My Diary 621 --- The Desynchronized Econcycles; Too Early for Fl

My Diary 621 --- The Desynchronized Econcycles; Too Early for Flatteners; Fine-tuning China Growth; Sweet Spot & Crowded Shot

15 November, 2009

“No Exit & More Stimulus vs. Dollar Carry & Asset Rally” --- The whole world rushed into one trade as the recent G20 consensus was quite clear, that is, we are still too early to implement exit strategy while maintaining stimulus policies. The message is similar to assure the punch bowl for the overall market. In addition, over the week, Richmond Fed President Lacker said it was too soon to say when the Fed might lift rates, adding it could be in 2010 but might take longer. Such a dovish central bank commentary suggests little risk to the USD carry trade in the near term, and should be viewed as a green light for further equity market gains. However, investors should keep in mind that exit coordination will be difficult and may create extra market vols. For example, despite raised growth (4% in 2011) and inflation targets in the Monthly Inflation Report, BoE said that last week’s reduction in the asset purchase program should not be viewed as the first step towards exit plan. But actual exit has started in some countries like Australia (rate hike) and China (lower credit growth) on the back of the two countries’ strong economic recovery, asset bubbles and inflation concerns.

That being discussed, the key remains in US as >10% UNE will trigger more stimuli. With no-exit & loose credit in US, the biggest source of funds, liquidity will be abundant to support global markets. Apparently, Asia is feeling the full force of low US rates, prompting the authorities in Taiwan & HK to adopt unusual measures. Taiwan has banned foreign investors from putting cash in TDs. In Hong Kong, the goverment is using administrative measures to target housing demand, with HKMA altering its almost 20yr-old policy of a 70% LTV ratio for luxury residential mortgages.  In China, economy groeth is still very much intact at 8% target and 2/3 of China companies’ interim results are BTE. With strong Rmb appreciation expectation and recovered exports, one would see more money inflows from overseas in 4Q09-1H10, driving up domestic liquidity (even loan growth slows down). In terms of fund flows, EM equity funds turned +VE (USD2.5bn) for the week ended 11Nov. These money inflows suggest strong participation by fast money accounts and asset allocators and leave equity prices in EMs vulnerable to sudden changes in risk appetite. Thus it is critical to monitor FX markets closely as a reversal of DXY would represent a major headwind for equities.

X-Asset Market Thoughts

On the weekly basis, global equity moved up +2.3% with +2.25% in US, +2.74% in EU, - 0.53% in Japan and +2.79 in EMs. Elsewhere, UST 2yr ended up 3bp lower at 0.806% and 10yr at 3.418% (-8bp). 1MWTI closed at $76.35/bbl, down $1.39 wow. USD weakened 0.63% on a TW basis at 75.33, with JPY89.66 (weakest in 3wks) and EUR ebbed 0.4% to 1.4903. Gold future closed at $1118/oz, up 2.6% wow…Looking across asset markets, equity investors are on hold due to +VE 3Q profits and 4Q guidance. But these were insufficient to convince investors that revenue growth, as opposed to cost-cutting, would be a significant driver of profits in the coming Qs. Meanwhile, LEIs for the US and global economies are still rising at a time when policymakers are not backing away from stimulus and are prepared to provide more support if needed. All in together, it seems the recovery in risk assets remains intact, although the consolidation phase is not over yet. However, the cautious sentiment also stays intact, suggested by UST price movements and strong inflows into bond fund ($6.2bn vs. $7.5bn into equity funds). In addition, I also observed that DXY can’t convincingly get through 75 and EUR couldn’t break above the yearly highs (1.5064). The most interesting development was in energy as the market seemed more focused on the US demand D/G than the world demand U/G ( and weaker Dollar) after DOE stats showing bigger inventory builds (760K bbls to 37.7mn bbls last week) and demand much lower on the week again driven by gasoline. Lastly, Marc Faber added fuel to the gold flame as he commented that “… we will not see less than the $1,000 level again, as central banks are all the same. They are printers…You have to own physical gold.”

