My Diary 636 --- A Global Peso Problem; A Big Deal for Rates; A Pulse Check to China; An Economist On Dollar
March 28, 2010
“Sovereign Debt, Consumer Deleverage, China’s Tightening” --- There was only a few days left for the 1Q2010 and therefore it’s worth to look back of the market. In fact, most of the global high-frequency macro data were on the positive side, along with the very low interest-rate environment, which have driven many investors to expect the turn of government stimulus/inventory-restocking led recovery into a mini global economic boom. Meanwhile, equity market is traded on par with MXWO at 21.4PE vs. its 10yr avg. @ 21.2X PE. However, it is interesting to note that both MXWO (1100-1200) and MSCN (60-65) been traded within a tight range of 10% up-down since last October. It seems there are much bigger concerns, instead of the valuation and growth, to cap the further upside of stock markets. Having said so, I think there are three primary downside risks to watch for:
1) Sovereign Debt: Over the week, IMF involvement is increasingly talked whilst the provision of EU assistance to Greece has become a red hot political potato with German public opinion becoming more hostile. An FT/Harris poll shows nearly 1/3 of Germans think Greece should be thrown out, 40% think Germany would be better of outside the Euro. Thus, the prospect of an imminent solution does not appear to be on the cards. During the Credit Suisse’s AIC, PBoC Vic Governor, Zhu Min, said that Greece's debt woes was the 'tip of the iceberg' and the situation in Spain and Italy was also worrying. As a result of the unclear, clouded and uncertain European sovereign debt issues, USD is poised for the biggest quarterly gain vs. EUR since 2008. At the same time, the stress of government B/S has now led to an unprecedented development – USSS10 has turned negative (-10bps), the first time in history. Negative swap spreads are historically unusual. They flag the effect of either credit concerns or supply pressure on government yields. Last week, investors clearly fired warning shots against UST bow with a 2.61X bid on the USD32bn 7-year auction vs. an average cover of 2.79 seen over the last six auctions. Indirect/Direct bidders took just 50% of the issue. There is a buyer strike here!
2) Consumer Deleveraging: A sustainable upturn in US consumer spending is at the heart of a self-reinforcing recovery in the global economy. While I keep my hope here, it is heavily reliant on the continued improvement in the wealth effect (housing price) and income effect (employment), both of which are at risks – a) swelling foreclosures and a sizable inventory overhang remain a significant headwind; b) SMEs (60% of job offers) is still finding them difficult to get access to capital and is there fore not expanding operations or hiring staff. Encouragingly, some leading employment indicators, like job layoff announcements, have improved markedly. Hopefully, the private sectors will gradually take advantage of the extremely low levels of interest rates available, when job outlook becomes better.
3) China’s tightening: The unexpected rate hike from RBI (repo and reverse repo rates. +25bps each), citing inflation concerns, has reinforced concerns that more aggressive China tightening cannot be too far off. Indeed, Indian inflation tipped at 16.22% in January and is clearly coming through much faster than in China. However, Indian interest rates (prime lending rate =11.75% before hike) are at a much more appropriate level than Chinese rates. At the current stage, the timing and extent of China’s tightening remains the key uncertainty for the markets. On one hand, stronger-than-expected CPI data in February led most of China economists to raise their 2010 inflation forecast from 3% to 3.5% and, consequently, most now expect three hikes of 27bp each, beginning in Q2 rather than Q3. On the other hand, their 2010 GDP forecast of ~10% remains unchanged, and the domestic drivers of energy and metals demand in the form of retail sales, IP and FAI remained strong and suggested continued strength in economic growth ahead. As a result, the Bloomberg consensus shows that most in the market expect a hike in the next two months or so.
In my own view, the near term (1-month horizon) risk pf rate hike is small, given that PBoC has been active in withdrawing liquidity through its open market operations. Over the week, as much as RMB218bn had been withdrawn and the yield implied by the sales of 1yr and 3yr bonds remained unchanged. In addition, two comments from PBOC officials had provided some support to my view -- a) Zhou XiaoChuan said that stimulus policies will not be withdrawn until it is confirmed that there will not be another slow down in China; and b) Zhu Min said that interest rate is a “heavy duty weapon” which implied there would not be a rate hike in the near term. That said, to the market, an early arrival of rate hike would help remove the overhang in the market.
