My Diary 601 --- It Is Consumer Counts; Keep Alert on Credits;

My Diary 601 --- It Is Consumer Counts; Keep Alert on Credits; Check & Balance in China; Some Caution over Metals

 

16 August, 2009

“Bear markets have 3 stages: sharp down, reflexive rebound and a drawn-out fundamental down trend” --- This is one of the 10 market rules left by Bob Farrell, the legendary chief strategist at Merrill Lynch, who witnessed the go-go markets from 1960s to 1990s, including the brutal bear market of 1973-1974 and October 1987 crash……If experience and wisdom count, then I think investors should ask themselves, where are we now? That being said, Friday global stocks tumbled as US consumer’s confidence (63.2 vs. 66 in July) unexpectedly fell in August. I think market reacted rationally to the headline news as without the help from consumers, the governments can not spend our way out of this long, dark recession. This is why I discussed in my last diary 402, saying that, “risk remains on consumers”.  Beyond the confidence figure, Wal-Mart, the world’s largest retailer, said that SSS at US stores open at least a year fell 1.2%. Market also concerned on what happens to the consumer if Fed letting its B/S shrink back while commercial banks are still on their healing process. In addition, CPI was unchanged from June dropped by 2.1% yoy --- the most in six decades. As a result, 10yr UST yields fell to 3.57% from 3.60%.

With little sign that USD1trn of injections into the banking system is feeding through to inflation, the Fed claims to sustain its efforts until a recovery is secured. Last week, FOMC basically did nothing to its last version of statement – 1) No change to the key phrase “exceptionally low levels of the funds rate for an extended period”; 2) To “slow the pace of purchases of Treasuries” but will still do the full $300bn; 3) See the economy “levelling out”; 4) Sluggish income growth added to the list of factors weighing on consumer spending. In generally, I think the Fed will not hike rates until at least 2011. More telling than the thoroughly predictable FOMC decision was the BoE’s quarterly inflation report which predicts the inflation will be 1% below target (2%) in 2-years time if its base rate followed the path implied by market rates --- Bank Rate rises from 0.5% to 2.2% in 4Q11.

In general, an extension of accommodative Fed policy is a positive outcome for equities. But it was a bad week for A-share investors as SHCOMP lost 6.6% to finish at the lowest level this week. Over the week, we had WTE macro data on Tuesday (discouraged the market sentiment and triggered the liquidity concern), the first WoW drop on new account openings (indicating retail investors’ enthusiasm cooled down) and CMB’s rights issuance (reminded us of PingAn case in 2008). As SHCOMP is closing to 3K psychological resistance level and a batch of earnings will be out in the coming weeks, where A-shares move toward will become the hottest topic in the next week, given its high correlation with regional markets.

X-Asset Market Thoughts

Friday saw a broad decline of equities in DMs with -0.8% in EU and -1.0% in US vs.  +0.8% in Japan. On the weekly basis, global equity edged down 0.2%, but is still up 1.5% in August. Elsewhere, 2yr UST fell 25bp to1.05% this week and 10yr is lower 28bp to 3.57%. 1MWTI oil slumped $3.52 to $67.51/bbl. The TW USD slipped 0.2% this week, closing at EUR1.420 and JPY94.9. Notably, USD stumbled 2.7% vs. JPY this week…It seemed bond markets does not agree with equity bulls on the back of economic fundamentals. That being discussed, recent statements from G3 central banks underscore that policymakers expect to leave rates on hold for the foreseeable future. In US, FOMC statement reaffirmed the Fed’s “extended period” language on rates. In China, I am seeing some fine-tuning in the form of tightening loan growth and raising bank RRR to contain speculative activity. Elsewhere in Asia,  I think we may see lower stimulus levels in 2H09, though a major withdrawal of stimulus spending is unlikely in 2010, in the absence of signs of a convincing recovery in US. Thus, I remain constructive on overall monetary and credit policy stance in Asia, with rate rises not expected until 2010 at the earliest.

