My Diary 731 --- Don’t Expect Much from Q3; Assessing ECB’s New Plan; Where is ‘C’hina Going?; 8% China Growth and Commodity Demand
Sunday, September 16, 2012
“Printing until the job market improves” --- The week saw the launches of iPhone 5 and QE3. An interesting thought is which one will win the race to 10? It will not be a surprise to me that a fresh QE4 focusing on USTs in the coming months as the Fed has already buried a hint to its statement that "If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency MBS, undertake additional asset purchases, and employ (other policy tools) as appropriate." That being said, risk assets embraced a good rally with SP500 finished its closing level of 1465 being the highest close since the last day of 2007. SP500 is now 6% away from its all time closing highs set on the 09Oct2007. Gold was another major beneficiary with the precious metal now at its highest ($1770/oz) since Feb2012. DXY is down for its fourth consecutive session and has lost 2.5% since the start of the month.
Having said so, the equation of market expectation and policy responses may be changing now as ECB and Fed have each signaled a significant shift in their reaction rules. It is premature to gauge the effectiveness of these changes against a backdrop in which other policy risks remain elevated. However, the macro landscape is changing as central banks dig deeper into their unconventional toolboxes to support growth and this week’s actions signaled a substantial shift in the way it plans to use these tools. The central bank's decision to tie its controversial bond buying directly to economic conditions was an unprecedented step that marked a big escalation in its efforts to drive US UNE rate lower. Whereas past asset purchases were one-off adrenaline shots, this week saw a commitment to open-ended MBS purchases until the labor market improves “substantially”. Similarly, the extension of the low rates through mid-2015 was linked to a statement that such a highly accommodative stance will remain appropriate for a “considerable time after the economic recovery strengthens.” These steps toward conditional commitment were reinforced by a central tendency forecast that shows policy rates on hold until after the UNE rate is forecasted to fall below 7%.
In all, Fed is signaling that it will act more aggressively to promote job creation than its past behavior. To the extent this strategy works, history may look back on Woodford's Jackson Hole advocacy of conditional commitment as a turning point in the way Fed attacked the sluggish recovery. Based on market reactions, the effectiveness of this policy shift was received positively. Chairman Bernanke’s bold move clearly went beyond expectations --- inflation expectations have surged higher by +20bp across the curve since the FOMC statement. Rising inflation expectations as the Fed shifts its bias toward growth is expected and can be a constructive element of monetary transmission. Stock and gold prices also celebrated, which underscores that reflation is once again becoming the dominant financial market theme. USTs yields also moved higher in nominal terms as the decision pushed inflation breakevens upwards.
The Euro area took another important step forward this week. Not only the Dutch election delivered a bigger surprise, with a strong vote for stability, but also ECB president Draghi's bond buying plan has restored some control over interest rates in those parts of the Euro zone which, it seemed, were in danger of becoming detached from ECB mothership. While many in the private sector harbor doubts, ECB president has to be fully signed up to the Euro's survival. He can therefore justify purchasing assets that others might regard as untouchable. And with the later qualified ratification of ESM by the German constitutional court, ECB can look back on an effective week. The court noted that it could look more closely at the ECB’s new bond purchase program, but this will not stop the OMT going ahead for now. The other important event this week was the publication of the European Commission’s proposals for a banking union.
