My Diary 569 ---Two Doubts from Central Banks; The Lost Favour o

My Diary 389---- Two Doubts from Central Banks; The Lost Favour of GBs; Where China Improves; Cut USD Long KRW

May 10, 2009 

I respect faith, but doubt is what gets you an education” --- This one of the famous quotes from Wilson Mizner (May 19, 1876 – April 3, 1933) and I will explain it later in this diary (please bear with me!). And before touching on several interesting topics I saw over the week, I want to begin with weekly asset market reviews as a broader market picture helps understand the currents beneath the surface…Global equities finished the week 5.7% higher than last Friday. In general, stocks have surged >30% over the past two months with + 38% in US, +35% in EMs, +33% in Japan, and +31% in EU. Elsewhere, 2yr UST hit 0.99% (+7bp wow), the highest yield since the day prior to the Fed’s announcement on purchasing Treasuries, while 10yr reached 3.29% (+14bp), the highest level since 18Nov2008. 1MWTI oil climbed $5.43 to $58.63/bbl, a six-month high. On TW basis, USD declined 2% wow and has fallen 8% since two months ago. It also lost 10% vs. EM currencies. The Dollar closed at EUR1.364 and YEN 98.5 (roughly sideway).

That being discussed, risk markets across the globe are near or at year high, and a majority of people including myself have been cautious since 2 months ago when market was 30% lower. It seems most people are caught either short or underweight since March and hence the recent fierce rally on back of short covering and panic buy. Indeed, I used to think that market moves are more likely driven by fundamental earnings, technicals or news flow as this is one of the worst recessions in the past eight decades, but the rally lately seems purely driven by good sentiment, a removal of risk premium and liquidity flows. As a matter of fact, credit spreads globally gapped tighter, even “swine-flu-inflected” MEX 5YCDS narrowed by 70bp wow to 230bp.  Meanwhile, various inter-bank spreads are narrowing with USD 3M Libor (0.9375) fixed below 1%, the first read since the financial crisis ensued, and 3M Libor-OIS spread has narrowed 35bp to 74bp (OIS fairly steady in 0.20%-0.25% area). Measured by 2-10 spread, govt yield curves steepened above 100bps across the G7 nations for the first time since 1991, a sign typically when traders anticipate a recovery. In addition, 10yr breakeven was 157bp vs. -8bp on 20Nov2008, reflecting the market’s inflation expectation. 

Meanwhile, macro data for US chain store sales(+0.7%)  to Aussie unemployment (5.4%) has been feeding the beast. Financial markets end up with massive relentless appetite for risk. The Dow was up. The S&P was up. The Gold was up and Oil was up. I was listening to everyone talking about the Great Recession since 1930s before April, but there seem like “Green Shoots” every where now. Many sell-side strategists are in the mood of recovery, flowered by roses and tulips --- Merrill Lynch talks of “three dimensional recovery”; Deutsche Bank says “spring is in the air” and JP Morgan believes “the end of the great Recession is approaching”…The V-turn of this kind of strategist talks is quite amusing to me actually! At the staRt of the year, there was talk of a Great Recession. By March that become the end of the World. In April, however, the global economy faced merely a stiff recession. May has now ushered forth expectations of a self-sustaining recovery. At this rate, the boom will be back by summer and that “sounds” great and makes many investors feel “better”.  

However, on the top of this sentiment turn, technical indicators have now signaled a huge over-bought position in global equities. In US, S&P went up by 33% in 38 days. Historically, the similar episode only happened 3 times and all in the 1930s. In Asia, MSCI AxJ has recovered to the Mid-2006 or Pre-sep2008 levels, after the 50% rise. To my knowledge, such a violent pace (in 2 months) and big scale (+50%) of benchmark jump really reminds me of the mid-2007 experience. In addition, RSI also indicated markets are severely overbought with the RSI on Singapore at 80, Taiwan at 78, Korea at 69 and HSI at 74. In fact, when I looked at the 1M, 3M and YTD performances of all the HSI and HSCEI components, I think we're in a bull market as most are up between 30-100% in any period. Thus, it is reasonable for many people to ask a question, that is, how long can this bear rally in the stock market last?  

