My Diary 560 --- Impossible to Make Prediction; Back to Yields H

My Diary 560 --- Impossible to Make Prediction; Back to Yields Hunting; Stay Closer to China; Behind the Commodity Run

April 26, 2009

 “Confusion, Position, Recovery and Capitalization” --- The overall market sentiment remains confused as bulls and bears are fighting inch by inch. In my own view, the market rally over the past 6 weeks is well explained by human psychology, but not fundamentals and technical indicators. As I discussed before, the market has a human side. As a whole, human beings don’t get into a status of continuous deterioration. Some of us do, but the vast majority of people gradually adjust. People start to engage again after a shock is passed. That being said, with most global equity benchmarks went up 30% and about 1/3 US earnings reported, it is a good time to do a reality check on the prevailing question of “Is this the end of the stock market rally?”…Before I dig into that question, let us review the weekly market performance first. Global equities moved forward only 0.11% wow, followed six consecutive weekly gains of 24%. Regionally, US and EU went down 0.4%, Japan -2.24% and EM +0.7%. Elsewhere, 2yr UST lost 1bp to 0.96% and 10yr increased 5bp to 2.99%. 10yr yield is now back to the same level prior to the Fed’s announcement. 1MWTI oil closed at $51.55/bbl, up $1.22 this week. EUR closed at $1.324 (+1.5% wow) and YEN at 97.2 (+2.0% wow).

Based on my X-asset observations, this market rally does present a few interesting signs – 1) Risk aversion parameters (VIX=36.8, -26% since 09Mar, EMBI sovereign spread=588, -142bp, NA HY CDS=1235, -565bp) are improved sizably. The drop in volatility, including FX Vols has even brought back carry trades; 2) TIPs and copper (+23%) prices are rising, which indicate the deflation risk has materially diminished. This is positive to stock price as inflation relatively is less destructive than deflation; 3) Bank earnings/capital raising ($5bn GS) and US/China high frequency macro numbers (PMI, Auto sales, FAI, Credit growth etc.) seemed somewhat like the worst of global economy have passed. The rate of pain has slowed sufficiently for many investors to consider value again; 4) Global fund mgrs are still underweight equities relative to other assets. Meanwhile, I saw the strongest EM equity inflow ($7.5bn) in 4WKs since Mar08. Thus, it seems fair to say the rally is NOT END YET. But it does not mean one shall buy more cyclicals into this consolidation because a unique feature of this rally has been the magnitude of outperformance (1720bp at peak) for the cyclicals/ high beta/oversold stocks vs. the defensives/low beta/high-quality stocks.

As a result, the risk-return tradeoff at this moment is not in favor of buyers, as the markets have priced in high expectations of positive surprises continuing. Fundamentally, chasing this equity rally is assuming a V-shaped recovery, which in my view is unlikely to occur soon. This is why I see a broader doubt over the sustainability of this rally as the quality of growth “recovery” remains weak and fragile, even considering China. I think Bernanke on April 17 made a good summary on where we stand in the cycle --- “The damage from this turn in the credit cycle, in terms of lost wealth, lost homes, and blemished credit histories, is likely to be long-lasting”. His peer, Treasury Secretary, Geithner later added that “the crisis is more than just a severe downturn in the business cycle, and is instead an abrupt correction of financial excesses that has overwhelmed economies' and markets' self-correcting mechanisms, and so can only be ended by extraordinary policy responses." All that said is “even if the economy has bottomed, it’s very likely that the eventual recovery will prove to be uneven, causing the flow of positive surprises to be uneven.” During such a market environment, the risk to stocks will be greatest when the market is overbought and as the proverbial “wall of worry” grows, the longer it remains, the better its chances of being right.