That said, to get their hands on the ECB's largesse, countries have to sign up to austerity and structural reform program. That's entirely understandable. No one - least of all, the Bundesbank - wants to see ECB writing unconditional cheque to renegade governments with dubious fiscal ambitions. Imagine that a country volunteers for the ECB's deal. Once EFSF or ESM buys in the primary market, ECB buys bonds in the secondary market at the short-end of the yield curve, ensuring relatively low interest rates, then there are two risks --- 1) the danger of continuous fiscal backsliding, perhaps because the regions are recalcitrant or because the electorate is uneasy - does ECB, doubtless prompted by the EFSF/ESM, withdraw support? The answer surely should be "yes". In the Euro zone, however, failure in one country has a nasty habit of infecting others; 2) a more worrisome challenge, is the possibility that even with low interest rates, economies may still end up slipping into recession, thanks to a combination of fiscal austerity and losses of competitiveness. In an interview with German newspaper Sueddeutsche Zeitung, ECB President Draghi said that Europe is already seeing positive results from the ECB's OMT program with the announcement contributing to rising confidence in Euro. However he conceded that there was more work to do. Looking at the day ahead, the main focus in Europe will be the ECOFIN/Eurogroup meeting in Nicosia. Some economists think that Spain may use the meeting to publicly request EU aid.
To sum up, the true test of successes for both Fed and ECB is whether these latest actions will translate into economic growth and job creation. In US, monetary easing has promoted spending gains among interest-sensitive products but has not succeeded in generating sustained above trend growth. The latest data suggest that the US is facing a sharp slowdown in export growth and investment spending this quarter. What’s more, the potential damage from the yearend fiscal cliff looms large. In Europe, though ECB OMT program can break the negative feedback loop between poor fiscal outcomes and rising borrowing rates, but it does not solve the region’s fundamental problems. The region needs to shift to a different point on the trade-off between national sovereignty and burden sharing. And necessary structural adjustments must be accompanied by steps to promote growth and financial sector reform.
X-asset Asset Market Thoughts
On the weekly basis period, global equities were +2.95% with +1.93% in US, +1.30% in EU, +2.97% in Japan and +3.69% in EMs. In Asia, MXASJ and MSCI China closed +4.88% and +3.84%, respectively, while CSI300 lost -0.07%. Elsewhere, 2yr USTs yield stayed flat 0.25% and 10yr’s added 20bps to 1.87%. In Europe, Italy 10yr sovereign bond yield has traded below 5% for the first time since March. 1MBrent crude went up+3.01% at $117.59/bbl. The USD weakened 2.43% @1.3130EUR and stayed relatively stable to 78.39JPY. CRY index was also boosted by nearly 3% to 320.92, while Gold price were up 2.1% at $1773.5/oz.
Looking forward, while policy response has come through more forcefully than expected, this raises the question of whether the equity rally has legs. I believe it does. For one, investors are starting long equities but not yet at overbought levels. In addition, the macro picture looks set to turn more positive as the Fed’s QE is added to further Chinese stimulus and to a sharp improvement in financial conditions in Europe. Within the context of increasing signs of US macroeconomic stabilization, the medium-term risk environment is becoming more favorable – with clear implications for asset allocation and strategy. Having said so, I am still not yet willing to OW EM equities in view of the deceleration in global trade, continued slowdown in the critical Chinese economy and rising food prices. I remain of the view that the underlying data trends rather than policy will be the key to a more sustained risk rally.
Based on the 1H12 earning results, EMs, especially China equities saw ROA and ROE have deteriorated both in absolute terms and relative to the US. This deterioration is broad based with non-financial sector OPMs have plunged well below US’ levels for the first time since 1999. The key reason why operating margins have declined so sharply in EM countries is that productivity gains across many regions have lagged wage increases, resulting in rising unit labor costs. In addition, overconfidence among managers and optimistic extrapolations of past growth for earnings projections caused a hiring binge among companies since early 2009. In other words, EM corporate managers have become less cost-conscious. One part of the corrosion in EM corporate margins is cyclical and the other part is structural. While renewed policy stimulus could address the cyclical slowdown in demand, it cannot alter structural factors that are driving ROA and ROE trends, such as productivity and efficiency. These structural factors can only be improved via corporate restructuring and structural reforms at a national level. Recall that the EM crises throughout the mid and late 1990s put acute pressure on the authorities to push for structural reforms and on EM corporate management to restructure. This laid the foundations for the EM bull market of the 2000s. It seems that the benefits of those structural reforms have now been exhausted.
