My Diary 742 --- The Weaker Recovery Extended; No Reliable Pattern on UST and EMBIG; Why China Equities Corrected +6%; Positive over Asian Gold Demands
Saturday, February 23, 2013
“The renewed concerns on growth, liquidity and policy” --- The last few days has certainly told investors that the market is still extremely sensitive to any concerns about the withdrawal of liquidity and also to growth. This has been accompanied by a big pick up in volatility where the VIX has risen by as much as 12% from the end of last week, as did the DXY index (81.5) closed at near six-month highs. Indeed, the latest correction started with the Fed’s hint of the possibility of slowing QE at sometimes in the future, the WTE flash European PMI numbers and concerns about a macro tightening in China. In particular, the January FOMC minutes which were supposedly more dovish than it was in 2012 due to personnel changes surprised the markets. But the minutes revealed an increase in the number of members that associated risks with further growth in the Fed’s B/S and were contemplating tapering out the APPs before the 6.5% UNE criteria (which prescribe interest rate policy) are satisfied. The market interprets “a number” of members as more than “several” which in turn is more than “a few”. Hence markets sold-off very hard post the Fed comments.
Meanwhile, more skirmishes in the currency wars have put particular pressure on GBP and NZD. Minutes from the BoE February meeting showed that downside risks to growth have become a larger concern for Mr. King rather than persistently high inflation. At the very least, the perceived risk for further easing measures in the future has increased. There was little specific mention of GBP in the minutes, but in fact it is the currency that has seen the larger reaction (-3.9% in 2 weeks at 1.5189). RBNZ Governor Graeme Wheeler also said, "the exchange rate is significantly over-valued relative to what would be sustainable long term in the absence of sizeable increases in the terms of trade and productivity." He added that the RBNZ "is prepared to intervene to influence the Kiwi."
Having said so, over the past few months, the press and sections of the financial community have become infatuated with the so-called “currency wars,” with the main catalyst the move by the new Japanese Government to more aggressively fight ongoing deflation. In fact, G7 issued a relatively short statement on exchange rates on February 12, as suggested by the newswires yesterday, which is designed to calm fears about a more overt round of competitive currency devaluations. The new element in the statement is an additional commitment from countries to use money and fiscal policies solely in the pursuit of domestic objectives and not to target exchange rates. The statement defuses the risk that Japan faces censure over JPY at the G20 meeting and opens the door for renewed, and potentially accelerating, JPY depreciation.
Japan’s Finance Minister Aso said that the government had not anticipated the move in USD/JPY from around 78 to around 90. Later, he said that the pace of weakening of the JPY has been too fast. I think none of these comments likely represents a shift in policy in Japan. Whatever the case, it is unlikely that the Japanese government has given up on its core policy, which is use all tools in trying to boost the rate of growth. Those tools include additional government spending and more accommodative policy by the BoJ, both of which would weaken the JPY. The currency may not be the target of policy, but it certainly is at least a secondary consequence. Indicating that the tone of policy has not changed, FM Aso's boss, Prime Minister Abe, later stated that there is "no need to speak about the tempo of the currency market." Again, that is consistent with the government's statements that the intention of policy is not to weaken the JPY, but to stimulate the economy through fiscal and monetary measures.
Japanese authorities argue that the current weakness of JPY is a correction from an overvalued level. This may be true, but it is a more difficult argument to defend from this point forward given the 20% drop already seen in the trade-weighted JPY. Within the Asian region, the KRW has appreciated by 30% against the JPY since May 2012. I believe that ultimately, failure by Japan’s authorities to deliver on the radical promises of reflation will see the JPY retrace much of its recent weakness. However, in the meantime, international political opposition to further engineered JPY depreciation is likely to intensify. German Chancellor Merkel noted that she was “not without some concern about Japan right now”. French President Hollande has been vocal about the impact of a strong EUR on competitiveness. Why does it feel like a war when much of what we are seeing is not new? In addition, it will be a further headwind to an extension higher in USD/JPY. The other consideration regarding Japan will be how successful the policy proves. If Japan’s economy responds quickly to the stimulus of a weaker currency and the boost to local asset values it delivers, then others will be more tempted to follow suit. Ironically, therefore, the more successful the approach, the greater the number of those likely to mimic it, which in the end makes it more likely all those playing the game will end back at square one.