I think this is the status of market we are in now. With major indices and most stocks trading above their 200DMAVG, the inevitable thing to me is to access the current market position, instead of trying to chase the last leg of this rally, assuming it will come. Starting with fund flows, foreign investors bought US$6.8bn of Asian equities in the past 5WKs, pushing local markets up by +30%. However, even after the recent rally, the regional index has halved in value since the peak. In terms of valuation, the 12MFWD EPS of AxJ is 44% below its peak and 12XFWDPE is approaching the LT average and is near the most expensive in 9 months. Meanwhile, the trailing PB is currently at 1.6X vs. 1.1X at Oct 08. Thus, valuations are not as attractive as a few months ago. But the bigger problem is this beta recovery trade has happened in the absence of earnings U/Gs. For example, when market EPS has fallen by ~10% over the past 6 months, HSCEI index surges +80%! Yes, EM banking systems were largely intact and could support growth. This view is now consensus and I need to see more conclusive evidence of an economic recovery and the end of earnings recession to extend stock markets further. Otherwise, history may repeat itself in different version again. Between Sep2001 and Jan2002, NASDAQ surged 45%, but was re-testing the lows by Jun2002. From March to November in 1980, S&P made a 43% bounce (98 to140). That low was tested by Aug1982, as the market went through the “drawn out fundamental downtrend”.

Macro economy front, LEIs indeed have both ticked higher, albeit from historically depressed readings, and similarly PMIs and business confidence appear to have bottomed across DMs, after free-falling late last year. But that looks to me suggesting global economy has merely shifted from falling off a cliff to sliding down a slope. Thus, even risk assets may continue to move higher over the next few weeks, but sustained upside requires evidence that the +VE 2nd derivative of growth indicators will turn into a meaningful recovery. It is expected that aggressive fiscal stimulus, along with a positive inventory adjustment, should stabilize GDP growth in 2H09. However, an ongoing improvement in growth conditions will rely on fixing the global banking system and credit channels, allowing liquidity to flow to real economy. The spinning wheel of fortune could flip against the US recovery which depends on housing and job market outlook. This week, existing home sales for March fell 3% to annualized 4.57mn units vs. 4.65mn expected. At the current sales pace, the supply of unsold homes increased to 9.8 months. In addition, weekly initial claims were up 27K to 640K, while which continuing claims advanced to another record high of 6.14mn.

Certainly, as pointed out by the IMF’s Global Financial Stability Report, “without a thorough cleansing of banks' balance sheets of impaired assets, risks remain that banks' problems will continue to exert downward pressure on economic activity.” Although on Friday, US Bank stocks bounded as participants prepares for the announcement of stress test measures (actual results on May 4th), I do not believe banks will bottom until growth in NPLs decelerates. Currently, no loan is safe whatever it is cards, mortgage, C&I, construction, and commercial real estates. For the most part, positive surprises in 1Q09 are related to trading and to the retroactive change in MTM accounting rule. Most of the core businesses of major banks remain in very poor shape. Credit card charge-off rates rise in 1Q09 (7.3% in 4Q08) with BoA and Citi at 9.7% and 10.4% respectively. Citi also reported the +60% QoQ of net charge-offs for its corporate non-accrual loans in US, and BOA reported 47% higher of total commercial and CRE NPLs in 1Q09. I think this is why investors took no comfort in BTE BOA results, instead focusing on the $13.4bn credit provisions. Moreover, the No.1 banking analyst, Meredith Whitney, also said that after a profitable first quarter, US banks will return to negative earnings. Beside concerns over earning outlooks, IMF lately raises its estimate of global loan and securitized asset losses to US$4.1tn, of which 2.5trn is from banks, almost triple the amount currently written off. In terms of progressing, US banks have written down roughly 50% of their anticipated $1.06trn losses from 2007 to 2010, the IMF said, while EU banks have written down just 17% of the $900bn losses. UK banks have written down about 1/3 of their $310bn in anticipated losses. That implies global banks still needs a huge amount of capitals in order to function normally. The KBW analysts led by Frederick Cannon estimate that US banks may need another $1trn in capital to cushion losses as unemployment rises and borrowers fall behind on payments.

