My Diary 645 --- A Message from Asia; The Yield Curve tells;

My Diary 645 --- A Message from Asia; The Yield Curve tells; China in the Puzzles; Some Constructives for EUR

Sunday, July 18, 2010

“Integrity, Wisdom and Competency vs. Framework” --- The week saw US Senate passed the biggest overhaul of financial-industry regulation since the Great Depression. I was very much impressed by Christopher Dodd’s speech, “…I can’t legislate integrity, I can’t legislate wisdom, I can’t legislate passion or competency… What we can do is create the tools and the architecture that will allow good people to do a good job on behalf of the American public. ” I share most of this underlying philosophy which is same as the Chinese proverb saying “不以規矩, 不能成方圓” (without rules, nothing can be done!).

That being said, recent disappointing macro data in several DMs has again raised the question as to whether the recovery is well established enough to survive the withdrawal of the public sector support that has been in place for the past 18 months. As fiscal stimulus turns into spending cuts and tax increases, monetary policy will be relied on to keep the economies going. This suggests that record low interest rates will be maintained for a protracted period. In contrast, EM economies continue to grow strongly and the focus here is on the need to prevent inflationary pressures from building, I.e. Indian WPI continued to rise in Jun, rising to +10.6% yoy from +10.2% in May. Core inflation is also starting to follow suit. The recent rate hikes from India, Malaysia, Thailand and South Korea point to Asian central banks’ increasing confidence in their ability to withstand US and European headwinds and continue to grow strongly.

However, the eye-catching data are still with China and US. China’s GDP slowed significantly to 10.3% yoy from 11.9% in 1Q10. The rapid deceleration in output was signaled by the new orders index of PMI, which fell over 11 pts from 61.0 in March to 49.7 in June. Moreover, June electricity consumption growth decelerated to 14.14% yoy from 20.80% in May. Cross the pond, confidence among US consumers tumbled in July (66.5) to the lowest level in a year. The 9.5 pts decline from June’s reading of 76 was the biggest since Oct2008, heightening the risk of a slowdown in economic growth.  Meanwhile, the latest FOMC meeting concluded that the pace of the recovery was likely to be WTE, but they saw no immediate need for more easing of monetary policy. In my own views, what really concerns me is the outlook of US job markets. In the 2H10, we are going to see a continued mediocre labor market recovery for three reasons – 1) there is the lack of evidence of a near-term increase in hiring by SME, the main engine of employment growth over the last 15 years. The June US NFIB small business optimism survey declined to the lowest level (89) since March; 2) there have +8.6mn people are working part-time for economic reasons. This is a significant amount of slack on top of the 14.6mn unemployed. The problem is further compounded by the 3.5mn people who have either exited or not entered the labor force since the recession began. While manufacturing capacity utilization has recovered, the labor market remains in a critical condition; 3) wage growth typically trends down long after UNE rate peaks. The high UNE rate and its slow reversal should keep wage increases modest. By 2012, average hourly earnings growth is likely to have slowed to around 1% pa. The US consumer has much to worry about ahead.

On the micro side, the Q2 earnings season has started well with BTE Alcoa's result followed by Intel's fourth consecutive earnings. CEO Paul Otellini also sounded a positive note saying that "…every geography was up above our seasonal norm. What's different now is that corporations are buying in addition to consumers". Q3 revenue guidance of USD11.6bn plus minus 400m is up 8% QoQ and much higher than consensus expectations of USD10.8bn. According to BBG, S&P500s are projected to increase profits by 34% yoy in 2010 and 18% in 2011, the fastest two-year gain since 1995.  Of the 23 companies reported since July 12, all but three have topped EPS forecasts. Market sentiment wise, the July ML’s FMS shows a net 12% of PMs expecting a weaker economic outlook in the coming 12 months, compared to a net 42% expecting a stronger global economy just 2 months ago. Optimism on China (a net 39% expect weaker economic growth) is at its lowest level since Jan2009. Asset allocators raised cash balances to 4.4%, a bit below buy signal for equities. Hedge fund net exposure at +18% is the lowest level since Mar2009. In addition, global asset allocators have cut back on their previous one-way positions against Europe: only a net 10% say they're underweight the Eurozone, down sharply from 27% last month. Europe is cheapest region with near-record value.

