My Diary 632 --- Fast is Slow; Central Banks on Pause

My Diary 632 --- Fast is Slow; Central Banks on Pause; Three Concerns over China ; US Deficit will be Back
 
 
 
February 7, 2010
 
 
“Happy CNY, plus Holy Cow, Flying PIIGS and Sino-US Friction” --- The coming Saturday is the Lunar New Year, the most important festivity in China . Hereby, I wish the best to all my diary reader friends…Having the best wish for the upcoming months, the past week ended up with panic and pain with falling stocks, weak commodity prices, USD strength, and lower Treasury yields, due to a combined impact of concerns over Greece’s sovereign debt, rising political/regulatory risk for financials, policy tightening in China and the lackluster company guidance. In particular, MXWO Index dropping the most in four months, while EUR slid to the lowest level since May2009. Even Warrant Buffet saw his Berkshire Hathaway’s credit rating d/g from AAA to AA+ by S&P after it has taken on debt to fund the $26bn takeover of Burlington Northern…Oh, before moving on, Toyota ’s 2010 Prius may have brake problems. According to US Transportation Secretary Ray LaHood, he said "if you own one, I say stop driving. Return it now". Go Geely, Go!
 
”Holy cow! Look at those initial claims (480K vs. cons 455K),” said Diane Garnick (Investment strategist at Invesco) ...“We thought we were finally going to have a positive month. It wasn’t in the cards this time. Unemployed people don’t spend money. That means the growth we’ve seen is not sustainable until people get jobs.” I think Diane made a good point as though January UNE rate unexpectedly dropped to 9.7%, the details of jobless claims do not paint a brighter roadmap as 1) the emergency benefits rose a staggering 281K vs. avg +200K for the past few months, plus 2) an even bigger problem is that many states have not even applied yet for these emergency benefits so they will continue to grow. That said, history will show 4Q09 GDP to be an exceptional quarter for US economy with headline rising 5.7% vs. cons@ 4.7%. However, the appraisal is less encouraging, given the dominant contribution from inventories re-stocking (3.4%), the most since 4Q87. Thus, some offsetting weakness in 1Q10 should not be surprised. On the political side, moves in US govt to push through various forms of banking-sector reform have caught markets’ attention. Because banking stocks led the rally in equity markets, this has been received unfavorably by investors. More generally, markets hate uncertainty, especially a new and important factor -- policy risk--has been added.
 
Unfortunately, there is more bad news or uncertainty. In Europe, Greece 's acute problem is the need to refinance its maturing debt in April and May, while preserving sufficient cash to fund current expenditure, with funding need at least EUR30bn by May. Both ECB president and EU Monetary Affairs Commissioner have said that there is no "plan B" for Greece , but also gave assurances that Greece would not default on its debt. In addition, IMF said it was ready to help Greece , while Greek govt reiterated that it had no plan to seek assistance from IMF. Obviously, markets remain unconvinced that Greek govt has the resolve to achieve a credible and sustainable reduction in the deficit, given the severe economic pain that will cause -- the Greece’s debt load will go to over 110% of GDP (2X high than EU average), along with deficit to 12-13% of GDP. As a solution, domestic demand needs to fall for 4 years to narrow financial imbalance, but this will mean growth suffers. On top of this, Greece has an aging demographic and a pension system that will mean age-related spending at much higher levels than the rest of EU. Such a market debrief has serious currency implications. Due to little or no practical liquidity in Greece debt, the needs to hedge or speculation has driven investors to use EUR as a proxy. Thus, EUR is apt to remain vulnerable unless or until a more credible resolution occurs. And not only does any such resolution seem unlikely just yet, but the market, always in discounting mode, continues to broaden its view and look elsewhere in Europe to other fiscally challenged countries, anticipating that they too could be vulnerable to and cause the same types of stresses Greece is currently inflicting on the EUR. As a result, I expect EURUSD is likely to remain on the downside, even after the considerable 6-plus big figure drop since mid-January. Having said that many of the fundamental problems that plague Greece are also present in the likes of Spain and Portugal, credit markets have reflected the risk premium with CDS on Portugal govt debt soared to a record 211bp, Italy to 138bp, Ireland to 169.5bp, Spain to 164bp and Greece to 415.5bp. All in all, it is not in the interests of the EU, any Euro zone govt or the ECB to permit a default of any of the mentioned govt debts. However, for a bailout to happen Greece must be in a deep crisis and contagion effect may happen where other economies in trouble rely on this. In short, markets will not let PIIGS flying until policy makers bail out the bankrupt and ease policy e.g. ECB cuts rates.
 
