My Diary 669 --- A Bad Mix of Inflation and Growth; The Encourag

My Diary 669 --- A Bad Mix of Inflation and Growth; The Encouraging EU Policy Package; The PBOC’s Battlefield Toward Inflation; Bullish on JPY, Bearish on USD

Sunday, March 20, 2011

“The Hollywood Disaster Movies Turn Into Real Events” --- The crisis in Japan continues to dominate headlines and what happened so far is much like a Hollywood disaster movie that combines the largest-ever earthquake, a huge tsunami and the lethal radiation leakage from  nuclear reactors. As a human being, I would like to extend my deepest sympathies to the country of Japan and to all who have been touched by these tragic events. However, as one of many Chinese grownups, I keep the deep memory on what Japanese invaders had done to Chinese civilians during the Second Sino-Japanese War (1937–1945) and WWII, including the 6-week long  massacre and war rape in Nanjing (http://en.wikipedia.org/wiki/Nanking_Massacre) as well as the most notorious war crimes carried out by the Unit 731 army, which undertook lethal human experimentation (http://en.wikipedia.org/wiki/Unit_731). What Japanese suffering now are natural disasters, but what Chinese have suffered are notorious human crimes. Unlike German, as of today, Japanese government has never apologized to its neighbor countries in Asia for their notorious war crimes!

Before I put down detailed notes on the potential market impact caused by aftermath of the disastrous earthquake, a few significant events in the past week also worth for some inks – 1) Euro area policymakers have made significant announcements aimed at tackling the sovereign debt crisis in the region, and 2) the MENA continues to experience significant political turmoil with the first Attack toward Libya led by the France Air Force yesterday. To the global economy, the very near-term hit to activity is likely to be quite big, especially to March IP. Meanwhile, with oil prices have moved back above USD110/bbl, my biggest concern continues to be that something will cause oil prices to spike from current levels, delivering a big hit to confidence and asset prices.

That being said, Japan had four unprecedentedly large disasters in a week: an earthquake, tsunami, power outage in Eastern Japan and the nuclear power plant accident. While those are basically natural disasters, JPY appreciation would have been another torture to Japan, which would be artificial disaster. Over the week, I saw Nikkei plunged -16.73% on Monday and Tuesday, JPY appreciated to a record high of 76 level against USD on Thursday, while JGBs have been relatively calm with 10yr yield stay flat at 1.02%.  Against this backdrop, BoJ has been aggressively injecting JPY15trn of same-day funds into banking system and pledged to do more if needed. In addition, BOJ expanded its APP to JPY40trn from JPY35trn, in which the central bank purchases JGB's, CPs and corporate bonds in an effort to maintain the smooth functioning in those markets, to specifically ensure stability in corporate financing and, to the extent possible, stock market stability, particularly in the approach to the conclusion of the fiscal year at the end of this month. In terms of scale, as of 31Dec2010, Japan's GDP was USD5.1trn and the latest BOJ injection is >6% in GDP.

More impressively, G7 decided to conduct the coordinated intervention on Friday. The MoF/BoJ intervened to the USDJPY market, with coordinated efforts from US, UK, Canada and ECB. Such actions were specifically in response to Japan's request, rather than something offered by the other countries. That is not necessarily a huge detail at this early stage, but it suggests that it is not an open-ended commitment from other G7 countries to continue to intervene.  Moreover, the G7 statement specifically notes that the other G7 countries will join with Japan on "March 18, 2011," which may also signal that this will not entail continual intervention efforts in the days and weeks to come. The key portion of the G7 statement explaining their actions and the rationale behind them reads as follows --- “In response to recent movements in the exchange rate of the yen associated with the tragic events in Japan, and at the request of the Japanese authorities, the authorities of the United States, the United Kingdom, Canada, and the European Central Bank will join with Japan, on March 18, 2011, in concerted intervention in exchange markets. As we have long stated, excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial stability. We will monitor exchange markets closely and will cooperate as appropriate." 