X-asset Market Thoughts

Witnessed a consumer confidence retreat, equities took a beating on Friday, falling 2.1% globally. However, on the weekly basis, global equities was flat (-0.12%), with -1.15% in US, -0.71% in EU, -0.29% in EMs and -2.25% in Japan. Global equities are down 5.2% on the year. Elsewhere, UST continued their rally with 2yr down by 6bp to 0.58% and 10yr by 4bp to 2.92%. The yield on 10yr note has come in 19bp since the rally began on Wednesday. Peripheral Euro area bond spreads to bunds were largely unchanged. However, the CDS spread on 5yr Spanish bonds rose 7bps to 225bp. The CDS spread on 5yr Portuguese debt rose 9bp to 293bp. 1MWTI oil closed flat to $76.01/bbl. EUR rose 2.28% against USD to 1.293, while the Dollar dropped 2.33% against JPY to 86.57, the second lowest daily cross over the last fifteen years.

Looking forward, the dominant story for the investment markets is whether the current mid-cycle slowdown will degenerate into a renewed business-cycle contraction. If the answer is yes, then the recent drop in global equity prices is just the beginning of a major cyclical breakdown. If it is no, then the recent shakeout has created another opportunity to buy on dip. Historically, during a mid-cycle slowdown, stocks often weaken, bonds rally and commodity prices tend to fall. Nonetheless, one should also note that the beginning of a recession always looks like an economic slowdown. In my opinions, there are 3 major risks that are threatening the world economy’s recovery process and provoking financial instability. First of all, the sovereign debt crisis in European economy has intensified and is now creating risks that have the potential to destabilize the entire European Banking system. All of this threatens to choke off credit flows in EU economy, causing growth to falter quickly. The only silver lining is that Germany and France may be benefiting from a cheapened EUR. The second risk is the Chinese authorities’ blunt efforts to confront property-market speculation. Recently, domestic housing transactions have virtually dried up in Tier-1 cities with prices softening a bit. In the meantime, other macro indicators such as the PMI and car sales are also pointing to weakening growth. The world economy has gotten used to double-digit growth in China, and as such any significant slowdown will be acutely felt by world financial markets. (A similar mid-cycle downshift in China’s economic growth also occurred in 2005 when the authorities tightened credit to combat economic overheating. During that episode, commodity prices fell sharply and global equities fell by 6%, while EMs tumbled by more than 10% in USD terms.) A third risk is that all G7 governments seem to have embraced fiscal austerity. It is odd that every country agrees that a premature withdrawal of monetary stimulus is dangerous, but at the same time cannot seem to wait to launch fiscal austerity programs.

Clearly, the financial markets understand that the key problem for the world economy is the explosive surge in private-sector savings, a lack of aggregate demand and weak credit expansion. Or in other words, the impact of debt, deflation and deleveraging will constantly be felt by financial markets. These problems will also create a tough environment to sustain nominal output growth. The implications are – 1) a lack of nominal growth means investors will likely seek out markets with higher profit growth potential. The average investor will also be willing to pay a premium for better growth. In this regard, emerging markets are the place to be. 2) In a world that is lacking nominal growth, is full of deflationary tendencies and has zero interest rates, the natural instinct for all government authorities is to pursue a “beggar thy neighbor” policy via competitive devaluation. Along these lines, there has been a persistent phenomenon that has prevailed in many markets of late: the cheaper the currency, the better the stock-market performance. The outperformance of the UK stock market on a weakening GBP is a classic example. 3) Stock markets will experience shorter cycles and higher volatility going forward. This is due primarily to the fact that interest rates have been brought to zero and fiscal policy is hamstrung by gaping deficits and debt levels. As such, the impact of both monetary and fiscal policy on the underlying economy and asset markets has been greatly diminished. Financial markets will feel the rhythm of the real business cycle much more than the impact of policy manipulation. Inventory and capital-spending cycles will play a much bigger role in dictating the stock market cycle. As a result, asset volatility will likely trend up, reflecting the diminished ability on the part of authorities to reduce and smooth out business-cycle fluctuations. Living in such a market circumstance, equities investors should balance value and risk control. I prefer to maintain benchmark weights and use extra cash to buy equities on price weakness. Government bonds are overvalued and I would suggest trimming duration to underweight. On currencies, USD rally will pause and EUR should undergo a countertrend rally. However, the general trend is for USD to maintain an upward bias vs. EUR and JPY, with a weakening bias vs. Asian currencies.

A Message from Asia

The markets have increasingly focused on US fundamental backdrop. Over the week, most data were concurred with a softer economic bias, including weekly jobless claims (429K vs. 445 expected), the Empire Manuf. Index (5.08 vs. 18 exp.), the Philly Fed Index (5.1 vs. 10 exp.) and consumer credit (-9.1bn vs. -2.3bn). June advance retail sales fell 0.5% MoM (cons -0.3%) reaffirmed that consumption and overall GDP is likely to slow to a 2.0-2.5% range in 2H10. That being reported, FOMC’s expectations for 2010 GDP growth were downgraded for the first time since Apr2009 meeting (currently 3-3.5% vs. 3.2-3.7% prev.). The change in the forecast for 2010 was not unexpected. However, the ratcheting down of the forecasts for growth and inflation in 2011 and 2012 was a surprise. As for the housing sector, sales softened immediately after the April expiration of temporary tax subsidies for home buyers. Mortgage applications fell to a 13yr low last week in spite of record low mortgage rates.