This is still not the end of the wall of worries. Investors have become concerned about the prospects of a slowdown in China . On 12 January, PBoC hiked its RRR by 50bp, catching the market by surprise. While PBoC officials sought to downplay this to some extent, saying that it was intended to manage liquidity and ensure stable bank lending, the move did exacerbate investor concern that Chinese policy tightening could trigger a slowdown in a key – perhaps the key – economy for the global recovery. Adding to the heat is that US-China policy friction has picked up markedly of late. US manufacturers’ discords, President Obama’s call for tariffs on Chinese vehicles and truck tires, US criticism of China ’s internet policy and the announcement of USD6.4bn arms sale to Taiwan are good examples of the already-formidable diplomatic saber-rattling. China has fought back and accused of "arrogance" and double standards" with arms sales to Taiwan , saying Beijing ’s threat to penalize US companies over the deal was very real. Moreover, US has upped the ante on China to revalue its currency since Obama lost Massachusetts . China is not attending G7 meeting in this weekend, effectively making any CNY commentary ‘unilateral’. In fact, the 17% appreciation in CNYUSD since 2005 has not materially narrowed China ’s surpluses. Ultimately, any decision to resume CNY appreciation will be political, though economic considerations remain important. China ’s FX policy should be driven by the domestic economy, not international consensus, said by Vice-premier Li Keqiang.
 
 
X-Asset Market Thoughts
Global equities close 1.9% lower the week with -2% in US, -2.4% in EU, -1.1% in Japan and  -1.5% in EM. Meanwhile, UST continued their recent rally, with 2yr and 10yr yields falling to 0.76% and 3.57%. 2yr has declined 37bp YTD, and 10yr has contracted 27bp. 1MWTI oil price decreased $6.04 intra-week to $71.19/bbl, a 4-month low. USD finished the week +1.8% on a TW basis, gaining 1.33% against EUR (1.3678) as well. In contrast, the Dollar slipped 1.13% versus JPY this week to 89.25…Reading across markets, risk assets have been primed for a correction since January as a result of ETE tightening in China, the debt crisis in Greece and uncertainty over the financial sector reforms in US. Regionally, positioning, USD strength and risk aversion has actually seen AXJ equity underperformed (-10%) YTD vs broad EM (-6%), US (-6%) and even Europe (-5%), though fundamentals has not changed much from a cyclical view point. Meanwhile, EPFR reports that EM equity funds had the biggest outflow (USD1.6bn) in 24 weeks. In the rates market, UST yields have declined further to mid-December low as volatility in asset markets has rised, reflecting boarder political uncertainty, credit contagion psychology and ongoing risk reduction. As a result, USD soared to new highs measured by DXY (80.44, a 7-month high). Note that JPY and CHF have both been rallying at the same time as USD, a sure sign of investor risk aversion. That being discussed, commodities tanked (CRB -2.65%) with oil plunging $6/bbl and gold dumped almost $60. Oil dropped also because US Energy Dept. reported a WTE weekly increase in crude inventories (+2.5mn bbls) from 331mn the prior week. Interestingly, while Europe ’s dire fiscal issues would normally be +VE for gold (on fears of monetizing debt and inflation risks), gold has suffered as investors have sought the safe haven status of USD and UST.
 
Looking forward, the collective wisdom in the sell-side strategists is that this is just another correction in overbought markets due to sovereign submersion and political battles. However, I think there is much more under the surface. From macro perspective, the latest Euro sovereign crisis could ultimately cause excess liquidity as central banks delay their rates hikes, and therefore another supper bubble (EM Equity & Commodities) could occur. From the market perspective, it is difficult to know how much more price weakness would be. But in the near term, there are a few things to keep an eye on – 1) USD, which is the key to the next phase of market movement, So far, the DXY has rebounded by ~4%, while S&P has been off by ~8%. Usually, a weaker currency tends to help equity prices, but what surprises the market now is is EU area stock markets have been selling off in sync with the falling EURO. This suggests the Dollar’s appreciation is indeed very deflationary. 2) The PIIGS’ crisis resolution, which could further drag down global risk assets. Obviously, the “easy” solution would be for ECB to reflate further and find ways to purchase debt from the troubled countries. But authorities are probably concerned about stepping down a slippery slope that could lead to full-blown monetization of insolvent paper. Nevertheless, the potential danger for global financial markets now is that more monetary easing is needed in EU area, but the authorities either refuse or simply fail to come up with ways to pump liquidity in the system.
 
As a market participant, I have to say that uncertainty is the single biggest enemy to the asset markets, and continued weakness in the asset prices can offset some of the easing in the financial condition that global central banks have been working hard to maintain. The later factor casts doubt over economy growth or recovery, of which is the backbone of equity market performance, and that maybe why I saw no change in policy rates in Indonesia , UK , ECB and Australia . Thus, the natural follow-up question is should long-term investors continue to hold on to their reflation strategy? The answer is YES. To be sure, this recovery will not be a straight line. It will have bumps. In my own view, the world economy will continue to move on the positive side, and that the monetary policy will stay supportive for stocks in most countries. At the end of day, zero interest rate is a big headache for investors and pension sponsors, and they have nowhere to go but stocks. In addition, with 40% of the S&P 500's market cap having now reported, the quality of earnings is improving, with 78% beat the bottom-line and 64% beat their sales expectations…Just keep some hope here.
 
