My Diary 665 -- Some Early Encouraging Signs; Not A Full-fledged

My Diary 665 --- Some Early Encouraging Signs; Not A Full-fledged Bear; Watch for China CPI Tuesday; Nobody Wants USD?

Sunday, February 13, 2011

 

“EM: caution warranted vs. DM: Money Wanted” --- The past week saw the third consecutive week of outflows from EM equity funds, with total USD13.09bn in the last three weeks. ETF funds accounted for 63% of the total outflows. MXEM was down 3.9% ending February 10 with EM Asia -4.6% while China -6.1% and India -5.9% underperformed the most. This is in line with Diary 437 of 2010, where I said that “[QUOTE] …there is increasing pressure over the potential outperformance of EM equities relative to DM equities in 2011 due to a) relative valuation; b) margin and earnings growth, c) policy risks and d) fund flows….” That said, this earnings season seems to be panning out really well with 70% of S&P companies reporting earnings that beat estimates. On the whole, earnings are expected to rise 37% yoy in 4Q10. More importantly, the market is starting to see that transition away from cost-cutting on the quarterly reports, along with the very early signs of hiring. This is a positive signal as sales & hiring tend to be highly correlated to economic activity.

 

In the near-term, inflation is here to stay in Asia and policymakers in EMs are tightening policy to combat inflationary pressures. Such policy tightening will eventually slow down growth, leaving emerging market share prices in a hostile spot. Latest example is that PBOC put in its 3rd interest rate hike in 4 months. What is interesting about this hike is the 4bps hike in demand deposit rates (demand deposits are >50% of total system deposits), the first time in this cycle. The PBOC also hiked LT deposit rate by a larger magnitude than lending rates (35-45bps vs. 20-25bps).In Indonesia, the government is trying to convince investors that inflation is largely a food price phenomenon. But investors reacted by selling off the bonds of the country (10yr yields up +100bps in Jan) and sending the Jakarta Comp Index –8.42% YTD. In contrast, DMs still have large output gaps which are able to sustain non- inflationary growth at least this year. Chairman Bernanke, in responding to a question on future monetary policy, suggests the US growth picture is moving in the direction that would make QE3 unnecessary, but he is less clear about the price picture. He states additional action would not be necessary if the recovery was on a sustainable track, adding things have moved in that direction, but adds the Fed also will be trying to assess whether inflation is low and stable at around 2% or a bit less. Inflation currently lies below 1% as measured by both core CPI and core PCE, and it is the core rates that Bernanke appears focused on. Bank of England left policy unchanged this week. While that was the outcome that most economists expected, there had been discussions in the market and financial press of a potential rate hike, given the recent rise in inflation (Dec Core CPI =2.9% vs. prior month =2.7% & Jan core PPI =3.2% vs. Dec =2.9%).

It is no wonder that DM are outperforming the developing markets by a pretty wide margin (S&P +5.69%, DAX +6.61%, CAC +7.79% vs. MSCI AxJ -5.44%). Monetary tightening does not bode well for asset prices, particularly with rates coming off such a low base and this remains the reason for my caution on Asian equities. Asia needs to put in more capex to increase productive capacity and that is where I would focus investments in 2011. Moreover, liquidity in Asia was falling rapidly and it is not surprised to see the underperformance in Asian equity markets. I am also concerned to see the spike in US govt bond yields over the past week. 10yr UST yields have risen an astounding 35bps over the past month and 30yr yields are also at a 3-year high. It won't be long before equity analysts use higher risk-free rates in their DDM models or CAPM asset pricing models. Bottom line is that many signs that typically precede a prolonged period of underperformance in EMs. Thus, caution is warranted.

