My Diary 661 --- Some Hopes but not All; Take a Closer Look at

My Diary 661 --- Some Hopes but not All;  Take a Closer Look at Europe; Chinese KongFu against Inflation; The Dollar Liquidity Watch

Sunday, December 05, 2010

“US Aircraft Carrier heads to Yellow Sea + Bank of America becomes Bank of Asia” --- The two interesting headlines caught my eyes over the weeks as both news indicates the dilemma of the diplomat policies taken by US. From its national interest, the U.S, wants to block China's rise, but it wants to benefit from China’s growth as well. That said, Friday’s NFP was a huge disappointment and contradicts recent improvement in a host of economic data as well as cyclically-sensitive sectors of the equity market. Payrolls increased only 39K, less than market expected 150K, after a revised 172K increase the prior month. The UNE rate rose to 9.8%, the highest since April, while hours worked (0.0%) and earnings stagnated (1.6%). Clearly we are still far from making up what we've lost in the last two years (+1115k YTD vs. -8015k in 2008-2009 for private payrolls). However the fact that private payrolls have not recorded a negative print this year (as oppose to 11 out of 12 in 2009) shows that there has been a recovery of sorts. Question is will the market now tank on this extremely weak backward-looking piece of data? Or will investors set their sights on the future and maintain their resolve? In fact, if compared this recovery to prior recoveries since 1975, the current recovery in business spending and profits are closer to the strong recoveries, while labor markets, consumer spending, and GDP are closer to the slower recoveries, and housing is weaker than in any prior recovery.

Meanwhile, the week saw ECB disappointed those expecting it to purchase government bonds in the range of EUR1-2tn (or 10-20% of EU GDP). Instead, ECB decided on a three month delay to the exit from its remaining nonstandard liquidity measures and it gave a reminder that its government bond purchase program (SMP) remains active (weekly purchases have been around EUR1-2bn recently).  In my own views, it is very clear that ECB would like to proceed with a gradual exit. It does not want banks to rely too much on its cheap and generous funding, and thereby delay necessary B/S adjustments. As Mr. Trichet said, “It’s not quantitative easing, we’re withdrawing all the liquidity…” In a tight-liquidity market, the desired impact was achieved as Greece, Ireland, Italy, Portugal and Spain CDS spreads closed -34bp, -20bp, -13bp, -34bp, and -21bp tighter at 922bp, 554bp, 216bp, 449bp, 294bp, respectively, after the ECB press conference. Practically, ECB did just enough to keep the European bears on the sidelines even if the central bank didn't go as far as many had hoped in terms of additional support for the troubled peripherals. As a result, investors should continue to show dubious amounts of faith in the Euro-zone's politicians. So what can we expect next? Given ECB has drawn something of a line in the sand with regards to the immediate future of the European debt crisis, few speculators will now want to challenge this prognosis in any reasonable size - with little if any refinancing required in December by the "peripherals". Thus, there are few catalysts to enforce downside pressure on these peripherals bonds.  However, if looking into 2011, what seems to be a consensus is that Portugal will be next to step under the 'Bailout Umbrella'. But, I think what really matters is to make sure that Spain doesn't need (or get pushed) to make the dreaded call. The market will test Spain's resolve some times before or by April, at the latest. In Spain's case, the key of course is recapitalizing their banking sector.

Elsewhere, the most important news came from China s the Politburo decided that next year's monetary policy would be "prudent" -- a change from this year's "appropriately relaxed" -- and fiscal policy would remain "proactive." This decision will provide the framework for specific macro policy targets to be announced during the forthcoming EWC to be held in the middle of this month. Such a change should not be a major surprise to most market participants, given the rapidly rise in CPI inflation recently.  The street economists mostly agree that monetary policy in 2911will be "tightening". Specifically,  M2 growth will likely slow from 19% to 15%, loan growth will slow from this year's near 20% to 14%, interest rates will likely rise another 75bps and RMB appreciation will likely be quick in the next 3-5 months.