Well, I take a simple method by examining the positives and negatives amongst the policy & economy, banking system, market position, valuation and other market behaviours, along with my doubts, to do a pulse check of the markets.  Looking at the bright spots --- 1) Major central banks and governments are still very vigilant and there is no sign they will let up on their reflation efforts. Led by the Fed, central banks show no inclination of raising interest rates until the housing market recovers, restraining ST yields. At the same time, the flood of money being pumped into the economy by policy makers (including $12.8trn in US) will ward off deflation and cause LT yields to increase. In Europe, ECB has just indicated to buy up to EUR60bn govt bonds to step up its reflation campaign; 2) The market is enjoying a slowing rate of decline rather than actual growth, as the logic is you have to stop falling before you can bounce. Meanwhile, Chairman Bernanke in a testimony to Congress said that the recession is abating but that recovery will be slow. [Quoted] “There are some tentative signs that final demand, especially demand by households, may be stabilizing." He also noted "some signs of bottoming" in the housing market. Working against this stabilization are a weak labour market, which he suggests will continue to weaken, and tight "credit conditions for consumers." I think the inpatient investors are interpreting "slow" as "slower than a bullet train", not  the 1% GDP growth for the rest of year or longer. The on-going problem to me is the quality of this “green-shoot” recovery as jobs and capital outlook do not suggest the return of a usual business cycle, while the B/S of consumers and banks under duress leaves room for doubt. Obviously, that does not concern the market and the actual NFP number at 539K (vs. consensus 600K). along with a downward revision in March (from 663K to 699K) and February (from 651K to 681K),  is read as a “green shoot” as well. That to me is another evidence of recovery mania as how could losing half a million jobs in a month be an improvement? I know that 8.9%UNE rate is a lagging indicator, but a job loss means a lost income and the continuing claims in US rose to 6.351mn from 6.295mn (revised) in May.  

3) Markets saw another rally in equities driven by the financials as 10 of the 19 banks only need additional $74.6bn to make the regulators happy.  In typical fashion, the Fed uses the media to leak key information and as such is shaping up to be anti-climatic. According to Bloomberg, BOA needs $34bn, Wells $15bn, GMAC $11.5bn, Citi $5.0bn and the rest are fine. But it is worthwhile to note that the worst-case scenario used in the US stress tests is actually the base case scenario for the IMF. Can you really call it a "stress" test, if not mentioning amuch smaller capital deficits resulting from a different measurement of bank-capital levels used by the Fed than street convention? But once again, it seems that the tail-risks about the economy and the banks are less feared as the street views the steeper yield curves are increasing trading revenue for banks (i.e. Goldman Sachs $1.81bn in 1Q09 and $ 3bn record earnings by Wells Fargo on April 13th) and helping banks earn their way out of bad debt burdens as they did after Latin American Debt crisis. As of today, UST yield curve has widened to 230bp from 125bp in Dec2008. It averaged less than zero in 2006. Thus, it seems that the broad message that the markets want to deliver is that equity is entering into a “Sunny Zone” equipped with very accommodative policies, ample global liquidity, falling funding costs and improved investors sentiment, looking for signs of economic improvement rather than continued economic melt-down.

On the flip side, there is still substantial doubt, pessimism and distrust of the current rally, which ironically is almost a prediction to keep this rebound going. Based on what I knew the majority of LO managers have held back from fully participating in the latest rebound. For example, you can go to the fidelity's website and get a list of YTD returns for their over 100 fund products. One can find only 3-5 funds ytd in the green, while the remaining are -5 to -15% down. This is material underperformance and fund managers will chase sooner or later as share prices continue to grind higher and will find themselves under increasing pressure the longer the rally lasts and the higher the prices go. Capitulation by institutional investors could extend the rally further. However, once this is done, I struggle to find marginal buyers. If this is the possible case, then the next question is at what level and what would trigger the sell-off? Indeed, prices have risen so rapidly that valuations are not as attractive vs. just a few months ago. MSCI AxJ trailing PE09 is currently 17X (PB=1.6X), up from 9.8X (1.1X) at the October market trough. But I think the question is NOT whether stocks are expensive on FY09 earnings as earnings is also a lagging indicator and no one can say for sure the coming earnings recovery for 2009/10/11 will not be material. The right questions are Q1 - whether we have seen the worst of the cycle? and Q2 - what would be the momentum of improvement from the trough of the economic cycle? Answer to Q1 has been driving this rally but the answer to Q2 will trigger a material consolidation once investors see evidences that the rate of improvement in macro data is indeed slow. 

