Econ-Outlook for Next 2Qs; Will ECB Ultimately Step-up; Two Conferences Set China’s Path; A Mixed Outlook of Commodities
Sunday, December 11, 2011
[Note: This diary piece mainly focuses on summarizing the thought & outlook of global asset markets and investment strategies in 2012.]
“Putting the world into EU’s Hands” --- The past week saw investors once again put their fates on European political leaders’ hands. Assets performance were volatile with markets trading on each snippet of news or rumors coming out of Europe, while not paying much attention to better news from US and China. In short, a cold shrug from ECB President Draghi dragged risk markets down on Thursday, but a BTE EU Summit on Friday then brought a net gain for the week. In general, EU summit delivered as much as expected, but still leaves a lot to be resolved. In seeking to contain deficits across the region, the new fiscal compact opens the door to some form of fiscal union further ahead. It may, however, be undermined next year by deficit slippage in the face of recession. The question of liquidity support for sovereigns is more immediate --- Bringing the ESM forward by a year and adding EUR200bn of funding via the IMF can only help, but are not enough to end the funding crisis. ECB, with the greatest ability to stabilize secondary markets, remains a reluctant buyer. As a result, I think the commitment to enshrine balance budgets and 60% debt ratios in domestic laws greatly improves credit quality, but by itself does not guarantee that bond investors will come back. What also worth some inks here is the attention gathered for the allegedly-widening channel between UK and EU. All EU members but Great Britain would adhere to the “fiscal compact” and could pursue joint bond issuance in a few years. That outcome implies that the majority of Europe would harmonize the three major policy domains - monetary, exchange rate and fiscal - while Britain only participates in trade and regulatory discussions. But this outcome probably matters much more for specific sectors such as financial services than it does for overall economic performance.
Moreover, the hope that ECB will in response start QE-ing in mass is consistently denied by ECB officials, and is in the end only based on the conviction that ECB will blink when the alternative is the death of EUR. Even though ECB remains reluctant in its support of sovereigns, it is becoming ever more generous in its liquidity provision to banks. Easier collateral terms and 3yr lending will encourage banks to borrow more from ECB, boosting the level of cash in EUR money market, and so depressing O/N rates. Hence, I think investors should views the Thu-Fri Summit as not the final response of EU policymakers, but only one of many steps towards eventual resolution. However, what is important for markets is to have confidence there will be an eventual resolution and not a chaotic break up of monetary union. Unfortunately, European policymakers will not --- Angela Merkel has stated this process will take 10 years, and cannot give such guarantees as the threat of a breakup is part of the repair process. There is purpose to the madness in Europe.
Given the whole process is still not yet complete, it leaves investors pessimistic and the global economy at risk, as the all-encompassing, market-calming end point remains elusive. Thus, risk assets will stay volatile and could yet suffer another rout before EU politicians (including the politicized ECB) go “all-in”. Looking ahead, the “Tear or Smile” scenarios are --- 1) if a return to a full-blown risk-off phase develops courtesy of a breakdown in Euro area, then there is little investors can do, other than to sit in cash, hold USD and JPY (or RMB), and government bonds in the non-infected countries. Even gold will not provide an absolute safe haven, if debt deflation spreads beyond Euro area. At most, investors might want to own corporate bonds to achieve some yield, but further capital losses will likely occur, if the global economy slides into recession; 2) if, however, Euro area can take the final steps, then watch for a compressed spring-like response from risk assets. While even “turkeys will fly” when investors become less risk-averse and short positions are closed, currently investors should focus on markets/assets/ sectors which should prove durable over the long haul. Generally, these are areas/countries with healthier B/S and which are plays on the drivers of global growth (outside G3).
