My Diary 638 --- Look for Growth Confirmation; the PIGS need Pat

My Diary 638 --- Look for Growth Confirmation; the PIGS need Patience; Where China stands now; the Rollover of Euro

Sunday, May 30, 2010

“Sell in May vs. China save the risk trades” --- These are the two points I can think about to summarize the risk markets’ performance over the past month. Looking back, risk assets in May are in a tailspin as EU sovereign debt and the seizure of Spanish banks had brought back the vivid memories of the post-Lehman banking crisis. Investors also face a potential property market collapse in China, financial regulatory reform in the major countries, and rising military tension between North and South Korea. As a result, MXWO and MXEF fell 11%, the worst month since Lehman's collapse. Dow ended up the worst May (10136, -7.92%) since 1940. Commodities extended losses on the back of growth concerns over China with CRB lost 8.31%. 10YR UST yield dropped below its longstanding trading range at 3.2%. Interestingly, investors managed to regain their composure after China’s SAFE helped squash widespread speculation that the country was abandoning European bonds and EUR. The comments were likely self-serving to avoid a material weakening in global demand for Chinese goods and prevent the trade-weighted RMB from rising further along with USD.

Fund flows wise, the past week saw a capitulation of equities. According to Lipper FMI, equity funds see huge USD17bn outflow in week to May 26th, the 4th biggest week of equity redemptions on record, since 1992. By asset classes, ETF-selling comprised USD11bn of the equity outflow and LO equity funds saw USD5.3bn of redemptions. Investors went to cash as MM funds saw an inflow of USD 8.2bn. Fixed income funds recorded tiny outflows of USD 1.5bn in aggregate. By style, the biggest selling was in riskier HY credit (USD1.4bn), large & small cap equities (USD13.5bn) and international equities (USD1.6bn). The week also saw the largest outflow from small cap equity funds on record. Talking to the market, my general sense is that investors have not properly positioned for this leg down and that many are hoping for a bounce to lighten up. Given that kind of positioning, my view is that the latest bounces are likely to be shallow, considering stresses still persist in the system as 3MLibor stays above 50bps, the highest level in almost a year. Libor-OIS spread has also been steadily rising and at 31bps is also near a 1yr high.

X-asset Markets Thoughts

On the monthly basis, global equity markets lost 10.77 % over the course of high volatility (with VIX CHNG in the last 4 weeks @ -20.02%, +28.36%, -23.71%, +85.7%). Regionally, US stocks went down 8.49%, EU -13.78%, EM-12.65% and Japan -10.99%. Elsewhere, UST yield curve flattened with 2YR down 26bp to 0.77% and 10YR down 47bp to 3.28%. Euro bond markets closed prior to Spain’s credit rating being cut. The yield on Greek 2YR remained 7.20%. 1MWTI oil fell $12.2 to USD73.97/bbl. EUR declined 5.45 to USD1.2570. USDJPY strengthened 4.28% at 90. 3M LIBOR held at 0.54% for the third consecutive day, a 10-month high hit earlier in the past week, while TED spread rose 0.3bp to 38.1bp……Looking across asset markets, although risk markets have stabilized over the past few days, some of the underlying stresses in the funding, money and bond markets persist. And those conditions and developments are likely to remain key inputs for currency movements. In my own views, risk markets in the near-term have three things to worry about --- 1) EU sovereign debt crisis and its resulted USD funding strains; 2) slowdown in China with more evidence in industrial and property sectors; and 3) regulatory uncertainty on US and EU financial sectors oversight. Meanwhile, there are too many geopolitical events to keep an eye on, including US/Korea reaction to North Korea, and US/China Strategic and Economic Dialogue.

Looking forward, another down-leg in global risk assets cannot be ruled out, as EU banking system still fragile. European policymakers still need to move more aggressively and provide an open-ended commitment in order to shore up confidence and prevent the crisis from spreading. Regarding equity as an asset classes, there are positives and negatives, which underpin my cautious stance. For +VEs, valuations and technicals are both supportive of OW equities here --- 1) 12MFWPE of MXWO is around single digit at 10.8X (EM at 9.6X & APxJ at 10.9X), which is 1STD below long run averages. These valuations only occurred in 08/09 and early 1990s global recession. In addition, Yield gap in US (DIY-UST) is positive at about 100bps, but lower than late 2002 and early 2003. European stock dividend yield also crossed over govt bond yield, the 3rd time since 80's. 2) Technically, the number of stocks in MSCI APxJ trading above their 200D MAVG is now 23.6%. It was over 90% in June-September last year. At the beginning Mar09 and late Nov08, the number was 7.6% and 3.2%, so there are some way to go before we see a real bottom.  That being said, overall current market valuation is attractive but not a real bargain.