Don’t Expect Much from Q3
The global PMI survey continues to point to a contraction in output in 3Q12 while hard data point to modest lift, led in part by a pickup in activity in the Euro area and China. By region, the US incoming data over the past several weeks have pointed to continued tepid growth over the next few quarters, in line with the forecast of only 1.75% real GDP growth in 2H12. The Fed shares this view and initiated forceful policy moves this week with regard to both asset purchases and communication. Part of the growth drag was due to higher fuel price, which holds down real consumer spending. Retail sales increased 0.9% in August, but the increase largely reflected the surge in gasoline price. Exports also start to slip with July export volumes declined 2.2%. Core capital goods orders saw declined five consecutive months through July and are down 16.7% in the past three months. Not surprisingly, demand-side weakness is bringing production cutbacks. Factory output declined 0.7% in August.
Across the Ocean, Euro area IP rose 0.5% mom in July, leaving the level 2.1% yoy above the 2Q12 average. The manufacturing part was even stronger, rising 1.0% mom in July and standing 3.8% yoy above the 2Q12 average. In contrast, the output index of the manufacturing PMI remains at around 44 and is pointing to almost a 5% yoy of decline in industry in 3Q12. The July IP print likely overstates the underlying trend, but it is also noteworthy that through the monthly ups and downs, the level of IP has now been stable since January. It is unclear how the divergence of the official data and the business surveys will be resolved. The IP data have also been surprisingly good in parts of the periphery. In July, IP declined 0.2%m/m in both Italy and Spain but rose 1%-2%m/m in Portugal, Greece, and Ireland.
The difficulty in reading global data is also evident in China, where the August economic data dump sent mixed signals. As IP growth is picking up, fixed investment and import releases align with surveys pointing to sluggish final demand. Against this backdrop, many economists has lowered Q3 GDP forecast to 7.4-7.6% but maintaining a lift to 8-8.5% next quarter. Reflecting lingering growth concerns, the Chinese central and local governments recently announced large-scale investment projects. Premier Wen publicly confirmed that all the measures are still within the budget plan of a RMB1.07 trillion (or 2% of GDP) deficit.
Policy makers’ wise, Asian central banks continue to move slowly. In Korea, a unanimous MPC decided to stay on hold this week. Elsewhere, both Indonesia and the Philippines also stayed on hold. For the BSP, a marking up of its inflation forecasts makes the market to expect the reverse repo rate to stay at 3.75%. Next week, Taiwan’s central bank will likely stay on hold, as a pickup in inflation will outweigh ongoing growth concerns. In contrast to the increasingly aggressive moves by e Fed and ECB, the BoJ appears set to hold off on taking any further action at next week’s meeting as well. This is despite an economy that looks set to contract at a 1% yoy pace in 2H12.
Assessing ECB’s New Plan
ECB has finally been compelled into joining the monetization game. The ECB’s bond purchase program consists of several important points --- 1) there is no particular amount specified, i.e. bond purchases can be unlimited, but will mainly focus on the shorter end of the curve; 2) the ECB’s bond purchases will be sterilized, i.e. the program will not lead to money printing; and 3) any bond purchases will be conditional on participating country commitments to LT fiscal solvency, and ECB will not have seniority over other bondholders. It is obviously too soon to assess the full impact of the ECB’s latest policy announcement, but our general impression is that the Draghi plan represents a major step forward in terms of addressing the euro zone financial crisis.