Macro wise, if excluding the deflation threats caused by the European debt crisis in 1Q12, the economic fundamental has found its feet. Over the past 2 Qs, global consumer spending has been getting a lift since commodity prices have stabilized, allowing sequential rates of inflation to recede and lifting purchasing power. The lag from purchasing power to spending suggests support will continue through year-end. Global retail sales volumes have already accelerated from 1.0% (3M/3M, Saar) in May to 2.8% in October, and based on the historical relationship, we could see another 2.5% growth pickup through the New Year. Meanwhile, global Capex has been surprisingly resilient, given the disappointment in growth this year. Based on G3 core capital goods shipments, global Capex looks to have accelerated from a solid 10% yoy in 2Q11 to a robust 16% gain in 3Q11. In US, a review of capital spending plans of more than 725 non-financial companies covered by Citi’s US equity analysts showed that companies intend to spend roughly 6% more in 2012 than they did in 2011. This is not unexpected as a recovery in ISM new orders, a return of some manufacturing to US shores and a continued pickup in capacity utilization all argue for more capital expenditures even as investors worry about a whole host of issues. History suggests that companies need to add incrementally when utilization rates reach the 75%-80% range.
Policy front, the rolling over in global inflation against a backdrop of increased global growth risks is green-lighting policymakers into action. Last week, RBA followed up on its Nov rate cut with another 25bp cut. Despite signs of the long anticipated investment boom, concerns regarding the global economy along with a softening labor market and a belief that inflation will subside in 2012 have pushed the central bank to move rates into an accommodative stance. In Europe, the severity of the debt crisis, the resulting deflation pressures and draconian fiscal austerity suggest ECB needs to reflate very aggressively. Beyond the crisis, however, ECB will always be run much more conservatively than either Fed or BoE. The main reasons --why monetary policy in Euro zone will always be tighter than necessary -- are that Germans are “inflationists” and their fear of inflation runs deep. The main implication of a policy mix consisting of severe and sustained fiscal austerity and only neutral (or even tight) monetary conditions is a weak European economy, but a potentially strong euro. Interestingly, European stocks have been positively correlated with inflation expectations. One interpretation of this perverse correlation could be that the European financial markets have been so fearful of deflation that they interpret any rise in inflation expectations as a positive development. In US, FOMC acknowledged the improved tone to the US economic data, but noted that the Fed’s tepid outlook for growth has not changed much. FOMC highlighted that two main downside risks loom large: fiscal tightening next year and the financial crisis in Europe. While there was no sense of urgency in the Minutes, policymakers are still leaning toward further monetary easing. Growth remains insufficient to reduce the UNE rate in a reasonable time frame. In China, the inflation risk in 2012 looks low due to the worsening European debt saga and the ongoing downturn of the pork price cycle. Thus, market generally now looks for 3-4 times RRR cut by PBoC next year.
X-asset Markets Thoughts
On the year-to-date basis, global equity was down 8.88%, with -0.3% in US, -12.5% in EU, -19.4% in Japan and -13.9% in EMs. In Asia, MXASJ lost 18.4% and MSCI China -19.4%, while CSI300 -19.97%. Elsewhere, 2yr USTs yields shrank 37bp to 0.22% while 10yr -123bp to 2.06% and 30yr -123bp to 3.10%. Government bond yields across the Euro periphery area were widened significantly with Greek, Portugal, Italy and Spain 2yr yields +10964bp, +1002bp, +204bp and +102bp, respectively. The 3M Euribor-OIS more than doubled from 41bp to 96bp as of Friday. 1M Brent crude was up 15.3% to $108.73/bbl. The USD was flat @1.3386EUR and weakened 4.47% to 77.65 JPY. CRB dropped 7.92% to 306.43, while Gold price was up 20.76% to $1713/oz. Regarding FWD valuation, MXWD is now traded at 10.6XPE12 and 8.2% EG12, MXUS at 11.6XPE12 and 10.3% EG12, MXEU at 9.4XPE12 and 4.4% EG12, and MXEF is traded at 9.3XPE12 and +4.1% EG12.
Looking back in August, financial markets were grappling with three big risks --- a double-dip recession in US, a total implosion in European banking system and a hard landing in China economy. Events since the shakeout suggest that the market was too pessimistic about the outlook and has come to terms with the fact that European crisis has not driven US into a recession. In fact the latest data suggest that US economy is probably gravitating toward its trend growth of 2.5%. The possibility of even stronger growth should not be dismissed. As said, the large accumulation of liquid assets on corporate B/S suggests that companies have much “dry powder” to increase capital outlays. Of course, political and policy uncertainty is a roadblock, but solid profits are also a powerful incentive for companies to invest. As for China, financial markets have slowly realized that the slowdown in growth is cyclical in nature and the government is well equipped to navigate a “soft landing”. Nevertheless, lingering concerns still exist and many analysts continue to predict that the economy could soon hit a brick wall.