For -VEs, earnings and Dollar funding stress are capping the upsides. In general, global earning growth are constraints by i ) spending cuts & tax increases in  US state & local governments; ii) policy tightening in China; iii) a sharp deterioration in USD/EUR; and iv) BTE fiscal tightening in large European countries. In fact, the latest UST and TIPs yield curve are seemingly pricing in a double-dip/deflation outcome. Meanwhile, according to ML research, their bottom-up EBIT margin analysis reveals too much optimism for 2011 with industrials the most bullish as margin are above 2007 levels. With regard to the interbank USD funding stress, the picture is far from pretty where 3MUSD rates have already doubled since the start of March, a period in which policy rate predictions have been going in the opposite direction. Policy transmission mechanism broken again it seems.

Look for growth confirmation

As the European debt turmoil deepens, investors naturally are becoming more concerned about the global growth outlook. Thus, we should pay more attention to the most current indicators, including May PMIs and surveys of business and household confidence, to confirm whether growth was strong. By contrast, the hard activity data that are coming in are for April or even March, which simply represent the pre-crisis momentum. The rational here is the EU sovereign debt crisis intensified so abruptly that most incoming macro data are capturing activity with a lag.

In US, the latest April headline data were mostly good, with BTE existing home sales (+7.6%), consumer confidence (+63.3), housing price index (+2.35%), durable goods and new home sales while the GDP (+3.0%), personal income (+0.4%) and Chicago PMI (59.7) fell short of expectation. The key to watch will be the release of the all important NFP next Friday. In particular, last week saw Durable goods orders surged 2.9%, while core capital goods declined -1%. Durables inventories rose 0.7% (shipments + 1.4%), bringing I/S ratio down from 1.55 to 1.54, another new low since July08. Still, the ratio remains above the 1.35 pre-recession norm. US home sales jumped 14.8% in April to a pace of 504K on top of an upward revised 29.9% surge in March. However, sharp declines in mortgage purchase applications over the first 3 weeks of May indicate that sales are poised for a near-term pullback now that the credit has expired. The number of new homes available fell to another record low, dropping from 227K to 211K. That brought the supply of new homes on the market to 5 months, well down from the peak of 12.1 seen in Jan09, and within shouting distance of the pre-bubble norm of about 4.0. But, In terms of the housing market overall, the new home sales are now only about 40% their  pre-bubble trend, and the withdrawal of government support is sure to see the numbers plunge back down in future months. On an ISM-weighted composite basis, the Richmond Fed PMI fell 1.8 pts to 59.2. This is a good reading, but the decline follows dips in the NY and Philly Fed surveys, raising the odds that next Tuesday’s national ISM survey moved down as well.

In Asia, there are more substantial reasons to worry about sequentially growth slowdown. Look at Singapore: output expanded at over 38% QoQ Saar in1Q10. In Taiwan, April IP rose 31.4% yoy (cons=29.1%), way ahead of expectations. In Thailand, 1QGDP grew 12% yoy, the highest in 15yrs. These are hardly something easily repeated. In addition, the lack of an imminent inflation threat also applies to many Asian economies, given the recent decline in energy and commodity prices. Economic uncertainty created by European sovereign debt concerns could dampen the region’s recovery and reduce inflationary pressures. Asian authorities’ worries about asset bubbles are probably taking a backseat for now amid the sharp correction in regional currencies and equity markets. The recent shortage of USD will also keep Asian policy makers on alert. While central banks may have limited influence on the availability of USD onshore, they can at least maintain a loose local-currency liquidity environment. To sum up, I expect Asian central banks to maintain their current benchmark policy rates due to a combination of domestic and external factors.

