My Diary 627 --- Fire on Asian Cylinders; Another Year on Spread

My Diary 626  --- Fire on Asian Cylinders; Another Year on Spreads; Behind Chinese Data Dump; Counting FX Reserves

January 24, 2010

“The B-4 Era: Beijing, Barrack Obama, Bernanke vs. Banks”  ---  The well-known “B-2 Spirit” is an American heavy bomber armed with the low observable stealth technology and the considerable capital and operations costs (totalled 2.1bn/aircraft in 1997 Dollars). To the financial markets, it seems we are entering the “B-4 Era” of which both Beijing top authorities and President Barrack Obama have dropped bombs to tame the banks across the Pacific Ocean. In China, CBRC required banks to halt their lending in January after MTD loan surpassed Rmb1.2trn and ordered a ETE 50bp RRR hike. Market also whispered that the differentiated RRR will be imposed to five banks. In addition, PBoC bill rate went up another 8bps, along with Friday rumor about possible IR hike by 27bps. Furthermore, some local medias have reported that Premier Wen Jiabao may remove "proactive fiscal policy and relatively loose money policy" from his address to the NPC in March. At this stage, banks' financing program will also come into attention after BOC announced its proposal to issue up to 20% of news shares or equal to RMB150bn new capital. Looking ahead, with RMB1.2tn of outstanding PBOC bills maturing in 1Q10, it is not surprised to see another RRR hike in the next 1-2 months.

In the US, President Obama proposes new banking regulations, which called the "Volcker Rule", designed to end the era of banks too big to fail. The Volcker Rule has paralleled with the defunct Glass-Steagall Act that created a wall between CBs and IBs, but doesn’t go that far. The proposal would prohibit banks from running proprietary trading operations or investing in hedge and private-equity funds. Also proposed was an expansion of the 10% market share cap on deposits to include other liabilities such as non-deposit funding (basically restrict growth). Such a policy move will add to bank deleveraging because 1) all big banks use proprietary trading (via leverage) to take down the ever exploding amount of debt (including USTs) issued. Thus, the amount of debt each bank can underwrite would be seriously compromised by a lack of prop trading/leverage, 2) and the FASB rule bring toxic assets back on to bank B/Ss begins this quarter. The market impact of Volcker Rule is immediate and across credits (NA IG CDS =90.25, highest since Dec09), IR swaps (2yr spread, +1.7bp) and EM bonds (spread over UST + 19bp to 284bp), according to the JPMorgan. Moving into next week, the focus will be on Chairman Bernanke. But I think the Fed’s policy statement would be a cut and paste exercise. Recent US data do not justify a shift in the language and Fed is unlikely to discuss exit strategy for QE.

Put into together, the unintended side effect of these “Bank-targeted” bombs have caused a reduced risk taking as markets wait to see the new rules. These should give a bullish tone to the bond market in the near term. Fund flows data supported this judgement as I saw USD4.4bn weekly inflows into bond funds vs. USD4.2bn outflows from all equity and money markets funds. That said, financial markets have had an unsettled start to the year of 2010, buffeted by a variety of risks related to tightening in China, fiscal concerns in EU and bank regulations in US. It is worth noting that the overall background liquidity and growth environment is still very constructive, although I am seeing some rotation away from China-related assets on the back of relative valuation and the gradual shift in Chinese policy.

X-Asset Market Thoughts

Global equities close 3.4% lower the week with -3.6% in US and Japan, -2.5% in EU and  -3.2% in EM. This week’s declines pushed global equities to their lowest price in a month. Meanwhile, UST continued their recent rally, with 2yr and 10yr yields falling to 0.79% and 3.61%. 2yr have declined 35bp from its peak, and 10yr has contracted 23bp. 1MWTI oil price decreased $5.34 to $74.54/bbl, a 4-week low. USD finished the week +1.2% on a TW basis, gaining 1.7% against EUR and 1.4% versus EM currencies. In contrast, the Dollar slipped 0.5% versus JPY this week to 90.3…Reading across asset classes, risky assets were under downward pressure due to news in China that the monetary authorities continue to lay tightening groundwork --- telling banks to stop making new loans following up on a 50bp hike in RRR and the recent hikes in PBoC T-bill rates. For exchange rates, DXY index reached its highest level since early Sep2009. However, the movement of major currency-X is more about relative fiscal outlooks. Over the week, the pivot point for USD to perform better was the outcome from the Senate election in Massachusetts. The implications is better fiscal outlook in US vs. a number of European countries. On that note the situation in Greece continues to attract attention and the Greek-German 10yr spread reaching 311bp, the widest since Greece joined EU in 2001. However, it is worth nothing that USDJPY actually moved lower due to lower UST yields