While an extension of accommodative Fed policy is generally positive to equities, there are several risk factors to be watched in the near to mid term – 1)The higher X-market correlations: YTD, the correlation between SHCOMP, MSCI AxJ, HSI, and HSCEI is at 90% on a daily basis. And market believes that SHCOMP looks overvalued on a historical PE of 29X, PB of 3.5X and ROE of just 12%. In fact, since March 2009, I saw the rush of liquidity to work, along with genuine improvement in the macro front, which propelled by a long-overdo technical bounce. But now with SPX up above 1000 and the signs of fatigue in A-share rallies, the market has begun to tread water; 2) The variation of policy reversal: while the world’s central banks coordinated rate cuts last October, their policy reversal is likely to vary due to considerable variation in the level of resource utilization and the decline of GDP during this economic downturn. Thus, countries like ABCS, New Zealand, India and Korea are likely to begin hiking rates next year, ahead of their G3 peers; 3) The upward movement of USD:  due to ZIRP and QEs, the Dollar has been negatively correlated risk appetite or the swings in equity prices, instead of fundamentals. If the market believes in the BTE US economic outlook, then USD could rally because of a perceived change in rate differentials. This is a sign of risk rally in the latter stages as leveraged bets for a weaker Dollar based on risk seeking will be taken off as stocks made new highs. But such argument would fly in the face of conventional wisdom -- stronger economy leads to higher trade deficits and lower USD.

It Is Consumer Counts!

Over the week, Fed did upgrade its economic assessment that activity is "levelling out" vs. 24June statement where it said the contraction is slowing. If anything, the Fed guarded assessment of future growth tipped the balance to a more dovish spin, as FOMC repeated the same three drags on household spending (job losses, lower wealth, tight credit) and even added a fourth, which was sluggish income growth. In general, I think the July FOMC statement gave no obvious indication that the Fed was planning on an early reversal of its accommodative policy stance. Later, US retail sales refreshed the central bank’s worry with the core measure falling 0.2% MoM in July. Market is now forecasting 3Q09 US consumption at +1.2% QoQ saar vs. 2% consensus. In addition, given US initial jobless claims were little changed at 558K last week, a further moderation in job losses will be needed to revive US consumption in light of the ongoing negative wealth effect on spending.

Moving on, the positive GDP readings from Germany and France are indeed important. Growth in both countries rose 0.3% QoQ =, notably  better than the 0.2%-0.3% declines expected, and following revised 1Q09 readings of -3.5% in Germany and -2.7% in France. The contributors to growth were similar in both countries, as fiscal stimulus boosted government spending and their own car scrapping programs. While some analysts suggest caution over reading too much into 'stimulus-induced' growth, the fact is that the stimulus is working and that is positive. As a result, EU GDP only contracted 0.4% saar in 2Q09, far better than the consensus -2%. The stronger 2Q outcome in Germany, combined with the booming pace of German factory exports and orders is likrly to raise the 3Q GDP forecast for the Euro area into 3%

To sum up, with the US consumer still under pressure – unemployment still on the rise, secular shifts are underwater in spending / saving habits, debt overhang from earlier binges, and credit that is still much tighter than it used to be, the markets can’t count on the Western wallets. In addition, when China, the other source of hope, needs to beat economists’ forecast in order to avoid disappointing the markets, positive surprises are not likely to come from the East side, too. So markets will see downside swings from now.

Stay Alert on Credits

The Fed said it will slow the pace of UST purchases as the recession eases, and signalled that the $300bn program will end in October. In my own view, the notion that the UST purchase program will end should not be a surprise, as that was implicit in the finite size of the operation ($252.8bn being used so far). More important to me is that Fed made no changes to its planned purchases agency MBS and agency debt, which is scheduled to continue through the end of this year. And that is arguably the more important QE measure, as purchases of those securities are much larger than those of Treasuries ($1.45trn vs. $300bn, or nearly 5X the size).  As a general principle, while BOE is to focus on supporting MS growth, the Fed’s focus has been on suppressing LT interest rates. However, such effort hasn’t stopped a jump in yields as investors began to anticipate a recovery. 10yr UST yield is 3.57%, 111bps higher than it was in March 18 (2.46%) after announcement of the plan. Moreover, 30yr fixed Mtg rates only declined to 5.38% from this year’s high of 5.74% in June.

Having said so, much of the improvement has been seen in the credit markets. As of Friday, LIBOR-OIS spread is 26bp, close to the least since Mar07. The NA HY CDX has more than halved from its wide of nearly 1924bps in Mar09. At its current level of around 780bps, the index is just 90bps short of its pre-Lehman level. Current spreads are discounting a default rate of 9.22% over the next 12 months, assuming a 20% recovery. This is much lower than the actual dollar-weighted default level (using Moody’s data) of 18.8%. Similarly, Asian HY spreads (using JPNIG Index) are implying a default rate of 4.27% over the next 12 months, whereas the actual default rate for (as of mid-2009, using Moody’s data) rose to 10%. Clearly, much of credit’s upside has dissipated during this rally and valuation wise, credit look rich. But it does not necessarily mean that the current bounce in credits must end, as the internal market momentum and other technicals are still positive, i.e. outflows from global MMFs have now exceeded USD200bn YTD, according to EPFR Global. That being said, I think it would be wise to remain alert to the possibility of a downturn in the near future.