The PIGS need patience

There are too many market debates over the European debt crisis and its possible solutions. In my own views, the key near term objective for ECB is to get the "PIGS" sovereign debt paper held by UK/European banks onto its B/S asap, so that remove any continuing concerns over banking systemic risk. Despite this, European financials have been clobbered and measures of inter-bank funding strains have ramped up. Why? I believe there are three reasons behind it — 1) debt restructuring may be the only way out for Greece and perhaps some other countries. While the ECB may not want to see any haircuts/restructuring taken on outstanding debt owed, history tells us (EU regulation not withstanding), there is a very good chance this will happen. Moreover, the damage to EU bank capital could be magnified by their exposure to private sector borrowers in the periphery, if these economies are forced to undergo a painful, deflationary, economic adjustment. In a worst-case scenario, the impact on bank capital from a 50% haircut of selected sovereign debt plus a 15% decline in the value of private sector assets held in PIGS could eliminate almost 1/3 of European banks’ tangible equity capital. BIS numbers suggest the banking systems of the UK, Germany and France together hold USD1.25tn of sovereign debt paper in PIGS.

On the other hand, the direct losses facing US banks would be far less than for EU banks because US lending to the troubled European countries is fairly small. 2) Nonetheless, the 2^ND round effects on US banks could be meaningful, as highlighted last week by Fed Governor Tarullo: “if sovereign problems … were to spill over to cause difficulties more broadly throughout Europe, US banks would face larger losses on their considerable overall credit exposures, as the value of traded assets declined and loan delinquencies mounted.” As a result, higher funding costs and liquidity shortages could spread world-wide, and we are already seeing these pressures building in credit markets. In fact, there has been increased speculation that central banks would make greater attempts to ease USD funding crunch, presumably by making greater use of the recently re-established USD swap facilities between Fed and ECB, SNB, BoE and BoC. Indeed, a WSJ article latterly suggested that Fed could lower the penalty rate charged on this facility, which is currently OIS + 100bp, in order make it more competitive with other types of funding. However, Chairman Bernanke was quoted last week as saying he does not view USD swap facilities as a permanent service for financial markets. That is logical as the swaps availability and usage has varied alongside the level of stress in USD funding market.

3) There are quite a few question marks over the recent EU/IMF bailout package. In terms of EUR440bn loan package that is being contributed by the EU members, can in theory be used piecemeal by ECB as each government approves their commitment. As to the IMF's separate EUR250bn commitment not clear how this going to be funded given their record high gearing level after already having lent Greece EUR30bn. Note over next year, PIGS have EUR300bn in redemptions alone that will need to be funded. Moreover, if history is any guide, the transition from deficit to primary surplus's for these countries is going to take a long time. On average in the past, similar transitions in Europe have taken 10 years (range 4-14 years ). At the same time more often than not also during periods of high inflation. The opposite is now facing Greece. I personally would doubt investors have the patience to allow Greece and other PIGs countries 10 years to make the required transition.

Where China stands now?

The market tone toward China growth prospect has changed, with several sell-side economist reducing China GDP growth forecast for 2011 to 8% from +10%, considering the slowdown in real-estate construction. But consumption growth will be decent, and FAI is still key to China’s headline growth numbers. Next week, as PMI data will kick in on Tuesday, market may turn attention to China’s May economic data again. Few data, such as IP, FAI and New Loan, may show QoQ and YoY growth decline. As a result, analysts are expecting no IR hikes in 2010, even though CPI will continue to rise until June. With Europe wobbling, and given China’s stronger real effective exchange rate, the opportunity for RMB-USD de-peg has probably also closed in the near term. Meanwhile, China is accelerating its structure adjustment. With regard to overcapacity, MIIT has significantly raised the targets and move forward the deadline to 3Qfrom 4Q10. The new targets include steel 8.3mt (vs. 6mt previously), iron 30mt (vs. 25mt), cement 91.6mt (vs. 50mt), paper 4.3mt (vs. 0.5mt). State Council also vowed to tighten control of bank loans extended to LGFV, which borrowed heavily in 2009 to fund an infrastructure spending spree. According to market estimates, the latest total debt size of local governments in China has increased to around RMB8trn.

Regarding to the domestic A-share market, the weak performance is mainly attributed to tigher market liquidity. PBOC's open market operation led to Rmb224bn net outflow in  May but we see inflow of Rmb145bn this week. Beyond that, banks financing plans in the coming weeks will suck nearly Rmb300-400bn out of the stock market according to CICC’s estimate. As a result, intra-bank Repo rate has rocketed nearly 80bps since April 20 after the 3rd RRR took effective May 12. This may be partially due to a surprisingly QTE BoC’s CB issuance as well as possible more banks’ financing plans to be announced next week. Currently, excess RRR is only 1.5% (about RMB1trn) after the May hike, which is the lowest level in the history (last time excess RRR was 1.5% in mid-09). Thus domestic banks are indeed competing for deposits and small banks are particularly aggressive given the fact that they are most aggressive in extending loans since last year. Government also took some mitigate measures, including CIRC increase the limit of equity exposures for insurance company.