X-asset Market Thoughts

On the weekly basis, global equities rose 0.7%, with +1.42% in US, +0.72% in EU, +1.67% in Japan and -3.41% in EMs. USTs got sell-off with 2yr yield up 13bp to 0.83% and 10yr up 8bp to 3.63%. Peripheral Euro area bond yields mostly rose this week. The 10yr Portuguese bond yield rose 12bp to 7.17%. The Spanish 10yr rose 20bp to 5.35%. The Greek 10yr rose 42bp to 11.37% while the Irish 10yr ticked up to 8.89%. 1MWTI oil dropped 3.88% to $85.44/bbl, while CRB index stayed relatively flat 337.8 (-0.34%). EUR fluctuated -0.2% to 1.3553USD, but JPY weakened 1.52% to 83.43JPYUSD. 

Looking forward, there are three broad themes over the coming months as the world economic upswing develops and matures --- 1) a burst of strong US growth near-term followed by renewed disappointment; 2) periodic waves of concern over European debt as austerity bites and the problem countries struggle to restore growth; and 3) monetary policy tightening in EMs amid huge uncertainty about how high interest rates should and will go. Firstly, the unexpected new US fiscal stimulus at the end of 2010 came on top of signs that US growth was already accelerating. In many ways this will be a repeat of 2010, though last year the main driver was inventories and this year it will be a combination of consumer spending (boosted by the cut in social security contributions) and investment. Latest bottom-up research suggests that demand for capital equipment in US is starting to pick up strongly. Caterpillar, the world’s biggest manufacturer of earthmoving equipment, is raising its capital spending budget from USD1.7bn in 2010 to USD3bn this year. >50% of the budget will be spent in US to build capacity. Such a strong growth outlook could bring forward expectations of rate hikes, a potential shock to risk assets. But UNE rate will remain north of 9% as discouraged workers reappear, keeping Fed in expansionary mode. While outsiders view Fed policy as unnecessarily expansionary, the FOMC sees an economy where the UNE rate is still far higher than at the worst point of the 2001 recession.

In Europe, the debt crisis is likely to continue to unfold in waves as Germany supplies liquidity to governments and banks only grudgingly and investors continue to worry about underlying solvency. Portugal can be easily financed if required, but Spain will require major new support from Germany, which may be difficult given the busy timetable of state elections. Political developments in Ireland, Italy and Belgium will also receive close scrutiny, and new European bank stress tests will likely once again fail to convince markets that the problems have been solved once and for all. Europe’s underlying problem is not just excessive debt, but also differing levels of competitiveness. Yet if countries deal with this by deflating wages and prices, their debt burdens increase. The biggest danger is that this unstable situation will cause problems in the banking system. European banks will need to refinance large amounts of long-term debt in the coming year. Strong growth in Germany is a double-edged sword for Euro area’s closely linked economies. It will help to support the economic adjustment in the periphery to some extent, but it also threatens to bring a rise in interest rates (both bond yields and official rates), which could hurt.

EM countries are growing strongly and facing inflation worries, with the threat that higher food and energy prices will feed into core inflation. Most countries have already made a full recovery from the Great Recession. Property prices are a worry in some countries as low rates stimulate demand. The authorities will likely continue to use a variety of macro-prudential measures. The common concern is that domestically, most EM economies have only limited experience of inflation targeting. Identifying anything close to a neutral rate (difficult enough in the West) is fraught with uncertainty. Meanwhile, rising food and energy prices depress economic activity to some extent, even as they boost inflation.

In my own views that food prices will recede in the coming months, while oil prices will stabilize, which may reduce the market pressure. But if headline CPI consequently dips in 2H11, there is also a risk that policymakers will not tighten enough. Inflation problem in EMs is not only about commodity prices, but also a mixed result of growth, liquidity and policy errors. Currently, the markets look for rate rises of 50-75bps in India and China. Events in China will matter the most for the overall picture. China’s economy finished 2010 growing at 9.8% (10.3% for the full year) – much stronger than expected and well above comfort levels. Any sign that the authorities are getting the tightening seriously wrong – in either direction – could upset world markets. But I expect China to continue to manage the balancing act. Higher FX rates will help to tighten monetary conditions  with somewhat faster appreciation (5%) of CNY in 2011. In short, 2011 should be another good year for emerging economies, but central banks will have to work hard for their keep.