Check & Balance in China

A-shares dropped 6.6% wow without big policy changes from government. Talking to the market, I think there are a few points which may help explain the nose-dive event --- 1) the market is not satisfied with the July macro data  as FAI/IP/Loan Growth all came under consensus; 2) SYWG changed their tone and thought that property sales will not be as good as that was in 1H09, which will drive developers to slowdown the newly start projects (-42% MoM in July); 3) CBRC checked Chinese Banks on how to use the loan quota in 7M09. That caused a massive sell off as most of ST lending may have gone to the stock market. In general, market overall feels this correction will be longer than last time when index is around 2800, and the next strong resistance level is 3000 and the next to 2800.

In fact, with +32.9% FAI, RMB355.9bn new loan, -23% export, CPI -1.8% and -8.2%PPI yoy, I do not feel too bad as --- 1) though YoY macro data continues to decline, MoM number is improving and keep in mind that most macro data is peaked out in July last year; 2) FAI is LTE mainly due to seasonal low fund flows from central govt. The 3rd phase of central govt lending (RMB80bn) will be spread out from August; 3) more importantly, WTE macro data will ease investors’ concern on tightening. Looking ahead in 2H09 and 2010, I think China economy growth will be more balanced towards private investments and exports. The former is far more important to the growth outlook as export is unlikely to be a key driver until the western households start to spend. Meanwhile, China’s efforts to boost domestic consumption can’t completely offset slumping export demand, according to MOC.

As a result, with respect to sector allocation, I like property developers, banks, building materials and consumptions. Some market analysts are worrying about the funding risks to property sector, I hold a different view as lending attitude from major banks are still in favour of mortgage loans – 1) CCB said it will not be aggressive in 2H09, but Mortgage is the focus in 2H; 2) ICBC claimed “…there is more room for loan growth in 2H (+RMB200bn) with Personal loans is the focus; 3) Mid-small banks didn’t lend a lot to infrastructure projects, so they have pressure to grant more loans in 2H. Industrial Bank vowed to focus on “Personal loans”. I believe that most of personal loans will be used as the substitute of Mortgage lending. A good example is collateral loans jumped 47% in July as buyers and bank loan officers are getting around the “2nd Mortgage” rules. To the banking sector, despite the slowdown in July, RMB loan growth remained robust at 33.9% yoy and this took loan balance to Rmb38.1tn. I also see some +VE trends as there is Rmb198bn decline in DBs. The funds are being redeployed in HY Mid-to-LT loans. Together with more favourable deposit trends, this bodes well for NIM recovery. However, there are elevated concerns over the S&D of steel industry. Steelmakers in China have the capacity to produce 660mn tons of steel a year, more than annual demand of 470mn tons. This industry has the worst excess capacity in China and that is why domestic steel prices have slipped this week, with -4% in HRC and -7% in rebar……Lastly, valuation wise, MSCI China is now traded at 17.1XPE09 and 8.3% EPSG, CSI 300 at 25.1XPE09 and 16.9%EPSG, and Hang Seng at 18.2XPE09 and -15.8%EPSG, while AxJ region is traded at 18.2XPE09 and +7.3% EPSG.

Some Caution over Metals

YTD Base metals outperformed the commodity complex driven by the recovery in demand from China (35% of global demand).  In the longer term, I remain bullish on base metal demand prospects in China, but it is worth to be cautious on the price outlook for 2H09, as the peak of stockpiling have past and a looming supply response would dampen price prospects for some metals by Q4.  From the macro front, I think three key indicators are the proxies for metals demand from China – a) FAI growth; b) PMI index and c) Industrial production.

By category, aluminium and nickel will continue to perform well in the short-run, despite some of the weakest fundamentals like high inventories. For aluminium, financing deals have substantially crimped the availability of the physical metals in the market, whilst stainless steel production restarts globally are helping nickel demand. Risks are on the supply side. In addition, I still like copper and lead due to a more compelling demand story and a structural shortage of supply. But both metals’ prices have overshot and look vulnerable to a correction in the short-term. With respect to crude oil, China's imports of oil and iron ore hit a record high in July. While global oil demand is expected to fall this year for a second year in a row, China's oil demand is expected to rise by 1.1%, according to IEA. The agency expects China's oil demand in 2010 to rise by 4.2% to 8.3mn bbl/day.

Good night, my dear friends!