I think Q2 is the base case scenario as negatives factors to the economy fundamentals do exist in many fronts, such as a supply-induced backup in interest rates, a large spike in prime/commercial -mortgage delinquencies, or the continued drop in consumer credit demand and the confusion over the ECB new policy. Here firstly I think the correlation between bond yields and the stock market is about to end.  Since mid-April, 30yr UST yields skyrocketed by 58 bps to 4.24% s and +50 bps in 10yr to 3.29% as selling overwhelmed the Street and after the 30yr auction tailed by a whopping 8 bps. This is not a surprise as dealers with now much less leveraged B/S have been overly impaired to take on a record $172bn of supply in just two weeks. Recall that on 18March 2009, when Bernanke revealed that the Fed would buy up to $300bn USTs  in support of its goal of lower interest rates, the 10yr closed at 2.53% yield. Now, only 50 trading days later, the bond is yielding 3.3%. In bond land, that is a very big change. I think this is also a red alert for both the Fed and Treasury that they are not going to get a recovery and low interest rates. Something will have to give up. Of course, stock markets will pay attention if 10yr yields break toward 3.5% or 30yr-mortgage crosses 5%, as anything above will push mortgage rates back up to a level that restarts the downward cycle. I would be difficult to imagine how the “recovery” can sustain itself for more than a few quarters, if that is the case. That being said, the pressure on rates will continue due to the unending supply. The Treasury has $2trn of paper to sell and the Fed has about $250bn left to buy. That is nearly 10 to 1 and the market knows it. 

In addition, the deleveraging process isn’t over according to recent data. The March US consumer credit came in down $11.1bn (consensus -$4bn) which is the largest % drop in almost two decades. JPMorgan CEO Jamie Dimon also said that the issue of NPL for the likes of credit cards and the general process of deleveraging have at least two more years to run in the US. I think Jamie’s claim is trustful and well echoed by the 2009 Spring Trade Show in Guangzhou. In total, order flows tumbled 31.4% yoy to $26.2bn, lowest in 5 years and down 16.9% vs. 2008 Autumn Show. Regionally, orders from EU (28.8% of total orders), fell 28% to $7.57bn, and orders from US (12.6%) decreased by 8.1% to $3.3bn. The credit/order data suggests that US/EU private sectors remain in debt deleveraging mode. Without a recovery in the final demand, it is also difficult for me to believe that the recent upturn in production will sustain. As a result, corporate profits would still drop because revenue (nominal GDP) would drop as the labour market was laid to waste. The fallacy of composition means that one company’s cost is another company’s revenue. To the aggregate economy, one can not assume it will keep cutting cost until it returns to higher profitability. Thus, while most commentators cheer the “green shoots” sprouting, they forget the significance of the fact that growth in nominal household pre-tax incomes and nominal GDP are now in actual decline. 

To sum up, looking forward I think the stock markets are likely in a big trading range and we should trace/trade on the sentiment extremes, i.e. the extreme bearishness in March vs. the extreme bullishness now. I strongly believe that the pace of decline slowing isn’t yet a recovery even as the street rushed ahead to price in. My observation is that based on April data, which may show pro-cyclical inventory led stability, it does not point to the recovery of final demand needed to create jobs or work off battered B/S whether for stressed consumers or companies. In fact, oil demand (-7.9%) was the worst this week since May1999. This news didn’t catch the market attention as crude market chased global growth views, China hopes and fears on inflation and USD.  That being said, I put a doubt on the JPMorgan (Mr. Kasman) view that GDP will recover by Q3 and resume +VE growth in Q4. I think this is overly optimistic, although the direction of days to come is becoming clearer. The problem is all such views are based on the hopes that China/ US stimulus or cyclical forces from inventories are sufficient for stability, even when govt spending or central bank QEs end. Assume this would happen, it means that by the end of this summer, everything is going to “feel’” a lot better, demand will be on the up-tick and prices will be on the rise…Ala, then such “green” assumptions make me very troubled to imagine how Bernanke/Geithner could continue to expand the alphabet-soup programs (TARP, TALF and PPIP) and monetary easing, if the US is to face the “greener” conditions in six short months.  

