My Diary 605 --- Reality Check on Bernanke Talk; What if Fed Buying Stops; Donot Bet Your Bonus; Inventory Correction is Underway
20 September, 2009
“We are there vs. Are Vs there” --- The first 3 weeks of September seemed to break the empirical “curse of September”, as US stocks closed at new 2009 high, despite the noise of a China/US trade war brewing, despite the doubts about US consumer, and despite the deflationary impact of job losses. That being said, if stocks are a leading indicator of better times to come, should we all be firmly in the bull camp? Regionally, S&P 500 (+3% wow) is now standing at 20% higher than its 200D MAVG, the first time since 1983. The positive market drivers include further signs of recovery in manufacturing, M&A in tech sector, dampened risk aversion with credits’ outperformance and more executive talks about recovery in advertising. In Asia , I saw the same picture as every market in AxJ is now trading higher than it was prior to the Lehman collapse. Meanwhile, the doubts over valuation once again slide into investors’ mind, as MXWO is trading at > 27XPE (vs. 10.8X in March low) and S&P 500 at 19.3X, according to BBG. Meanwhile, AxJ market (17.9X) has also rapidly moved from 1STD below average to 1STD above. It seems that some value investors have taken their action, as NCSSF has been cutting holding of H-shares since August and sold over HKD 600mn, according to HKEX data.
Surely the bull camp fights back by data mining into the financial market history. According to their findings, Asian corporate earnings appear to have only recently troughed, rising 22% in the last 6 months. In comparison, earning increased 66% during the upturn in the early 1990s, 47% in the Tech Bubble, and by 133% during the upturn earlier this decade. So where do we go from here? Given the inch-by-inch movement in the stock indices, I think the current sweet spot of strong growth and low inflation is obviously met with scepticism. Hence it looks like the risk market will reluctantly melt higher in a low volatility environment.
X-asset Market Thoughts
On the weekly basis, global equity prices (+1.8%) reached an YTD high with +4.6% in September. Regionally, equities added +2.75% in EMs , +2.4% in US, +1.33% in EU and down 0.94% in Japan . With a surging equity market, risk appetite improved and EM Bond spread -34bps to 3.2%. Elsewhere, 1MWTI oil increased $2.75 to $72.04/bbl, up 4% wow. 2yr UST firmed 9bp to 0.996% and 10yr added 12bp at 3.47%. JPY closed at 91.29, down 0.64%, while EUR reached its new high at 1.4712... Looking at asset markets, V-shaped recovery may be priced by stocks but not bonds or economists. Moreover, while USD and equities were under the spotlight, but it's perhaps credit which is most impressive, with EM credit up over 3% wow ( Mexico alone -35 bps). On the relative term, it seems credit is still a Long as while HY credit is up 50%, EM equities up 62% YTD. However, in general, rate market has lost its elasticity to positive economic surprises. I think part of this deflation fear is reflected by USD as almost everybody can find an explanation on why USD is doomed – cursed by debt, zero-rates, poor growth and a world decoupling. In my own view, the outlook of USD relies more on the growth curve instead of rate curve. Looking back, from the recent peak (DXY at Mar2009), USD has depreciated by -14%, while copper has appreciated by +78% during the same period, and oil has also gone up by +58%. Now with DXY finally broke the 77 supporting level and many investors are loading up with the risk, it seems to me that equity investors should be cautious at this moment as bond investors tend to be closer to fundamental/risk side than other assets.