Unlike the previous LTRO programs, which addressed the liquidity problem but still left sovereign credit risk to commercial banks, the ECB’s new bond purchase program will allow lending institutions to shed their “bad” bonds onto the central bank.This is a significant step forward in reducing “systemic risk” in the European banking system. Most importantly, ECB is not going to impose a cap on its bond purchases, suggesting it will buy whatever amount necessary to compress bond yields to whatever levels the central bank seems appropriate. In the meantime, ECB has attempted to make its bond purchase program redistributive rather than expansionary. Obviously, by sterilizing, ECB will try to keep its B/S unchanged. There are several ways ECB can sterilize its market intervention. The first is full sterilization through selling an equal amount of “good” bonds such as German bunds, while buying “bad” ones such as Spanish paper. This action would be strictly B/S neutral for ECB and thus does not amount to any quantitative easing.
The question is -- what if ECB runs out of “good” assets such as German bunds or foreign exchange reserves. Can it continue to engage in bond purchases without changing its balance sheet? The answer is no. Under these circumstances, ECB would no longer be able to swap its assets because it would have run out of “good” assets such as bunds or foreign exchange reserves. The only way to absorb additional bond purchases would be to expand its liability side via money printing. Overall, the ECB’s B/S is more likely to expand rather than not. Its holdings of “good” assets have been dwindling over the last few years as the central bank has already quietly bought troubled bonds. There simply may not be enough high-quality assets left to be used for sterilization. Money printing seems inevitable. In addition, it is not clear why ECB has made its sterilization commitment. I suspect the intention is to placate German opposition. This, together with the central bank’s decision to keep short rates steady, suggests that the bond purchase program, though bold by European standards, retains a strong strand of German DNA in it. Regardless, the ECB’s commitment to unlimited bond purchases is a game changer:
Where is ‘C’hina Going?
Chinese VP Xi Jinping (Mr. C) attended events at the China Agricultural University in Beijing on Saturday, making his first public appearance since speculation over his health began earlier this month and signaling that the leadership was seeking to counter the market speculation. Some foreign investors have been tired of watching the endless news headlines ove the once-in-a-decade transfer of power. However, keeping an eye on political reshuffling and policy reaction remains important to the Chinese equity as +70% of earnings are still under the direct control of government, including Banks, Telcos and energy sectors.
That said, the Q3 Chinese economy has continued to decelerate and the full year target is now comfortably accepted by the leaders at 7.5% FY12. Recent indicators suggest that most manufacturers’ output continued to deteriorate, and forward-looking signals are not yet flashing clear signs of a bottom. Domestically, the most visible sign of growth difficulties of late is from the metals market. Despite the notable rebound in the global commodities complex since July, prices of steel, iron ore and coal all tumbled last month, highlighting the Chinese authorities’ accelerated efforts on infrastructure spending have yet to have any meaningful impact on the economy. Export order data within Chinese PMI surveys continues to contract, and there are no signs of improvement. Furthermore, early readings of Korean exports reveal shockingly weak demand among core European countries, which also bodes poorly for Chinese sales to the region. Compared to a year ago, Korean exports in the first 20 days of August to Germany and the U.K. tumbled by 20% and 23% respectively, and sales to France collapsed by a whopping 70%.
Given the continuous weak data and the needs for stabilization during the CCP leadership transition meeting, policymakers are mulling another round of coordinated growth-boosting measures. NDRC last week announced 25 urban/inter-city railway projects in 19 cities, 13 highway projects and 7 port/waterway projects which were approved over the past few months. Considering most RMB800bn urban/inter-city railway projects are for long-term plan (2010-2020), 13 highways only represent c. RMB75bn investment over the next 2 years. Last week, State Council also announced eight measures to stabilize growth of foreign trade. Meanwhile, there are several promising signs that argue against being overly pessimistic. Inventory destocking have been fairly aggressive, though overall inventory levels remain elevated at the moment (from 48% sales to 40% now in August).The housing sector continues to recover, not only in terms of volume but with prices also firming, signaling some regained pricing power among developers. Transaction volumes in major cities (Aug sales +40% yoy in key cities and 8M12 sales +29% yoy) have been rising for quite some time, and more recently overall home sales nationwide have also been bottoming out. Money and credit growth (M2 = 13.9% in July, 13.6% in June, 13.2% in May and 12.8% in April) have clearly bottomed and are gradually basing out, which have historically always led to a turning point in economic cycles.
