My Diary 741 --- From Consumer Power to Asia Exports; The Demand & Supply of USTs; The Hope and Challenges in China; Another Milestone in Currency
Sunday, January 27, 2013
“Market sentiment has reached multi-year bullish territory” --- The past week saw risky assets such as equities, commodities, and HY corporate continue to rally on supportive economic and political news, while USTs and German Bund yields are reaching multi-month highs. VIX (12.89, -28.5% ytd) is at levels not seen in six years, showing that investors stay in bullish mood with YTD seeing USD3bn of inflow to equity mutual funds --- a magnitude that has only been seen on two other occasions in the past 12 years. Macro wise, impressive PMI data, a 3-mth suspension of the US debt ceiling, and a higher than expected early LTRO repayment in Europe, all bolstered investor confidence. The US Congress’s decision to suspend, but not lift, the debt ceiling for 3 months shows that Republicans recognize that they cannot use the threat of a US default in a credible fashion. But it makes it now likely that they will no longer delay sequestration. This by itself is a net negative for our US GDP forecasts, by almost 0.5% of GDP. Worth for noting is that the Euro area flash PMI jumped 1pt in January to 48.2, which makes economists think that the Euro area economy will stabilize in the current quarter and grow modestly by 0.8% saar in 2Q13. In fact, this week’s worldwide flash PMIs point to a sizeable January gain in global manufacturing PMI. Economists estimate that the global PMI will rise 1.8pts to 52.0. This is the strongest monthly change since the global PMI started improvement last Sep.
From now on, OW positions and potential growth disappointment, especially given elevated consensus expectations, pose the two biggest risks for equity markets going forward, as we have seen the limits of the extent to which global central banks could further surprise investors. Meanwhile, the so-called “Great Rotation” from Fixed Incomes to other asset classes have being well debated and probably executed to some extent by institutional investors, but many investors in US, Middle East and Asia were not worried about a shift by retail investors from Fixed Incomes to other asset classes, even though a spike in USTs as a result of BTE US growth was the primary risk factor cited by most investors. I think a true sell off in the broader fixed income market will require an approaching end to QE and speculation about rate hikes, and/or signs of credit trouble among issuers that have borrowed beyond their ability to pay back. On the latter, I see many signs of indiscriminate buying in the HY Corporate world over the weeks, but we appear to be very far from the leverage that has doomed previous booms in credit and EMs. The other force that has the potential to damage the broad bond world is a reversal in easy money, and thus in slow economic growth. The street is seeing signs that the world economy is staging a rebound from the sub-trend 2% pace of the past 3 quarters. The most recent set of flash PMIs point to a sizable January gain in global manufacturing PMI, pointing to the upside risk for 1Q13 GDP, which is around 2.3%.
Central Bank wise, the BoJ this week adopted a 2% inflation target and open-ended asset purchases. This is a clear sign that the BoJ’s easing has become more aggressive. Previously, the BoJ’s policy had been a 1% inflation goal for the time being, with an ultimate goal of 2%, under the framework of “the price stability goal in the medium to long term” announced in Feb2012. In the new policy, the word “goal” was upgraded to “target,” and surprisingly, the 2% inflation target should be achieved “at the earliest possible time.” However, what has become clear this week is that, although the government pushed the BoJ to accept a 2% inflation target, the BoJ did not offer much change. Now open-ended APP will start only in 2014, leaving the previous 2013 APP unchanged. The expected net increase in the Fund is only JPY10trn in 2014, and the size of the Fund will remain unchanged in and after 2015. The market had expected that open-ended APP would start in 2013with an expected increase in the Fund of JPY48trn a year. Worth noting is that, Unlike the Fed, the BoJ appears to be reluctant to purchase long-dated JGBs. One of the reasons is that the 10-r JGB yield, currently 0.72%, is so low that room for further decline, and accordingly any impact on the economy, is limited. Another reason is that, it could undermine the credibility of the government if the market feels that the BoJ is financing the fiscal deficit and could eventually lead to a jump in bond yields. But more importantly, the BoJ appears to be concerned about its exit strategy. As investors move on, the market now expects the BoJ leadership change in April to be accompanied by more easing—an increase in open-ended purchases, a cut in IOER, and JGB purchase maturity extension. All these likely have the potential to add further fuel to the Japanese trade especially if they are combined with government reforms.