Looking forward, unlike all previous recessions in the past 60 years, which primarily caused by monetary tightening and inventory cycles, this so-called “balance-sheet” crisis will take much longer than boosting growth via rate cuts or inventory liquidation. It involves deleveraging, debt restructuring, bankruptcies and other painful adjustments before a sustainable growth could be established. In the current environment, it is not the marginal changes in the pace of contraction matters. It is the level of economic activity that could lead to businesses’ cash breakeven counts as the improvement in “2nd derivatives” of economic activity will not mean anything, if companies are losing money and/or facing debt repayment problems. This is particularly important as despite all policy efforts, credit origination is still lackluster and lending standards in both US and Europe are still tight. In addition, only since March have US private sector borrowing costs started to fall, which means that monetary easing in US really only started a month ago – not 18 months ago when Fed began cutting rates. The point is that even in a normal world, it typically takes a few Qs before lower rates impact consumption and investment trends.

As a result, risks to the outlook remain skewed to the downside. As pointed out by IMF, “in a highly uncertain context, fiscal and monetary policies may fail to gain traction”, and “recovery isn’t assured and will depend on policy efforts to cleanse banks’ balance sheets and craft measures that spur demand. The agency said in a forecast last week that the world economy will shrink 1.3% this year vs. its 0.5% projection in January. It also predicted a 1.9% growth in 2010 instead of its earlier 3% projection. To the equity investors, the bigger issue ahead remains the economy and its ability to provide the backdrop for companies to produce profits sufficient to justify the LT price expectations. At moment, S&P (14.2XPE, 1.7XPB) is trading as far above the consensus EPS estimate as it was at the market peak in May 2008. If equities continue move higher and valuations become more stretched, it will be a constraining factor until the consensus earnings estimate stops declining. Having said that, any market corrections will likely be mild since global fund managers are still largely underweighting equities relative to other asset classes according ML’s April FMS and investors who have missed the current rally are waiting for market pullbacks to buy on dips. In addition, US long bond yields continue to climb in recent weeks and it has put pressures on asset allocators to cut OW bond weighting in favor of equities. In Asia, given the significance in policy stimulation and liquidity worldwide over the past quarter, the next correction for HSCEI should be 10% above the recent low of 6500. I think investors should take profit now and buy again when HSCEI is close to 7500.

Impossible to Make Predictions

Marc Faber has a great comment of the status of global economy, that is, “it’s very difficult to predict the future when you have a perfect free market. But when you have a market that is disturbed by govt manipulation and money-printing, it’s impossible to make any predictions.” Well I do not disagree but it is always possible for us to look back what had happened… I think the world starts melting-down on 15Sep2008, the day (Lehman default) earmarks the contagion from finance world spilled over into the huge declines in overall economic output.  Technically, the bankruptcy of LEH came in as a great shock to the global financial systems as it essentially shut down the ST credit markets. One can recall that at the moment, you had to bid 600bp+LIBOR to get any money. The economic impact is almost immediately and profound. First of all, the global trading market and exports fell sharply in every country, including Japan, US, Germany and the whole Asia. Then the fall-off in trade impacted immediately on industrial production pretty much throughout the world because there is lots of inventory-in-transit in the global economic system. As a result of global trade being shut-down, in-transit-inventories back up significantly, and they back up into the production processes, which later on we watch the global production declining sharply in 4Q08 and the first 2M09 to a level that is well under the level of consumption of goods. It is now the unsustainable rate of inventory liquidation suggests that at some point, we’re going to turn and indeed, the weekly IP index ended April 4th shows the first uptick in quite a while.

