My Diary 400 --- The Synchronized Concerns; The Double-Hedge of

My Diary 400 --- The Synchronized Concerns; The Double-Hedge of Crude Oil; To Stay Flexible on Equity; The Short-lived USD Rebound

May 25, 2008

Inflation concerns coupled with rising oil and commodity prices finally took their toll on global equity and bond markets and there is a question now that should we go long now? I think technically, it is YES. If you make a chart of the past 6 month of S&P500, the latest 3 bottoms in March 17, April 15 and May 23 all saw a +5% correct from their near highs. Now if you believe that the market will not return to the Bear Stearns lows, given negative real rates, we should have a rebound soon, at least technically …

Having explained this interesting technical trend, global equities actually dropped -1% on Friday, or cumulatively -2.8% wow. Regional wise, DMs and EMs declined 2.9% and 2.1%, respectively, with US and EU markets contracted +3% each this week, while Nikkei decreased 1.5% (expect to go down on next Monday)… “Sell in May and go away” once again proved to be right…As a result, UST rallied with 2yr yield fell 10bp and 10yr sank 7bp, each finishing nearly unchanged wow. During the week, USD receded 1.2% vs EUR and 0.8% vs YEN, 0.8% on a TW basis. Oil prices surged this week as 1MWTI price closed at near $132/bbl, a +$5/bbl gain wow. Meanwhile, industrial metals and agriculture prices dropped 4% and 2%, respectively.

The biggest answer taken from the latest FOMC minutes is that Fed has a "close call" on April, given lingering concerns about upside risks to inflation and the reduction in credit market strains. Nonetheless, the minutes highlight that US policymakers remain nervous about the outlook over both growth and inflation, keeping their options open. In fact, future markets are pricing a 50% chance that the Fed will hike rates by 25 basis points before the end of 2008 … Is the market bet rooted inside of FOMC members? Not likely, I think as the economy is still struggling. But other central bankers may have different views…So today let us start with the central of this financial world --- Central Banks.

The Synchronized Concerns

Reflecting a fact that growth is primarily concern around US economy, Fed is still the only major central bank that has been easing aggressively, while the rest of the world is either standing still or considering hiking rates. Going forward, the desynchronized monetary policy among global central banks may prevail for a little longer, along with low US interest rates w and pro-growth Fed policy. The key observation to support this judgment is that among G7, US core CPI & inflation expectation is well behaved, while labor market flexibility and rising productivity should give the Fed much room to keep policy accommodative.

In contrast, ECB is not able to enjoy the same luxury with its main concern over rising food and energy costs being transmitted into the broader economy. The lack of flexibility in the labor market, low productivity growth and strong labor union influence are increasing the risk of excessive wage hikes feeding into rising core inflation. As a result, the hawks at the ECB have the upper hand, which means the policy rate will stay high. Monetary policy in the major developing economies such as China, India and Russia will be tightened, witnessed by strong growth and cheap currency, and commodity trade surplus.

Despite the central banks’ desynchronized policy stance, there are growing synchronized concerns over inflation. Over the month, the 15% oil price increase has hurt both debt and equity markets in the US, reflecting by the rising correlation between bond yields and stock prices. During the first 4 month, the correlation between 2yr UST and SP500 reached 81%. Having said so, bond markets were a SELL with 2y UST yields approached the highest level since early January sue to Fed’s done-job call and record oil prices renewed inflation concern. In the TIPs market, the 10yr BE rate was approaching 2.59% on May 22 (2.54% on Friday), the widest since 13March2008. Overall, it was inflation fears that have pushed rates up, but US housing data, remains very weak as home resales dropped 1% to a 4.89mn yoy in April. Concerns on inflation and record-breaking oil prices also turned Asian credit market sentiment negative. The iTraxx AxJ HY and IG index went higher at 460bps and 105bps, respectively……nowadays, it is nothing else but oil and inflation, which seems to have replaced the credit crunch as the predominated risk factors……

The Double-Hedge of Crude Oil

Over the past 5 year, oil price has gone up 350% from $29.69/bbl to today $132.19/bbl. In fact, from 23May2003 to 23 Jan2007, the crude oil price only went up about 69.5%. It was the recent 16 months that oil price saw a blow-off (from 52/bbl to 132/bbl, +5bbl per month). As a result, there are a lot of debates around oil price move, ranging from Goldman Sach’s $141/bbl 2H08 forecast, to US Treasury Henry Paulson’s argument on the tight supplies and growing global demand, and to Mike Norman’s pure and simple speculation say on Fox News.