X-asset Markets Thoughts
On the YTD basis, global equities were up +4.52% with +5.51% in US, +5.85% in EU, +6.69% in Japan and +4.73% in EMs. In Asia, MXASJ and MSCI China closed +1.23% and +3.13%, respectively, while CSI300 also climbed +1.93%. Elsewhere, 2yr USTs yields added 3bp at 0.272% and 10yr’s widened 20bps to 1.95%. In Europe, 10yr German Bund yields widened 32bp to 1.64% as medias reported that Banks that borrowed more than EUR1trn of emergency funding from ECB may chose to pass up on an early repayment window starting later this month. The 10yr Spanish bond yield (-5bp) closed at 5.15% and Italy's 10yr yield (-36bp) at 4.12% is at its lowest level in 2 years. Elsewhere, 1MBrent crude moved +2.44% at $114.67/bbl. The USD weakened 2.02% @1.3464EUR and strengthened +4.95% to JPY90.91. CRY index was up 1.46% to 299.31, while Gold price were down -1.04% at $1658.75/oz.
In general, the recent rise in risky asset prices and business sentiment represent a collective sigh of relief as the concerns that weighed on sentiment and activity last year (including Euro area financial stress, China’s slowdown, and the US fiscal cliff/debt ceiling crisis) have largely abated. Certainly this force of lift is working against two significant drags constraining growth --- 1) fiscal tightening in the US and Europe; and 2) a profit margin squeeze and tight credit access that weigh on firms in EMs. But the sense of reduced macroeconomic tail risk should become more firmly established and strengthen the positive dynamic between sentiment, activity, and financial markets.
Looking forward, I think the major driver behind the risk asset is whether easy money is bringing a cyclical recovery. I think there are 4 main economic themes in 2013, namely 1) a cyclical recovery with China and the lagging West, driven by very easy monetary policy almost everywhere; 2) a turn in the monetary policy cycle, again with China one of the first to begin to tighten; 3) fiscal tightening holding back the US in 1Q13 and Europe throughout the year; and 4) a market focus on reform progress --- implementation in peripheral Europe and India, and plans in China. For the US, 1Q13 activity is likely to be slow at best, as the effects of higher social-security taxes and uncertainty over policy delay spending. Elsewhere, signs of a recovery should intensify in coming months. By 2H13 and into 2014, I expect to see EM economies growing strongly, US growth pushing up to 3% yoy and even Europe growing again. This improvement reflects receding tail risks and the inventory cycle working through, along with very easy monetary policy. Despite strengthening US growth, I still expect Fed QE to continue at a high rate throughout 2013, though markets may begin to anticipate a cutback in 1H13. EM will face strong capital inflows and the risk of higher inflation and bubbles, with further rate cuts now very limited and focus shifting to rate hike before long. To investors, I think the progress on reforms will be watched closely. In the near-term, a critical issue will be whether the US can reduce long-term entitlement spending and rationalize the tax structure. Weak progress would likely trigger another debt downgrade, potentially creating stress in markets. Good progress on fiscal reforms would be a huge plus for confidence. In Europe, Greece, Spain, Italy and France, reforms are the only way to escape the crisis in the long term. In Asia, they are also critical. Hopes for reform are high for China, but fairly low for India, with mixed prospects for others.
From Consumer Power to Asia Exports
The economic calendar this coming week will provide important information on US economic performance, including the first report on 4Q12 real GDP(from 3.1% in 3Q12 to only 0.5%), the January labor market, ISM manufacturing, and auto sales, December releases on durables, consumer income and outlays, and construction, and an FOMC meeting and accompanying statement. The more timely information will be the early reports on January activity. The labor market report is expected to show NFP of 160K, similar to the prior two months, and an unchanged UNE rate of 7.8%. The ISM manufacturing survey is forecasted to rise 1.3pt to 52.0. More interestingly, December report shows that the US housing market continues to tighten. The inventory of unsold existing single family homes declined 1.5% and is down 21.2% yoy and the months’ supply has declined from 9.1 months in Dec2010 to 6.9 months in Dec2011 and an unusually low 4.9 months in Dec2012. The market is nearly as tight as it was during the previous housing boom, and so it is not surprising that house prices have started to firm. November house price has gone up 7.4% yoy and the FHFA index also climbed 5.6% yoy.