However, what remains the biggest problem is still housing. In US, about USD10trn home equities serves as the base collaterals for the MBS markets. With 30 % decline in home prices already from it peak and a lost of $11.2trn household net worth in 2008, according to Fed data, this has wiped out huge amounts of equity which was once the backbones of the economy boom. In addition, the on-going problem is not the defaults of sub-primes and Alt-As, which is fading, but the delinquencies in the conventional conforming mortgages (“CC Mtg”) backed up by FNM and FRE. According to Fed, in 2005-06, there were 8mn homes in US purchased with CC Mtgs and about 20-25 % down payment. That part has gone. Thus, at this particular stage, the critical issue is -- how much can this market take and how far can home prices fall? According to FHFA, US median home prices fell 8.2% in 2008 and mortgage delinquencies in 4Q08 increased to 7.88% s.a., the highest records since1972, according to MBA. Loans in foreclosure rose to 3.3%, also an all-time high. Subprime mortgage delinquencies stood at 22 % in 4Q09 compared to 5% of “prime” borrowers, according to the Mortgage Bankers Association. To keep track of the overall US housing market, I think the critical indicator is --- the inventories of single family homes.  According to the March 31st Conference Board survey, the number of people who plan to buy a home in the next six months fell to a 26-year low, meanwhile US homeownership rates fell to 67.5 % in 4Q08 from 68.9 % in 2006, according to US Census Bureau data. Yes, the market is almost for sure to have a significant contraction of excess inventory, mainly because single family home completions have come down extremely sharply. However, the turnaround or stabilization does not occur so far based on statistics, and unemployment continues to rise (8.5% in March, the highest since 1983). Beyond joblessness, another barrier is affordability. US median house prices ($165K) are about 3X the avg household income vs. 2X in 1950s. This is why MBA mortgage applications for purchase fall 4.2% in latest week, while LT MTG rates have fallen to 4.8%.

This outlook actually supports my judgment of “No V-shape” recovery in the world economy. Moreover, the notion of “Decoupling” should have been consigned to the bin and the problem of export-reliance for Asia has been so clear over the past six months. Many analysts are now suggesting that Asia has sufficient domestic demand to be able to stand on its own two feet economically. The answer to that is NOT YET. Given that China currently produces 11% more than it consumes, I think Asia is still some way from that goal. That being said, with a stronger fiscal position in general, Asia would seem well positioned to benefit as global trade levels eventually normalize. In particular, EM Asia is well positioned to post sequential gains in output and exports in coming months, consistent with its leading position in the global industry cycle and the vigorous recovery in China. Taiwan is an example, with March IP and export orders already 5.5% and 6.8% above its 1Q averages.

Back to Yields Hunting

Better risk sentiment has compressed credit spreads across fixed income universe globally (NA HY=1235,-644bp since 09March, ITraxx Asia HY=1050,-540bp, EU HY CDS =837, -303BP), helped also by a combination of very low and stable benchmark rates. Thus, yield hunting gains its traction and the carry trade of fixed incomes relies critically on the sustainability of low and stable benchmark bonds. That being discussed, I saw an improvement in liquidity starting with IG issues, which may then work its way down the credit spectrum. In fact, IG Spreads (NA IG =233, -57bp, ITraxx Asia IG=266, -190BP), while still wide, have dropped to pre-Lehman levels. Moreover, issuance has surged in recent months. However, boosting risk exposure in corporate bonds is not without risk. The two main risks are the banking situation and whether the upturn in some economic data truly represent the beginning of a sustainable recovery. Moreover, the default rate may remain elevated for much longer than normal in the current cycle. Netting it out, the rally in spread product may soon consolidate but downside will be limited by attractive valuations.

In fact, based on YTD return performance, it seemed to me that the spread pickup available in the Asian corporate bond market has been more than enough to compensate investors for the risk of prolonged defaults and/or downgrades, particularly for IG sector. Asia HYs are paying investors a record 29.5 % return ytd, double US junk debts (12%) and European securities (15.3%), on bets the region’s economies will emerge from recession first, according to Merrill Lynch. This year China may be a “bright spot” in the global economy, leading Asian neighbors into the first stages of recovery, the World Bank said in an April 7 report. However, the past week volatility suggests again that Asian credit market could weaken across the board on renewed concerns over the US banking sector and weaker Asian currencies.

Stay Closer to China

According to the 08April Merrill Lynch (214 global mgrs, $561bn AUM), asset allocators are still underweight equities, indicating most M/N and L/S funds have not accepted the idea of a new bull market. This could be potentially positive for equities, if HFs, with substantial cash on hand and facing lower outflows in 2Q09, return to the markets. Regional wise, PMs are optimistic on Chinese growth, which help improved sentiment towards EM equities. There are 26% allocators OW EMs, followed by 18% on OW US compared with 18% on UW EU and Japan. Sector wise, the most OW call is Tech = 27%, Pharm =21%, while 17% UW Industrials. Asset allocators are neutral on materials.