Fairly to say, Japan’s efforts to weaken its currency are far from first or the only one. Many nations have been cutting rates and embarking on nonconventional easing to help revive activity, and currency weakness was always a likely side-effect, whether intended or not, of such action. Switzerland introduced its floor on EUR/CHF back in Sep2011. Intervention to limit currency strength or target currency weakness has long been in the tool-kit of some emerging markets, where local central banks are under from government to stimulate growth, including having a weaker currency. A question is if much of what we are seeing is not new, then why does it feel like a war when? The answer is likely the state of the world economy. Previous FX manipulation sought to retain or build a share of a growing global economy. The pain of your neighbor stealing some of your market share through currency manipulation was offset by the happy realization that your situation was still improving. Your share of the pie was smaller, but the pie was so much bigger, it did not matter. Now, the pie is not growing, and the pain of dwindling market share is much more apparent. So the same behavior feels more like war.
To investors, the currency war phenomenon means FX will lead other asset classes, rather than following them. Or rather, FX becomes the obvious way to express a given view. If one believes the Japanese will successfully engineer ongoing FX weakness, you express it through the JPY. The equity market may rise due to JPY weakness, but it will be in response to the FX market. Equities will not lead the way. Japanese bond markets will face the ambiguity of additional buying from BoJ against the threat that the revelation policy might ultimately prove too successful with attendant problems for bond prices.
X-asset Market Thoughts
On the weekly basis, global equities were down -0.46% with -0.45% in US, -1.01% in EU, +1.95% in Japan and -0.22% in EMs. In Asia, MXASJ and MSCI China closed -0.76% and -3.96%, respectively, while CSI300 dropped -6.32%. Despite all the concerns about the "tapering' of Fed purchases, 2yr USTs yield gapped in 2bps at 0.25% and 10yr’s narrowed4bps to 1.96%. In Europe, The 10yr Spanish bond yield (-8.6bp) closed at 5.13% and Italy's 10yr yield @4.44% (+4.3bp). Elsewhere, The USD strengthened 1.24% @1.3194EUR, but relative stayed flat to JPY93.42. The weakness in commodities extended from concerns about a macro tightening in China weighed on the CRB commodities index (-2.05%) with Brent (-3.59%) and copper (-4.94%) leading losses. Gold price were down -2.14% at $1572.4/oz.
Looking forward, I think the global macro background remains little changed. In particular, the DM deleveraging cycle has not ended. Though it has shifted from the private to the public sector, it is the private sector that ultimately must pay for the increased government debt anyway, either through higher taxes, reduced services or higher inflation. Given the magnitude of debt levels and the many headwinds to demand, it is a stretch to believe that the major economies can significantly lower debt ratios via faster real growth within any reasonable time period. Nor is outright default by one of the G7 economies a plausible scenario.
Under such environment, equity investment is not just about QE and low interest rates. On their own, those would indeed be poor justifications for taking on risk. The more important reason is that corporate finances are healthy in many of the major economies. And where earnings are not doing well, that generally is fully reflected in valuations. As long as earnings hold up, then equity should grind higher over the coming year. Meanwhile, it also is worth noting that we do not have the bullish investor sentiment that typically signals a top in the market. Surveys indicate that only around 40% of financial advisers and individual investors are bullish on stocks. Typically, this rises to around 60% at peaks. That said, I don’t stress that we are not looking for huge stock market gains: total nominal returns of around 6% a year over the medium term seems a reasonable expectation for a global equity portfolio, and almost half of that will come from dividends. So this only warrants modest OW equity positions. The same logic applies to corporate bonds.
A more bearish stance on risk assets would be warranted if one or more of the following conditions were met --- 1) earnings suffered a major setback, 2) interest rates spiked higher; or 3) valuations were at an extreme. Either deflation or significant inflation would be toxic for stocks: the former would be very bad for earnings while the latter would signal the end of accommodative monetary policies. For at least the next couple of years, I expect the market to walk a fine line between these two extremes. Beyond that, the picture gets not clear.
That said, the biggest driver of commodities in the past couple of years has been monetary policy rather than economic growth. This shows up the outperformance of gold over base metals. However, the ratio of gold to base metals looks as if it is breaking down, pointing to a looming change in the underlying environment. I do expect a renewed uptrend in economically-sensitive commodities to reassert itself after a rather directionless year. China will be very critical to the outlook because it remains the marginal buyer of many resources. On a positive note, many base metals prices have fallen below their LT production costs and do not need much demand to appreciate. Oil prices have proved to be very resilient in the face of weak global growth and increased crude production in the U.S. This is consistent with solid underlying fundamentals, and supports a positive view for the coming year. Prices are no doubt benefiting from a geopolitical risk premium in prices related to ongoing tensions in the Middle East, but the odds are good that this risk premium will persist.