 
Fast Is Slow
The US economy appeared to finish 2009 on a high note, but the 5.7% expansion in Q4 owed more to the inventory cycle than an improvement in final demand. This explains Dec factory orders rose BTE 1% mom (cons=0.5%), but Jan ISM non-manf came in LTE at 50.5. The ISM figure fails to prove that a robust recovery is underway given ISM non-manf (80% of US GDP) has not tracked the improvements in the ISM manf (20% of US GDP). In addition, though pending home sales increased 1.0% in December, in line with consensus, housing vacancy survey showed that homes vacancy rate inched up to 2.7% in Q4 from 2.6% Q3, while the homeownership rate slipped to 67.3%, down from the record high of 69.4% in Q2 2004 and returning to the lowest since early 2000. The downturn in homeownership is likely to continue amid high foreclosure rates and tight credit, highlighting the residual challenges in the housing market.
 
Across the pond, European inflation was BTE at +1.0% in Jan (cons+1.2%) vs. +0.9% in Dec. UNE rose to 10% from 9.9% in Dec and M3 fell 0.2% in Dec vs. -0.3% in Nov. A similar disappointment was reported by UK , where Jan PMI svcs fell to 54.5 from 56.8 in Dec. Thus, it seemed that services sector in US and UK appears to still be stuck in a rut. On the back of weak data, BOE is keeping the QE at £200bn but did say that "further purchases would be made should the outlook warrant them". In German, Dec factory orders surprised sharply on the downside, coming in at -2.3% mom vs. expt.@ +0.2%. This is surprising in light of the further improvement in IFO business climate. In general, de-leveraging pressures and impaired credit availability remain a feature of DM economic landscape, and together with subdued inflationary pressures, an elevated level of unemployment, major central banks are likely not to deliver the first rate hike until 2H10.
 
Moving on to Asia, the main event was China's official PMI fell more than expected to 55.8 (cons= 56.5) from 56.6 in Dec. Meanwhile, many economists cut down their FAI forecasts for FY2010 after a disappointing Dec FAI (30.5%). Elsewhere, strong numbers continued out. In HK, Dec retail sales were rocking at +16% in value terms and +11.3% in volume terms. In India where CRR was hiked at 75bps (cons=50bp). Korean Dec IP rose to 33.9% yoy (17.9% in Nov) and retail sales rose 12.1% in Dec (9.9% in Nov). Its Jan exports clocked in at +47.1%, missing expectations of +55%. To sum up, the fundamentals in EM Asia remain solid.
 
 
Central Banks on Pause
It was a busy but no-change week for major central banks around the world. The ECB kept the ‘refi’ rate on hold at 1.00% as expected, and reiterated that current rates are appropriate, the economy should grow at a moderate pace, inflation should remain low over the medium term, and inflation expectations are firmly anchored. I think more decisions will not be taken on unwinding unconventional measures until next month’s meeting (4 March). On the European Union front, ECB President Trichet warned of large, sharply rising fiscal imbalances in many Euro-area countries, but expressed support for Greece ’s efforts to reduce its public-sector deficit. On the same token, BoE also left base rates unchanged at 0.5% but decided to pause the QE program for now, while leaving open the option of resuming asset purchases “should the outlook warrant them”. Same as ECB, MPC will wait for the next Inflation Report (10 February), with updated forecasts on growth and inflation, to make the next major policy move.
 
Meanwhile, in US, 10yr Treasury yields (3.57%) remain substantially higher than their 3.28% average over the past year and also above their 3.40% median. In the past weeks, several key factors have exerted a balancing effect on the UST market – 1) recent US economic releases, such as the ISM manf, have maintained their upbeat tone, pushing yields higher; 2) concerns about sovereign creditworthiness in Europe continue to result in a more risk-averse investor environment, boosting USTs and pushing yields lower; 3) UST quarterly refunding statement suggested that there would be no need for an increase in the nominal coupon auction sizes or no marginal increase in UST supply; and 4) bond market continues to focus on the termination of the MBS purchase program in March, which should result in slightly higher yields, all else being equal. Swap spreads remain unusually low in 10Y sector (11bps), while 30Y swap spreads are still inverted (bond yields > swap rates). Overall, given the NFP numbers have not showed +VE surprises, I am Neutral on duration.
 
