My Diary 626 --- The Argument for Asia Inflation; The Dialogue o

My Diary 626 --- The Argument for Asia Inflation; The Dialogue of Rate Environment; The Policy Outlook of China; The Tale of Commodities

January 10, 2010

“The Year of 2010: A Tale of Two Countries” --- One of the lessons I learned from the financial Armageddon starting from late 2008 is that the world would not end. Decisive responses led by the US and China, acted rapidly in the face of the global credit crisis, succeeded in averting financial disaster and restoring confidence. Stepped into the new year, the global economy continues to recover. Chinese economy remains strong, US is showing renewed vigour despite the headwinds it continues to face, and EU, despite heightened concerns about Greece, has seen a stabilization in economic activity. As a result of these improvements, investors are increasingly focused on central bank “exit strategies”. Based on future contract, the market is looking for 93bps in rate hikes by FED over the next 12 months, 108bps by ECB, and 85bps by BoE. In my own view, such expectations are wildly overdone as even though the “Great Recession” is over, the “Great Deleveraging” continues. Consumers in US and Europe will continue to reduce debt and boost savings for the foreseeable future. Faced with consistently weak DM’s demand, EM exporters (in particular Asia) will put much greater emphasis on domestic demand as a source of growth to support the overall economy. Such a global rebalancing will happen at a price.

Market wise, S&P was dull for 5 consecutive sessions. It seems that US market is reaching an exhaustion point and probably needs a correction soon. So does HK, where HSI is also nearing its critical level at 23K, the peak in 2009. Such highs are significant because the 23K level on the Hang Seng marks a psychological boundary between the reasonable bull market valuation (prior to Sep2007) and a venture into cuckoo-land valuations which I saw in the final phase of the 2007 rally. That said,  investors as a group have their second thoughts as risk markets continue to exhibit increasing complacency, witnessed by 1) NA HY CDS continues to collapse, falling to a new cycle low (486bp) this week. In the historical context, HY spreads are back were they were pre-crisis in 2007; 2) 3M variance future (testing 400 level) and VIX (near 18) have collapsed >40% since Nov2009. The collapse in volatility has been the best performing trade globally for macro funds over the past month. Certainly, if one simply looks at the collapse in variance, the fall in HY spreads and the VIX back under 20 as an ominous warning sign of excessive complacency, then there follows a rising risk of a serious equity market setback.

However, I think investors need to watch it in conjunction with some other indicators - notably the yield curve, the base metal prices as well as the broad market valuation. Over a 45-year period, all of the S&P500's capital gain took place when the 10Y-3M curve spread ( by Fed’s definition)  is above 65bps. That's about 70% of the time. For the other 30% of the time, the market was flat. Today, the spread is about 380 points, nearly 2stdev above its historical average. Looking back, the only other time that the spread got this wide was back in Aug1982, a time when the equities markets were at a low and the economy was in a recessionary phase. What looks strange this time is that we are witnessing a peak in the yield curve after a 65% rally in the equity markets. Secondly, the LME base metals index has enjoyed a remarkable recovery and is already back to the low end of the trading range which held the market between Apr2006 and Sep2008. In general, HY spreads and base metal prices are an effective leading/coincident indicator of EM equities. The fact that the rally in metals prices shows no evidence of -VE divergence, suggesting that the markets just break an important resistance level. Thridly, the broad market is not over-valued, even after the strong rally in the past 9 months. Using S&P500 as a benchmark, the key metrics look fairly acceptable, including 10YR Trailing PE (20.42X, slightly O/V), the current PB (2.29X, slightly U/V), the current DY(2.29, F/V), the Market Value /GDP(81.2%, F/V), and Tobin's Q(0.91, slightly O/V). Based on these boarder risk indicators, it is understandable why those adventurous asset managers have been enticed back into equity and commodity markets since the beginning of 2010.

Another near-term supporting factor may come from central banks and policy markers. In US, the December FOMC minutes indicated that policymakers are seeing the world pretty much the same way as before, despite additional good news on the economy and financial markets. The FOMC reiterated its low for long stance, while also maintaining plans to wind up purchases of MBS and agency debt by the end of this quarter. That said, some members indicated willingness to extend and increase the program if the economy were to weaken or the mortgage market functioning were to deteriorate. The overall dovish tone of the minutes caused the yield curve to steepen. In China, Premier Wen signalled steady economic policies for 2010, indicating there would be no tightening in the near future. He expressed concerns about inflation expectations and rising global commodity prices, while stating that there is currently no CPI problem. Premier also signalled that he will continue using measures to damp down house price growth and curb speculation. In Asia, other major central banks (Bank of Indonesia and Bank of Korea) followed suit and kept rates unchanged.