Looking forward, I still think that, aside from more tailwinds/fewer headwinds than G3, EM and commodity countries will continue to benefit from the same forces that drove asset markets in US and Europe in the 1990s-2000s. Deflationary impulses from EM world and Japan kept interest rates too low in US and Europe for most of those decades, spurring asset and debt inflation (but not consumer price inflation). Nowadays the shoe is on the other foot, as ZIR in G3 countries will suppress interest rates in the healthier parts of the world, breeding inflation – most likely asset inflation in many countries, rather than spark an upward spiral in CPI. That being said, the near-term asset markets may prove to be among the most difficult periods. Some of the biggest Euro zone economies are finding it hard to fund themselves and no obvious solution seems imminent. The European financial system is frozen, thanks to the sovereign debt crisis. Worse, banks are deleveraging in a bear market to help meet higher capital requirements. Elsewhere, data from US, the world’s biggest economy, may have been BTE recently, but EMs are weakening.
Despite this backdrop, there are huge valuation gaps favoring equity over bond markets. The yield gap between 10yr UST and S&P is around 6.7%, one of the highest levels in the history. Though all three of the major rating agencies agree that any attempt to circumvent the caps on discretionary spending as laid out in the Budget Control Act, or to tinker with the sequestration process, could justify a US credit rating downgrade. Nonetheless, even a downgrade by all three agencies would not necessarily spell disaster for USTs. The US enjoys reserve currency status, and interest and tax burdens are low. The budget deficit will also improve as the recovery unfolds and Congress has already implemented multi-year spending caps. Thus, US will not follow Europe into a debt crisis anytime soon. The implication is that the major near-term risk facing S&P500 stems from Europe, not from USTs. In short, there are many arguments in favor of accumulating equities now --- valuation is attractive, sentiment is depressed, US economic recovery appears to be on track, profits are in good shape, China has begun to ease policy and we could see another shot of global monetary reflation next year.
The outlook of S&P500 bodes well with EM equities, give that stock price correlation has remained above 80% since 2009 – the highest period over the 25-year period. Currently, EM equities are cheap as well (1.4XPB). Since 2000, when PB has been in the range of 1.4-1.6x, the index has provided on average 29% absolute total return over the next year with a 100% hit rate The result is that a 30% return in 2012 is highly probable as the shift in EM policy priorities from inflation to growth is favoring an overweight in China within EM. China has been underperforming steadily since the end of 2009, mostly due to overheating and tightening fears. These fears are gradually fading. Timing the market is difficult, but I would like to take a guess here --- 1) In the past 5 weeks, LO outflows as a % of AUM is about 0.7% (not far from the 0.9% threshold). Another USD10bn outflows over next 2 weeks would trigger a "BUY", based on historical experience. 2) Given the huge amount of sovereign refinancing that is needed next year, it is very difficult for me to see how the market can avoid an “event” of some description 1Q12. However, unless investors wish to subscribe to a very bearish 1931-style financial collapse, there is likely to be a strong policy response. Therefore I believe a good entry point might be near.
Global Econ-Outlook for Next 2Qs
The moment when this world is getting toward year end, there are two important themes taking shape as global economy moves from 4Q11 to 1Q12 --- 1) growth is downshifting materially despite stronger US performance; and 2) a policy response is beginning to take hold across a number of fronts that include easier monetary and fiscal policies and coordinated actions to contain European financial market stress. However, policy actions are not likely to alter the course of action in the near term as 4Q11& 1Q12 look likely to deliver subpar global growth. However, the latest developments on the policy front are increasing my confidence that a turn in the global business cycle will take place next spring.