 
Three Concerns over China
The final set of macro data demonstrated that growth in 2009 was very unbalanced in China , with capital formation contributing 92.3%, net exports -44.8% and consumption 52.5%. There surely will be rebalancing in 2010 and thus it is bad for FAI related, particularly mid-stream sectors such as cement, steel, dry bulk shipping and construction machinery. That being said, SIC expects China 's GDP to grow at 11.5% in 1Q10 and CPI could accelerate to about 2.5% yoy, on the back of the continued impact of govt stimulus policies and restocking of inventories of manufactured goods. However, recent weakness of PMI could become an overhang to stock markets, besides RRR/IR/Stamp Duty as we have had 8 consecutively rising monthly PMIs since May2009, which is the longest run in China 's economic historical record. It looks likely that the LEI will decline further in February and March, and if that is the case, along with a slowdown in loan growth and MS growth, the market consensus on China's economic prospects may turn upside down, which could hurt market sentiments a lot.
 
In addition, many strategists are keen on comparing 2004 with current macro and policy dynamic. Both 2004 and 2010 are years after crisis and all kinds of structural problems start to uncover due to govt monetary and fiscal stimulation side-effects. But there are also two major differences between these two periods --- 1) in 2004, the govt acted late after the inflation and overheating caused major economic problems, while this time the govt is more “ahead of the curve”; 2) China is now a much bigger country while the global economic environment is much worse than it was in 2004. That means China may not be able to rely on exports to reach a “soft landing” this time. Meanwhile, it will be much more difficult for the govt to adopt extremely restrictive measures in the investment sector today. This may indicate that the H share market may not plunge as much and quickly as it did in 2004.
 
Another market focus is on inflation as many expect that CPI may surge to 2.5-3.5% in February on shift of Lunar New Year. Investors paid very close attention on CBN yield as the 7-day repo rate, the auction yield on PBoC 3M bills and CPI inflation historically moves closely together. On the week, PBoC auctioned RMB42bn of 3M bills at 1.4088%, in line with market expectations, and injected a net RMB214bn of funds into the markets via open-market operations, the third week of net injections after 14 weeks of net withdrawals. Though rumors continue to circulate on both the amount of new bank loans extended in January and likely actions taken by the central bank, I think, for now the PBoC’s focus appears to be on policing the credit quota rather than tightening overall liquidity. That said, I believe the PBoC will guide MM rates gradually higher after Chinese New Year. As a result, MSCI China could see more downside in the coming months, because 1) China ’s M2 growth is expected to slow down from 27.7% in 2009 to 17% in 2010. China’s money supply growth tends to lead China equities' performance; 2) multiple contractions due to the rise in China equities’ risk premium from the uncertainties over China’s exit strategy, and the inflationary outlook; 3) MSCI China’s trailing PB at 2.23X is still above the trough trailing PB of 1.91X in 2004, when China equities suffered a tightening triggered correction. But from PE perspective, 12M FWDPE at 12.6X is in line with the historical average, say fair valued!……Lastly, valuation wise, MSCI China is now traded at 12.6XPE10 and 21.9%EG10, CSI 300 at 17.8XPE10 and 29.1%EG10, and Hang Seng at 12.6XPE10 and 21.8%EG10, while AxJ region is traded at 12.5XPE10 and +30.1%EG10.
 
 
US Deficit will be Back
Long time diary readers know that I believe in the theory that FX markets lead all markets directionally, followed by bonds and then the risk markets. Interestingly, on a historical basis 1M -volatility is generally lowest in currencies, UST are close and vol in equities/commodities is much higher. In the diary 413 wrote in December, I predicted that the turn in USD was more likely due to a return to risk aversion as a result of relative growth and policy imbalance around the world. So far, I still believe that USD will stay strength in 1Q10, consolidate in 2Q10 and weaken in 2H10. I think current USD strength is due to temporary factors and concerns over Greece 's fiscal position, budget stresses elsewhere in the Euro zone and the pressure that is allegedly putting on EUR. In contrast, markets have been surprisingly relaxed about the US fiscal position, at least in terms of what is doing to USD. It is true that US fiscal deterioration is not a new story, but note that the Obama Administration has released a budget with USD1.6trn deficit this year and USD1.3trn deficit for 2011, according to the WSJ. While the recent shift in the US political winds have seen greater focus on deficit
reduction, this hardly appears to be progress from the most simple of standards, and I continue to believe that the massive deterioration in US fiscal position will again prove problematic for USD, particularly given the USD's still-dominant reserve status globally. 
 
That said, Gold prices have pulled back in recent weeks, as USD has strengthened and investor interest, through ETF and futures markets, has been pared back. I think these two factors will remain bearish influences on gold for the time being and prices are expected to remain under downward pressure as a result. But further USD weakness will emerge in 2Q, which should help reignite the rally in gold prices…Stay put now.
 
 
 
 
Good night, my dear friends!