Looking forward, the bigger issue is whether the cyclical rally has already run its course, and how much is downside risks. For equity, I am positive as macro environment and policy stance remain conducive. Meanwhile, valuations are reasonable. For rates, I am bearish on USTs at current yields, amid at the heavy supply and an end to the Fed’s direct UST purchases. For FX, I think the mid-term negative view over DXY are still firmly in place, given global economy is slowly recovering and capital is being put to work, largely in higher-yielding markets outside of US. For commodity, demand for gold is typically negatively correlated with risky assets. But the recent mix of economic weakness and QEs has driven a more fundamental upturn in demand for gold. I remain positive on the yellow metal.

Fundamentally, I think investors should pay more attention to China markets and assets. As this juncture, it is clear that policymakers are unlikely to allow tighter credit conditions to jeopardize the economic recovery. But, structurally China’s macro environment is very conducive for asset bubbles due to 1) low inflation and interest rates depressed by the productivity-induced growth; 2) a limited supply of domestic assets chased by massive domestic savings contained by CA controls, and 3) the procyclical global hot money inflows and abundant liquidity in the domestic banking system. Furthermore, corporate China’s profit growth may surprise on the upside (vs. cons.=20%) as a result of 1) aggressive cost cutting; 2) a weak RMB and 3) a strong volume recovery. Despite the aforementioned positive factors, there are a few risks for China markets to bear in mind -- 1) a sooner-than-expected policy tightening which could be triggered by three preconditions, including an inflation outbreak, a reemergence of bottlenecks in transportation and energy sectors, and a full-blown asset bubbles; 2) a mix of tough administrative measures to cool stock markets, including large-size IPOs. So far, the increase in equity supply has been easily absorbed by domestic savings, witnessed by the massively oversubscribed and feverishly chased Growth Enterprise Board. However, the pace of IPOs and their impact on the liquidity situation should be closely monitored. The key barometer is the money market rate; 3) the intensifying global protectionism against China. As pointed out by Erik Nielsen that “…Complaints to the WTO over alleged protectionist measures increased by 27% to 281 during 1H09...China has seen the greatest increase in complaints against its practices. In sum, inflation and Rmb appreciation will become main investment theme in next 3-6mos, and A-share market will directly benefit from Rmb appreciation. Financial sectors including banks, property and insurance will also benefit from Rmb appreciation, while commodity and materials sector will benefit from inflation.

The Desynchronized Econcycles

In the latest quarter, G3 capital goods orders, a LEI of global capex, surged 23% yoy, suggesting that there may start a shift in business spending to transform the 2H bounce in global growth into a sustained economic expansion. However, the disappointing October US UNER (10.2%) highlighted the main downside risk is that business sector might fail to complete the transition from retrenchment to recovery. Outside of US, global UNER was also high at 7.8% in 3Q09. That said, if job growth does not pick up in the coming months, consumers will lack the fuel to spend as fiscal stimulus winds down. In fact, compared with early 1980s, Americans have more than triple the debt they had in 1982, and less than half the savings. They spend 10 weeks longer off the job, and a bigger share of them have no health insurance. Furthermore, Fed’s latest SLOS shows that banks continue to tighten terms and standards on all types of loans, although the net % of banks taking such action continues to shrink. Therefore, it is fair to say there is still considerable risk around as the various data and surveys have not aligned to give a consistent picture. Looking ahead, one should not be surprised that the +VE feedback loop between confidence, financial markets and spending would break down, if anything goes wrong.