In Asia, there were a few important Q2 GDP releases and, on the surface, they seem to tell different stories. Singapore’s economy grew at a blistering pace of 19.3% yoy (vs 1Q=16.9%), the highest on record. Meanwhile, China decelerated from 11.9% yoy GDP growth in Q1 to 10.3% in Q2. Despite the difference in direction, I believe the message from these two sets of data is the same – the strongest phase of the Asian recovery is behind us. The Chinese economy is moderating due to the fading of fiscal stimulus, as well as the cooling measures targeting the real estate sector. For Singapore, 1H growth was led by manufacturing which expanded by 45.5% yoy. I hardly believe in its sustainability. The key is the moderation in Chinese growth offers more foresight into Asia's economic outlook in 2H10.  Some countries with nig exposures to Chinese growth are vulnerable to a China slowdown, including HK (70% of export to China), South Korea (40.6%), Singapore (35%) and Malaysia (32.8%)

The Yield Curve Tells

In the rates markets, the key risk event is the upcoming European bank stress test. The European Commission has told government officials that failure to publish individual banks’ exposure to sovereign debt could damage investor confidence. One concern in the market is that the tests aren’t rigorous enough and won’t assume large enough potential losses. Regulators have told lenders the assessments may assume a loss of about 17% on Greek government debt, 3% on Spanish bonds and none on German debt. However, I think for the government bond market, the call is essentially whether the G7 economy looks decisively similar to that of post-crash Japan. If yes, then bond prices have further to gain and equity prices have more to lose. In my hindsight, I do not believe a Japanese-style liquidity trap will prevail in US. But the G7 bond market will face new equilibrium ranges in terms of bond yields. For UST, the equilibrium of bond yields could range between 3-4% --- real growth at 2.5% plus 1% inflation. For German bunds, the range should be 2-3% --- real growth of 1.5% plus 1% inflation. For Japan, JGBs should yield between of 1-2%. Clearly, unless the world economy is indeed plunging into a new recession, the path of least resistance for bond yields should be up rather than down.

In addition, the flattening of UST yield curve is telling us a moderation in the rate of growth, but not a significant slide lower. The 3M-10Y spread (277bp, down from 378bp from the beginning of 2010) has strong predictive ability for the coming 12-month trend of ISM. Over the past 40 years, there has never been a recession without the yield curve first having inverted. In addition, 2Y-10Y spread also dropped to 2.33%, close to the lowest level YTD. It widened to the record 2.91% on Feb. 22 as reports showed evidence of a US recovery from the worst economic slump since the Great Depression. The spread signals almost no chance of the economy slipping into another recession, according to a July 1 report from the Cleveland Fed. The 2/10 yield gap is more than double the 20yr average and about the same as in 2003, just before gross domestic product rose 3.6%, the report said.

However, because ST rates are stuck pretty close to 0%, a logic question is if a recession is possible with the yield curve upward sloping even though that has never occurred before during the modern-day monetary regime (i.e., fiat paper currency with floating exchange rates). My answer is that it is possible to have a recession under these conditions. After all, although monetary policy has the most influence on the business cycle, there are a multitude of other factors that can cause harm.  For example, higher taxes and punitive regulations can undermine investment, production, and growth, which is exactly what, prolonged the Great Depression of the 1930s. Again, it is possible to enter recession with the yield curve upward sloping, if short-term rates are stuck at zero. For the current situation, it's possible, but not likely in my opinion.

China in the Puzzles

China’s latest economic data fell short of expectations, triggering the debate over whether or not to change the current policies. June IP increased by 13.7%, or 2.8% lower than May. CPI dropped to 2.9% vs. 3.1% in May. Investors are somewhat surprised by the sharp decline in 2Q GDP yoy growth at 10.3%, vs. 11.9% in 1Q.  The slowdown in China growth is already being seen in many sectors.  For example, BDI has dropped by almost 60% in the past 33 trading days, reaching 1 year new lows. In contrast, container shipping prices almost doubled YTD. Moreover, domestic big steel makers (Angang, Bao steel and Wugang) have cut Aug delivery price by ~10%. Beside the macro data, there were couples of important events over the week. The most eye-catching event is the listing of ABC. The performance of ABC was basically stable due to the protection of green shoe option.