Looking forward, with more global CBs tightening monetary policy, markets will be sensitive to the notion that the global recovery could be vulnerable if policy makers do not strike the right balance. As a result, I keep thinking when volatility expectations are going to rise, as discussed in Dairy 413. The VIX index has experienced a constant decline over the past 12 months from a level of >50 to a recent low of 17. There is good reason for the decline given the precarious state of the world and the immense uncertainties that were faced this time last year. But the “relief” that has since flowed has hardly been built upon a solid foundation (more debt to solve the problem of excess debt, government handouts, excessively loose monetary policies, etc). At some point the many economic and financial fault lines that still exist are likely to jolt markets around once more. In addition to this are the uncertainties surrounding policy implementation in China (tightening or no tightening, credit growth or growing restraint) and the US (health care, financial regulation). Maybe the 19% jump in VIX was the start of something.   

In addition, USD’s recent sharp spike has raised an interesting Q --- Can the 8-year bull market in EMs continue if the Dollar continues to advance this year? The question is based on the last twenty years during which EM stocks have maintained a  strong -VE correlation (both in local and common-currency terms) vs. USD. For instance, between 1989 and 1992, when USD declined around 15% as a result of the S&L crisis and the resulting economic recession, EMS outperformed the global BM by nearly 70%. By late 1994 and early 2002, a Strong USD triggered a series of devastating EM crises and stock market crashes. Since 2002, a prolonged bear phase of USD has coincided with the longest bull run in EM equities in the modern history. Moreover, the EM-USD question is particularly important because global portfolios’ exposure to EMs have dramatically increased over the years. According to the latest ML FMS, in January asset allocators raised their equity OW to 52% from 37%, the highest since July2007. EM positioning remains near all-time highs, with net 47% OW. So any correction in global equities would be felt deeply in EMs.

Another of my thought is related to HK markets. Since China has now signalled its intention to exit from its super-loose monetary policy, HK now faces a big test --- it benefited from China’s liquidity boom in 2009, as capital flooded in, but will it suffer from the PBoC’s gradual withdrawal of that liquidity in 2010? Part of answers is lied in the HKD spot rate – one of the available proxies for capital flows. HK Dollar (testing 7.76 above) has weakened against USD since the announcement of the RRR hike (HKD@ 7.755). This, combined with the recent drop in HK equity prices, suggests that foreign investors have sold HKD as they exited the local market. I think while HK will remain highly sensitive to policy shifts in China, the good news is that there is little risk to its economic recovery in 2010.

In sum, the coming year is a longer and even more challenging journey for policymakers who must find a way to start the process of unwindingvextraordinary measures, but without unwinding the gains in asset prices or confidence. As a result, 2010 will witness the transition from a liquidity driven environment to one that relies more on underlying fundamentals. In this environment, sector/stock selection will become ever more important and the focus of investment will increasingly need to be on relative value within individual sectors.

Fire on Asian Cylinders

The week saw EM Asia continues to fire on all cylinders even as parts of DMs show signs of losing steam. China leaped 10.7% yoy in 4Q09 and the most recent indicators suggest increased momentum entering the new year. For 2009 as a whole GDP growth reached 8.7%, higher than market FC @8.4-8.5%. For 2010, I think there is some upside to the market estimated at 10%, largely due to the strong export momentum. That said, Chinese policymakers are facing a much more complicated macro environment this year. On one hand, domestic sectors have rebounded sharply in response to last year’s extraordinary growth-boosting measures, and a few pockets are becoming stretched. On the other hand, government officers are still very concerned about the global environment and the labor-intensive export sector, and are willing to maintain an overall stimulative policy stance to ensure the recovery proves durable. In general, with activity ramping up throughout EM Asia, upside risks to growth and inflation are appearing, underscoring the call for the region to lead the world in policy normalization.

While EM Asia outperforms, I saw further evidence that growth in EU is flagging. Despite the WTE domestic spending data (retail sales, capital goods orders) and reported flat GDP reading in Germany, January German ZEW Index fell to 47.2 from 50.4 in December, a 4^th consecutive monthly decline, suggesting a more tepid recovery in Europe. The services component of latest Euro area PMI reading fell a full % point, leading to a drop in the overall composite to a level consistent with GDP growth of just under 2% yoy.