X-assets Market Thoughts
Asset markets wise, global equities edged up 0.22% this week and with +0.56% in US, +1.2% in EU, +1.9% in Japan and -0.49% in EM. Elsewhere, 2yr UST yield climbed 5bp to 1.04%, and10yr ticked up 16bp to 3.84%, following disappointing Treasury auctions this week. 1MWTI oil was about flat at $80.00. USDEUR appreciated 0.9% to 1.341, from 1.353 a week earlier. It was headed for a gain of 6.8% for 1Q10, the largest since it advanced 11.8% in 3Q08. JPYUSD dropped 2.1% to 92.52, from 90.54. JPY was set for a decline of 3.8% this month, the most since Dec2009. The Yen actually fell against all 16 of its most-traded counterparts this week as domestic CPI (core= -1.1% yoy) dropped for a 12th month, increasing the chances that BoJ will lag behind its peers in raising interest rates…Looking across asset markets, US equity markets posted the 4th consecutive weekly gains with DJ +1.01%, S&X +0.58% & NAQ +0.87% driven by positive economic numbers and the passing of the healthcare bill. Technically, SPX has broken above its January high. Currency front, the rating downgrade in Portugal had led to the rally in USD (DXY+1.1%) which in turn weighed on the commodity names, with oil -0.84% to $80/bbl (also due to higher inventory), gold -0.31% & CRB Index -1.95%.
Looking forward, I think that equity investors should stay with a pro-reflation strategy and that the path of the least resistance for share prices is up rather than down. Value is not yet stretched for most markets and I would maintain above-benchmark weights, although some corrective action is possible in 2Q10. Regarding rates market, govt bonds are still in a bear market and investors should modestly underweight duration. I tend to think the rally in IG corporate credit is over and investors should generally be short quality, while being long HY paper. For currencies, USD strength will continue to dominate in 2Q10. However, the selloff in EUR seems overdone.
Having said so, the most heated topic of late was the currency talk between US and China. The US said that China has been artificially deflated its currency. While China (The governor of MOC and Premier Wen) reiterated that its currency is not under valued. It is interesting to note that the latest market whisper is that China trade will turn into USD8bn deficit in March, the first time since Apr2004. In general, RMB appreciation already became a political issue as one could see the govt comments almost every day. In the latest AIC conference Mr. Zhu Min said China 'should and could move towards a floating currency regime'. Meanwhile, US congress is confirmed to postpone the date to finalize the name list of currency manipulation countries. The game should go on from here…
A Global Peso Problem
Recently, most of US economic numbers were positive, including ICSC retail sales, existing home sales, durable goods ex-transportation, UoM confidence and initial jobless claims, while new home sales and GDP were below forecast. Policy wise, Fed's current statement does a fine job linking its economic outlook to the "extended period" language. Beyond the data and Chairman Bernanke, there are two profound social-economic events over the week – 1) Initial jobless claims have started to stabilize over the past few weeks and market expects a similar 455K this week. The 2010 market concensus is to add temporarily 1mn jobs during the next three months, making the expected average gain in job creation around 325K over that period. This positive trend is supported by the expectation that current and past policies will have a greater impact on aggregate demand in the coming Qs. That said, I am not so much a fan of this prediction due to the above-mentioned risk factors. 2) The US House passed the most sweeping health-care legislation in 40 years, rewriting the rules governing medical industries and ensuring that tens of millions of uninsured Americans will get medical coverage. The two bills together will cost USD940bn over 10 years and cover 32mn uninsured Americans, the CBO estimated. That’s more than made up for with a new tax on the highest earners, fees on health-care companies and hundreds of billions of dollars in Medicare savings, which will reduce the federal budget deficit, the CBO said
In the rest of world, UK retail sales data were BTE, rising by 1.6% mom in Feb, compared to expectation of a rise of 0.6% mom (ex-fuel). There was a large revision lower to January data but more due to VAT impact and weather distortions. The February bounce was driven by demand for household goods, which was up 11.2% mom (biggest since records began). In Asia, Taiwan Feb export orders were BTE at +36.3% yoy (cons +30.7%). By destination, China/HK is still far outperforming the US & Europe, reflecting the two-tier of growth between DMs and EMs. As a result, India and China have been providing upward pressures on inflation expectations. So far, food prices are partly behind the increase in inflation, but the surprise has come from the unexpected robustness of non-food prices. This is consistent with the much smaller output gaps in the two countries. While inflation remains below target levels, a global 'peso problem', where central bankers are behind the curve as they weigh in on the risk of a double-dip, could lead to above-target inflation in 2011. Falling output gaps and central banks' tolerance for higher inflation are key factors when assessing the investment environment during the rest of 2010, I think.