What were very controversial are the denials of easing housing market policies by ministries? Early the week, market sentiments were definitely boosted by the policy easing expectation, especially when an official from Ministry of Urban Construction confirmed that the restart of the 3rd-home-purchase mortgage loans and permission for home purchase without local IDs will be rolled out. Interestingly, the market gave back mostly of Monday’s gains after various ministries clarified market rumors of policy easing on the 3rd home mortgage. However, there are reports saying that the 16 property SOEs have been active on land acquisition. During the last 3 months, they have spent a total astounding amount of RMB29.5bn in purchasing land. Of course, SASAC on Jul 12 denied local media’s report that the agency was encouraging the 16 SOEs to expand. But, this has lead some investors thinking the policy ease is undergoing and the government is just trying to pretend nothing happened. The weekly show around property sector is confusing. From one hand, it reflects the possible policy ease on property industry after the LEIs indicated economic slowdown. The ease could help reboost up the economic growth in the short-term. On the other hand, investors may return pessimistic on China's LT growth sustainability since the movement could halt the government's effort to restructuring its economic models.

In my own judgment, such kinds of confusion and frustration won’t go away any time soon, as the senior government officials have many interests to balance. Thus, I expect the market may stay range trade around 2400 for SHCOMP.  Question is what policies are possible, if things go wrong? With the decline of QoQ GDP growth and the target of shifting from “preventing over-heat” to “stabilizing growth”, I think the Chinese government has started taken gradual actions to deal with the economic slow-down. At the end of May, when inventories piled up in home appliances distribution channels, government surprisingly expanded the trade-in program. At the end of June, when vehicles production dipped, government began to subsidize energy-saving vehicles. When market worries about contraction of property investment, welfare house construction picked up. When we concern over the peak of infrastructure construction under the RMB4trn package, 23 western China development projects was emphasized again. These pre-emptive policy reactions did happen one after another, of which could stabilize economic growth in 2H10.

From capital market perspective, both A-share and Chinese property stocks have been underperformed and underweight for long time. A-share market has lost almost 30% in the last three months. However, the recent money and bank loan growth data, though continued to moderate in June, shows still supportive. M2 yoy eased to 18.5%, but higher than PBOC target at 17%. Loan growth was 18.2%. Regarding the breakdown of new loans, Mid-to-LT household loans (> 95% is mtg loans) slumped to RMB105.9bn in June from RMB163.2bn in May and RMB196.1bn in April, suggesting the property tightening measures started in mid-April has been effective. However, it also says that the mortgage lending did not freeze up. Thus, as time goes by, people will be aware of the policies’ cumulative effects and find that their worries are too much. If expectation improves, valuation of stock market will improve as well. Looking ahead, I expect the rebound to be led by coal (22% U/F MXCN), pharmaceuticals (good earnings visibility), F&B, auto, home appliance and machinery sectors (8-10XPEs). In contrast, large caps with only small earnings upside potential may lag behind.…Lastly, regional wise, MSCI China is now traded at 13.1XPE10 and 24.5%EG10, CSI 300 at 14.5XPE10 and 29.9%EG10, and Hang Seng at 13.4XPE10 and 25.1%EG10, while MXASJ region is traded at 12.8XPE10 and +36.6%EG10.

Some Constructives for EUR

 As I discussed in the previous diaries, the basic theme in FX market is competitive devaluation. The EUR has come down from its recent high and the crisis in the Euro zone may still weigh on the currency. Although the structural forces for EUR remain negative, USD recent rebound has been very sharp and substantial, +8.2% since early June. Many indicators suggest that a retracement of the dollar’s recent gains is inevitable. That said, from a cyclical viewpoint, USD could still trend higher against EUR, but not by a huge margin. The Euro zone peripherals are facing the classic choice between devaluation and deflation. Although EUR will never drop to the level required to stabilize and stimulate the crisis-stricken Eurozone economies, the fact remains that the cheaper the euro, the better it is for the region’s economy.

On the fundamental perspectives, there is more constructive backdrop for EURUSD, as successful debt auctions in Spain (and France) further reduce perceived stresses in Eurozone sovereign debt market, while weaker US economic outlook and downward pressure on US yields was reinforced by FOMC minutes. In fact, the dampened economic outlook in US and the lower bias in US yields have played a greater role in FX market developments and the USD's pullback. Those sentiments were reinforced with yesterday's FOMC minutes, which not only produced a near-expected downgrade in their growth forecasts (2010 and 2011 GDP is now seen at 3.0%-3.5% and 3.5%-4.2% respectively vs. 3.2%-3.7% and 3.4%-4.5% for 2010 and 2011 previously), but also reintroduced the potential for additional QE if the economic situation were to worsen "appreciably." Note that Fed Chairman Bernanke will shed additional light on these matters when he testifies on monetary policy before House and Senate committees on July 21 and 22.

Good night, my dear friends!