A Reality Check on Bernanke Talk
Fed Chairman Bernanke said last week at the Brookings Institution that the worst US recession since the 1930s has probably ended, while warning that growth may not be strong enough to quickly reduce UNE rate. That being said, macro data were in general positive with BTE advanced retail sales, Empire Manufacturing, Industrial Productions and Philly Fed and the lower jobless claims. With regard to these +VE data flows, several brokers are upgraded their growth forecast of global GDP to 3.7% yoy in 2H09 on average, after contracting 3.6% peak-to-trough (2Q08 to 1Q09) and expanded 1.2% yoy in 2Q09. However, I remain sceptic to such positive outlook after quickly reading between the lines. In US, jobless claims were underestimated by a late Labour Day and continuing claims rose 129K to 6.23mn, nearly reversing the previous week's 146K decline. In Housing data, single family starts are generally more stable than multi-family, fell 3% - the first drop since Jan2009. And although Philly Fed headline surprised upside, virtually all components were read to be WTE. It appears that inventory rebuilding cranked the sentiment survey higher on a headline basis.
In addition, US core CPI rose only 0.1% mom in August, alongside a substantial 0.4% (energy-led) increase in the headline measure. The core rate of inflation is grinding steadily lower in response to resource slack and depressed real estate markets. Elsewhere, this week’s reports show that core inflation held steady at 1.3% yoy in EU and 1.8% yoy in UK . From now on, it is likely that DM core inflation will fall toward zero next year as high UNE rates and low manufacturing capacity utilization bear down on wages and prices...Another noteworthy piece is a key event risk. Recently, US-China relations have deteriorated sharply after President Obama signed an order to impose a new duty of 35% on Chinese tyre imports, on top of an existing 4% tariff. China has subsequently accused Washington of "rampant protectionism" and later responded "tit for tat" by threatening action against imports of US poultry and vehicles. In my own view, Sino-US trade war is the last thing we want to see during this “green-root” recovery stage, as a slower economic recovery in the mainland China or disappointing earnings growth could trigger a "sudden and disorderly reversal of fund flows," the HKMA warned in its quarterly report.
What if Fed Buying Stops
As discussed, Mr. Bernanke gave a +VE comment saying that the recession is now over but at the same time the recovery would be slow and prolonged. The latter comments together with the mild CPI number ensured that rates would remain low for the foreseeable future. On the back of that, ample supply of debt and increasing optimism in the stock market pressured 10 year UST yield higher by 11.6bps to 3.465% over the week. However, I have to acknowledge that government bonds are holding remarkably firm, despite the breakout in equities and other risk assets. Much of the strength in government bonds over the past couple months has been due to an easing in inflation expectations and investor acceptance that the major CBs will have sufficient flexibility to remain on hold well into 2010. In addition, extremely well bid UST auctions also helped alleviate issuance concerns.
Having said so, the big picture is that Fed will have purchased USD1.7tn of UST, Agency and MBS. On the equivalent spread duration basis, this is roughly equal to USD1.4tn in 5-year notes. This is undoubtedly a very big number in any way one could calculate it. For a comparison, China ’s FX reserves grew USD360bn per year before 2008 and coupon Treasuries outstanding grew USD1.1tn over the past 12 months. Thus, it is easier to understand the market concerns over USD as the dynamics of the rate and spread market should change significantly if Fed's buying stops, as increasing debt issuance will only put upward pressure on government yields when private sector credit demand revives meaningfully. Nonetheless, crises suggest that credit restraint is likely to persist for several years.
Beyond that, I turned increasingly cautious about ST outlook for credits. At the current market levels, investors are virtually discounting a world of perfection with minimal default rates, a position that is clearly at odds with reality. As of Friday, CDX NA HY has more than halved from its wide of ~1924bps in March2009. At 650bps, the spread index is discounting only 8.9% default over the next 12 months, assuming a 20% recovery rate. This is much lower than the actual dollar-weighted default level (using Moody’s data) of around 18.8%. Similarly, Asian HY spreads (using JPM NIG Index) imply a default rate of 4.4% over the next 12 months, whereas the actual DW default rate for the region (1H09 Moody’s data) rose to 10%. With actual default levels likely to rise over the next 12 months, credits appear fairly rich.