Talking about China, there is a note on its deflation as if we consider the -2.4% CPI and 6.1% of real GDP growth in 1Q09, then nominal GDP growth was just 3.7%, suggesting China actually slowed down more than the newspapers suggest. I think this is why Premier Wen said that China should get prepared to face bigger LT challenge, echoed by Governor Zhou XiaoChuan who said China economy has showed signs of recovery, but it is still struggling with the financial crisis. Policy front, Premier Wen emphasized that China will continue its relatively loose monetary policy and focus on to boost domestic consumption, while actively seeking external demand. In my own view, China should do more with domestic consumption but not external demand. Recently, GZ Expo has seen exports contract value (USD) dropped 20.8% yoy and overseas buyers’ traffic -5.4% yoy. In terms of 8% GDP growth target, Mr. Liu Minkang, head of CBRC, said this is a very challenging task and Rmb5tn credit plan in 2009 is not a set limit. I think the NPL (2.04%) and ROE (17.1%) will not be WTE in 2009, but loan growth is for sure to slow down and it is expected that the whole incremental loan in April is around RMB300bn.

With respect to other key sectors, there some key takeaways from recent conference all and analyst meetings: 1) Life insurance saw good premium income growth (>10%) in 1Q09 and China life 1QNP +55% yoy on much better investment returns as well as a lower claims ratio and surrender ratio; 2) In contrast, China Mobile saw decline in subscriber net adds (6.49mn in Mar, -16.6% yoy and 11.4% below 2008’s monthly avg) and share of net adds (-5.4 % to 61.5%). Moreover, the firm had MOU fell yoy for the first time ever (-1% QoQ vs. +2% in 4Q08 and +6% in 3Q08 as a result of negative elasticity (-0.1 vs. 0.4/ 0.2 in 3Q/4Q08). The monthly ARPU decline yoy widened to -11% (vs. -8%/-9% in 3Q/4Q08), indicating the intense competition in domestic 3G generation; 3) Coal and IPP may have some +VE surprises gong forward as YZ Coal mgmt said thermal coal prices have bottomed, but coking coal may have more downside. Meanwhile CR Power Chairman expects a tariff hike of 2-3c in May with the details of tariff pricing mechanism reform for IPPs. But China power output slipped 4% yoy in 3WK of April, reflecting of the fickleness of demand recovery.

In addition, sentiment for 4) property turns to cautious as volumes may come down in coming months after developers raise prices, albeit from low levels. According to the 12M rolling GFA sold, national avg inventory is about 18.8 months, while costal Tier-1 cities like SH, GZ and SZ are ~12 months, while BJ, TJ, Shenyang and inner cities like Wuhan, Chengdu and Xian are >18 months. On the supply side, NBS reported 1Q09 FAI on property -30.2% yoy, following the downward trend since Aug08. Land sales volume dropped 85.5% yoy, but construction completed +21.9% yoy with new construction -57.7% yoy. Meanwhile property sales stay flat 6 weeks in a row. As a result of poor private/export demand and excess capacity, 5) domestic steel price has went down for the 10th week in a row, according to Mysteel. Steel markers posted total net loss of Rmb1.8bn in Mar with annualized output 517mt, far exceeded the govt target= 460mts. That means even demands from infrastructure could be boosted, China's commodity players can not fully enjoy benefit of government's stimulus policy due to global pricing and overcapacity. Sectors with huge on-going overcapacity are Dry Bulk Shipping (40%), Steel (25%), Aluminum (25%), Container Shipping (15%) and Coal (10%). The only beneficiary from infrastructure stimulus seems to be 6) cement with 1Q09 production up 12.9% yoy vs. +9.2% in Q108. Except for coastal China (-3% yoy), all other regions saw volume growth in 1Q09.