Thus, regarding the recent asset markets performance, my thoughts are 1) Stocks are more a hunt for a pro-cyclical rebound rather than a bull market rally declared by Mark Mobius; 2) Government bonds are more leaned to selling as the huge issuance is not a shallow creek to cross or if “greener” conditions turns out to be true; 3) Commodities are based on the hopes and sentiment, rather that the demand equation with the parameter of economy outlook equals zero, and 4) Currency is about global decoupling of G3 vs.  BRICs and others as growth sensitive currencies keep strengthening vs. USD. In fact, the upcoming weeks or months could be even more challenging and confusing as well. I think Mr. Wilson Mizner is right and the market is always unpredictable and ever-changing. No one really knows where the market is going. But as a profession investor in this industry, you should do your own homework, have a view with conviction and listen to yourself at the first before you listen to the so-called experts like Nouriel Roubini. One should always put a doubt to other people’s views instead of blindly follow whether it’s right or wrong.

Two Doubts from Central Banks

Despite markets were rallying on the "second derivative" of growth, two of major central banks have recently voiced their doubts over the sustainability of global recovery. The Bank of Japan maintains its earlier view that the probability of a sustained global recovery is far from certain, despite the possibility that the decline in the global economy has started to recede, helped by the progress of inventory adjustments, and expectations that the benefits of fiscal stimulus packages will take effect over the rest of the year. The PBOC 1Q09 Monetary Policy Report reemphasized its accommodative monetary policy stance. PBOC is concerned about the outlook for global inflation due to QEs adopted in many DM countries and says that the global economy outlook much depends on the success of efforts in US and Europe to rebuild the shattered financial system and the pace of recovery in global demand, including demand from EMs. 

Looking back over recent months, the monthly PMIs have provided a front-row seat for these “green-shoot” developments. Not only are these surveys available on the first business day of the month, making them the most timely reading on manufacturing, but they are also comprehensive, providing a snapshot of changes in new orders, output, and inventories across the globe. These attributes are well known. Another key attribute after a more careful analysis of the global and G3 indexes reveals that the new order/inventory index leads the PMI output index in about three months. With the PMI inventory index now nears the series low, the internal momentum of the global PMI remains very powerful. According to JPMorgan, a model based on the recent trends in these two series predicts an additional 10ppts rise in the PMI output index in the next few months. This would lift the national PMIs above 50 with the leadership is coming from the US, Japan and BRIC countries. In Europe, April services PMI in both the Euro zone (43.8, a six-month high) and the UK (CIPS=48.7, an eight-month high) also reinforce perceptions that the pace of economic contraction in Europe has eased, which in turn supports the "green shoots" notions.  

Meanwhile, consumer confidence and sentiment surveys also indicate 2Q09 is turning out to be BTE. Recent production data also suggest that following 12 straight monthly declines, global manufacturing output is on a path to stabilize by midyear. Manufacturers slashed output at an unprecedented 25% average annual rate in 4Q08 and 1Q09, even as consumer spending firmed. This combination delivered a massive worldwide inventory adjustment, as the level of output fell well below that of sales. Manufacturers’ success in lowering stocks is now prompting them to stabilize production. To be sure, a return to sustained output growth needs to be fuelled by final demand, not inventory dynamics. Thus, looking ahead it is important to keep track of inventory dynamics as catching the turning points in the business cycle is crucial.

 

The Lost Favour of GBs

The effects of higher equities, increased risk appetite, a huge increase in supply, and probably some other factors as well, have combined to push UST yields measurably higher, with the 10yr note making a forceful rise above what had been good resistance at the 3% threshold last week. In fact, the largest distortion in global capital markets resulting from the unprecedented policy action is in the G7 govt bond market (specifically real yields), where LT yields are roughly 2% below of fair value, according to Fed research. Thus, with growth conditions showing tentative signs of stabilizing, it is natural for govt yields to edge higher and at least partially close this valuation gap. Of course, a major support for govt bonds has been QEs and commitments by policymakers to keep yields anchored. But central banks are now primarily focused on private-sector borrowing rates and appear to be willingly to tolerate higher govt bond yields as long as it occurs at a slower pace than the narrowing in spreads. Based on the recent SLOS, although the survey suggests ongoing tightening in lending terms, albeit at a slower pace, the turn in lending terms is consistent with the narrowing credit spreads, which is a first-order improvement.  