Some Early Encouraging Signs

The cheer signs lately came from US labor market with initial claims fell 383K in the week ending February 5th. That marks the lowest claims reading since the week ended July 5th, 2008. But the 0.4% fall in UNE rate (9%) in January was met with much confusion. To be sure, much of the improvement occurred because many people gave up. Economy wise, 1.0% rise in December wholesale inventories was BTE vs. cons=0.7%. The inventory to sales ratio of 1.16 is up from 1.15 in November but down from 1.17 a year ago. In general, early signs are that the recent acceleration of 1Q11 US growth will be extended delivering a 4.4% yoy, up from 3.2% in 4Q10. The key contribution is that final sales should show a 3.7% increase and inventories should rebound from a very –VE contribution in 4Q10. But positive signs are that business lending awakens after tightening sharply throughout 2008-09. The G4-avg of the %- balance of banks reporting a rise in demand ramped up to 9% in 1Q, the first report of demand growth since 3Q07 and the strongest one-quarter reading since 2Q06. The rise was strongest in US, where net demand spiked from -7% to a 5-year high of 28%.

With global growth now reaccelerating, Euro area PMI has risen 3pts to 57.0 since October. This is due to the expectation of stronger growth and the upside surprise to core inflation already seen. Economists expect core inflation to rise both this year and next year from the current level of 1.1%. Together with the ECB’s other concerns about keeping its policy interest rate too low for too long, this economic backdrop will make the central bank increasingly uncomfortable with its very accommodative policy stance. It is therefore likely to embark on gradual policy normalization in December, with 25bp tightening per quarter. In contrast, inflation generally is climbing across EMs, the evidence from available January reports is far from universal. In Mexico, inflation declined from 4.4% yoy in December to 3.8% in January. Taiwan’s CPI eased from 1.3% yoy in December to 1.1% in January. Brazil’s inflation rate reached 6.0% yoy in January, not far from the 6.5% upper bound of central bank’s target. Russia’s inflation rate jumped from 8.8%oya in December to 9.6% in January.

Not A Full-fledged Bear

The recent breakout of the 10yr UST yield above 3.5% is an important technical signal, highlighting that the macro backdrop is increasingly turning against the bond market. In fact, many asset allocators have talked bearish for some time and valuation is poor in most of the major countries. The only missing ingredient for a full-fledged bond bear market is the start of monetary tightening cycles in the US or Europe. Recent comments from Chairman Bernanke, President Trichet and Governor King give us little reason to question that Fed, ECB and BoE are on hold until early 2012. Nonetheless, there is room for the market to discount a faster pace of rate normalization even if central banks do not get started until early next year. Thus, I think it is now extremely bearish on government bonds in the near term because the absence of central bank rate hikes should limit the upside for yields in the coming months.

In Asia, Standard and Poor’s recently downgraded Japan’s debt from AA to AA-. But the bond and CDS markets barely blinked. 10yr JGB yields stand at a mere 1.2% compared with 4.6% in Italy, 5.2% in Spain, and approximately 7% in Portugal. It seems that Japan’s modest sovereign risk is tied to the fact that it does not borrow from abroad --- Japan has a large CA surplus and a long history as a net creditor to the rest of the world. The lack of foreign borrowing eliminates the risk of international money fleeing the country, and causing a collapse in JPY or a sharp rise in JGB yields. Moreover, domestic creditors hold 95% of Japanese public sector debt. Domestic bank participation in the JGB market has shot up over the past two years due to low demand for corporate loans, and few alternative domestic investment opportunities for the banks. For these reasons, Japan does not face an imminent risk of descending into a debt spiral, even though longer term problems remain.  