Data out of US this week highlight the divergence between US and the rest of world. US is on track to deliver a 3% yoy GDP gain as hours worked and consumer spending are tracking solid quarterly gains and construction appears to be staging a revival led by nonresidential activity. There was also a surprising rise in the Nov ISM new order index to 57.6. Measures of consumer attitudes continue to climb out of the hole they fell into over the summer. The latest figure to register such an improvement is the preliminary December report for the Michigan consumer sentiment gauge, which rose from 64.1 to 67.7, the best reading since June. Long-term inflation expectations held steady at a fairly low 2.7%. Initial jobless claims for the week ending December 3rd fell 23K to 381K, the lowest level since Feb2011. Just as encouraging, continuing claims plunged 174K to 3.583mn, their lowest level since Sep2008.
By contrast, global PMI has posted readings below 50 for three consecutive months with the orders index currently standing at 48.5. An important element of the global downshift reflects the onset of recession in the Euro area where Nov PMI orders index fell to 42.3. However, the combinations of a significant fall in China’s Nov PMI reading (orders slipped to 45) and continued evidence of weakness in production readings across EM economies points to a broad-based slowdown outside the US. Sell-side economists are expecting EM growth this quarter and next to be average 4%—as weak as anytime in the past decade outside of the Great Recession. Part of the weakness in EM growth represents drags—from the Thai floods and an inventory correction — which are set to fade as we turn into next year. But the latest news does point to weaker domestic demand growth and early indications that trade with Western Europe are turning toward a material drag. As the disappointment on demand looks likely to extend the inventory correction and interact with a tightening in credit conditions as European banks deleverage, the risks to the near-term EM growth outlook are skewed to the downside.
It is against this backdrop that encouraging news from policymakers is emerging. The coordinated action by central banks to ensure access to FX funding for banks received considerable attention this week. But it is the signals, rather than actions, that provide the biggest news. Despite the failure of the super-committee, US Congress is signaling that it is moving close to a deal to extend the payroll tax and emergency UNE benefits through 2012. Action on this front would lift 1H12 US growth forecast back above 2%. For its part, China lowered RRR and look to be moving toward fiscal stimulus and stronger credit creation. ECB now looks likely to help provide support for IMF lending as it continues to ease policy and increase its activities in funding banks.
To sum up, there remain a number of risks on the road ahead as policymakers try to arrest downward pressure on activity. However, I am becoming more comfortable with the view that a bottom in the global growth slowdown will come next quarter, and that the case for midyear lift is building. That said, we will have a busy week coming with 6 central banks meetings, including Fed, SNB, India, Norway, Chile and Colombia. Only SNB deserves the most attention, as the outcome of the other five meetings is fairly certain. The data calendar is reasonably heavy globally, including US retail sales, Empire survey, IP, Philadelphia Fed and CPI on Friday. The Euro area’s key releases are German Zew survey, IP and the flash PMIs. In Asia, watch Indian IP, WPI and Japan’s Tankan plus the China flash PMI.
Will ECB ultimately step up?
There are two questions after the latest ECB meeting and EU summit, that are – 1) why has Europe not stopped the crisis by creating its own massive IMF? And 2) why has ECB not taken on that function? The slowness in creating an EIMF (EFSF+ESM) is due to both the size of the imbalance, the speed of the crisis, the lack of currency adjustments (which raises the credit exposures of the lending nations), the need to get agreement among 27 EU countries, and the difficulty in enforcing budget discipline on borrowing countries. The ECB in turn has refused to become an E-IMF as that would not be consistent with its mandate. I think at this stage,
Looking ahead, the risk is clearly that the continued threat of EMU breakup creates massive capital flight that does more damage than any benefit from the gathering reform process. The ECB is right to fear that a full commitment on its side will just stop the reform process in peripheral countries. Hence, it needs to keep the risk of EMU breakup alive, despite the chaos it keeps in markets. What can we expect now? The Euro area faces two huge funding issues over the coming months, for Italy in the sovereign space and for banks more generally. As a whole, Euro-area governments have to repay > EUR1.1trn of long- and short-term debt in 2012, with about EUR519bn of Italian, French and German debt maturing in 1H12 alone, according to Bloomberg. European banks have about USD665bn of debt coming due in the first six months, according to Dealogic data. Bank funding pressures remain a concern as the Euro area governments failed to agree this week on an area-wide guarantee for unsecured debt. The European Banking Authority updated its October bank capital analysis which revealed the needed capital increase to EUR114bn from the original EUR106bn (vs. most private sector estimates surpassing EUR200bn). Such an avalanche of refinancing needs in the next 2-3 two months means the crisis could worsen and the ECB would then finally be forced to step up its anti-crisis response to save the euro and itself.
