My Diary 607 --- Question is How Much? Fed is Gradually Out

My Diary 607 --- Question is How Much? Fed is Gradually Out; What Could Cool A-shares? DXY on Downward Trend

September 27, 2009

“American Football + History Professor = Winner from the Recession” --- For most of the times, I believe that the secret of success in investment roots on other areas of human activities, including American football, a game which its defensive linemen are taught to "read the head" of their opposing offensive linemen since their heads lead their bodies and thus their actions. This is the underlying philosophy why investors show interest in technical analysis or in the line-by-line comparison of FOMC minutes. It is also why historians like Niall Ferguson (a history professor at Harvard) are entitled to be the winners from the recession and now listened to on economic issues, as economists and even central bankers couldn’t see the crisis coming, couldn’t explain it to anyone once it broke, and couldn’t come up with a way forward after it happened. I listened to professor Ferguson’s speech during the 16th CLSA Conference. His view is skewed to the deflation camp with key points ---1) the unlikely fast recovery of US consumption; 2) the slowing global trade; 3) the potential damage of six TBTF banks and the risk exposure to CRE; 4) the serious of the fiscal crisis and 5) the China’s binge on USTs.          

That said, two week ago the world has seen a bullish close for risk with USD at 1-year lows against EUR and BRL, gold moving towards $1030, Oil near $72/bbl and stocks near their 2009 highs. As I discussed in my latest diary 406, there were many signs of fatigue in major asset classes and equity investors should be cautious. Over the week, my view turned out to be correct, witnessed by Wall Street went South, as investors sold on the back of the Fed's decision to hold FFTR steady and keep its outlook on the economy relatively unchanged. Major asset classes saw profit-taking with GBP tumbled below 1.6150, Gold crashed through $1000, and S&P closed below the 1050 pivot. In fact, S&P had completed a key reversal down (higher high, lower low and close below previous day low). This is a classic toppish signal in technical terms and if you are willing to “read the head”. The reasons behind this correction could be attributed to the ripples from FOMC, IPO indigestion in China, and WTE US existing home sales. Policy wise, WSJ has carried an article by Warsh (Fed governor since 2006) who says that Fed may need to move with "greater force" than usual and that policy may need "normalization" before it's obvious. He also says that officials must be mindful of the "costs of policy error". In addition, coupled with the reduction in size of 2 Fed programs, it appears that Chairman Ben Bernanke is trying to land his helicopter. This makes USD carry-trade risky and so do the risk assets. Moreover, Bank of Israel paused after having hiked the first of all central banks in August, citing output gap and the effect of stronger currency. These concerns are widely shared and BOI’s decision is a reminder that any central bank that decides to raise rates in the foreseeable future is going to move very cautiously.

X-asset Market Thoughts

On the weekly basis, global equities declined for the fourth day till Friday, with -2.3% in US and -1.9% in EU and +0.5% in Japan. After falling 1.9% wow, global equity prices are still up 2.3% MTD. Elsewhere, yield curve flattened, with 2yr UST rising to 0.98% while its highest yield in Sept. and 10yr just 1bp from a September low. 1MWTI oil closed at $66.02/bbl, after slumping $5.66 Wednesday-Thursday. As a reference, oil has ranged from $59.52 to $74.37 in 3Q09. JPY surged ~2% against USD to 89.6, the strongest since Feb, while EUR closed flat at $1.469…Looking at the key asset markets, obviously, after Fed promised free money for an extended period, bond investors braced for the statement, while equities & oil got smacked as fundamentals continue to weaken (i.e. weak macro data, no demand and rising inventories). Market sentiment also weakened as MCC went >10% underwater from its IPO @ HKD6.35.

Looking forward, I continue to take cautious view on equity and commodities market, as I am expecting USD to strengthen in near-term. I think the key for the global marketS to go further up is whether there will actually be +VE surprise in US retail sales. Although expectation are building up in the sell-side, so far hearing from the container shippers, they haven’t seen yet. Moreover, my expectation on manufacturing data is going to be WTE as  de-stocking has come to an end or normalized, while ISM Inventory / Durable orders (-2.4%) indicate that restrained consumer spending and near-record excess capacity will prevent companies from boosting capex expenditure in coming months. As for equity markets, the investment environment has become more complex than before. The sharp price gains may have reached a temporary ceiling as both fundamental and technical indicators have become either stretched or overbought. Thus, the bigger issue is whether the cyclical bull market has already matured. As for govt bonds, the backdrop remains very benign. The global system is awash with excess savings and private-sector credit demand is still very weak. Thus, the public sector should keep borrowing and spending with 10yr at 3%-3.5% before yields potentially move higher sometime next year. On credit side, the market has entered its last bull leg as HY spreads have been ahead of the default curve. However, with US/global economy on the cusp of a recovery and interest rates staying at very low levels, it is too early to offload corporate bonds. As for USD, I think 2010 should be prepared for a potentially sharp rally in USD after QEs end. In the meantime, gold prices should drift higher along with exploding liquidity growth around the world and soaring Marshallian demand.