A Big Deal for Rates
US interest rate volatility fell for much of 1Q, helped by a number of factors – 1) the flare-up of sovereign risk fears in parts of Eurozone, which sparked a flight-to-quality bid. This is in particular true after Fitch Ratings D/G Portugal’s LT foreign and local currency ratings to “AA-” from “AA,” citing the nation’s deteriorating public finances; 2) Fed’s continued purchases of agency MBS helped absorb issuance; 3) the most important factor was lingering skepticism about the US recovery, given the weakness in labor market. As a result, after rising 40-60bp across the curve in Dec2009, US rates markets did very little in the first three months of 2010. Looking forward, I expect all these factors should reverse over the next few months.
That being said, investors have their confidence vote out already. The US 10 year swap spread is now negative for the first time in history. The 10 year USSS is the gap between the 10yr LIBOR-UST yield. Swap spreads are typically +VE because govts can usually borrow at the cheapest rate. That's now changing. The negative swap spreads are "kind of a big deal" for the market. What’s striking is how many different explanations in the market for the phenomenon? Indeed, there are several factors are at work, but the most important is the ongoing massive supply of UST. The market concern is that incremental buyers in 2009, like Fed and households, may not be willing or able to add more positions. Based on Fed’s data, after accounting for Fed purchases, the total amount of issuance in 2010 is nearly 3X more than that in 2009 (2550bn in 2010 vs 839bn in 2009). Private demand should rise but is unlikely fully to fill the hole left by the end of the Fed asset purchase program. In addition, another important driver of rates will likely be the economic data, including payroll numbers. With other economic indicators picking up, the labour market has been one of the strongest mainstays of the bond bulls. For example, the rate sell-off in December was sparked by a payroll report that, while weak, was not as bad as the market had expected. The implication to Asia equity markets is the the elevated levels of public sector borrowing/ rising funding costs may truncate capital flows into the region. Thus, a longer term solution for Asia is to re-cycle more of its external surpluses within the region.
A Pulse Check to China
Earning season has kicked in this week. According to ML, ERR for AxJ moderated in March, down from 1.53 to 1.19, indicating still more stocks U/G than D/G in the region. But earnings expectations have weakened in Hong Kong recently. So far 58% of HSI have reported. 75% have beaten expectations and the avg +VE EPS surprise has been 4.87%, with an average yoy growth of 28%. Industrials and Consumer Services have been the standout +VE surprises, whereas Consumer Goods and Basic Materials have disappointed. In China, according to the MOF, govt controlled SOE had total net profits of RMB702bn, + 8.9% yoy. Sector front, the key focus is on the Chinese banks’ result announcement. In general, based on BOC and ICBC statements, banks are all showing signs of re-gaining of pricing power. In addition, Huijin said that they would get USD50bn injection from CIC. This should ease some pressure of fund rasing from A&H markets. Furthermore, BOA and GS said that they had no intention to sell CCB and ICBC respectively. Interestingly, The range of consensus to march loans is very wide, from RMB150bn to more than RMB500bn. Meanwhile, China property space fell on concern over more tightening measures to be imposed by the Government. The Governments in some cities require developers to make a full payment for land purchases within 30 days of signing contracts vs. currently 60 days. This puts extra burden on developers with a weak balance sheet.