I am not a specialist on the oil sector, thus I would like to take a blended view on each of the mentioned factors. In terms of S&D, there is no question that China now has replaced G7 as the marginal price setter of crude and other commodities, witnessed by the tight correlation between Chinese IP figures and most commodity prices. Japan’s historical experience in 1960s also suggests that the growing China and rising Oil price may extend for a while. A key sidetake is that there are few signs of an imminent policy change to the energy subsidies in China, India and the Middle East. Supply side, things are tight. No mentioning, global oil rig count is losing upward momentum; supply growth is now constrained by OPEC discipline and non-OPEC bottlenecks. As a result, even US decide to stop adding 76K bbl/day to its SPR, it has only a minor effect on crude price.

Elsewhere, the still well-contained core price inflation & labor cost have allowed Fed to injected huge amount of liquidity via low real rates and plentiful money growth, resulting in another precondition for asset price overshoots. Now with the resources sector exposure to EMs growth and a traditional hedge against inflation, oil and other commodities are not surprised to be viewed as a “Double Hedge” investment, which explains why investors are pooling their money into this asset classes, whatever from pension funds or speculators.

To Stay Flexible on Equity

Regional markets (AxJ) saw a 3.2% drop over the week, with A-share down the most 6.6%, measure by CSI300 index. Valuation wise, MSCI China is traded at 16XPE08 and 23% EPSG, vs. MSCI HK is traded at 17.2XPE08 and -1.1% EPSG. H shares are at 15.3XPE08 and 24.5% EPSG vs regional market is traded at 14.5XPE08 and 10.1% EPSG.

While the recent rally in global equities is being seriously challenged by ever rising crude price, I think oil is not the only factor impacting economic growth and stock prices. Other supportive factors include negative real interest rates (-2% in US), the fallen credit spreads and labor costs, as well as strong economic growth in EM countries with solid fiscal status. All of these forces have allowed share prices to rally from the dead-trap of the Subprime crisis and should continue to work in favor of equities. Having said so, we should keep an eye a further large blow-off in oil prices, as which could choke off global growth and cause a new down leg in share prices...What can send the stock market fly higher --- a period in which oil prices level off… But before we see that, just stay flexible in this rapidly changing market conditions.

An interesting thought to A and H shares is that, unlike the growth concerns in the rest of the world, a weak growth could be a catalyst that triggers a rally in China’s equity prices, as it would remove tightening bias over domestic monetary and credit policies. Going forward, with corporate profits growing strongly and 15XFWPE, Hong Kong listed H-shares remain attractive to investors.

The Short-lived USD Rebound

The rebound of USD over the past few weeks seemed to be a correction from previous trend weakness. The recent USD rebound since 22April is largely due to a dramatic shift in interest rate expectations with money markets have gone from pricing in more rate cuts over the next 12 months to a peak of 77bpsrate hikes as of 15May (67bp now).

Form what we have seen over the past week, it seems that the 2007-08 Subprime crisis is just over within the boundary of financial world, while its impacts to the real economy are just coming, starting from US and then spilled over to EU, JP and elsewhere. Judging form the declining consumer confidence index, The US domestic consumption looks set to fall sharply as the impact of housing foreclosures and job losses is increasingly felt. Certainly, this will be offset to some extent by fiscal and monetary easing this year. However, neither of these is likely to have any beneficial impact on people who have lost their houses or jobs - or both. Thus, I expect that USD weakness is not over yet.

To the rest of the world, as said before, the desynchronized central bank policies will continue to drive currency-crosses. The important EURUSD may stay at the1.57 level for a little while as due to a combination of low USD yields and softening EU growth. JPY is hard to say as the currency has been viewed as a proxy of global carry trade and been very negatively correlated with equity prices. But given Japan’s deflation is still around the corner and weaker US demand, it may not as cheap as people think……Some random thought over Japanese currency as Christopher wood pointed out, global-wide, inflation is the friend of Nikkei.

Good night, my dear friends!