Having the above discussed, the major changes in 2010, if compared with the pre-crisis years, would be  characterized by lower growth rates, deleveraging and higher saving rates in DMs, a greater emphasis on consumption in EM, and more regulation generally. In US, the tight credit conditions and the caution in HH/business spending will lead to a slow recovery and only a gradual decline in UNE rate (10% in December). Moreover, US budget deficit has reached a record of $1.4trn in 2009 and its total debt is now $12trn, according to the US Treasury Dept. I think, in many ways, US today is worse off than it was in the 1930s as the govt has created problems of moral hazard and is facing with an astounding public debt. In my own judgment, the problems with the US is not an isolated case. The key question for world economy in  2010 is whether the recoveries in the HH and business sectors will be strong enough to enable the authorities in each economy to start to withdraw their exceptional stimulus plans without precipitating the “second dips”. On the surface, it might seems that all the ingredients are in place for healthy recoveries in 2010. After all, rates are at extremely low levels, bond yields and corporate spreads have fallen considerably, share prices have rebounded, world trade volumes are recovering, housing prices are stabilizing. Moreover, labour market has shown early signs of stabilization, and inflation is low or falling in many economies, allowing central banks and governments to continue with their stimulus programs.

Despite all these improvements, there are still numerous obstacles to a smooth upward trajectory in may economies, the fundamental causes of the downturn --- the over-indebted B/S of the households and the financial sectors in DMs have not yet changed. Thus consumption spendings is likely to remain restrained and business capex and hiring is unlikely to resume previous level until final demand returns to normal. The lower level of interest rate is not helping consumers as ample funds available for banks have not been reaching the end users --- households and companies as banks are reluctant to lend. This leads to the extremely slow growth in the broad MS as the repairment of household B/S relies on a healthy economy and vice versa. The implication to financial markets under such conditions are not too bad --- low rate, modest growth and low inflation, with respect to equity and bond markets. The key risks are the policy uncertainty and the potential inflation threat. With regard to the “tale of two worlds”, the point is that China is booming, while the real swing variable is the US.

X-Asset Market Thoughts

On a weekly basis, global stock prices rose 2.4% with +2.72% in US, +1.95% EU, +3.73% in Japan and +2.72% in EM. Elsewhere, 2yr UST closed 17bp lower this week to 0.97%, while 10yr ended up flat to 3.83%. 1MWTI oil sits just below 14-month high of $83.18/bbl and the price has gone up $10 over the past month. Currency wise, EUR closed at 1.430 (-0.3% WoW & -5% MoM), while JPY closed at 93.3, weakened 0.2% WoW and 4% MoM…Looking across asset markets, three observations have caught my attention. The first is the evolution of interest rate expectations with FFTR-2YR spread has steepened by 47bps since Nov2009. But one factor that could distract the Fed will be the oil price. Crude is re-testing resistance at US$85/bbl despite the recent strength in the Dollar. In EUR and CHF terms, oil has already broken to new highs. In JPY, it is re-testing the yearly high. Irrespective of the currency, the renewed vigour of the oil price is a worry because if crude shifts higher again, it will be a negative for final demand recovery in the West. Lastly, USD seems gaining upward momentum as I expected in the last diary on the back of rate hike expectation. In my own view, although the FED minutes gave green light to USD carry trades, choosing the appropriate funding currency is not as easy as it was in 2009.

Some friends asked why I spent quite some times on the relative performance of different asset markets, which seem very time-consuming and exhausting. Here are some good data for your reference. Over the past decade, say on 31 December 1999, if one invests $10000, you will be left $9090 now. If you put the same amount in 10yr UST, you would end up with $18000 (6.1% per year). If invested $10000 in commodity (say CRB Index) you would have $13,803, while if in Gold you earned 14% per year and turned your money into $37852. That being said, the average annualized return for US equity mutual funds was 1.7%, compared with Hedge funds’ 6.3% over the decade. Now, if history is a guidance, would the substantial divergence of asset performance caught your attention, in particular after your retirement fund lost more than one third in 2008-2009.