The Weaker Recovery Extended
The latest new flows are lean to downside with EU recession extended to next quarter, along with the softer US spending data over the coming months, raising uncertainty on 2013. In US, headwinds from the expiration of the payroll tax holiday keep this optimism in check while rising gasoline prices offset much of any upside risk. Meanwhile, US data flow didn't help matters lately with jobless claims (362K vs. cons=355K), flash PMI (55.2 vs. cons=55.5), and Philly Fed (-12.5 vs. cons=1.0) all printing WTE. The positive note is that existing home sales for the month of January increased +0.4% to 4920K, while the inventory of existing homes for sale fell to the lowest level since 1999.
In EU area, composite PMI fell to 47.3 (vs. 49.0 expected). In France, although manufacturing improved (42.9), services fell to the lowest level since Feb2009 (42.7) against expectations for a 0.9pt improvement in both indices. On a more positive note, German manufacturing PMI moved back into expansionary territory (50.1 vs. 49.8 previous) for the first time since Feb2012, as new export orders rebounded strongly on the back of Asian demand. In addition, the services PMI is still well in expansion mode despite the monthly fall (54.1 vs. 55.7 previous). All in all, the Europe zone composite PMI pointed toward a continuation of the recession in 1Q13. Looking ahead, if the market does not get a better EU growth in 2Q13, then risk is due for a sharp correction until the OMT is eventually activated.
In Asia, a risk has been that Chinese policymakers respond to a QTE pickup in the housing market by putting the brakes on once again. The recent reported jump in total social financing in January even as bank lending growth slowed raises further concern that non-bank credit has been finding its way back into a resurgent housing market. In response, a number of larger cities have reportedly tightened home loan controls this week while the PBoC drained liquidity today for the first time in eight months. In Korea, BoK kept its policy rate unchanged, reflecting concerns over lackluster domestic. India’s central bank has been sitting on the horns of a dilemma not directly related to currency considerations. Growth has slowed well below trend and WPI pressures have been moderating. Yet, a bloated CA deficit has imperiled macroeconomic stability and CPI inflation has hovered around double-digits, constraining a more aggressive follow-through from the January cut.
Net-net, even accounting for an expected upward revision to the US, the outcome will be the weakest of the expansion which the global economy expanded 1% below trend. As a result, the legacy of weak growth will keep a lid on underlying inflation and maintain the central bank bias toward easing for some time to come. However, the frustrations of central bankers dealing with consequences of widely divergent monetary policy stances have been sometimes characterized as generating a currency war. These tensions play an important constructive role on a global scale. Faced with the ZIRP constraint, DM monetary policy has been unable to deliver an appropriate degree of additional accommodation through the past two years of weak growth. The limited tolerance of EM central banks to allow divergences in policy stances and growth to feed currency appreciation has produced some needed additional easing in overall global monetary policy.
No Reliable Pattern on UST and EMBIG
The sell-side client survey showed that 54% of investors see UST yields rising as the top risk for EM in the next 12 months, with ‘Country Specific risks’ the next factor on the list getting only 18% of investor responses. In theory, there is a mechanical link between UST yields and the price of EM USD sovereign bonds, given they are a USD denominated credit asset class. All else equal, as UST yields rise, all USD payments should be discounted by a larger discount factor and so the price of an EM bond should fall. If spreads are unchanged (i.e. all else equal), then the yield on an EM bond should rise round as much as the UST yield curve rises. That would result in negative returns on EM USD bonds as UST yields rise –a negative correlation between EM returns and UST yields – and no correlation between EM sovereign spreads and UST yields.
However, there are two factors make this theoretical relationship less clear in practice. First, UST prices and yields tend to move as a reflection of risk-on / risk-off sentiment, with UST yields falling as investor sentiment becomes more negative and safe-haven USTs are bought. EM Sovereign spreads also react to risk sentiment and so EM sovereign bond yield moves are a function of how both UST yields and spreads are reacting at the same time, and this relationship varies through different periods. The fact that over the last decade EM fixed income has moved to be a more mainstream asset class, acting as a safe haven at times, has also complicated this relationship. Second, most EM USD sovereign bonds are still quoted in price terms (i.e. 100.00/101.00), as opposed to quoting in spread terms (i.e. 150bp/160bp), even though much of the market is low spread investment grade. This causes a lag in the reaction of EM sovereign bond prices to UST moves.
Historically, there is no consistent relationship between moves in UST yields and EM sovereign spreads as well. There have, however, been four periods where there was a statistically significant relationship between UST yield changes and EMBIG spread changes over a three month period --- 1) -VE correlation from Jan – Sep 2002 on Latin America concerns; 2) +VE correlation from Jan – Jun 2004 on US Fed tightening fears; 3) -VE correlation from Jan 2005 – Aug 2008 due to supportive credit environment; and 4) +VE correlation from May – Oct 2010 due to QE2 & Jackson Hole speech. Again, this shows that there is no overall reliable pattern.
