My Diary 717 --- A Week of Heavy Macro Calendar; What’s next for the ECB; China's NPC and Its Agenda; Should We Worried about Oil?
Sunday, March 04, 2012
“Not Quite the Happy Ending, Why?” --- It was another week when all markets gained, despite mixed economic data. Equities reached new highs for the year, with SP500 scoring a new high for the cycle. Commodities similarly reached a new high for the year, and credit a new low in spreads for the year, even as they remain well above the lows of last year. Cash remains the worst performing asset class YTD. However, global risk appetite is going nowhere, but hovering around the same level 3 weeks ago when I wrote the Diary 459. So I think the relief rally is largely over. On the one hand, the CDS indices are low, but not getting lower. The risk appetite is high, but not getting higher. On the other hand, the global equity PE is 12X, lower than 14X of historical mean, but justified given the global deleverage. The 2nd LTRO is out, and US double dip is a non-risk. So from now on, the market will be no longer driven by “risk on risk off” type of trades, but more fundamental driven. Overall speaking, I am still constructive, but now it is the time for stock picking to generate returns. Such an observation is supported by the earnings expectations in AxJ region. In February, ERR fell from 0.52 to 0.45 while SRR improved significantly from 0.72 to 0.88. Improving sales coupled with falling earnings suggests the region is experiencing margin squeeze. Meanwhile, earnings revision is mixed between cyclical and defensive sectors and there is no clear leadership with highest for Software (1.00), Consumer Staples (0.88) and Utilities (0.73), and lowest for Materials (0.21), Telecom (0.30), Media (0.30) and Health Care (0.40).
That being said, I still feel somewhat disappointed to the recent asset prices correction cycle. The fact, that SP500 had traded below its LT real price adjusted trend-line for the first time since 1995, suggested that the bubble years for US equities that started in 1995 were now officially over. With hindsight I wished it cheaper rather than just below fair value but the reality was that very heavy and persistent intervention prevented it going significantly below LT fair value. One thing I have learnt over this crisis is that intervention matters, especially in the size it’s been conducted in some countries. However as seen from the poor performance of many European equity markets since the EMU started, without policy flexibility and coordinated intervention, we could now be a lot lower than we actually are in US. Moreover, just as important for markets is also the authorities' willingness/ability to keep easy policies going. The week saw markets react negatively to a more upbeat Bernanke who noted that the fall in UNE was QTE. The Chairman also noted that higher gasoline prices will likely to push up inflation temporarily while reducing consumer's purchasing power. Expectations of any imminent QE were revised lower. The revised expectation for QE led to extreme volatility in Gold as it hit the highs (USD1790) and lows (USD 1688) for the month in one session. To sum up, there remains substantial resistance to the current asset price rally on the argument that it is fake, not fundamental, the result of the same easy money that caused the last crisis, and bound to lead to tears when the money spigot is eventually turned off. It is surely true that global growth, at barely over 2%, is insufficient to repair the world’s high UNE rates and government debt loads. Company profits have done wonders during this lukewarm recovery, benefiting from low wage pressures, but margins have now reached new highs and thus do not have that much upside any more. The traditional fundamentals that I like to see to support higher prices for risk assets are thus not really there.
Moving ahead to European continent, the latest LTRO auction saw 800 European banking institutions tap the ECB for EUR529.5bn in cheap 3yr funding. This was largely in line with market expectations and compares with 523 banks and a gross take-up of EUR489bn in Dec's auction. The higher participation rate this time round probably suggests that the stigma of using the LTRO has reduced. The net new liquidity injection was also higher this time and was estimated at EUR314bnbn vs. EUR191bn in December. As a result, on Friday European leaders declared a turning point in the Greece-fueled debt crisis, shifting their focus away from the budget-cutting spree that has dominated two years of rescue operations. I agree that the risk of a disorderly default by Greece has been reduced through the introduction of a segregated debt repayment account and new national laws prioritizing debt repayment. However, questions about the future of Greece (and the rest of Europe) linger. It is not yet clear to what extent the private sector will participate in the proposed deal, of which private investors is required to take losses of >70% on Greek bonds in a bond exchange, the key plank in a strategy to reduce Greece’s debt to about 120% of GDP by 2020, a figure still double the Euro-area limit. Policymakers assume 95% take-up, but the imposition of Collective Action Clauses might be required to force participation by reluctant hedge funds, and the impact on the CDS market remains uncertain. Finance ministers will hold a March 9 teleconference to review the outcome of the swap offer. Moreover, a large dose of skepticism still remains regarding Greece’s ability to significantly reduce its debt/GDP load given that sharp fiscal tightening has pushed the economy into a deep recession and the contribution from potential asset sales remains highly uncertain. This might not be the last of the deals for Greece. We might also see Portugal and Ireland requesting the preferential lower bailout interest rates conferred on Greece.