Looking Forward, the global recovery will face several challenges in 2010 as favorable basing effects ebb and policy-makers begin to unwind the massive easing put in place from 2008 --- 1)  Whether the major economies are able to make the transition from stimulus to private sector-generated growth? 2) How would the central banks move towards an “exit strategy” and unwind their QE programs? These two risk factors are inter-connected and I am sure there will see risk aversion related to the timing and mechanics of the exit strategy, along with the WTE economic data and the underlying weakness of the banking system. 3) Will USD continue to be the funding currency for the Carry Trade? As the policy rate hikes are likely to come, the direction of expected nominal interest rate spreads will regain attention. Thus, currency trading may be more challenging in 2010 as investors will have to focus on relative valuation.

To sum up, if 2009 represented a classic top-down trade, anticipating that the world economy would not end and that markets would recover, then 2010 represents the style of bottom-up and value-driven where returns will be much harder to come by, reflecting weaker aggregate growth. Regional allocation will favour the EMs based on the key investment drivers, such as valuation and the quality of growth. With respect to the major asset classes, the mix of weak data is ideal for stocks because the Fed will focus on the jobs markets (or Household B/S). So tightening will come later than the market currently expects and USD strength is not going to be a major issue. But gains in the coming year will be relatively modest as the rally moves from a liquidity-driven phase to one driven by earnings. In addition, over the past 15 years, sustained rallies in USD have invariably required a US real FFTR of 2% or more. Once the real Fed funds rate gets to 2%, we should know an expansion is on its final legs (usually) and the bulk of an equity rally should be behind us. Meanwhile, as base metals approach the previous cycle highs, I expect investors will move towards the laggards, including natural gas, Uranium, agriculture and fertilizers. In general, the level of overall commodity indices would depend on the strength of USD and the continuation of the FX carry trade. The Chinese government’s efforts to diversifying away from USD and dollar-denominated paper assets will be another major supportive factor for the industrial commodities. Therefore, I would guess that metals, the energy sector and resource based currencies will continue to be outperformers in 2010.

The Argument for Asia Inflation

Over the past few weeks, investors saw an inflow of mixed US data – strong production (factory orders +1.1% vs. cons=0.5%, ISM at 55.9 vs. cons=54.3 ), modest final demand (3Q GDP +2.2% and personal consumption +2.8%) and disappointing payrolls growth (-84K in ADP & -85K in NFP in Dec). Meanwhile, the pending home sales for Nov was WTE (-16.0% mom vs. exp -2.0%) as favourable policy ended. Since pending sales lead existing home sales by about 3 months, and existing sales lead retail sales by up to 6 months, so the message from the housing market remains that the consumer demand recovery would be slow and weak, if without government’s life support. That said, Friday saw US consumer credit dropped a record $17.5bn in November as UNE rate close to a 26yr high discouraged borrowing and banks limited access to loans. Revolving debt, such as credit cards, also plunged by a record $13.7bn in November, followed a revised $4.2bn drop in October, the Fed’s statistics showed. These are the vivid evidence of my arguments to a slow and bumpy growth in the years ahead.

In contrast, good economic news were round Asia. Chinese PMI rose to 56.1, the highest since Apr2004. Asian export continues to surprise on the upside. Taiwan December exports were up 49.6% yoy and 9.3% mom. By destination, shipments to China/HK almost doubled (+91.2% yoy) while exports to the US are still weak but finally back in the positive zone (+4% yoy). Shipments to Europe also showed +23% yoy. Moreover, Korea also reported a 9.2% mom increase in exports in the same month. However, Singapore reported a 6.8% QoQ annualized fall in 4Q09 GDP while Indonesian inflation continued to surprise on the downside (only 2.8% in Dec).

Broadly speaking, I expect 2010 to see a continued recovery in global growth. In DMs,  while the current steep yield curve in the major economies could be a reason to expect a vigorous economic expansion, the lingering after-effects of the financial bust will remain a serious headwind to growth for 2010. in comparison, Asia would consolidate its position of growth out-performance and inflation levels remaining benign overall. However, the loose monetary policy and ongoing capital inflows are prompting concerns that Asian economies could experience asset-price and general inflation in 2010-11. With Asian central banks keen to maintain currency stability, active market intervention will inject further liquidity into their domestic economies. Conventional economic theory argues that this surge in the supply of money will ultimately increase nominal economic activity via higher output or higher prices, or a combination of both. Once full capacity is reached as a result of higher economic activity, the theory predicts that higher inflation is inevitable.