Why China Equities Corrected +6%
The recent significant correction in A-share (-6.3%) and MXCN (-3.96%) seems triggered by negative news (tighter real estate policies), but the real reason is that the recent excessive growth of TSF has changed the market’s expectations for future macro policy. That said, tightening in the property space definitely caught all eyes as it sets a tone for the new government which will take office in March for the new policies. Sectors including Property, coals, banks, cement were all corrected 3-5%. In fact, the market has been worrying about such rumors, including transaction tax and tighter requirements in second mortgage. Now it seems the policy risks got partially released, but there could have more policy noise before the March Meeting. In particular, there could see detailed measures in the Beijing regarding to the transaction tax and tighter requirements in second mortgage, as well as extending property tax in more cities. The overall China property sector has corrected 15% YTD. I think part of the policy risk and bearishness have been priced in as the overall sector Disc to NAV is >40%. Given the technical indicators (RSI) are already bearish, we could see a rebound after the policy noises get cleared, as the bank loan growth stays very high in Feb (> 800bn said) and January and the overall liquidity environment in China remains good.
That being said, another catalyst behind the recent selloff is PBOC starting to drain liquidity from the system with recorded weekly RMB910bn reversed repos. Since Dec2012 to the CNY, liquidity conditions and market expectations were both very positive to stock prices. But due to the recent excessive growth of social financing, the market’s policy expectation has gradually turned neutral or slightly pessimistic.
Meanwhile, the 2013 CNY retail sales number (+14.7% vs. +16.2% in 2012) pointed to a weak economic environment. Given that most of the economists expect a weak recovery, the excessive money supply growth may drag the economy into high inflation, which will be the biggest risk to equity performance in 2013. From now on, the Beijing policy makers are likely to be hesitant in the next few months. On the one hand, it would be difficult for them to significantly tighten policies now, for fear of stifling the economic recovery; on the other hand, they must do something in the face of soaring financing and an imminent rebound of inflation and property prices.
In the near term, I maintain a conservative view for the market after a strong 2 month rally. I saw some big blue chip sectors like brokers, property and insurance turning weak before CNY and banks (1988HK -16.4% MTD) also look facing profit taking pressure. Another sign is B-share market seems stop rising for some times. I think a pull back is quite normal for Chinese equity markets due to --- 1) from now till NPC meeting, market will lack of any good catalysts; 2) Feb economic data should see a yoy weakness due to the CNY effect and 3) PBOC started withdraw liquidity from market after CNY after a strong M1 growth in Jan..…… Lastly valuation wise, MSCI China is now traded at 9.9XPE13 and 11.1% EG13, CSI300 at 11.8XPE13 and 15% EG13, and Hang Seng at 11.4XPE13 and 8.5% EG13, while MXASJ region is traded at 11.96XPE13 and 11.3% EG13.
Positive over Asian Gold Demands
Gold prices have struggled in recent months and weeks, as investors seem to be losing confidence in the gold bull-run and momentum is clearly slipping. Media reports said that a major fund manager has been reported cutting his physical position in gold in recent weeks and reallocated this into equities and other assets to gain increased exposure to the economic cycle.
Looking back at this bull-run, it is useful to put this recent pause into context. This time we have spent 75 weeks below the most recent peak in prices (Sep2011), which is a long pause. Previous extended pauses in the rally took place in 2008-09 (76 weeks), 2006-07 (69 weeks) and 2004 (39 weeks) – often after sharp rallies. Thus, investors should turn more cautious in the near term. However, in the mid-to-long term, there is limited downside for investor positioning from here and as economic activity picks up, inflation risk will probably increase. This should lead some investors back into gold. Over the past four years, the average US net managed-money position in gold was 164K contracts and its lowest level was 71K contracts (July 2012), not much below current levels (86K).
Meanwhile, from a physical perspective, the long-term Asian demand remains strong. We continue to see good appetite for gold from India. Imports were very strong in early January, ahead of an anticipated hike in import duty, but then eased back. Local sources estimate that India imported 75-80 ton in total in January, a 28% yoy rise. For the full year, Chinas demand was stagnant, as credit tightening had an impact. The most recent report from the WGC estimated that demand was down 0.5% at 776 ton, still lagging India, but it is catching up rapidly. The outlook for Chinas demand looks positive. The latest Gold Demand Trends report estimated that central banks bought 145 ton of gold in 4Q12 − its highest quarterly level in 48 years. Overall global gold demand was up 4% in 4Q12 to 1196 ton, which is quite bullish.
Good night, my dear friends!