In the US, though the Beige Book indicated US economy was on track of steady recovery, most of data released were on the disappointing side w/ lower advanced retail sales (-0.3% mom) and UoM condifence (72.8) and higher initial jobless claim (444K). In addition, So far earnings from the US big banks have been OK but revenues are again falling short and outlooks are based on an uncertain economy. Over the week, JPM results beat consensus but the real economy part of JPM continued to hurt. Mortgage losses reached USD4.2bn in 4Q09 (vs. USD653mn last year) and LLR on its CB unit increased to USD494mn from USD190mn last year. Prime mortgage net charge-offs reached 3.81% of the book vs. 1.2% a year earlier. CEO Jamie Dimon said that "we don't know when the recovery is". Elsewhere, BoA reported a WTE loss (Qty loss=USD5.2bn or 60c/sh vs. cons=52c/sh). MS Q4 results (29c/sh) were more of a miss, compared with a loss of USD10.5bn (11.35/sh last year) and analyst estimate@36c/sh. That being said, global activity data continue to point to signs of moderation in Europe and strength in China. I do think that Beijing will continue to actively control the fast pace of credit growth, but not to step on the brakes abruptly. Inflation front, despite the rebound in headline figure, G7 central banks are expected to remain attentive to UNE rate and not accelerate tightening. 1Q10 inflation releases will test the economists who called that headline inflation will continue to rise in EM and stabilize in DMs.

Another Year on Spreads

As pointed out in the last diary, 2-10yr UST yield curve slope has risen to over 280bp, surpassing the previous two cyclical peaks in 1992 and 2003. This steepness reflects the fact that ST interest rates are at all time lows. In addition to lower rate, the coupon curve has steepened even further in recent weeks, as the 10yr yield rises on the back of an increase in both LT inflation expectations and the term premium. This is worrisome because the cyclical bull market in risk assets is unlikely to be sustained if bond yields are rising for reasons other than better economic growth. Some strategists argue that 2010 will look much like 2003-04. Though inflation will remain quiescent, the real yields is depressed and has considerable upside. Uncertainty over monetary and fiscal outlook will also put upward pressure on the term premium. Thus, UST yields will move higher in 2010 as government bond issuance escalates and private sector demand for credit revives.

For beta assets, along with economy recovery, the 12M trailing HY DF rate edged lower to 13.2% in Dec2009, the first time the rate has fallen since the financial crisis began. The street now expects a steady decline in the DF rate, perhaps to ~5% by the end of the year, assuming further improvements in lending standards and corporate health. Meanwhile, the recovery rate also shows a significant rebound in recent months. This upturn is not atypical; the recovery rate tends to be inversely correlated with the DF rate and is on track to return to >50% by year-end. Therefore, the average loss rate on defaulted HY debt will likely drop to about 2.5% in 2010. Since the avg default-adj spread during the past 15 years is about 250bp and the latest index spread is around 600bp, the HY segment should outperform USTs by 350bp, assuming mean reversion in credit spreads and and the avg default loss levels off in the range of 200-250bp.

To sum up, I think fixed Income investors should Short duration and OW high-beta corporate spread products

Behind the Chinese Data Dump

The past few days basically dominated by the Chinese macro data. GDP and retail sales both came in BTE, as did inflation. IP was WTE but looks like it was weather related. In addition, unlike most people expected, despite the 8.7% growth and nominal GDP at USD4909.5bn in 2009, China failed to pass Japan as the world’s 2^nd largest economy. Looking through three key macro indicators, the Urban FAI growth slowed further to 30.5% in Jan-Dec from 32.1% in Jan-Nov, suggesting that December single month FAI growth decelerated sharply to only 20%yoy from November’s 24% and the peak of 39% in May. This is mainly due to the slowdown of govt-sponsored FAI in the infrastructure sectors and suggests a cautious near term outlook for building materials. Beyond steel and concrete, China remains the best consumption story  with total real retails sales rose 16.9% yoy, up 2.1% from 2008.  Urban disposable income rose 9.8% yoy and rural cash income rose 8.5% yoy. I think this trend will continue as long as the government continues to invest in soft infrastructure, such as health and social security (+58% yoy) and education (+37% yoy).