Another big picture question is what could further derail the risk asset markets from up-trend. I think there are a few things to be watched – 1) Exit strategy, BOC and Fed has started or hinted on the remove of excess liquidity but not tighten policy. In US, policy makers have already acted separately, with Obama administration ending its USD3bn “cash-for-clunkers” program on Aug. 24 and Fed starting to wind down its UST purchasing program which totaled USD285.2bn between 25March-16Sept; 2) Inflation, the output gap has been the universal panacea against concerns that growth bounces will quickly fill up and lead to pricing power.  So far that hasn’t happened anywhere but this is the very concern; 3) USD rally, a stronger USD could simply happen as a result of market positioning or pushed by G20 intervention or otherwise. However, rebalancing the global growth model may require a weaker USD to prevent US from returning to trade deficits and USD recycling; 4) Trade protectionism, the China and US actions on trade remain a concern but no one sees this as a fire out of control.  But it could flame up and G20 remains a forum for more trouble. The risk is that others join into the fray.

Question is how much?

The latest FOMC minutes indicated that FFTR at 0-0.25% can stay for "an extended period". In general, the Fed quietly presented a more upbeat assessment of the economy -- a) activity has "picked up" compared with the last statement's "leveling out"; b) "the housing sector has increased", the first +VE statement in years; c) businesses are still cutting back,"…though at a slower pace"; d) and policy will support "a gradual return to higher levels of resource utilization" was added. The last point is quite strange to me as by definition, rising resource utilization would imply above trend economic growth and falling unemployment…Not seen yet…In addition, Fed continues to say that "activity likely to remain weak for a time" regarding consumers due to job losses, sluggish income growth, lower housing wealth and tight credit. Thus, consumption remains an obvious downside risk for US economy. 

Data wise, things are mixed with initial US jobless claims at 530K (-21K wow), while Aug existing home sales fell down to 5.1mn from 5.24mn in July, along with WTE durable good orders. Going forward, housing market could get worse on the back of a triple whammy -- the expiration of tax credit, the end of Fed mortgage-buying program and rising foreclosures. In Europe, German Sep IFO rose for the 6th month but WTE (91.3 vs. cons. 92). In Asia, Taiwan kept rates unchanged at 1.25%. HK exports fell 13.9% yoy, a sharp improvement from July 19.9% fall but also WTE. HK exports have grown sequentially for 4 consecutive months but the pace of growth in mom terms has diminished.

In fact, except for China, the rest of Asia's growth did not re-balance towards more domestic demand regardless of policy stimulus. For Asia ex-China, it was largely the sharp turnaround in net exports that boosted 1H09 real GDP growth. Meanwhile INV/GDP shares fell while private consumption shares were roughly flat. In other words, the export-growth model in Asia is very much alive, while only China has meaningfully pushed toward domestic demand, but largely via investment, to support growth. Looking ahead, there are increasing signs that Asian IP and trade flows are moderating from the booming pace of 2Q09 and early 3Q. Taiwan’s IP rose a little over 1% mom in August, only 1/4 the pace of the previous 3 months. So did the Japanese exports, with export volume rose 1.5% mom, compared to average gains of 4.4% in the last 3mos. China’s IP growth rate also has moderated somewhat. That being discussed, from a QoQ standpoint, it seems that the downshift will register mainly in 4Q09. Question is how much?

Fed is gradually out

Fed announced to shrink some facilities last week – 1) 28D TALF will continue until Jan 2010, but smaller afterwards; 2) 84D TALF will be lowered from $75bn to $50bn in Oc09, and $25bn in Nov- Dec09; 3) 28D TSLF will be lowered from $75bn in Oct to $25bn in Nov. Together with its slowed purchase of mortgage assets, Fed is ‘fine tuning’ liquidity just like what PBOC did in August. In part, I think this leads to the correction in US equity. On the other hand, Fed extended USD1.45trn MBS/GSE (1.25trn/200bn) buying to 1Q10. Although size is not enlarged, the program is only 68% (862bn/125bn) done, leaving +$3bn purchases per day going forward. The concern is that, once the Fed exits the market, the spread between yields on MBS and UST will have to rise, perhaps by 50bps, in order to attract buyers. The spread now is about 140-145bp, down from 215bp at the start of 2009…Remember, one of the key points for Fed to stabilize US economy is getting housing back.