In addition, credit market has seen a lot of issuance (equity as well) from companies who a few weeks ago wouldn't have had access to the market at any price, like US Air and Goodyear Tire. The later launched at USD 500mm and upsized to USD 1bn. As a whole, companies have sold about $477bn of bonds this year in US, compared with $354bn during the same period of 2008, according to BBG. The corporate spreads over Treasuries narrowed to 6.4% on May 1st from 8.96% on Dec 15th, according to Merrill Lynch. In Asia, Hutchison bonds were announced a secondary offer for up to USD1.5bn. Korean sovereign credits were the recent out-performers and 5yr Korea CDS tightened 78bp to 170bp since end April. The 5yr China CDS also gathered momentum, tightening 42bp from end April to 85bp. The iTraxx AxJ IG index declined 60bp to 174bp, the tightest level since last October.

 

Where China Improves

In the past six weeks, EM equity funds had net inflows totalled $11bn and most of EM benchmark is 45% above its 27thOctober low. In Asia, foreign net buying in April was $8.2bn with $2bn occurred in one day, the Apr 30th!  Interestingly, YTD the net buying is still small at US$4.3bn vs. -US$69bn last year, which could suggest some further run in the current rally. In the other hand, regional earnings continue to surprise to the upside. MSCI AxJ 2009 earnings growth estimate was revised up to -9.6% from -10.7%, the sixth consecutive week of upward revisions. According to Merrill Lynch, the AP regional ERR increased from 0.37 to 0.56 in April. The two consecutive monthly improvements could be early signals of a trough in the earning cycle. But there are two other possibilities – 1) seasonality and 2) range-bound of economy recovery. Overall, earnings D/G continue to outnumber U/G in all sectors, while earnings expectations remain relatively strong for the most defensive sectors - Utilities (0.87), Consumer Staples (0.77), and Health Care (0.55) vs. weakest for Media (0.21), Banks (0.23), and Diversified Financials (0.29) 

In China, all A-shares have reported their 1Q09 earnings. On a yoy basis, aggregate EPS declined 26.8% in 1Q09 as sales dropped 12.4% and net margin compressed by 1.6%. In general, results are WTE with 1Q earnings accounting for only 15.3% of the full-year 2009 consensus estimate. That being said, 1Q EPS grew over 5X QoQ, suggesting that earnings may have already bottomed in 4Q08. Sector wise, IT-services, Staples, Health care and IPPs are the only sectors that posted positive yoy EPS growth in 1Q09. Bank EPS dropped modestly yoy but still accounted for 42.5% of the aggregate market earnings. In addition, there seems some downside risks to H-share growth expectations. Among all A-H dual listed stocks, H-share 1Q09 EPS dropped 21% yoy vs. the current market consensus of 6.8% growth for 2009. 

Macro front, SIC expects 2Q09 GDP to be 7.0% and CPI at -1.3%. The agency also estimated FAI +27.6%, Consumption +14.0% and Exports -20.2%. It also said the current average utilization is roughly 60% and capacity elimination will be a long process. I think this set of forecasting data suggest that Chinese economy may not above to jump-start quickly in the ST as 1) domestic consumption can not fully replace the lost external demand; 2) a rapid economy growth still relies heavily on investment, which will leave no space for economy restructuring and will boost inflation. In terms of major sectors, banks total assets expanded 25% yoy in 1Q09 and their NPL ratio narrowed 30bp to 1.76%. Moreover, I saw a dramatic NIM compression with NIM declined 67bp on average to 2.36% over the past two Qs. Looking ahead, NIM could bottom in 2Q09 on the back of rising L/D ratio, slowing flows to term deposits, improving structure of new lending, and rebounding market yields. Thus, banks could a potential buy, given BTE asset quality, potential NIM stabilization and the laggard performance in the recent market rally due to share supply overhang. 