The key focus is on inflation as Dec headline number did jump up to 1.9% (vs. cons =1.4%) from 0.6% in Nov and -0.5% in Oct. But the important factors are that 92% of the CPI increase was from food, in particular vegetable prices. Going forward, the money supply-CPI transmission will be the major driver of inflation, and if Feb inflation could rise above 2.25% BM deposit rate, then it is likely to see 1^st rate hike coming in March. December PPI was up 1.7% yoy (vs. cons=0.8%), which is another reason (cost push) that will add to CPI inflation pressure. In fact, some of F&B companies have announced price hikes, including Yanjing Beer (25% retail price hike) and Coke (4-5%) due to cost concerns. Thus, there is a risk of government price intervention, like what we saw in early 2008 when reported CPI reached 7-8% yoy. Market expects that central government this time may not wait until things get worse before capping prices. That being discussed, a pre-emptive and gradual tightening is positive to the markets, as it reduces the chances of overheating or asset-price bubbles down the road.

However, outlook over domestic property price may not be so stratightforward. According to CICC, in the first half of Jan, transaction volume in SH & BJ have been more than halved. But big developers are collecting assets, i.e. SH Industrial/Neo, CapitaLand/OOIL and China Life/Sino-Ocean. I think the answer lies on the Supply/Demand. The recent property investment data shows that S&D situation was not balanced. In 2009, GFA sales rose 42.1% and GFA completed only rose 5.5%, while GFA new start rose 12.5%. As a result, D&S situation in 2010 could get worse, if demand maintains at 2009 level, due to tight supply, price may rise 20% or more. If demand dropped by ~ 20% to meet supply, it may trigger developers to further cut investment, putting pressure China’s GDP growth and local govt’s financial health. Either side, it’s going to be a tough year for 2010. Regarding to banking sector, the constant noises about tightening/capital raising are key risks to stock performance. Interestingly, most fund managers and analyst I talked with are agreed with the earnings outlook of 20~25% EPSG for China banks this year. The key is whether multiples can expand from current 9.9X PE10 and 2XPB10. I think actual earnings delivery (FY09 and 1Q10 results) will trigger a rerating of banks.

In sum, Chinese top authorities are likely to continue the incremental stimulus withdrawal that has been underway since last summer. The implication to the markets is that investors should UW FAI-related sectors(cement, steel, dry bulk shipping and construction machinery) and OW anti-inflation sectors (basic commodities, property, F&B and super markets)…lastly, valuation wise, MSCI China is now traded at 13.4XPE10 and 21.8%EG10, CSI 300 at 18.9XPE10 and 29.7%EG10, and Hang Seng at 13.3XPE10 and 21.6%EG10, while AxJ region is traded at 13.4XPE10 and +28.1%EG10.

Counting China's FX Reserves

Nothing could stop the accumulation of China's FX reserves, which rose by USD453bn in 2009, a year of sharp export decline and external volatility. Interestingly, a latest research pointed out that, contrary to the common belief, it is the CA surplus and FDI, not "Hot money" flows, that accounted for the bulk of the increase in FX reserves. For 2009 as a whole, trade surplus and interest earnings accounted for 75% of the total reserve increase, while other capital flows (excluding FDI and valuation changes) accounted for <10%. There are two important reasons behind China's resilient trade surplus, even though it decreased about USD100bn over the past 12 months to USD200bn, according to customs data -- 1) +50% of China's trade is processing trade, which export and import is move in sync; 2) Global commodity prices dropped.

Looking forward, it is expected that China to accumulate another USD400bn in foreign assets in 2010, based on the assumption of a gradual RMB appreciation, a slightly smaller trade surplus, an increased FDI with no major tightening in capital controls, and no major FX policy changes. However, there are more evidence that dealing with the persistent large FX inflows in the coming year will be challenging on two fronts – 1) the need to sterilize the large inflow to maintain appropriate monetary conditions; and 2)  the challenge to allocate the ever-rising FX assets properly in a more uncertain global financial market. Theoretically, it is possible for PBoC to continue the sterilized intervention in FX market - keeping the nominal value of the RMB steady while accumulating FX reserves, and raising RRR to keep banks from lending too much. However, such policies have costs, including financial costs to the central bank and to the banking system, loss of political capital versus trading partners, and more importantly, possible misallocation of resources as a result of cheap capital and distorted relative prices.

In addition, once PBoC buys out all the FX, it is then faced with another issue ---  where to invest? China already has roughly 2/3 of its USD2.4trn reserves in USD-denominated assets, of which USD800bn in USTs. While the value of Dollar seems uncertain, other alternatives are not easy to find --- 1) EUR has been volatile, along with the questions of sovereign default in some EU countries; 2) Commodity sectors, including gold, are quite small, not mentioning storage issues. China's total bulk commodities import was about USD150bn in 2009 and present; 3) Equity investment in other countries often faces political obstacles.

Good night, my dear friends!