Meanwhile, many investors should remember that a year ago at this time, inflation was elevated and posed two related risks to global growth --- 1) a set of supply shocks pushed commodity prices higher and raised the specter of ongoing drags to HH purchasing power; 2) many large EM economies were operating with +VE output gaps and appeared to be in the early stages of overheating. This posed a threat to the sustainability of their expansions. What’s more, these pressures were being passed through to DM consumer price inflation through imported goods. What a difference a year makes. A combination of weak growth, stable weather, and geopolitics has pushed inflation sharply lower. Headline consumer price inflation has fallen >1% over the past year and is set to move lower during 1H13. In part, this reflects an unwinding of global commodity price pressures that accelerated in recent months. The benefits of this decline are already evident in the rebound in global consumer spending into year-end. It is also encouraging that, while levels remain elevated, there are no signs of agricultural price pressures on the horizon.
As discussed above, January official data indicate that global IP returned to growth in the final few months of 2012. With all three reporting nations moving higher, a significant rise in the global manufacturing output PMI can be anticipated. Equally encouraging, the increase in the new orders index this month could top 2pts. Asia is most levered to the global manufacturing cycle and tends to lead it. So far, China’s upbeat reports of December IP and exports and its January flash PMI (51.9) reinforced this case, but optimism has been tempered somewhat by incoming December activity reports of large drops in Taiwan IP (+2.39% vs. cons=6.8% and Nov =5.85%) and Korean exports (-5.5%). Japanese December trade data (-5.8%) also disappointed this week and next week’s December IP report along with the January PMI is under watched.
The Demand & Supply of USTs
I think US rates are likely to stay low in 2013, with a risk scenario of higher rates linked to a rise in global risk appetite on better data. Ongoing foreign demand for USTs, increased purchases of T-bonds from the Fed and a tighter fiscal stance will put downward pressure on USTs yields in 2013. In fact, external creditors continue to add to stocks of USD reserves, as the latest COFER and US Treasury data show, even as they diversify into other assets. Their rate of purchases is of similar magnitude to the USD45bn per month that the Fed now buys as part of an enhanced QE3 program. This higher demand will meet lower supply in similar order of magnitude from tighter fiscal policy. The demand & supply balance shifts firmly towards excess demand, keeping downward pressure on bond yields. The close linkage between bond and swap yields means this pressure will also be felt in IRS markets.
The upward pressure on UST yields is more likely to come from more appetite for risk rather than from the inflation, growth or default risk channels. The rise in yields towards the end of 4Q12 was clearly linked to more risk appetite, stemming both from good news, i.e. changes for the better in leading and contemporaneous indicators, the partial passing of the fiscal cliff and also a response to bad news – the increased QE3 program. My base assumption for the year is low inflation risks and inflation shows little response to variation in the money supply, as the street forecasts modest growth forecasts for the US in years ahead. Inflation and default risk expectations remain unaffected by the attention drawn to the explosive debt path in the long run for the US by the debt-ceiling debate. Finally, there is little sign that the Office of Debt Management will take advantage of low rates and significantly shift out the duration of the US debt to reduce refinancing risks.
The start of 2013 has gone well so far for the Asian bonds with spreads tightening across the board and HY corporate. However, UST widening has affected total returns. In a repeat of 2012, technical factors continue to underpin the search for yield in the Asian markets. Global growth remains muted, and with tail risks reduced by central bank actions and base rates remaining low, I expect continued fund flows into EM debts. So far USD 5.1bn of new issues has priced in AXJ USD credit markets (as of 22 January). Interestingly, ~50% of this amount has been in the HY space. Looking ahead, I am generally bullish on Asian bond markets over the next six-12 months, driven by sanguine local demand/supply dynamics (driven by banks, insurance companies and pension funds) and a positive Asian FX. Here most AXJ central banks have already finished their easing cycle, with the exception of Thailand, South Korea and India. RMB is expected to appreciate by 2%, which will be supportive of Asian currencies generally. Meanwhile, the diversification from central banks and SWFs into AXJ bonds that emerged in 2011 was sustained through 2012 and could persist in 2013.