Despite the lingering concerns over Europe, globally the macro picture is better so far and the global manufacturing PMI index is still pointing to upside momentum. With this week’s release of strong gains across Asia (QoQ through January), global manufacturing output is estimated to have increased at a 5% pace (or equivalent to 2% global IP growth). To be sure, growth is being boosted temporarily as the damaging effects of Thai flooding fade. In assessing the sustainability of the latest lift, I think the key is held on the hands of global consumer. The foundation for the turn in global industry was laid last summer by the pickup in consumption as shocks related to commodity price increases and the Tohoku earthquake faded. The restoration of HH purchasing power and a rebound in global auto demand helped firms align inventories closer to desired levels. It also provided a pleasant surprise countering growing recession concerns. However, this foundation for lift appears to have weakened in recent months. Following a 5% annualized gain in global retail sales volume from July-October, increases since appear to have slowed to a craw, with risk concentrating on US. However, this is offset by positive news in the sustained strength in durable spending, a rise in consumer confidence, and signs that the household saving rate has been broadly stable for more than a year.
Having discussed the macro picture, central banks will be in focus in the week ahead, with rate decisions in Australia, New Zealand, Malaysia, Indonesia, South Korea, UK and Euro area. Despite the heavy schedule, I expect most rates to remain on hold. RBA cash target rate is to remain at 4.25%, after comments from RBA officials and benign inflation and UNE data releases. The RBNZ could hike rates in 2H12, but for now it is likely to remain on hold as inflation is contained. Indonesia’s BI rate is likely to remain at 5.75%. While the bias is for lower rates over 2012, the risk of higher inflation in Q2 after the plan to hike electricity tariffs should keep the central bank on hold. I also anticipate no change in O/N policy rate in Malaysia, given resilient growth and inflation easing more than expected. BoK has a more challenging task, with growth concerns balanced by higher inflation due to oil prices. Thus I expect BoK to maintain its cautious stance and keep rates unchanged. In India, following this week’s release of 4Q11 GDP growth fell to just 5.5% QoQ saar, the lowest level in three years, the market has raised the clamor for the RBI to cut rates this month. In US, I expect to see the 3rd straight month of 200K-plus NFP prints. The firmness of the labor market is evident in the persistent decline in initial jobless claims, the ability of consumer sentiment to rise, and the whole economy ISM employment index moving to its highest level since Feb2006.
X-asset Markets Thought
The month of February is largely dominated by news flow in Europe as Athens seeks to gain its EUR130bn second bailout program. We also had the build up to the second 3yr LTRO auction yesterday. The ongoing tension between Iran and the West was also a key theme which drove Brent nearly 11% higher in February to top the returns in major asset classes. Generally speaking February was a positive month for risk assets with equities, credit and commodities all producing positive investment returns while core government bonds lagged. In particular, Nikkei was the top performer in equities with returns >10% in February and almost matching the strength in Oil. The weakness in JPY (-6.0%) and increased BoJ activity was a key factor here. Moving along I saw strong returns in Irish equities (+6.7%), Hangseng index (+6.3%), DAX (+6.1%) and SHCOMP (+5.9%). SP500 and Stoxx 600 were both just above 4% higher on the month. Greek equities saw the worst performance with a negative 6.6% return in February which comes after a very strong 17% return in January. Cash credit indices did well but lagged the performance in equities but excess returns were strong and helped by the weakness in core rates. EU and US HY indices were +4.2% and +2.6% respectively vs. a flat month in Bunds and a -0.7% return in USTs. Italian bonds returned 5.2% in the month likely on the back of LTRO hopes. Gold is -2.3% after Bernanke’s fall but still 8.5% up on the year.