Market side, policy concerns still played major swinging factor this week, regarding to the property sector, RRR hike and the resumption of stamp duty. In particular, the hike of stamp duty-which was subsequent denied by the officials. In my own view, the key concern is still the liquidity and further tightening policies. There are 3 latest news flow underpinned my worries over liquidity --- 1) market whispers that the borrowing cost of private borrowings has jumped up to 25-30% yoy in Zhejiang, one of most active areas of private activities; 2) local newspapers reported that some Shenzhen-based private funds prefer lending money for as high as 30% of annualized return rates to investing in the stock market; 3) the yields on Repos still declined slightly this week. These phenomenons indicated to me that a) we still have loose monetary condition, but we are in the tight credit market; 2) intra-bank market hasn’t feel obviously the heat of tightened money supply, but it will do so as PBoC has accelerated liquidity withdraw. So far, PBOC had net mopped up RMB630bn after CNY, equivalent to the impact of 100bp RRR hike. It seems that open market operations has become PBOC’s favored tool. Timing of rate hike is hard to tell and the drought in Southwest China is another potential CPI lifter.
From the economy structure perspective, income distribution reform is a priority in 12th-five-yr plan. NDRC said it’s working on the plan, trying to boost residential consumption. Historically, the government is taking too big share in the 1st time distribution, while residents got too little. From 1995 to 2007, China’s fiscal income grew by 570%, but disposable income of the urban residents only grew by 170%, while cash incomes of the farmers only grew by 120%.This is a reversal B/S restructuring, compared to the West...Lastly, valuation side, MSCI China is now traded at 13.7XPE10 and 23.5%EG10, CSI 300 at 18.1XPE10 and 30.8%EG10, and Hang Seng at 13.8XPE10 and 24.7%EG10, while AxJ region is traded at 13.6XPE10 and +29.8%EG10.
An Economist on Dollar
Given the plenty of talk in both the US and China regarding RMB, I would like to quote Dr. Krugman, who is highly respected in China. He points out "…It's true that if China dumped its US assets the value of the dollar would fall against other major currencies, such as Euro. But that would be a good thing for the United States, since it would make our goods more competitive and reduce our trade deficit. On the other hand, it would be a bad thing for China, which would suffer large losses on its dollar holdings. In short, right now America has China over a barrel, not the other way around." To be honest, I probably shouldn't comment on a Nobel Laureate who got his prize for his work on trade, but this truly scares me. People pay attention to this nonsense, including the five Senators, led by Schumer of New York, who want to start the process of targeting China.
With the latest remarks made by both Premier Wen and Minister Chen, I am not expecting an immediate one-off appreciation, as a concession to the external pressure. Moreover, the development of the Japanese asset bubble after the Plaza Accord reminds us that China’s government must be cautious following currency appreciation. The most controversial point here is how can politicians to identify where exchange rate equilibrium should be, if economists don’t even have a clue. I think Chinese government wants FX policy to be one of domestic policies to help promote economic structural transition. Externally, China's global trade surplus was USD7.6bn in February and the combined Jan-Feb surplus was USD21.8bn. Its trade surplus with US in the Jan-Feb period shrank by 27% to USD20.9bn. The gap with EU, China's biggest trading partner, has widened by 34% to USD22.3bn. There seems some data proof in China side.
Beyond the Sino-US trade tension, the inverse relationship between USD and Asian markets seems to be broken since last Nov. USD has exhibited tremendous strength, and yet MXAJ generally remain unscathed. Where are we going next? Is the recent divergence suggesting a changing relationship between the two asset classes? So far the USD strength has been on the EURO weakness, and also the fact that money has been going back to DMs vs EMs (relative performance), a trend which is likely to last for the next month or so without much major catalysts in sight.
Good night, my dear friends!