Based on the Kobe earthquake which occurred on 17 January, 1995, several street economists gave some guides to predict the impact on economic activity in coming months. However, in my own views, there are many differences --- 1) the unprecedented Tokyo subway sarin gas attack happened in March 20, 1995, which certainly hit consumer sentiment; 2) there was no tsunami damage or nuclear crisis in 1995; and 3) the area affected by the tragedy is much wider this time. Thus, it is believed that the damage and negative impact on economy are much larger and require a longer recovery period. According to JPMorgan, the total physical capital damage from the Tokyo earthquake will reach USD190bn, 50% larger than Kobe’s USD125bn. Given low insurance coverage, earthquake-related claims for private Japanese insurance companies are unlikely to be significant. The JPMorgan analysts estimate that claims payments will not exceed USD2bn, mostly non-life insurance claims. Meanwhile, Japanese HH have >USD500bn of FX exposure, including FX-denominated investment trusts (USD340bn), Uridashi bonds (USD70bn) and margin trading (USD100bn). Of these foreign-denominated investment trusts, USD200bn are invested in foreign bonds and USD64bn are invested in foreign equities. Historically, in 1Q95, immediately after the Kobe earthquake, Japanese HH sold around 10% of investment trust assets. If this were to be repeated now, Japanese HH would sell USD27bn of FX-denominated bonds and USD10bn of foreign equities.

Furthermore, including the latest FOMC minutes, most global government authorities are silent on the implications for the global economies of the tragic disasters in Japan, the world’s third-largest economy. Some of them may be due to the lack of the information required to take even a preliminary judgments. The others may be due to their belief that the economic impact of Japan’s disasters will be transitory. Indeed, according to IMF data, Japan’s share of global GDP has fallen over the past two decades from a high of about 10% in the early 1990s to under 6% today. Even more noteworthy is that on a purchasing power parity basis, the IMF estimates that Japanese growth has only accounted for about 1% of the world’s growth over the past five years. This is of course mostly due to the rapid expansion in emerging economies. In terms of the DM countries, the economy that is likely most susceptible to a slowdown in Japan is Australia – about 20% of Australia’s exports are destined for Japanese markets. However, according to PIMCO, there are three reasons why it’s way too early to conclude that the aftermath of these events will have only a transitory impact on the global economy --- 1) Consider the nature of this terrible shock. In addition to the large wealth destruction and the worrisome health risks of released radioactive material, the spiraling crisis at the Fukushima nuclear reactors raises difficult questions about how and when electricity will be fully restored throughout the country. It will also fuel a global debate about the future of nuclear power, an important source of energy. 2) Think about the funding of Japan’s reconstruction program. The mix, particularly involving debt financing and the repatriation of Japanese savings invested outside the country, will matter quite a bit in terms of the impact on different asset classes. As the Fed knows well, changes in asset valuations can influence consumer behavior and market volatility. 3) The Japanese disasters are not happening in isolation. They add to the supply shock that the global economy already faces due to the uprisings in the Middle East and the related increase in oil prices. As such, the risk of a global macro tipping point cannot, and should not, be ignored.

X-asset Markets Thoughts

On the weekly basis, global equities dropped 2.12% with US -1.88%, EU -2.85%, Japan -9.24% and EMs -0.89%. Elsewhere, 10yr UST yields declined 13bp to 3.27%, while 2yr yields -6bp to 0.58%. The 10yr Portugal-German spread fell 20bp to 418bp, the lowest since mid-February.1MBRDT +1.24% to USD114.26/bbl and 1MWTI @USD101.07/bbl, roughly the same level as last Friday. USD weakened 2.01% to 1.4182EUR, its weakest position since early last November and lost 1.54% to 80.58JPY after G-7 intervention.

Looking forward, the past month's earthquakes in New Zealand and Japan have had tragic results with significant loss of life and caused major economic dislocations. Global growth appears set to downshift, problems on the MENA continue to ferment, and the fiscal and monetary backdrop is beginning to look less accommodative. That bias will potentially be compounded by the prospect of at least some repatriation flows over time to aid in rebuilding. Diminished risk appetite associated with the after effects of the earthquake and tsunami, even after the nuclear sites are more properly addressed, seems likely to persist. All these events are something which investors now have to contemplate as they handicap the forward-looking views of risk assets. Although I am relatively optimistic that the current crisis situation will stabilize in coming weeks, uncertainty remains extremely high. In such a situation, significant market volatility is to be expected.

Global policy wise, US will maintain an accommodative policy stance. The USD600bn QE2 program of purchasing USTs will continue until it is completed in June. The FFTR will stay in a range of 0.0% to 0.25% for an "extended" period. Commodity price increases are putting upward pressure on inflation, but these effects are expected to be "transitory." In fact, the key statement summarizing the FOMC's assessment of economic conditions was repeated "…...the UNE rate remains elevated, and measures of underlying inflation continue to be somewhat low......The quintessential guides for monetary policy, unemployment and inflation, still point to the need for an accommodative policy stance for the time being.”