After the Fed launches QE3, there is renewed debate over that the China may opt to cut banks' RRR or rates as part of a globally coordinated policy action to shore up the world economy. Predicting the timing of China's monetary policy moves can be a daunting task given PBoC does not hold regular policy meetings as its counterparts in the West, and it has a track record of surprising the market. My base case is that unlike central banks in the West, PBoC still has plenty of room to cut borrowing costs. The benchmark 1yr bank lending rate is at 6%t while deposit rate is at 3%, while the RRR level remains at 20%t -- among the highest in the world. Fundamentally, I have seen a poor set of 1H12 results. On a slowing economy, the combined sales growth of non-financial companies slowed further and fell into single-digit territory (up only 8% yoy) while the combined net profit of those companies was down 13%. Using CSI300 as the benchmark universe, its FY12 ROE is only 6.8% (noon-financial only 4.8%), all at the tough levels in the history...….Lastly valuation wise, MSCI China is now traded at 9.7XPE12 and 3.2% EG12, CSI300 at 10.7XPE12 and 9.3% EG12, and Hang Seng at 10.9XPE12 and 4% EG12, while MXASJ region is traded at 12.4XPE12 and 6.7% EG12.
8% China Growth and Commodity Demand
The Chinese economy has entered a critical phase. The authorities are trying to downshift growth towards 7.5-8% which is well below the average of the past 5, 10 or 15 years. In fact, growth was in double digits for 11 of the past 20 years. Obviously, the biggest challenge facing by China is the transition from an era of plentiful labor, savings and capital to a period where demographics and domestic savings are less favorable. This transition could take many years, but the flood of infrastructure and property spending that relied on cheap labor and capital will become more discriminating.
This change in growth trajectory has much implication to the commodity complex, especially if the growth downshift is primarily achieved via slower Capex expansion. Especially, 7.5-8% is consistent with capital spending losing a 1% GDP share (currently 47%) to consumption per year. This will lead to 4% yoy metal consumption over the next three years vs. 17% over the past decade, but from a much higher starting point. If that is the case, I am more bullish on copper, tin and nickel as there remains 3 key areas should provide metal upside over the next 18-24 months --- 1) infrastructure 2) real estate and 3) domestic consumption.
Infrastructure -- The government has deployed less than 50% of its planned power grid, rail, water and highway infrastructure for the year, and just unveiled a new transport package. Concerns of overcapacity, coupled with the July 2011 railway accident have frozen many plans. Nevertheless, the majority of the country still suffers from extremely poor infrastructure, even if coastal cities are well up the development ladder. I am constructive on the power sector, with copper and aluminum standing to benefit. Energy efficiency is a top priority in China’s 12th 5-year plan, while alternative energy is also set to gain market share in electricity generation. This sector accounts for about 40% of copper and 16% of aluminum consumption in China.
Real Estate --- Though I do not expect the authorities to loosen their grip on the real estate sector, but it should no longer be a drag on base metal demand. The LT potential for residential construction is well known. There are 10-15mn rural-to-urban migrants every year and recent housing reforms, enabling farmers to easily obtain urban household registration, will boost demand for houses. Construction accounts for the bulk of metal demand in China: ~60% for zinc, 55% for copper, 30% for aluminum and 15% for nickel.
Consumption --- For every 1000 persons, there are only 60 automobiles in China versus almost 500 in the U.S. China also lags the US in refrigerators, phone lines, TVs and personal computers per capita. Aluminum and nickel will be big winners from the longer-term shift to consumption-based growth. Transportation and packaging account for almost 50% of aluminum demand in China, while 60% of nickel goes into the manufacturing of stainless steel, mainly used in cutlery, refrigerators, washing machines and cell phones.
Good night, my dear friends!