X-Asset Market Thoughts

On the weekly basis, global equities closed +3.04% with +2.93% in US, +1.58% in EU, +1.52% in Japan and +3.74% in EMs. Elsewhere, UST curve steepened with 2yr fell by 4bps to 0.47%, while 10yr increased 14bp to 3.01%. Peripheral Euro area bond spreads continued to be crushed by rising bund yields and falling peripheral yields. The 10yr Irish-German spread came in 121bp to 529bp and The Portuguese-German spread 120bp to 307bp. 1MWTI Oil added $5.43/bbl or 6.4% to USD89.19/bbl, a two-year peak. EUR surged 1.32% to 1.341USD and JPY also strengthened 1.87% to 82.92USD.

Looking forward, I think there is several issues worth for attention --- 1) Economy wise, one surprise of 2011 will be more robust employment than currently expected. Of course, the long lead times cannot forecast a particular piece of economic data in a specific month, such as the Nov payrolls. However, the data is saying that the risk is toward the upside. 2) Throughout the recent bout of financial instability, commodities prices have held up fairly well. Copper is just 4% away from the cyclical high that was hit on Nov 9th. Silver is at the highest level since 1980. Gold is less than 3% away from its all-time high (also on Nov 9^th). Strength in the cyclical commodities in particular indicate that global growth remains strong and that concerns about Chinese tightening may be overblown; 3) EURUSD has bounced on hopes that ECB stands ready to support the peripheral bonds. Additionally, the Portuguese T-bills auction went well, indicating that the sovereign credit crisis is not snowballing out of control. Although this is helping EUR against other fiat paper currencies, it certainly is not doing so against real money. That is, the EUR price of both gold and silver have risen to new all-time highs as a result of the expectations of more aggressive debt monetization by the ECB. To sum up, I believe the following factors will likely limit downside in equity markets before the year-end --- a) a diminishing fears of a “double dip” in US; b) the Fed’s ongoing liquidity injection and ECB’s delay of exit; and 3) relatively attractive valuations in terms of FWD PEs.

Some Hopes but not All

There is a string of economic data in US over the week. Though latest job numbers disappointed, ISM non-manuf index increased to 55.0 in November from 54.3, a little bit better than expected. This index is a few points off its summertime lows but still about a half point below its cycle high reached in the Spring. Other high frequency data are decent with better tone in the Fed Beige book, +10.4% monthly gain in October pending home sales  and ICSC chain store sales reported a +5.8% yoy increase in sales (vs. 1.6% in Oct), the best yoy print in 8 months. Consumer confidence also stood well at 54.1 vs. consensus =53. However, better US data are not being felt in house prices. US mortgage purchase applications went down 16.5% and Case-Shiller house price index fell 0.8% for a third straight month in September.

In the Euro area, GDP was confirmed to have gained 1.5% QoQ saar in 3Q. Data showed 2/3 coming from domestic sales and 1/3 from net trade. The inventory contribution was minimal. Fortunately, Greece, Ireland and Portugal are too small to have a significant impact on overall growth, accounting for only 6% of EU economy. Therefore, ECB appears content with a forecast for moderate growth of 1.4% in 2011, with inflation of 1.7%, consistent with its view that a large part of the increase in unemployment in the region is structural. German retail sales (ex autos) rebounded 2.3% MoM in October and tracking a +3.6% QoQ in 4Q10. Looking ahead, business surveys suggest that growth momentum in Germany is carrying over very strongly into the fourth quarter. This will continue to support EU area-wide growth.

In Asia, country-level PMIs confirm a positive turn in EM Asian manufacturing. China’s PMI stay strong at 55.2 with other regional players appear to be following suit this quarter, including Korea (50.2 vs 46.7 in Oct) and Taiwan (51.7vs 48.6in Oct). Not only is this visible in the impressive gains in their PMIs in November, but it also can be seen in the widespread pickup in EM Asian exports with +24.6% in Korea;  +22.7% expected in China and +18.9% expected in Taiwan. The turn in EM Asia is an important signpost that the growth pace of global IP will pick up by early 2011. In addition, Bank of Thailand hiked its policy rate 25bp to 2.00%, suggesting BoT is prepared to continue its rate normalization path as it sees core inflation pressures building. Indonesia's Ba2 credit rating was placed on review for possible upgrade by Moody's. The rating trends are fully reflective of the divergence in fiscal strength between EM and DM economies.