Market wise, EM equity performance relative to global benchmarks has stabilized as of late. But the majority of X-market indicators do not support a sustainable outperformance by EM, at least vs. US stocks --- 1)Base metals/lumber ratio serves as a good indicator for emerging markets’ relative performance versus the US because lumber is sensitive to U.S. growth while metals prices are leveraged to China. This ratio currently does not confirm a renewed upleg in emerging markets; 2) AUDCAD cross rate also correlates with emerging markets’ relative performance and it does not point to an imminent uptrend either. The rationale is that CAD is more exposed to trends in the US economy while the AUD primarily reflects tendencies in the Chinese/emerging Asian economies; 3) Equity valuations among EMs remain stretched. Currently, EM is trading at 12XPE11, but there could see downward revisions to earnings since consensus is still expect ~20% EPSG; 4) Crisis in Japan exacerbated the already-deteriorating investor sentiment. As a result, investors sold equities en masse and took risk off the table. Over the week, we saw USD8.1bn outflows from equities, the biggest redemption since July 2010. Meanwhile, there were only USD0.5bn inflows to Bonds, indicating no massive flight-to-quality bid. Such observation suggested that investors should avoid the temptation to bottom fish the EM equities. In addition, the spread of HY US corporate debt widened 22bp last week to 510bp, according to Merrill Lynch’s US HY Master II Index as rising oil prices and the earthquake in Japan threaten to slow the world’s economy. VIX rallied 21.71% wow, above its 200DMVG line. On the relative basis, I think European equities looks interesting, although ECB has begun to wave the big stick of monetary tightening and EUR is rising, which could begin to undermine profits at some point. But such negative factors are widely known and may have been fully discounted --- 1) Price/normalized earnings (10.6XPE11) is 30% lower than US counterparts; 2) DY for EU stocks (3.9%) is +190bp higher than US market; 3) Euro area shares are trading at a 40% disc to US equities on PB basis (1.4X). Therefore, European equities can be viewed as value plays.

A Bad Mix of Inflation and Growth

In the coming months, investors will have to face the challenge of sticky inflation and slower growth. The latest macro data showed that US PPI jumped 1.6% in February (+5.6% yoy), which was the largest monthly increase in 1.5 years, though core PPI  increased a tamer 0.2% (+1.8% yoy). The headline PPI was boosted by huge increases in food prices (+3.9%) and energy prices (+3.3%). Such move has caught FOMC’s attention as the Committee is making a judgment call about inflation expectations. LT inflation expectations as measured in UoM Survey of Consumers have crept up over recent months, with 5YR expected inflation rising to 3.2% this month from 2.8% in December. The 3.2% reading is at the top end of the 2.6% to 3.2% range that has been in place since the middle of 2008. Meanwhile, TIPS seems to be agreeing on FOMC’s concerns as 5yr BE rate has moved up from 1.79% at the end of 2010 to 2.24% this past week, reflecting the likely impact that higher oil and fuel prices will have on near-term inflation.

Across the pond, the final report on Euro area inflation in Feb showed that CPI increased 2.4% yoy, with core CPI decreased one tenth to 1.0% yoy. Although the amount of resource slack in the Euro area is thought to be less than in US, the low rates of core inflation and unit labor costs in both regions imply that excess slack is damping inflation. In contrast, the inflation scare continued to haunt the Asian markets with Vietnam and Korea hiked rates, Thailand increased its 1-day bond repurchase rate and Malaysia may boost its RRR. China also hikes 50bps RRR on Friday market close. The Reserve Bank of India hiked its policy rates by 25bp last week as widely expected. February WPI inflation rose to 8.3% yoy driven by a sharp increase in non-food manufacturing prices, leading the Bank to revise up its March inflation forecast for the second time in as many meetings. As a result, the street expects another 25bp hike on May.