The Dialogue of Rate Environment 

2009 is an excellent year for Fixed Income investors as HY bonds returned +44%, corporate bonds rewarded +17.3% and even mortgage bonds provided 5.8%, according to Yield Book indices. In contrast, US Treasuries returned -3.3%. In fact, compared to a duration-matched UST position, HY credits outperformed UST by +45% and IG credits by 21%. However, at this point of rate cycle, the more important factor is the Fed’s monetary policy decisions in the coming quarters.

The street is using several techniques to “guess” what would be the likely results of the next FOMC meetings. When using the Taylor Rule (by headline PCE), the estimated FFTR is roughly 1.25% by 2010YE and 3.75% by 2011YE. When using a recent survey of the 18 primary dealers, the yield on 2YR UST is expected to end 2010 at 1.825% (the highest since Oct2008) and 10YR is expected to close in 2011 at 4.125% (the highest since July2008). Such predictions are not unexpected as within the next 12 months, the US Treasury will have to refinance $2trn in ST debt, not counting additional deficit spending which is estimated at $1.5-2trn. This could be a problem for the American as since 1985 their debt has been financed by foreigners (or 44% of its debt). The point here is, with the total gold, oil and FX reserves at around USD500bn, plus total domestic savings of USD600bn annually, how would Mr. Geithner fund the 3trn short of this next-year obligations is a valid concern to the market. Would US withdraw more money from its printing press or would The President Obama raise taxes? At this point, none of the two options seem to be doable.

Regarding the credits, spread are generally influenced by the changes in the financial condition of the issue entity. But higher rates will eventually filter through to higher borrowing costs which then raises operating costs and weakens profitability. In the short term, a move up in rates tends to compress spreads as there is a lag between the more liquid UST market and the less liquid corporate markets. It is important, therefore, to keep in mind the general rate environment when examining credit spread movements. Down the road, there is no doubt that the FED would become more hawkish in its monetary policy, but that is a concern for another day. For now, at current levels along the yield curve, USTs are not attractive and will move higher in the 2H10 as private credit demand revives and markets start to discount higher ST rates. IG credit yields are more attractive than Treasuries, from a 224bp pickup on the 2yr  to 189bp over the 10yr. Using another term, the US credit OAS spreads are ~200bp above commensurate UST right now. The 10-year mean for such an average is 174bp. So there is still some tightening to go. However the risks are also obvious, including volatile interest rates, higher inflation and an increase of sovereign credit risk in European EMS. Therefore, from an asset allocation standpoint, investors should be mildly O/W equities and corporate credit, while U/W government bonds.

The Policy Outlook of China

The 2009 rally in S&P500 failed to rescue investors from the worst return in two bear markets after the Internet bubble collapsed in 2000 and +$1.7trn in global bank losses sent the index to a 38% decline in 2008. The S&P 500 posted an average -0.9% annual return since 1999 including dividends, the first -VE return for a decade since data began in 1927, according to the Index analyst Howard Silverblatt. In fact, the S&P500 earnings for 2009E was the only major global region with D/G (-1.2%) over the last month. In contrast, European Stoxx 600 earnings have been upgraded by 0.2%, slightly better than the global trend, while Japan, AXJ and EMEA have been the regions with the strongest U/G. In particular, China A-shares so far have seen 605 companies gave the full year profit guidance. According a rough estimate, these companies are going to make total profits of ~RMB100bn (+ 48% yoy) with 63% indicating +VE guidance. On the back of this earning prospect and economic fundamentals, AxJ funds record the largest inflow in 2009 with net inflow of USD19bn, offsetting the net outflow from the previous year, as per EPFR.

Looking forward into 2010, nobody can give a sure prediction about how the Chinese economy and market will evolve, especially after such a dramatic year in 2009. In the near-term, Premier Wen’s remarks about the timing of policy exist and the launch of index future could bring the market with new hopes in the New Year. Even so, I still tend to believe that the chance for Chinese government to continue implementing policy "exist strategy" is high, since the exist has actually started since August and the recent partial exist from property and auto markets is just another step. The only question is about how quick and how strong of the policy exist. Last week, PBOC in its 2010 annual meeting did not specify money supply target (given in 2009) or new loan target (given in 2008). Instead, the central bank simply states “to keep the appropriate growth of loans…”to support economy growth, while manage inflation expectations...” In addition, PBOC said that “the loans to new projects must be strictly controlled”. In my own view, the Chinese policy makers are well aware that the longer this debt-fuelled investment boom is allowed to continue, the greater the danger that it will create increasingly unprofitable excess capacity – just like the US asset bubble.