Do Not Bet Your Bonus
Interestingly, while academics have been arguing all summer about whether the recession is over and how long it will take the economy to recover, equity investors don't seem to care as statistically speaking, spikes in joblessness have been fairly reliable buy signals. The sole exception since July 1953 was the post-dot-com bust recession in 2001, when the overhang of possible terrorist attacks, looming war with Iraq and bulging corporate inventories delayed the market's recovery until a year after the recession ended. In every other case, including this one to date, unemployment rose either just before or in tandem with a strong stock rally. That being pointed out, I saw two outstanding trends over the past few months --1) stocks are rising on bad news; and 2) cash is no longer king. This phenomenon is being explained well by human behaviour theory --- when people who have lost money perceive a chance to recoup or catch up, they tend to get ahead of themselves. This was the same pattern during the Great Depression, a decade during which the Dow posted three of its five all-time worst years, as well as two of its five all-time best years--up 64% in 1933 and up 39% in 1935--when monetary policy was austere. With today's aggressive stimulus policy, the volatility could be even more pronounced.
On the other hand, according to ML’s FMS, despite improvement in the macro backdrop/ outlook, cash balances rose to 4.1% from 3.5% and a net 18% of all investors are O/W cash in portfolios, up from +10% in August. Within GEM portfolios, investors have shifted to U/W on China , first time since Aug2008. In my own view, I think it is about the right time to lock in profit when Hangseng Index around 22 K levels, if I am an ABS return manager. YTD, stock bets should have accumulated +40-50% return so far by anticipating the potential +VE surprise from the macro side. Now with most macro data already surprised on the upside, the only critical issue is that I still do not know is when the macro data start to double dip...Remember it is near the bonus time...
Back to China, the decline in profits of China SOEs eased last month for the sixth month in a row - profits totalled Rmb813.5bn in the first 8 month, -19.6% yoy compared with -22.8% in the Jan-July period and -27% in 1H09. However, I think the overhangs in A-share are still there as 1) the number DXF in October will shoot up to 3192.2bn shares vs. 9bn shares in September, and 2) banks will face pressure to raise capital or slow loan growth as new capital rule imposed by CBRC will prevent banks from counting mutual holdings of subordinated bonds as part of their capital base...Lastly, valuation wise, MSCI China is now traded at 16.6XPE09 and 13.5% EPSG, CSI 300 at 23.7XPE09 and 18.4% EPSG, and Hang Seng at 17.2XPE09 and -6.3% EPSG, while AxJ region is traded at 17.9XPE09 and +12.8% EPSG.
Inventory Correction is Underway
There are warning signs from commodities after most metals have rallied sharply ytd, with copper and lead more than doubling from their January lows, and even markets such as aluminium and nickel, with poor fundamentals, show substantial gains. Looking back, restocking activity and speculative buying have also been powerful drivers, as well as expectations of a strong cyclical rebound.
China has been particularly important. China ’s commodity imports surged in 1H09. Partly this was driven by a rebound in economic activity, with car sales soar and incentive schemes boosting purchases of consumer goods. There has also been clear evidence of stock building as SRB, traders, and even private individuals went on a buying frenzy on the back of cheap credit and anticipation of rising prices and demand. Aluminium imports rose to almost 400K ton in April – 20X of their normal level, copper imports were at record levels in June, and nickel imports rose to 5X their normal level in July. However, recent months have seen these imports falling back, raising concerns that China ’s commodities demand is slowing down. Trade data for August released shows that imports of aluminium are down by 57% from their recent high, copper is down 32%, and iron ore imports have slipped back by 14% mom.
I think inventory correction is underway. This can be seen most clearly in the steel sector, with steel prices in China currently down by 9% from the start of August and weaker orders being reported in early Sep. Inventory of iron ore at Chinese ports reached a record high of 76mn ton in August, +28% this year, while stocks of HRC in SH have doubled over this period. The traders have also seen widening arbitrage between aluminium and copper prices in London and Shanghai . SH copper prices are currently at a deep discount to London , consistent with anecdotal reports of high inventory levels and talk of cancelled import contracts for deliveries due in Sep and Oct.
Good night, my dear friends!