Looking forward, my LONG & NEUTRAL position in risk assets is not based on any hopes for strong economic growth, but instead on asset reflation and a gradual waning of downside risk perceptions, both supported by aggressive central bank easing through QE and rate cuts. It is not macro-economic fundamentals, but finance ones that investors rely on, based on the comparison of risk premium to delivered risk and the relative supply of safer vs. riskier assets. Fiscal challenges in DMs have not faded, but aggressive monetary policy easing, including this week’s record ECB LTRO, are buying governments much needed time to start redressing these challenges. However, I believe that smart investors should have noticed the disconnect between interest rates and equities becomes more glaring by the week, even for LT forward rates, which should be less affected by the present easy monetary policy. Thus a valid question to the bulls is indeed how long this liquidity-driven rally can last, and whether we will have to give it all back when central banks start the eventual QE exit. The elder investors remember the carnage in bond markets in 1994 when Fed hiked rates from 3% to 6% to combat a spike in inflation. Bonds yields had reached new lows in 1993, in response to a mad search for yield after Fed had held rates at 3% for a year and a half. So it is not surprised to see investors are now wondering whether we are setting ourselves up for a 1994 in size, given that rates will have been held lower and for much longer than in 1992-93 and that G4 QE has reached new extremes. To the bears, the end of QE spells either bond carnage much worse than 1994, or inflation if central banks feel markets and economies cannot handle rate normalization.
Indeed, the history may provide us a guide on when the bond bubble will burst. I agree that history never fully repeats itself as both investors and policy makers each learn from history and try not to make the same mistakes again. It is easier to state that interest rates will eventually normalize than to figure out when this will happen. One should not take lightly the Fed’s signal it will stay on hold for 3 years. The search, and need for yield are totally overwhelming at the moment, as central banks have destroyed the yield at the short end of the curve. Then, the next question is what could trigger the reversal of the current elevated risk appetite? I think there are three principal risks to the +VE stance on equities, namely EU debt, Oil Price & French Election. The first would be a renewed escalation of financial sector stress in Europe in the form of widening spreads on Italian or Spanish government debt, and rising Libor spreads. So far, the evidence to show LTRO helping to slow bank deleverage and kick start new lending is poor. Most of the money is still sitting back at ECB. A weak patient handed with a lifeline is still weak and we can't hope a jump up and run again shortly. In addition, ECB has indicated that this week’s LTRO) is the last offering, but I would assume further liquidity support would be forthcoming if financial conditions warranted. The second key risk would be a sharp rise in oil prices as a result of geopolitical tensions or other supply-side forces. Anxieties on this front are already elevated given the run-up in oil prices since October and tough talk between the West and Iran about the latter’s nuclear program. For now, such anxieties seem overblown, but potential damage to global economy should not be ignored. In fact, any further escalation of conflict with Iran could add $20-40/bbl and a war incurred in the Straits of Hormuz could add as much as $100/barrel. This is not an unreasonable number as Iran supplies about 5% of world production and a year ago oil prices were up $15-20 on Libya crisis (less than 2% of world production). According to ML, energy prices can’t be 9% ($135/barrel) of global GDP for more than 3 months – could trigger a global downturn in the next few months. Lastly in my list, the upcoming French election in April may well be one. The possible victory of the front runner, Francois Hollande, from the Socialist Party, could mire up the current progress towards European fiscal integration, including the building of the firewalls. This political shift will have serious consequences to EU, to the newly pro-active ECB, and to the entire world.