Good news is that most EM countries weathered this crisis remarkably well despite some initial scepticism. As a whole, the emerging economies may not have fully decoupled, but global influence has moved from the slow-growing G7 to a booming China contributing to EM growth outperformance. Behind the success lie two fundamental developments--1) gains in inflation credibility, and 2) fiscal consolidation. As a result, EMs enjoyed unprecedented room for countercyclical policies for the first time since 1990s. That said, it seems that regional economic cycles are becoming increasingly desynchronized. Many EM countries would benefit over the next two Qs from an inventory rebuilding cycle. Meanwhile, policymakers are looking for signs of a more durable upturn in the underlying economy before tightening policy. Similarly, central banks are closely monitoring the health of their domestic banking systems to see how much of the liquidity being provided is reaching the overall economy. All these imply that monetary policy will also diverge in the months ahead as central banks try to gauge whether their domestic economies can withstand a gradual reduction in policy stimulus.

Too Early for Flatteners

In general, major central banks would stay in put over the mid-to-near term. The Fed reiterated a pledge to keep borrowing costs at a record low for an “extended period” last week. BoE Governor Mervyn King also said he has an “open mind” on further bond purchases, signalling officials aren’t ready to withdraw stimulus yet. In Asia, South Korea’s central bank left interest rates on hold for a ninth month at 2% to underpin growth. However, the dovish tone from central bankers may not ease the bond investors’ nerve as inflation fears might threaten bond markets and the ecnomy recovery. Sentiment wise, scepticism over some central banks’ abilities to limit inflation is potentially conducive to higher inflation risk premia, and this phenomenon is likely to be amplified by the unavoidable rebound in CPI (yoy) induced by base effects on oil prices, as well as indirect taxes in some countries like UK. Next week, the market will see the release of CPI in US, EU and UK. Such releases will be carefully monitored at a time when the liquidity-inflation/deflation debate is still raging. In other words, real returns associated with higher liquidity-induced inflation are probably one of the reasons why yield curves remain historically steep in G3 bond markets. For example, 2-10 swap spreads are anywhere between 150bps in Japan and 246bps in US, making steepening trades attractive in terms of carry.

As discussed above, govt bond curves steepened to extremes across the globe during this cycle as central banks moved aggressively to provide support and in many cases resorted to credit/quantitative easing. Looking ahead, yield curves will flatten dramatically over the next 24mos as policymakers embark on their next tightening cycle. However, the timing of yield curve shifts will vary significantly given that interest rate cycles will not be synchronized. In practice, 2-10 curve slopes tend to flatten several months before policy rates are lifted, given that investors are forward looking. For example, RBA and Norges Bank have already begun their tightening cycles. RBNZ and BoC will be next. BOE, Fed, ECB, and BoJ have the most flexibility and will take longest to tighten. It remains too soon to play flatteners in these markets. 

Fine-tuning China Growth

The 3Q earnings season saw corporate America's ability to cut costs continues to surprise. But I doubt that corporate sector can slash their way to a sustained profit recovery. With 462 S&P500 companies reported, non-financial earnings have beaten forecasts by 5%, but dollar-weighted revenues have fallen 0.7% short of forecasts. In contrast, the recent improvement of earnings in AxJ has not all been driven by cost-cutting. According to Merrill Lynch, sales forecasts have risen 8% in the last 3mos with margin improvements across all sectors. In short, sales growth and margin expansion bode well for the sustainability of earnings growth in the AxJ region.

In China, about 1600 A-share companies reported their 3Q09 results, with total net profit rising 26% yoy and non-financial profit up 18.7% yoy. The main contributors to growth are insurance, banks and utilities. NPM and OPM for 3Q09 were 6.0% and 8.2%, flat from the last Q and up slightly from last year. On the back of better earning expectation, bulls believe that China will outperform global markets as its weighting in MXWO is only 2% (9th) vs. Japan’s 9% (2nd). However, bears hold their views that domestic asset inflation is well in advance of CPI inflation, so authorities will act sooner to curb the excesses. In my own view, Chinese economy is indeed at a critical stage and there is a danger of over-relying on property/stock markets to maintain prosperity. Incidentally, money supply continued to expand aggressively with M2 growth ticked up to 29.4%, while M1 growth surged to 32.0%. This came despite the PBOC mopping up Rmb366bn of liquidity through its open market operations in October and acts the same pace in November. The turn in policy stance is clear, but liquidity conditions remain supportive of recovery. In the inter-bank market, 7D-repo rate dropped 20bps to 1.47% since the beginning of October.