Watch for China CPI Tuesday

Latest newsflows regarding worsening drought in 8 provinces exacerbated concerns over 1Q11 CPI and prompted Premier Wen to announce measures on ensuring grain supply (subsidies, minimum rice price etc.). However, based on CS’ research, the impact of draught on wheat price may be over-stated. Currently, the reported area of draught covers about 40% of the sown area in these eight provinces. There is a possibility that -VE impact on wheat output from this draught could be much less than the area affected. The key question is timing. Put it this way, if the draught could end by around end of this month, the impact of wheat output will be very limited. At the same time, CS estimates that the grain reserve in China is roughly equal to 40% of annual output, i.e. 200mn tons, within which a significant portion is wheat. In contrast, if the draught last until April, the loss of wheat output will only be around 10mn tons. Therefore, the government is still having enough buffer to dampen the rise in grain price.

Data wise, China will release its January inflation data on Tuesday, 15 February. Headline CPI is set to rise again in January with some forecasting 5.8% yoy (versus 4.6% prior) – a view reinforced by the latest rate hike.  Many now expect CPI inflation to breach 6% yoy in May-June, but remain in the 3-4% range in 2H. As such, I expect a further 50bps hike in benchmark rates , taking 1Y deposit and lending rates to 3.50% and 6.56%, respectively. Meanwhile, DB raised forecast for China's nominal export growth to 22% this year from the previous 15% driven largely by its recent upgrade of its US GDP forecast (by 1ppts to 4.3% for 2011). Their strategist expects, based on historical correlation, a 7% rise in export revenue tends to add 10%to earnings growth in export-related sectors, including in particular merchandise exporters, shipping lines, and ports.

Market wise, Chinese equities performance diverged dramatically, with MXCN - 5.3% vs. A-shares +1.4%. MXCN performance was pressured by rotation out of EM into DM, as other Asian markets also traded very poorly....Lastly, regional wise, MSCI China is now traded at 11.2XPE11 and 18.2% EG11, CSI 300 at 14.1XPE11 and 23.8% EG11, and Hang Seng at 11.8XPE11 and 16.0% EG11, while MXASJ region is traded at 12.0XPE11 and +13.7% EG11. One thing I want to highlight here that HSCEI is the cheapest index (except Korea) in the region with 25% EPSG ( better than Korea) now. Bloomberg 10 year monthly avg is 13.8XPE with highest 30X (2007) and lowest 6.6X (2001). It seems not much further downside unless hard landing/inflation running out of control in China.

Nobody Wants USD?

Total short USD positions jumped to USD30bn in the week ended February 1 from USD22.7bn the previous week, based on IMM data. The large imbalance in positions increased the risk for some corrective gains in USD and indeed, that has occurred in the past two sessions (+1.05%). In my own thoughts, Bernanke’s reaffirmation of the existing QE program seems unlikely to alter the current uptrend trend in yields. And while those yields gains have not necessarily been correlated with USD gains on a day-to-day basis, the broader rise in yields since early-November has been consistent with USD gains over that time. Also in US, the S&P 500 closed last week at its highest level since the Lehman bankruptcy in September 2008. The gains are partly a function of what many economists see as an improving economic outlook. On balance, the rise in equity prices is consistent with the type of expansion in risk appetite that is often been associated with a weakening USD, at least since the economic and financial crisis developed 3.5 years ago

In the crude oil space, China’s rate move, easing tensions in Egypt, and increased supply continue to promote a retreat in oil prices. Lower oil prices would remove a near-term threat to inflation and real consumption growth in the DM economies. On the other hand, agricultural commodity prices continue to climb. This suggests that consumer food prices will continue to rise, especially in the EMs, where commodity prices are a much bigger share of total value-added in the food sector. The continued rise in commodity index will extend the base effect in food inflation, meaning EM headline inflation rates will remain elevated for that much longer. I.e. Russia’s inflation rate jumped from 8.8%oya in December to 9.6% in January. As expected, food inflation rose further to 14.2% last month.

Good night, my dear friends!