A Week of Heavy Macro Calendar
The busy economic calendar this past week provided a mix of weak and strong data that is broadly consistent with the market forecast for moderate growth in 1Q12. But the source data used to estimate real GDP have generally been WTE and highlight downside risks to the forecast of 2.0% of US GDP. In terms of +VE news, the one striking anomaly in the latest ISM manufacturing survey is the 4.5pt increase in new export orders to 59.5. This is the fourth consecutive increase in this series and takes export orders to its highest level since last April. A few other incoming data are the strong side of expectations, including February readings on auto sales (15.1mn yoy vs. 14.1mn in Jan) and the CB consumer confidence (70.8 vs. cons=63.0). And the high-frequency indicator, initial jobless claims (351K), declined again in the latest week. But not all spending indicators are positive. With CPI set to increase 0.4% to 0.5% in February, largely reflecting much higher fuel prices, real spending last month probably edged up only 0.1% samr. Available data suggest that real consumer spending was stalled for the third consecutive month and 1Q12 will see
Across the Ocean, the risks of Euro area remains stuck in recession for most of this year. This view has been premised on the belief that fiscal consolidation and a considerable tightening in credit conditions would weigh on economic activity. At this week’s EU summit, leaders communicated the tough message that “countries under an assistance program should stick to the targets and structural reforms agreed in the program. Similarly, member states under market pressure should meet agreed budgetary targets and stand ready to pursue further consolidation measures if needed.” The sell-side forecast assumes some slippage, with a fiscal drag worth 1.5%pts on GDP growth this year. In Asia, February PMI data from China, Taiwan, South Korea and Singapore are vital to a clearer impression of business conditions, which may have been distorted by the timing of the Lunar New Year holiday. Also important is inflation data from Indonesia, South Korea and Thailand. We expect headline inflation to head lower, particularly for the lower income countries. We do not expect to see any impact from higher oil prices on inflation just yet. Korea is the first in the region to release export data for February. So far, indicators suggest Korean exports are still expanding yoy, despite the weakness in the January data.
The official Chinese PMI manufacturing printed at 51.0 vs. consensus of 50.9. The HSBC PMI, which has a focus on SMEs, also saw a modest improvement to 49.6 from 48.8 in January. Next week’s data releases on retail sales, FAI and IP—which will feature combined Jan/Feb results—and international trade for February are expected to underscore the soft economy. Meanwhile, CPI inflation is forecast to subside to 3.6% yoy in February, more than reversing the upside surprise in January that resulted from holiday-period distortions and cold weather. Several economists expect this data set will pave the way for an additional easing of fiscal and monetary policy, with the next RRR cut expected in April.
What’s next for the ECB?
European banks were given a part- day opportunity to meet their liquidity needs for the next three years. They now have breathing room, but still face numerous challenges that will create headwinds for European growth and could result in renewed widening of bank credit spreads in Europe. In details, banks borrowed a gross amount of EUR530bn (EUR200bn was replacement needs). This was slightly more than the EUR489bn at Dec’s LTRO, but roughly what the market had expected and discounted. Having already fallen from 6.84% in early Dec before the announcement of the 3yr LTRO’s on December 8, Italian yields fell another 33bp over the past two days. Money market spreads and EUR were stable in response to the LTRO tender.
The market will not know the breakdown by country until individual central bank data come out in more than one month’s time but Italian banks say they participated significantly. Italian and Spanish banks were the big users of the December LTRO and that they purchased over EUR20bn each of government bonds in January (mostly their own sovereign debt). French and German banks stayed mostly on the sidelines in December. A similar pattern was probably in play this time. The implication is that there will likely be more debt issuance by French and German banks in the next few years, with relatively little from Spanish or Italian banks. In aggregate, European banks have EUR1.4 trillion of debt maturing in the next three years. Nearly EUR1trn has been accessed through the 3yr LTROs. The LTRO and the ongoing offer of ST liquidity have assured markets that a Lehman moment will not occur due to lack of funding. This removes an important tail risk and is good news for holders of European and US bank debt and for risk assets more generally.
However, European bank spreads remain elevated, reflecting risks that are not addressed by ECB’s policy – 1) Deleveraging: most European banks face a protracted period of B/S contraction to bring leverage ratios (tangible common equity to total assets) from an average of about 3% toward the more sustainable levels found at US banks, in the 5% range; 2) Credit Risks: many banks’ B/S are still full of questionable assets that have not been provisioned for; 3) Recapitalization: most European banks have a long way to go to meet forthcoming stringent CAR requirements. Recapitalization plans submitted by the banks to the European Banking Authority last month claiming that deleveraging will not be needed to meet the new standards seem far-fetched. The macro implication is that, although ECB has provided ample liquidity, these lingering problems mean that banks will remain averse to lending. The contraction in the supply of European credit as a result of a broken money multiplier will be a drag on European growth. Just as in 2009 following the 1-year LTRO, the ECB’s B/S expansion does not necessarily translate into growth-stimulating bank credit. The LTRO also does nothing to solve the competitiveness problems faced by the southern European countries. Only a round of competitive devaluations in Portugal and Ireland, and possibly even Italy and Spain could ensue.