In the face of the unfolding tragedy in Japan, near-term global growth prospects have moderated further this week. The annualized global GDP in 1H11 is projected at 3.4%, down from 4% predicted at the beginning of this yea, on the heels of growth D/G due to the oil-price shock and signs that the US and China turned into the year WTE. While the earthquake has prompted a 2% reduction in 1H11 Japanese GDP growths, the foremost concern is the 20% ytd jump in oil prices. The direct impact of this move is damping global GDP growth by about 0.5%. To the global economy, the key risk is that oil prices move up materially from their current highs and that the macro impact is amplified by a more damaging deterioration in confidence and financial markets. Such a dual adverse shock would more than double the direct impact of the move up in the price of oil alone. For the EM outlook, the even more impressive surge in agriculture prices is more of a concern and less so for DMs spending, where pass-through to consumer food prices is limited and the share of food in the consumer basket is also smaller. On the back of the hit to real income and consumer spending from higher energy costs, economists have revised down the forecast for US growth to average 3% in 1H11, vs. the original forecast of 4%, with a smaller downward adjustment to the Euro area growth forecast. Meanwhile, after the Tohoku earthquake in Japan, the island country’s growth has being revised down from 2.2% to 1.7% in 1Q11 and from 2.2% to 0.5% in 2Q11, but revised up 3Q and 4Q GDP from 2.5% to 4.0% and from 2.0% to 2.5% respectively.

The Encouraging EU Policy Package

From the current global policy rate cycle, one question that arises from all is whether ECB is still likely to follow through on its “strong vigilance” signal and raise its policy interest rate in early April. In brief, I do expect ECB to raise rates and think that the bar postponing an April hike is quite high. Indeed, unfolding events will have to be watched though, but the EU’s latest comprehensive policy package is supportive of an April move. The ECB would have liked the package to go further, but given that its announcement has not triggered renewed financial market stress, it will make it easier for the central bank to raise rates.

Most important, Euro zone officials provided an upside surprise to the market by agreeing to a more comprehensive program to attempt to manage the peripheral sovereign debt crisis --- 1) officials increased the effective lending capacity of EFSF to EUR440bn (that was the full size of the fund previously, but the effective capacity was EUR250bn due to the need for cash buffers).2) the EFSF will now be permitted to purchase sovereign debt in the primary market (i.e. at debt auctions). However, it still cannot purchase debt in the secondary market as ECB currently does with its Securities Market Program (SMP). 3) The interest rate charged to Greece on its loans was lowered by 100bp and the maturity on all of its loans was extended out to 7.5 years. In my previous diaries, I have argued that the liquidity support that is being provided is too expensive to enable the peripheral sovereigns to achieve anything more than simply stabilize Debt/GDP ratios at close to the peak levels. Even though the magnitude of the reduction in the borrowing cost envisaged at this stage (100bp) is not enough, it is a step in the right direction and it sends a signal that concessional lending could be used to enable the peripheral sovereigns to return to debt sustainability without disruptive debt restructurings. Overall, this is an important development and the peripheral sovereign debt markets have responded positively to the news, with yields lower across those curves. That kind of improved bias in those debt markets is generally positive for sentiment in the EUR and indeed, EURUSD has responded positively. In the near-term for EURUSD, I will focus on ST interest rate spreads, which remain firmly in the EUR's favor following the increase in ECB tightening expectations.

Also in the Euro zone, Moody's cut Portugal's sovereign debt rating by 2 notches to A3, an unwelcome development for Portuguese debt markets, although one that has not seemed to cause many headwinds for the EUR itself. Also, Portugal's 12 month bill auction drew less demand last week than two weeks ago, with yields rising 28bp to 4.33% and the bid-cover falling to 2.2X from 3.1X. The EUR's sensitivity to stresses in the peripheral debt markets had already diminished in recent months, and the "surprise" agreement to enhance and marginally broaden the scope of the debt back stops at last week's European Council meeting has further reduced this issue as a negative factor for EUR. As a result, the attractiveness of EUR to Asian’s reserve managers is rising.

The PBOC’s Battlefield toward Inflation 

The 50bp RRR hike by PBoC after market closing on Friday seemed not a shock to the investors after we have saw earth quake and bombs in Libya as well as the upside surprise in February inflation and output. This is the sixth RRR hike since last November reflecting PBoC’s intent to continue tightening to mop up all excessive liquidity in China’s banking system. The market expects anther 50bp RRR hike and one more 25bp rate hike in the coming months. Looking back, recent intensive quantitative tightening measures have shown initial signs of success, with January and February’s new lending and money supply growth both coming in below market expectation. The latter eased from nearly 20% yoy last Dec to 15.7% yoy in Feb, the lowest level since Dec08 and close to 2011’s annual M2 growth target of 16%. Despite this, it is still too early for Beijing to stop tightening. The latest data flows show that inflationary pressures continue to build. February’s headline CPI and PPI both surprised markets to the upside, while rising international commodity and food prices plus firmer investment demand and output growth are all complicating Beijing’s attempt to contain inflation.