A Closer Look at the Europe

European leaders made two key decisions over the week --- an Irish bailout to help the region exit the current crisis, and an agreement on collective action clauses (CACs) to help to deal with future crises. That said, although the Irish support package has been labeled as amounting to EUR85bn, only EUR67.5bn actually represents external support. That said, debt crisis in Europe could linger and leave a bad taste for financial markets for a while longer.  The EU area faces two huge challenges in the months and years ahead --- 1) how to exit the current sovereign crisis; and 2) how to create a framework to deal with future sovereign crises. The current effort or intention is to set up the framework to deal with future crises before the region has fully exited the current crises. Given that the new framework is likely to drive up borrowing costs for the peripheral sovereigns, it will make exiting the current crisis even harder.

Looking ahead, although EU and IMF have quickly assembled a EUR85bn bailout package for Ireland, the market does not believe Ireland, Greece, Portugal, and to a lesser extent Spain can meet their debt obligations. This is why the credit default swaps of these countries have continued to widen. To be sure, Greece and Ireland are small economies, with a total population of 17.5mn and GDP of EUR400bn or 4.4% of Euro zone total GDP. The concerns, however,  are 1) that in the event of a sovereign debt default, the damage to the European banking system could be substantial, causing another episode of upheaval and even a renewed credit crunch. For example, German banks have the largest exposure to Ireland, reaching over USD138 bn; 2) The Spanish problem is not public-sector debt. It is private borrowing. The key is to prevent a US-style fallout in real estate prices. A full-on crisis in Spain will very likely impact overall growth in the Euro Area. But unlike Greece and Ireland, Spain’s finances are not spinning out of control. Spain’s debt-to-GDP ratio will be about 63% in 2010, lower than Germany. And in the first 10 months, Spain’s budget deficit narrowed to 3% of GDP from 5.6% a year earlier. In a worst case scenario, real estate loan losses could add 12% to the debt-to-GDP ratio.

Having discussed Spain, in the medium –term, Europe needs a bold solution to restore confidence and stabilize markets, but there is a limit to what the ECB can deliver. The European policy response so far has been reactive and incremental, as the crisis sweeps across borders. It has not been effective. Sovereign CDS spreads for peripheral countries have widened to record levels while contagion seems to be spreading to the core European countries of Belgium and Italy. In my own views, European policymakers must get ahead of the curve to confront future risks —not simply respond to current events. Extending the EFSF is one option, and the expression of US support for this through increased IMF participation is a positive development that could change the current dynamic. Otherwise, the ECB can merely hope to buy time by confronting Europe‘s solvency issues with liquidity measures.

Unfortunately, the ECB does not seem to be ready for any drastic action. A key reason for the ECB’s inaction is that the common-currency regime has created a dramatic and painful dichotomy among member countries: The German economy is doing fine, with manufacturing and export activities strengthening rapidly and the DAX reaching recovery highs. However, the peripherals are deflating and their economies are imploding. Faced with this dichotomy, policymakers seem paralyzed. The ECB just extends its bond purchases as a means of correcting dysfunctional markets, but dissent among Council members may limit what the ECB can commit to. Specifically, CACs will be included in newly-issued government debt from June 2013 and private sector "bail-ins" will be applied on a case-by-case basis. Such clauses have injected uncertainty as there are no standards by which to judge this the "case-by-case" policy. In any case, the application of CACs to future debt issuance holds out the prospect of a two-tier credit market. Will government debt issued before June 2013 be trades at a premium over debt that is issued from that time? It is hard to know how the market will price it, which in turn has increased the level of uncertainty. Increased risk necessarily accompanies the increased uncertainty, which is currently working against the EUR. The EUR price of gold has hit an all-time high.