China’s growth will accelerate to 8.8% in 2010, 4X faster than the US, as the world economy expands 2.4%, according to the UN forecast last month. However, China also faces several key challenges in the year ahead, including the need for a more efficient allocation of resources, the need to rebalance the economy as external demand remains weak, and the prospect of domestic inflation. A potential solution to all three challenges is to have a more flexible exchange rate. But PBOC has also claimed “to keep RMB reasonable and stable.” Given the concerns over inflation,  growth restructuring, banks fundraising and interest rates hike, investors should O/W Insurance, Coal & Gas, Information Technology and Consumers services in the near-term…Lastly, valuation wise, MSCI China is now traded at 14.4XPE10 and 21.7%EG10, CSI 300 at 19.7XPE10 and 28.3%EG10, and Hang Seng at 14.3XPE10 and 21.8%EG10, while AxJ region is traded at 14.2XPE10 and +27.1%EG10.

The Tale of Commodities

For the currency world, 2009 has been a year of broad weakness in USD. Risk appetite has been strong, equity and credit markets have soared and currencies have retraced some of the losses seen in 2008. From “risk-off”, the market turned back to “risk-on’. However, since early December, USDJPY has risen about 5% and almost as much against EUR. The bounce of USD may be a signal that 2010 would be more complex for FX trader than it was in 2009. Interestingly, as a comfort, financial columnists explained such a reversal in USD-X from different angles, i.e. UST yields are ticking up, some economic indicators point to growth recovery, the US BoP is forecast to shrink and so on. In my own view, these arguments are all valid. But the key is the traditional growth and interest rate fundamentals will exert a greater influence on the major USD-Xs, as the economies continue to normalize and financial market stresses recede. In recent weeks, USD has correlated well with movements in 2-10YR US yield curve as well as in relative interest rates. EURUSD fell as UST curve steepened through much of December. Similarly, the Dec 2010 Euribor-Eurodollar implied yield spread narrowed from 65bp in late November to just 23bp on the year-end, consistent with the decline in EURUSD over that period. Looking ahead, I continue to expect a weak USD in the mid-term as real money or benchmarked investors would increase foreign asset allocations in favour of EMs with higher return prospects.

Perhaps more importantly, oil prices are notably higher back over $80 bbl. The rise in oil prices is seen partly as a function of cold weather and  also consistent with the 4% jump in natural gas prices. In addition, geopolitical tensions have been getting more attention again following the attempted terrorist attack in the US over Christmas holidays, the closing of the US and UK embassies in Yemen, and what appears to be rising tensions regarding Iran’s nuclear program. It would not be unreasonable to assume that it will get above $100/bbl during the year. But I think it will take a bit longer before we see the $147 high again.

In general, commodities have seen a longer-term secular bull market since 2000. This type of bull market tends to last around 20 years. Thus, buying stocks and commodities on near-term drops seems to be the correct strategy in such markets. For example, buying oil in 1Q09 produced substantial profits and was once again one of the best investments in 2009. Given that price moves in oil and the other energy commodities can be considerably lagged, it may give investors another chance to profit in 2010. Such candidates are natural gas and uranium. In 2009, NG futures fell to $2.40/cum and spot prices were even lower. Uranium fell to around $40 at its low in 2009 and stayed relatively flat. Recall that Uranium had a strong rally from 2003 to 2007 when it rose from around $10 to over $130.

In my own view, the prices of NG and uranium are not likely to go lower in 2010 because they are so close to their production cost levels. This does not mean a major rally is imminent as prices can stay low for a long time, as was the case in the 1990s. However, the S&D for NG and uranium is bullish in the intermediate –term because 1) China is aimed at tripling is natural gas consumption as a % of total energy demand as of 2015; 2) a number of new reactors will be coming online in Asia over the next few years, with the market deficit about 60mn pounds a year. 3) It is estimated that uranium prices would have to move up to around $75/$80 to improve supply. One last point is that, regarding the opening remark of “A tale of two worlds”, the US has been the leading sources of economic and policy uncertainty in recent years, boosting financial demand commodities as a safe haven from monetary debasement, inflation and systemic financial stress. At the same time, China is the leading consumer “at the margin” of many commodities.

Good night, my dear friends!