It looks like ECB is prepared to play a critical role in relieving both sources of stress. With regard to Italy, ECB is considering providing bilateral loans to IMF that will be used to form part of a bailout package along with EFSF and more traditional IMF funding. At around EUR450bn over three years, the package will keep Italy in the primary market but greatly relieve its stress. Credit risk on ECB loans channeled through IMF would likely be borne by European sovereigns as ECB would likely request this in exchange for its support. Regarding the bank funding needs, ECB announced that it will offer longer-maturity loans out to two or three years and further broaden the eligible collateral pool. ECB also could extend the commitment on unlimited liquidity at all tenders, which currently runs to the middle of 2012.
As the crisis goes deep to the core of the political system on the European Continent, investors, recognizing the unsustainablility of the situation in the absence of a central bank that acts as a lender of last resort, have become reluctant in some cases and outright refuse in others to continue to fund those governments through purchases of their bonds. Ultimately I believe that ECB will step up buying of problem peripherals. The justification is simple. In the absence of ECB intervention, EUR simply will not be able to survive. It is impossible to imagine a world in which Italy continuously has to pay interest rates of above 7% while Germans pay interest rates of below 2%, particularly when Germany itself has hardly been a paragon of fiscal virtue. Put all talk of Treaty changes, austerity packages and new Italian Prime Ministers to one side, ECB has to act now if the Euro isn't to collapse. It always seemed to be the case that Euro was too big to fail. In the absence of ECB support, it will be too big to save. Indeed, investors took a hawkish impression after Draghi cooled down the hope of enlarged intervention in sovereign bond markets. I think we should be cognizant of the about-faces that ECB has performed in the past. For example, on Thu, May 6, 2010 Trichet said at his press conference that ECB did not consider and would not buy Greek bonds. On the following Sunday, May 9, ECB announced that it would buy those bonds. The same thing recently happened with Italy. The ECB said it would not buy Italian bonds. Italian leaders came up with a fiscal plan on a Friday and then the ECB started buying Italian bonds the next week.
Two Conferences Set China’s Path
China macro data released last week generally underpinned the earlier cut of RRR on Nov 30th. The latest reported Chinese CPI fell to 4.2% yoy in Nov from 5.5% in October while the market was expecting 4.5%. The rest of economy activity data (IP, retail sales, FAI) are broadly in line with market consensus -- IP (14% vs. +13.9% YTD), retail sales (17% vs. +17.0% YTD) and FAI (24.5% vs. +24.8% YTD). Data worth highlight are – 1) on a MoM basis, FAI growth again dropped below zero to -0.2% from 1.2% in October; 2) real IP growth decelerated from 13.2% yoy in October to 12.4% yoy in Nov, the lowest rate since Sep2009, suggesting GDP growth looks set to decline further in 4Q11 as IP accounts for about 40% of GDP; 3) CPI fell by 0.2% MoM, the first drop since March, led by food prices (-0.8% MoM). In addition, the 50bp RRR cut has released about RMB350bn money to the banking system; and market expects new loans could remain strong at RMB580bn in Nov and around a similar level in Dec, without breaching the annual quota at RMB7.5tn. O/N shibor rate fell to 2.86% this week from 4.9% in early Oct, and discount rates of bankers’ acceptance slumped to 7.5% this week from 13.0% in early Oct.