With respect to property, rumors and clarifications on property market policy have dominated the headlines in the past week, starting from NDRC research center said "no property tax within 3 years" to SH local govt’s property tax policy. At the end of day, only one piece of news is real that SAT released the notice over LAT Settlement. For the physical markets, I expect to see very low transaction volumes starting in April, and housing price would correct + 20% (more in Tier-1 cities) beginning in June as new primary supply comes onto the market. The latest news is Vanke is about to lower price by 10%-30. One interesting report here is that of China’s 1958 billionaires, 567 people have businesses in real estate. That being said, I think the tightening policy in China is not equal to either property market containment or liquidity tightening policy. The economic rules tell us that it is an inevitable course for government to exist and turn monetary policy to neutral from extra-easing after the very aggressive stimulus plan. Moreover, China has only applied administrative and quantitative measures to try to cool down the economy, but the pricing tools have been touched yet – both interest rate and exchange rate.....Lastly, valuation side, MSCI China is now traded at 12.9XPE10 and 25.3%EG10, CSI 300 at 15.7XPE10 and 32.4%EG10, and Hang Seng at 12.9XPE10 and 25.1%EG10, while AxJ region is traded at 12.2XPE10 and +36.9%EG10.

The Rollover of Euro

Based on my observation, the FX dynamics associated with risk trades have changed. During much of the past 3 years, contracting risk appetite tended to work in USD's favor, as market participants unwound and liquidated USD funded positions, and/or simply moved into the “least bad” investment, which was the deeper, more liquid USD market. Conversely, periods when the risk trade proliferated tended to work against the USD, as that process was reversed. However, recent events have clearly demonstrated a different dynamic. The massive unwind in the risk/carry trade on Wed and Thu coincided with sharp gains in EUR/USD, rather than losses.

I think there are several factors behind this development -- 1) the squeeze of the sizeable short position in EUR that had recently been built up with perceptions that EU policy makers were inefficiently handling the sovereign debt crisis. 2) It is increasingly apparent that the "EUR carry trade" has been more broadly used than we thought. Higher yielding and commodity currencies such as AUD, NZD, CAD and NOK have seen huge declines vs. EUR since the middle of this week. In the second last week of May, EUR's dramatic appreciation alongside the asset market declines gives measurable credence to the notion that EUR carry trades are being liquidated.

That said, some negative and positive could lead to a range bound of EUR in the coming months. The first is with re-introducing LTROs, ECB has effectively surrendered some control over its B/S to the banking system. In essence, ECB will provide as much liquidity as EU banking system will require. If European banks remain under stress, ECB’s B/S should expand further undermining EUR. Second, LT capital inflows are starting to roll over. In the early months of the Greek debt crisis, long term investors were steadfast. This is no longer the case. Additional EUR weakness may fuel the fear that the move by global central banks to diversify reserve holdings away from the Dollar towards EUR will stop. This would mean the removal of an important source of demand for EUR for a protracted period. Since EUR's launch in 1999, its status as an international reserve currency has grown. International reserve holdings have increased from about EUR200bn to just under EUR900bn over the period.

While de facto QE by the ECB and deteriorating LT capital inflows should continue to push the EUR lower for now, a few positive dynamic are under the bearish outlook – 1) FX is about relative fundamentals. US is hardly a safer place itself with a larger structural budget deficit and has a heavier debt burden. Larry Summers, Director of White House’s NEC, is urging Congress to pass USD200bn of new spending measures. The CBO forecasts cumulative US fiscal deficits of nearly USD10trn over the coming 10 years. The US budget deficit will never fall below 4% of GDP in any single year. In contrast, PIGS are all tightening fiscal policy. This week, Italy announced EUR25bn of budget cuts for the next two years. Germany has a balance budget law that will limit its deficit to just 0.35% of GDP from 2016. Even France is talking about a constitutional amendment to restrict future public deficits. Another factor that will become increasingly supportive for EUR/USD over the coming months is relative trade balances. The breakdown of German export data is quite telling. German exports to outside of EU area are recovering rapidly and have already surpassed the pre- Lehman bankruptcy peak. The weaker EUR will only supercharge the German export machine.

Good night, my dear friends!