Regarding the growth outlook, historically, a 1% change in US GDP growth leads to about 5% change in China’s export growth. This would in turn impact China’s GDP growth by about 0.8-1.1%. Meanwhile, exports to Japan constitute about 7.7% of China’s total exports, and imports from Japan constitute about 12.7% of China’s total imports. As such, the recent downward revision to the US and other advanced economies’ near-term growth forecasts would likely have some moderate impact on China. (Please see the above-mentioned points) On the domestic front, the government’s basket of policy measures to cool the housing market, manage inflation, and prevent over-heating risks appears to have begun to carry some impact on the real economy. In particular, while FAI continued to register solid growth (25% yoy) in Jan-Feb, retail sales disappointed (15.8% yoy), dragged by the notable slowing in auto sales partly on the back of expiration of preferential tax treatment.

For boarder market theme, according to Premier Wen, the key to 12th FYP is higher quality and slower 7% GDP growth. The key investment themes from “Lianghui” are social housing, consumption, strategic industries, and RMB internationalization. However, inflation combat has not completed yet as China’s CPI growth may peak at about 5.5%in April and decline to about 4% by the end of the year, Caixin Online reported, citing an unidentified official at the People’s Bank of China. In addition, the State Council announced that it will suspend approving new nuclear projects until new safety rules are ready. China currently has 33.7GW of new nuclear power capacity approved before July 2010, and construction has already started. This should be enough for 4-5 years production for Chinese nuclear power equipment makers. So the ban of new approval should have limited earnings impact in the coming 3-4 years. Thus. The week’s 25-30% sell-off of Chinese power equipment makers looks overdone.....Lastly, regional wise, MSCI China is now traded at 11.2XPE11 and 19.1% EG11, CSI 300 at 14.5XPE11 and 25.9% EG11, and Hang Seng at 12.4XPE11 and 17.0% EG11, while MXASJ region is traded at 12.1XPE11 and +13.2% EG11.

Bullish on JPY, Bearish on USD

An interesting observation over the week’s big decline of Nikkei is that the correlation between the NKY and USDJPY has weakened recently. But the correlation between NKY and AUD/JPY remains relatively strong. As a matter of fact, AUDJPY's correlation with NKY is one of the highest among all JPY crosses. Judging from the current level of the Nikkei index, AUD/JPY seems to be too high, when Japanese retail investors’ long AUDJPY position through margin trading is at a record high. That said, even with the coordinated G7 intervention, the upward pressure on the JPY is likely to persist, mainly due to --- 1) in the near-term, the potential for increased repatriation is significant, as domestic HH liquidate some portion of their foreign investments in order to begin to pay for rebuilding and compensate losses associated with the earthquake. This was the pattern that developed following the Kobe earthquake in 1995, although that pattern took several months to actually play out; 2) considering the aftermath of the disaster, including energy resourcing following damage to some nuclear reactors, as well as the effects of a further deterioration in Japan's fiscal position, this is currency negative, if other things being equal. But with the vast majority of JGB held by domestic investors, the foreign reaction to fiscal deterioration seems unlikely to generate a material flow in the FX market. Indeed, that is one reason why the JPY has remained strong despite Japan's already high 200% Debt/GDP ratio.

In contrast, Although USD is a counter-cyclical currency and it is also considered to be a safe haven currency during periods of “risk off” over the last two years. But most of those episodes were simply driven by growth concerns - investors sold their high beta positions in global equities and commodities (including crude oil) and bought USTs and USD. The  current risk aversion driven by MENA turmoil and higher oil prices may not be so supportive for USD --- 1) the regime changes in the Arab world are not necessarily favorable to the U.S.’s economic and political agenda; 2) US is the world’s largest net oil importer and consumer. Higher oil prices will be relatively more harmful to the US economy; 3) the potential policy responses to rising oil prices will be USD bearish. Higher oil prices would be considered by policymakers to be a negative growth shock rather than an inflationary impulse.

Good night, my dear friends!