What’s next for the ECB? With Italian and Spanish 10yr spreads firmly in the comfort zone below 6%, the ECB’s SMP is now inactive. The ESM will be implemented in a few months, which will be able to purchase bonds in the secondary market. Thus, Mr. Draghi is to downplay but not cancel the SMP. Draghi will start talking tough again to maintain pressure on the peripheral countries to get their fiscal houses in order. This is the same concern that makes European policymakers unlikely to approve larger EFSF/ESM funds, which is a requirement for additional help from the IMF/G20 that will be discussed again in April. Nevertheless, ECB has proven its willingness to step in to avoid disaster, supporting our overweight stance in credit overall. However, I think the important LT question is whether the ECB will tolerate above-target inflation in the core countries to continue to support growth in the weaker countries. No doubt Draghi will be questioned on this topic next week.
China's NPC and Its Agenda
China's 11th NPC will convene its fifth annual meeting on 5 March. What can we expect from this year's NPC meetings with uncertainties still dominating the global economic and political environment, and the domestic economy still slowing ahead of the central leadership reshuffle in October? In particular, there are three key events which investors should perk their ears up --- 1) Premier Wen's government work report outlining 2012's key economic targets and detailed policy agenda; 2) The Finance minister's 2012 fiscal budget report; and 3) Press conferences held by Primer Wen and other senior policymakers.
For the details, the market is now focusing on --- 1) 2012 key economic targets: likely a lower GDP growth target of 7.5% yoy whilst maintaining CPI at 4% yoy, leaving room for resources pricing reform and fast wage growth; 2) Pro-growth policies: to ensure a soft-land, stability in economic growth and social development is likely to be the top priority before the political reshuffle. From Vice Premier Li Keqiang's recent published article, he emphasized speed, structure and price/inflation as the policy objectives. Li also discussed necessary changes in the following areas: urbanization, balanced regional development and development of the service sector; 3) Monetary policies: PBoC targets 14% yoy M2 growth for 2012, up slightly from 13.6% recorded in 2011. To ensure smooth liquidity growth, monetary easing needs a few more RRR. Interest rate cuts, however, seem less imminent until CPI slows to below 3%; 4) Fiscal policies: likely budget at RMB900bn or 1.7% of 2012e GDP (vs. RMB519bn in 2011 or 1.1% of 2011 GDP). China's strong fiscal position - the fiscal revenue-to-GDP ratio reached a 26-year high at 22% in 2011 and with nearly RMB3trn of fiscal cash deposits - allows policy makers to make bolder actions via tax cuts and fiscal spending; 5) Property tightening: existing policies unlikely to be lifted or reversed, posing downside pressures to growth. Recent tension between the central and some local governments suggest that the central government maintains its tightening stance; 6) LGFV debt: a significant proportion of local debt is to mature over the coming years. By the end of 2014, 37.8% of the total RMB10.7trn local debt will mature (RMB1.8trn will mature this year). The latest signs suggest that the ultimate solution will be a nation-wide extension of pilot municipal debt issuance program and the rollover of bank loans; 7) Reform policies: critical area including resources pricing, income distribution, investment deregulation, financial liberalization to sustain China's growth. However, progress has been slow.
Looking ahead, given the need to smooth growth ahead of the leadership transition and the apparent determination of the Beijing authorities to put the economy onto a more sustainable footing longer term, any overly aggressive easing would be hard to come by soon. As a result, I am not surprised the LTE Feb incremental loans for banking sector at around Rmb650bn. One thing to note here is that the traditional correlation between ST bill rates and A share markets may not work well this time due to --- 1) the decline of ST bill rate may not persist as the LTE bank loan growth could drive the demand of private funding markets and the price of private borrowings; 2) the trend of economy recovery could be “L-style”, instead of “V-style”, under the tight constraints of housing price and CPI. In addition, the downstream demand remains weak due to the continuous downward trend of property investment, and the restocking after CNY has almost done; 3) the mid-to long term cost of capital remains going up as the super easing/stimulus in 2009 needs a few more years to digest, implying overall tightening policy environment to stay long.