Having said so, the Fed's repeated that "economic conditions are likely to warrant exceptionally low levels of the Federal rate for an extended period”. What was noticeable was that the Fed dropped any upside inflation risk coming from commodity prices - it was simply not mentioned this time around. The statement shows that there is no rush for the exit of Fed's accommodative monetary policy stance. Looking ahead, given core PCE has just about halved over the past 12mos from 2.7% to 1.4% now (below Fed's target of 1.75-2%), and I think it will be likely to halve again over the next 12mos to 0.7%. The investment implication of a low FFTR for an extended period is outperformance for long SE duration vs. cash.

Back to Asia, HY spreads closed at historical average. Despite the rally, fundamentals generally remain supportive for credit with the recent wave of earnings results mostly pointing towards improvement. In the near term, the outlook for credit fundamentals remains benign, and the current environment is encouraging new issuers to the market.

What could cool A-shares?

Although I remain cautious in ST, the broader environment remains a “sweet spot” for stocks for the next 6 months, including monetary and fiscal stimuli, low interest rates, falling inflation and improving corporate profitability. In the meantime, a large output gap will force policy maker to focus on promoting and protecting economic growth. That said, according to Citi strategist, at 2.1XPB, 14.6XFWD PE, 21.1XTRL PE and 11.5XPCF, AxJ is at +1 STDEV above its long-run average. Based on valuations alone, there is a greater than 60% chance that markets will be lower in 3mos' time. In addition, earnings revisions have dropped from a post-1990 high of +47.3% to +35.7% over the last month. It seems that the momentum is clearly down. I also cross-checked with other earning metrics – 1) ROE fell to 12.5% in 2008 from 17.8% in 2007. But that is higher than in previous recession years (6.3% in 1998 and 9.1% in 2001). This suggests the fall in ROE in 2008 is cyclical rather than structural; 2) but gearing increased sharply last year. Net D/E rose to 35% (from 25% in 2007), the highest gearing level since 2002.  

Back to China, since end-July, A-shares has sharply underperformed H-shares. The A/H premium is now at 18% - very close to historical lows. It seems that market has concerns over China economy & policy shift.  Timing wise, local PMs are taking profit ahead the long holiday. In general, I do not think government will tighten meaningfully due to 1) loan growth target will be RMB 7-8trn for 2010 vs. 9.5-10trn in 2009; 2) property transactions have slowed down since Aug09 & stock market is consolidating; and 3) the latest A-share IPOs have failed to beat expectations, clearly hindering investors' enthusiasm or speculation. The GEM Board IPOs will not cause substantial liquidity drain as they're small cap stocks. Policy front, PBOC governor Zhou Xiaochuan said monetary policy has four fold objectives --- low inflation, economic growth, employment, and payment balance, and currency stability was the most important goal. Beyond his comments, the overcapacity issue will evolve into a mid-long term pain for Chinese economy. Several warning are seen over the week --1) China’s steel production capacity may rise by at least 50mt to 710mt next year, citing CISA; and 2) the domestic wind-power turbine industry is headed for a major consolidation, with fewer than 10 out of +100 manufacturers likely to survive the shake-out…Lastly, valuation wise, MSCI China is now traded at 16XPE09 and 13.6% EPSG, CSI 300 at 22.4XPE09 and 19.2% EPSG, and Hang Seng at 16.7XPE09 and -6.2% EPSG, while AxJ region is traded at 17.6XPE09 and +12.8% EPSG.

DXY on downward trend

The past week saw USD registered notable gains, and not surprisingly, commodities have lost ground as well. While there is no catalyst or fundamental change in the market that fully accounts for the swing in FX, there are several developments and events which may account the contraction of the “Dollar carry” trade, suggesting the likelihood of further run in ST. First, the USD's recent slide resulted in a large build of short USD positions, with the latest CFTC data showing the largest such skew since 2008, a period that directly preceded the USD's significant 23% rally from late-July through Oct2008 (see DXY). Certainly, financial market and economic conditions are different now from they were and as such, a similar % bounce in USDJPY seems less likely as the market believes that Japan's new DPJ-led government will be less resistant to a strong JPY.

Another two events contributed to a scaling back in risk are FOMC meeting on and the G20 Leaders Summit. The Fed sounded a bit more upbeat in its economic assessment and began the gradual transition towards normalizing monetary policy over the next year-plus. This should now provide USD with sustained support. Furthermore, the plan of rebalancing global growth and debate surrounding protectionism should not expect a material progress on either front and for markets. Thus, I remain to see a break lower in DXY index, driven by strong EUR and EM currencies as the ongoing global recovery will keep policy makers comfortable with more currency strength in Asia throughout Q409.

Good night, my dear friends!