Property sector heard some +ve news over the week as 1) Developers re-start to buy land, suggesting the land price bottomed and demand is back, plus their funding pressure is much relieved; 2) YTD sales grew over 60% yoy and developers are easily seeing their presales doubled or tripled, locking in largely 2009 profits; 3) Statistics show inventory declined from 27 months in Oct/Nov2008 to 14 months in Mar2009; 4) SZ reported new projects sales in first 4M09 doubled yoy, with ASP of RMB12331 sqm, +12% mom and +3% yoy.  If both sales and ASP continue to build momentum, then Chinese property stock may have more upside, given narrowing NAV disc, new land bank acquisition and higher ASP vs. market expectation of 5-100% down in FY09.  Names trading <1XPB seems attractive including Greentown, BCL, Shui On, and SPG Land at 0.6XPB. In material sectors, steel prices went up 4 weeks in a row with flat +1.4% mom and long +5.1%, according to Mysteel. Since steel prices are a good leading indicator of the coal sector. Thus it is worth to keep a close eye on the industry bellwethers like China Shenhua and China Coal, as well as coking coal manufacturers like Hidili Industry and Fushan Energy. In energy sector, the new fuel pricing policy implies a utility type of return as long as crude below $80/bbl with 22 day lag. Negative data came from National Grid that Apr power generation -3.55% yoy vs. -4.02% in Q109 and -2.01% in March. CRP announced its April net generation volume declined 6.3% to 5105GWh, while the 4M09 was flat yoy.

 In addition, April's container throughput for major ports in China fell 13% yoy to 9.2mn TEUs, worse than March's 8% yoy decline…Lastly, valuation wise, MSCI China is now traded at 14.7XPE09 and 5.0% EPSG, CSI 300 at 20.7XPE09 and 20.1%EPSG, and Hang Seng at 15.9XPE09 and -26.8% EPSG, while regional market is traded at 17.2XPE09 and -10.6% EPSG.

 

Cut the USD, Long the KRW

Much of recent USD decline, in particular vs. GBP/AUD/ CAD, seems predicated on increased risk appetite, and all of the three currencies have hit new highs (>200MAVG). The recent significant developments not only suggest further gains of major currencies against USD, but the broadening USD weakness suggests EURUSD can also continue to move higher, with many now targeting the March highs @ 1.3740. In addition, the past week was all about the ECB as the 25bps easing didn’t have any details about QE, and then the Trichet declared the plan on buying 60bn debt --- so the EUR rallies.  

As discussed, in addition to the stock market's improvement, conditions in the inter-bank funding market have improved as well. The later one is not only another indication of diminished stress/increased risk appetite, but is also presumably reflects diminished demand for USD from a global funding perspective, and that too is consistent with the recent USD depreciation. Given that USD is the most broadly used funding currency by financial institutions worldwide (BIS Quarterly Review, March 2009), the sharp losses in financial assets and stresses on bank B/S last autumn and again earlier this year caused a disproportionate increase demand for USD relative to other currencies, contributing to USD surge during those periods. Now the opposite is happening. Granted, significant risks remain. Real GDP data in G10 are still contracting though the pace of contraction is decelerating. However, markets anticipate economic recovery rather than react to it and usually by around six months. Given my base case that real GDP data will turn positive again in 4Q09, this FX market rally appears to have legs ahead.  

That being said, rationales behind USD weakness have major implications to our Asian currencies, as our home market, Asia is effectively a leveraged bet on the global industrial cycle to its external exposure with G10. In my own view, KRW is a Buy although it has technically broken through the 200DMAV. Fundamentally, KRW won remains intact for several reason – 1) KRW and other Asian currencies are typically "early cyclicals" and are among the first to benefit from global reflation; 2) Korea's overall CA balance should improve dramatically as the country posted a record monthly CA surplus of $6.7bn ($80bn annualized) in March as exports jumped 20% mom and IP rose for a third consecutive month; 3) KRW has fallen to extremely cheap levels and even before the sell-off in the won, Korean export sector was competitive. Meanwhile, foreign flows into Korean equities should help strengthen the Won. 

Good night, my dear friends!