Chinese KongFu against Inflation

Since Chinese government started the campaign to tackle inflation, talk of price levels has become part of everyday discourse and policy debate in China. In the past ten-days since the State Council announced its sixteen measures to restrain price increases, numerous administrative steps have been taken to steady supplies of food and energy. Authorities appear to have achieved a measure of success in arresting the uptrend in vegetable prices (which had soared 29% in October) and limiting the activities of speculators in other areas of the food economy. The upcoming November CPI (on 12/12) will be closely scrutinized by investors weighing the prospect of further tightening and possible price controls. For tightening monetary policy, NBS released Oct economic data, CPI was 4.4% (a new high in 24 months) and PBoC lifted RRR by 0.5%. Rumors said that PBoC would shrink next year’s incremental credit scale by around 10% from this year’s RMB 7.5trn to next year’s 6.5trn. In fact, the rising rates of inflation are undermining confidence in Chinese financial markets. Top officials have continued to threaten additional restrictive measures to control prices.

Looking forward, I remain bullish in general though market volatilities could be higher, given global liquidity should remain excessive, China’s fundamentals are strong, valuation is below the 10-year average, and 2011-12 earnings growth forecasts are decent. Macro wise, Chinese policymakers seem to tolerate a bit higher inflation to fulfill 8% growth and the key risk are hyper inflation, over-tightening in credit and strong USD. Earning wise, the A-share listed companies' net profit are forecasted to growth 30% in 2010, and 20% in 2011. Thus, their valuation is still very cheap now. The key issue is with inflation escalating, there is talk that the PBoC may be behind the curve in monetary tightening. Some econometric model does suggest that the 1-year lending interest rate should be 6.45%, 90bp above the prevailing rate of 5.56%. But such a level could be politically inappropriate, potentially triggering a hard landing for China. Sector Strategy wise, under the transition period toward 12th five-year plans and inflation pressure, investors should OW the insurance, cement, consumer and technology sectors...Lastly, regional wise, MSCI China is now traded at 12.2XPE11 and 15.7% EG11, CSI 300 at 14.2XPE11 and 27.6% EG11, and Hang Seng at 12.7XPE11 and 15.7% EG11, while MXASJ region is traded at 12.8XPE11 and +12.1% EG11.

The Dollar Liquidity Watch

Some corrective actions have taken place in the commodity complex, on the back fo rising yields and concerns about China tightening. However, most commodity prices contributed to trade above their 200DMAVG, in particular after the release of China PMIs, helping to ease concerns of a slowdown in demand growth in China—which has been a restraint on higher oil prices. For oil, despite ongoing price volatility, comments by OPEC secretary General El-Badri indicate that prices will move higher as the fundamentals improve and OPEC will not act to counter price increases unless a physical shortage appears in the market.

Currency side, USD liquidity situation has worsened in EU area markets, triggered by sovereign debt concerns. As discussed above, the likelihood of recent market dislocations deteriorating into a large-scale funding squeeze depends on whether the situation in the periphery deteriorates further in the new year. While I do not think a crisis is imminent, things could deteriorate quickly. Looking further afield, there may be a limit to how severe USD funding stress may become as the major central banks, including the ECB and four other G10 institutions, still have USD swap lines in place with the Fed.  In Asia, USD liquidity has tightened in Korea and the Philippines. However, in both economies, this appears to have been triggered by local events, including North Korea’s artillery fire at South Korea’s Yeonpyeong Island and Bangko Sentral ng Pilipinas’ (BSP) decision not to roll over maturing FX swaps. In other AXJ) markets, USD liquidity appears to be ample. This is supported by AXJ economies’ relatively low ratios of ST debt to FX reserves and, with the exception of Korea, AXJ banks’ relatively low dependence on wholesale funding. Hence, so far, there is no evidence of a systemic shortage of USD in Asia triggered by EU area sovereign debt worries.

In the near term, I expect USD-AXJ to head lower again, supported by AXJ growth outperformance and widening US-AXJ rate spreads. However, as said  EUR remains a vent for periphery concerns meanwhile USD is proving to be the safest port in a storm which has taken the EURUSD down to a fresh low of 1.3061 during Monday's downdraught.

Good night, my dear friends!