Looking ahead, the rapid fall in inflation and growing downside risks to the real economy suggests that at the forthcoming National Economic Work Conference (to be held on Dec 14.) the government will likely formally shift its policy focus to supporting growth, while downplaying the need to fight inflation. Some mainland based economists predicted that the likely priority order is set as --- Economic Growth, Structural Adjustment and Inflation Control. In fact, Bloomberg on Dec. 9 reported that …” China will maintain a ‘prudent’ monetary policy and a ‘proactive’ fiscal policy next year, according to the official Xinhua news agency”. However, I think the BBG journalists ignore another more IMPORTANT point here --- “the great flexibility of the forward looking measures to counter the ever-changing environment” (Quote: 会议提出，要更加有预见性地加强和改善宏观调控，准确把握好调控的力度、节奏、重点，并根据形势的变化及时作出预调、微调，解决经济运行中的突出矛盾，提高发展质量和效益). It seems to me that policies will likely continue to be centered on prudent monetary policy and a proactive fiscal policy, but extra efforts will be made to push forth monetary easing and structural tax cuts to support economic growth. The rapid decline of inflationary pressures should also provide Beijing with ample room to further loosen its policy. With 2012 being a year of political reshuffle, the ultimate target for all policy changes will inevitably be to maintain stable economic growth. In addition, according to Daiwa’s China Economist, Dr. Sun Mingchun, the National Finance Work Conference held once every five years during the same period will likely to come up with good progress in the long-debated issues, such as LGFV’s role and local government debt, the new funding sources of bank recapitalization, and deposit insurance, etc. Any breakthrough in the policy fronts of these topics will likely trigger a rerating of China market.
For macro metrics, on average China economists expect 3-4 more RRR cuts (150bp-200bp) in 2012, new loan creation around RMB8.5trn, M2 growth at 14-15% plus 3-4% RMB appreciation. That will lead to 8-8.5% GDP growth next year with inflation at 3-4% range. On the HoH basis, combined with fiscal easing measures in the form of tax cuts and spending increases, economic activity should accelerate into the middle of next year, with GDP expanding at ~10% yoy in 2H12.….Lastly valuation wise, MSCI China is now traded at 8.5XPE12 and 12.8% EG12, CSI 300 at 9.6XPE12 and 23.4% EG12, and Hang Seng at 9.4XPE12 and 3.5% EG12, while MXASJ region is traded at 10.2XPE12 and 11.3% EG12.
A Mixed Outlook of Commodities
The outlook of commodities looks like a mixed picture to me in 2010 as weak economic growth early in the year coupled with generally less supply constrained commodity markets than we saw in 2011 should result in -VE returns over the next 3 months. This economic slowdown will likely force policy makers to react and do more to support growth. This in turn should see the demand picture improve sharply later in the year. The story for base metals is of course heavily related to Chinese demand and inflation in China is the key to this. Agricultural commodities are down 25% since their peak at the start of the year and oil prices have essentially been in a volatile range since May. Further weakness in commodity prices in 1Q12 means Chinese policy makers can move from fighting inflation to focusing more on growth which would support demand from 2Q12 onwards. Copper supply is much tighter than other metals and so is likely to benefit the most from this change in Chinese policy.
Energy markets should outperform other commodities. The return of Libyan and also some Iraqi supply mean OPEC will likely need to rebalance their production quickly if, as expected, they intend to keep prices above USD100/bbl. The EM countries’ demand has put chronic upward pressure on oil prices over the past 10 years. However, whenever oil prices rise too far, too fast, then it crowds out the high energy-consuming/weaker-income growing countries. In the long run, either G3 consumes a lot less oil, or prices will have to rise sufficiently to lift new output to meet increasing EM demand (or alternative energy sources will have to replace oil, etc). The bottom line is that energy will be one of the more durable investment areas once “risk-on” returns.
For USD, the developments in the Euro area debt crisis and the Euro zone's anchor economy remain critical. This week brings national and Euro zone wide PMI data, with most readings expected to remain wholly below the 50% threshold. Meanwhile, the front-end "core" Euro zone yields remain soft, but have nonetheless been holding in a range for over three months. But interestingly, front-end USD interest rates have been rising. The implied yield on the Dec2012 Eurodollar interest rate future has risen roughly 25bp since the beginning of this month and stands at 0.82% at present, its highest since the end of this past July. Similarly, two-year USD swap yields have trended upwards over that same time, rising from 32bp on October 31 to as high as 55bp late last week and stand at 50bp. The net effect has been a narrowing of Euro zone-US yield spreads, with the two-year EUR and USD swap spreads trading down to 70bp last week before rebounding to 77bp. While these types of "fundamental" developments are often overwhelmed by the news flow and/or swings in risk appetite, it still represents an important development that, in this case, diminishes a potential leg of support for EURUSD.
Good night, my dear friends!