My observation is that the government’s fine-tuning efforts have started to generating some visible impact, particularly on money and credit growth. New bank lending has cooled off (253bn in Oct vs. cons. 400bn) in recent months. And as of 11Nov2009, 36 A-share companies’ placement plans were approved by CSRC, to raise +RMB100bn. Sector wise, property is likely to face increasing policy risks in 2010. The actions are expected to include mortgage rate rises, a reduction of leverage ratios and an increase in RRR for mainland banks, according to SSJ. However, other demand-side stimulus policy will be extended into 2010. For example, MIIT suggested extending the policy of a 50% discount on purchase tax for autos < 1.6L and on "autos to rural areas" with broadening coverage of supports. In addition, the China’s Association of Pharmaceutical Commerce believes that the pharm industry will continue to grow at ~20% yoy in the foreseeable future…Lastly, valuation wise, MSCI China is now traded at 14.4XPE10 and 21.2%EG10, CSI 300 at 20.3XPE10 and 26%EG10, and Hang Seng at 14.8XPE10 and 19%EG10, while AxJ region is traded at 13.8XPE10 and +27.4%EG10.

Sweet Spot and Crowded Shot

As an asset class, commodity remains in a “sweet spot” due to 1) LEIs have been rising for several months, 2) real rates are low and yield curves are steep, and 3) USD is falling. However, with CRB up 52% (annualized) yoy since February low. I think a large chunk of good news is already priced in. That said, this cycle is very unique for oil as historically oil price has been determined by real S&D and were coincident with growth. During this crisis, oil prices rose way ahead of economic fundamentals as investors viewed the cyclical bear market as a cheap entry point to a positive secular story. Equally important, OPEC intervention has kept oil supply constrained. But it seems, to certain degree, that higher oil prices are self-limiting and OPEC has begun to make noises about boosting production at its 22Dec09 meeting. Moreover, as indicated in the IEA’s 2009 world energy outlook, the long-term energy prices stay at upward trends as 1) overall energy demand increasing by 40% from 2007 to 2030, primarily from non-OECD countries (China/India  account for 50% of increase); 2) oil demand to increase (1% cagr) from 85mn bopd in 2008 to 105mn bopd in 2030. The main issue is on getting enough investments to ramp up production sufficiently; 3) natural gas demand to grow from 3tcm/y in 2007 to 4.3tcm in 2030 (1.5% cagr, 80% non-OECD). As a result, I would prefer to U/W base metals, O/W precious metals and energy.

With respect to the Dollar, my long-term view over USD remains –VE. Similar to energy, this upcoming USD cycle is different from previous crises during 2000-01 (Tech) and 2008-09 (Housing and Banking). During both cases, USD were supported as a result of the ultimate need for safe haven asset –US Treasuries. Given the higher aggregated debt after public/private swaps, it seem the next crisis would occur in UST itself, and USD would be a casualty as investors unload both UST and the greenback. If that would be final case, gold would be the strongest currency of all because it would benefit as the safe haven inflows. In the near-term, I think the market may see a temporary revaluation of USD as 1) after Jan1010, investors will likely anticipate an unwinding of favorable base effects for economic growth; and 2) real money accounts will dump high-beta assets as a result of crowded Dollar carry trades. As pointed out by David Rosenberg, the dollar short/long equities trade has become the no-brainer trade and is beginning to appear crowded. Looking at the latest COT report, the only areas where speculators are net short are in USTs and in USD. Everything else has massive net speculative longs (i.e. 208K contracts in SP500 and 271K in gold) and hence near-term vulnerable to a reversal.

Good night, my dear friends!