In my own views, the near term focuses of Chinese shares are on policy and liquidity, besides their earning/valuation and macro development – 1) Over the period of 17Mar– 20April, CSI300 rallied 16.1% while HSCEI +22.9% and Hengseng +22.3%; 2) At the same time, earning recovery has not seen the life signs. So far 151 A-share companies have reported 1Q09 results with total NP= RMB7.06bn, -26.4% yoy. In addition, MOF released statistics on non-financial SOE profits for 1Q09 with Revenue -7.6% yoy and EBT -36.8% yoy. This implies the March numbers are -6.7% yoy and -25% yoy respectively. Having said so, I am less concern on China’s growth risk but more on policy risk in the coming Qs. 3) I think IPO/Credit tightening/inflation are the three key "STOP" signs, which could pose significant setback to the market sentiment. Amid recent concerns of credit tightening, PBOC has reassured that there would be no credit tightening. However this contrast with CBRC which has voiced its concerns over rising NPL and reemphasized risk controls. In addition, it is important to note that PBOC withdrew around Rmb860bn from the open markets over the past 3 weeks, including Rmb100bn though 3M REPO. It is actually 14-months high that central bank pull back money from market and suggests the government want s good control on the liquidity if it flooded. To sum up, how Beijing manages the flow of credit in coming months will be critical to China's trajectory of growth. The explosion in China's bank lending ytd, compared with the credit contraction in DMs, has been crucial to shoring up consumer and business confidence, and to keeping China's economy expanding at a time when all other major economies are in recession.

Lastly, according to Citi, MSCI AxJ is now at 1.5XPB with 10% ROE, vs. 0.9XPB and 8.1% ROE in 1983. Since Asian earnings are closely related to export performance, the regional EPS and ROE are seeing downside risks. It is noted that export prices are -4.1% yoy and volumes are falling faster than input costs. However, IBES EPS forecasts continue to suggest this is the 2nd shallowest recession ever in AxJ. Technically, MSCI AxJ can't sustain at 200DMA (325) with 88% of stocks above 50DMAVG vs. 93% below 50DMA on Oct2008. Valuation wise, MSCI China is now traded at 13.2XPE09 and 2.1% EPSG, CSI 300 at 18.9XPE09 and 14.8%EPSG, and Hangseng at 14.1XPE09 and -27.3%EPSG, while regional market is traded at 15.9XPE09 and -15.3% EPSG. 

Behind The Commodity Run

Commodity prices have risen strongly this month with DJ AIG up 9%. This run was driven by a better risk appetite following Fed’s QEs and the Treasury’s PPIP along with a weaker USD and some evidence of a recovery in China’s appetite for raw materials. On relative basis agriculture and precious metals outperform ytd as expected. But, the recovery in base metals is surprising given weak global economy. I think it more related to the improvement in risk appetite, supply cuts and the fact that the poor demand is already built into the price. As a key production input, industrial metal prices correlate well with manufacturing activity. To be sure, manufacturing evidence from around the world remains weak on balance. But I observed recently China is the only country where manufacturing has began to expand as the economy responds to aggressive policy efforts. In US, the economy is undergoing a massive inventory adjustment which continues to drive a contraction in manufacturing activity. However, several indicators suggest that the pace of contraction is slowing, such as ISM, regional PMI. As discussed above, the current pace of production cuts and inventory depletion should set the stage for output gains in 2H09.

Currency world saw our Asian FX rally in recent months, which appears to be driven by global recovery expectations, rather than QE driven weakness of USD vs. Asia. But given the signs of global stability, FDI and portfolio inflows are likely to weaken further, if resulting from deterioration in trade balances and a looser monetary policy, Asian currency could depreciate again.  Cross the oceans, EURUSD has been pushed below the 1.30 threshold last week. Even though, the next ECB Council meeting is still 2 weeks away, speculation about the central bank's policy outcomes, in terms of interest rates as well as possible QEs, is pressuring EUR lower. Meanwhile, European economic fallout has gained momentum and slack is building rapidly. Slower final demand has already caused capacity utilization and wage growth to roll over. In turn, consumer confidence will remain weak as unemployment rises, undermining consumer spending. These all suggest the downside risk of EUR in the near term.

Good night, my dear friends!