The Hope and Challenges in China
The year ahead China‘s new leadership is expected to adopt a reform agenda, though it remains to be seen how aggressively this will be pursued, which is a key focus this year. One of the major thing to watch is how the government implement the rural land reform. Historically, foreign investors have attributed the fast GDP growth in this nation to the high FAI and strong export underpinned by cheap currency. However, I think the real driver behind China’s growth story is all about land. It is the abundant supply of land supported high FAIs for decades and the cheap land costs underpinned the export manufacturing. From 2006-2010, the local governments have applied and used over 10mn Mu (1/15 of a hectare) per year, and the land supply has very high correlation with GDP growth from 2003-2010.
For 2013, the average market forecast for China’s GDP growth stands around 8-8.2%. On the policy front, China will continue to adopt proactive (modest easing) fiscal policies and prudent (neutral) monetary policies this year. On the fiscal policy front, the government will continue to run a fiscal deficit (2% GDP) and expand structural tax cuts to support targeted sectors (e.g., service, SMEs, new strategic industries). On the monetary policy front, PBoC is to keep policy rates on hold throughout the year, as economic growth will continue to recover modestly, and in the meantime inflation will remain at benign levels (avg 3.2% in 2013). The central bank is likely to use OMO and RRR to manage liquidity. There is room for 2-3 RRR cuts throughout 2013. On the credit side, it is expected that bank loans to increase by RMB9trn in 2013 (+14.5% yoy).
Meanwhile, q lower growth rate and structural changes signal that China has entered an era of normalized growth rates from 2012, with the lowest GDP growth rate since 1999. A rebalancing process, marked by an increase in the share of consumption to GDP growth, lower growth in the manufacturing industry and lower export growth, has started. By industry, secondary industry growth declined from 10.3% in 2011 to 8.1% in 2012, a drop of 2.1 ppt. The BTE growth in China’s Dec exports does not change the fact that China’s trade growth is also returning to normality. China’s total trade grew by 6.2%in 2012, short of a 10% target set by the government. The challenges ahead are growth deceleration in the manufacturing industry could WTE, due to rising labor and environmental costs, overcapacity, uncertain external demand and slower-than-expected industrial upgrading. NPL may rise as the problems with loans to LGFVs have been delayed, not resolved. The rising share of shadow banking presents another risk to China’s banking system. The demographic changes tend to raise wage levels, increase spending on health and old-age care and put downward pressures on China's growth potential.
Back to markets, this week fund inflows into China remain heavily skewed to the banking sector, which probably makes sense given that they are seen as very liquid and cheap proxies for the broad-based economy. HangSeng Index consolidated around 23,500 level weighed by >30 companies' profit warning & cash calls through share placements & bond issuances.…… Lastly valuation wise, MSCI China is now traded at 10.4XPE13 and 11% EG13, CSI300 at 10.9XPE13 and 15% EG13, and Hang Seng at 11.5XPE13 and 8.7% EG13, while MXASJ region is traded at 11.6XPE13 and 14.9% EG13.
Another Milestone in Currency
Currency markets are approaching another milestone this week. Correlations across USD pairs are collapsing to their lowest level in five years, which are statistical results for currency moves having little to do with global issues and almost everything to do with local ones. Indeed, 2013 in FX appears mostly to be about country specifics, such as money market normalization for EUR, Abenomics for JPY, triple-dip recession plus EU exit for GBP, or a shifting central bank bias for Brazil.
That being said, JPY is living up to its reputation as the world's most politicized exchange rate. It's also one of the most volatile (after ZAR) as well as the most oversold. The view is unchanged despite the warning signs, however: Japan’s current policy mix is unlikely to generate sufficient inflation to induce Japanese investors to increase capital outflows and sustain JPY weakness past this summer until thenew BoJ reveals what tactics will be used. Short JPY is still the good funding source for carry trade, unless conditions reversing, such as government rejection of the foreign bond purchase proposal; G-7 opposition to further JPY weakness; trend improvement in the CA surplus; or evidence that international investor positions have reached a natural risk limit.
In the commodities, the complex is up around 1% this week, with gains for industrial metals and energy offsetting losses for precious metals and agriculture. US natural gas is up almost 12% over the last two weeks as much colder weather hit the US, leading to much stronger declines in inventories Industrial metals have been doing much better recently, on the back of economic data starting to surprise on the upside and PMIs and other measures of industrial activity rebounded. But metals have yet to move out of the range they have been in since Q311. This is likely because the improvement in activity data was only enough to confirm existing growth expectations.
Good night, my dear friends!