As a result, earnings and stock selection are likely the main alpha sources in the coming quarters. The 2011 earnings likely mixed as China’s growth moderation likely weighed on earnings growth last year. Market consensus now forecasts 12% EPSG, down from 32.2% a year ago, and also the second-lowest growth trajectory in the past decade. This narrowing growth is similar to the trend seen in industrial profits, which posted 24.4% growth last year vs. 53.6% in 2010. Downside risks relative to market consensus should be limited but uneven among sectors. In general, upstream and monopolized sectors have better margins than those in downstream and competitive ones. For the outlook of 2012 outlook, due to China’s growth slowdown and policy overhangs, earnings growth will likely face further pressures in 2012. Key challenges this year include elevated costs (oil and commodity prices) and weak demand, but a BTE US economic growth could be an upside surprise to earnings. I expect the market to see further downward revisions to earnings growth forecasts before upward revisions kick in. As discussed above, Brent crude recently touched USD125/bbl and is almost back to the high recorded during spring last year. At the same time, the Brent-WTI spread has widened to more than USD10 for more than a year. Sectors like Industrials, Materials and Real Estates are historically most vulnerable to high oil prices, while Consumer Staples, Utilities, Telecom and Energy are the most defensive..….Lastly valuation wise, MSCI China is now traded at 9.8XPE12 and 12.4% EG12, CSI 300 at 10.7XPE12 and 20.9% EG12, and Hang Seng at 10.9XPE12 and 3.8% EG12, while MXASJ region is traded at 11.9XPE12 and 9.7% EG12.
Should we Worried about Oil?
Crude oil has rallied around 13% since the end of January but oil products have lagged behind, up only around 6% on average. This means that some refinery margins have been significantly compressed, causing credit-constrained refiners to temporarily reduce production and in turn limiting demand for crude. Product demand had surged in January due to the cold snap across Asia and Europe. With the arrival of spring and warmer weather, prices are likely to fall, before rebounding into the summer.
From the macro perspective, the level of oil prices does not mean much as economy will adjust to any level of oil prices. It is the rate of change, or intensity of oil price increases, that causes economic and financial dislocations. This is akin to the CPI’s level vs. consumer price inflation: no one really cares about the level of the CPI of an economy, but financial markets acutely focus on the rate of change in the index level, or inflation. In post-war history, the rule of thumb has been that for oil shock to cause a bear market in stocks and an economic recession, crude price inflation has to reach at least a 100% yoy. At $108/bbl today, annualized oil price inflation is less than 7%. Therefore, we are still some way off from that “choking point”, according to historical experience. Of course, this rule of thumb has some limitations. For instance, income growth in the G7 is much lower today and hence the ability to absorb the oil shock or “growth tax” is weaker. Therefore, no one should be dogmatic. I think investors should be worried if oil prices climb to $130-140/barrel in a short period of time, say, two to three months. How about high profit margins? Would that spur stock market troubles? In general, very elevated profit margins are a negative for stocks because the forces of mean reversion tend to bring them to lower levels. At a minimum, high margins limit the potential for future profit growth.
However, a few things need to be taken into consideration here too. First, an increasing portion of US corporate profits comes from overseas markets. As a result, corporate profits as a share of GDP no longer mean the same thing as when companies derived all of their profits from the domestic economy. Second, for earnings to contract, it is usually preceded by a recession. In other words, profits rarely contract unless the economy is hit by recession. Of course, a severe oil shock was the culprit behind the two recessions in the 1970s and early 1980s, but in recent decades, recessions often require economic “bulges” to precede them. For instance, the 1990 recession was preceded by the collapse in the big bulge in commercial real estate and thrifts. The 2001 recession was preceded by the meltdown in the dot-com bubble, so the bulge was over-investment in technology. The collapse of the housing bubble was the direct trigger for the 2008 Great Recession. Looking around today, the biggest potential “bulge” could be government bonds, but without vigorous economic growth or a sustained spike in inflation, the Fed would stem any potential rise in bond yields. Therefore, it is still very premature to expect a blowup in the bond market.
Good night, my dear friends!
