My Diary 666 --- The EM Equities vs. Base Commodities; The Fed’s

 

My Diary 666 --- The EM Equities vs. Base Commodities; The Fed’s QE2 vs. Food Prices; The Exist Programs vs. The Potential Collapses

 

 

 

 

Sunday, March 06, 2011

 

 

 

This diary is served to put down a summary note of my observations & thoughts over three market debates latterly, including 1) the decoupling of EM& China equities vs. Base Commodities; 2) the Fed policies vs. Food prices and 3) the potential market impacts of central banks’ Exit Programs. Each of the above-mentioned topics has critical investment implication over global markets and X-asset class strategies. As a result, this diary piece will not follow the conventional format I have written for years.

 

 

Topic 1: The Decoupling EM Equities vs. Base Commodities

For macro hedge funds over the past +10 years, EM equities, China economy and base commodities have been essentially one trade. This seems no longer the case. During the first two months, MXEF dropped 3.82% while CRB index made new highs (+5.86% to 352). Gold has been weak (-0.16% in 2MFY11) even though political upheaval is spreading through the entire Middle East and North Africa. In the same token, China’s policy tightening has taken SHCOMP down 8% from Nov10 to Feb11, but Copper price has surged 21.3% during the same period to all-time highs. Thus, it is not a surprise that some politicians & Journalists are blaming on Fed Chairman Ben Bernanke’s monetary policy for high and rising commodity prices, food prices in particular. Interestingly, the bond markets have stayed incredibly calm, with 10yr UST yields staying at 3.3%-3.5% range, a level that is inconsistent with any danger of a major inflation outbreak.

 

There are two possible explanations about the decoupling between EM stocks and commodities – 1) though economy growth in EMs is a bit weaker due to China and India’s tighten policies, it has been more than offset by the US growth recovery. As a result, global growth has not been affected by monetary tightening in EM and may even be strengthening, which has led commodity prices higher. This explanation may sound plausible, but there is a problem -- due to the secular decline in its manufacturing sector, US economy has never been a huge consumer of base commodities. Meanwhile, corporate American’s Capex has not come back as strong as a typical cycle would imply. In short, US is not the marginal price setter for the commodities. 2) Another explanation is though China and other EM countries are tightening, policymakers are still behind the curve. As a result, though EM stock prices have weakened (as equities tend to be forward looking), underlying economic growth has not yet slowed materially. This strong growth momentum in EM (plus a strengthening US economy) is creating a mini-boom in global economic activity. I think, the later view is a more plausible explanation. Historically, equities are always anticipatory in nature with share prices often weaken before economic growth softens, while base commodities almost always go hand in hand with underlying growth.

 

In other words, much of the monetary tightening in EMs is in fact a “monetary renormalization.” Interest rates and FX are still way below equilibrium levels and underlying monetary conditions remain very simulative. For example, the average China’s import growth during Oct10-Jan11 has averaged 34.5% yoy, leading to a rapid decline in the country’s trade surplus. This is a typical sign of a booming domestic economy, along with still booming Capital spending (24% yoy 4MAVG) in China. Thus, there is no reason to believe that the country’s intake of raw materials has yet slowed at all.

 

To investors, if strong commodity prices are a reflection of policymakers still being behind the curve, it means that this asset class will eventually re-synchronize with EM equities. Chinese share prices will likely drop to levels lower than today’s. Part of the rational is that rising food prices are generating pressure on policymakers to react. It may seem totally unreasonable for any government to use monetary policy to combat food price inflation, which is set by the global marketplace. But It is true that monetary conditions in EMs are genuinely too simulative so that rising food and energy price may pass on to general CPI. China is a good example for this observation as our CPI figure t is strongly influenced by food prices. With food prices spiking to new highs and interest rates far below nominal GDP growth, PBOC will have to raise interest rates more to rein in aggregate demand, preempting a further rise in core inflation. So does a quicker RMB appreciation help reduce money creation. These moves are restrictive for economic growth and therefore, are negative for both Chinese stocks and industrial commodities at large.

 

 

Topic 2: The Fed’s QE2 vs. Food Prices

There are quite some media reporters holding a view that Chairman Bernanke is the ultimate hand behind rising global food prices. Such an argument sounds intuitively appealing, but in reality is not fair at all. The rationale behind is that the Fed’s QE2 has generated “too much” money which is the root cause of rising food prices. But this is also the logical weakness of this “money-food price” viewpoint as “too much” money should have inflated the prices of everything, not just some selected commodities.

 

In the reality check, I observe that price levels in the OECD countries remain very stable, i.e.  Core inflation is 1% in US and 1.1% in Euro zone. Price levels are still falling in Japan. In addition, there is hardly any sign of excess money growth as M2 (or MS growth) is still below its historical average in DM world, even though central banks have all actively engaged in varying degrees of QE. This is why core inflation in the OECD has been extremely tame. According to latest SCB research, the true reason for rising food prices is mainly due to the supply gap. For example, global grain output contracted 2.2% in 2010, a decline likely exacerbated by continuing severe weather conditions in Australia and Russia. China is also experiencing a severe drought in key agricultural areas, impacting about 36mn MU wheat production according to local media. All of this has constituted a significant negative supply shock.

 

In contrast, the world economy, especially the developing counties, has experienced a strong recovery since 2009, with real global GDP up by 4.8% in 2010. Using real GDP growth as a proxy for food demand, the world grain market has probably suffered a severe inventory depletion - a 2.2% output contraction plus 4.8% growth in real demand. This supply/demand gap is likely to be the key reason behind the explosive surge in agricultural prices in general, and food prices in particular.

 

To investors, one unique feature of the agricultural market is call “hog cycle”. This usually leads to violent price fluctuations. High prices today lead to oversupply and price destruction the following year. The same is true in the reverse. More importantly, some street political-economy analysts claimed that the recent spike in food prices has contributed to the ousting of former Egyptian President Hosni Mubarak. Nevertheless, the agricultural price hikes are redistributive in nature as it implies higher income for farmers. Today, +70% of the Indian population is rural. In China, the farming population still accounts for almost 50% of the 1.3bn population, according to Premier Wen Jiaobao.

 

 

Topic 3: The Exist Programs vs. The Potential Market Collapses

I bet no one really knows how financial markets will react to monetary normalization, which could be adopted by Fed and other major central banks soon, given more data pointing to a strengthening recovery. Therefore it is helpful to look at the Swedish case, of which the Riksbank is the first Western central bank to begin normalizing its monetary policy rather aggressively.

 

During 2008-09, Riksbank dramatically ramped up its B/S by close to 3X in an effort to shore up the nation’s banking system, which was teetering on the edge of wholesale implosion due to large exposure to the bad debt of the Baltic countries. Since June10, the central bank has aggressively rolled back stimulus --- 1) it has shrunk its balance sheet by close to 60% since then; and 2) it has raised interest rates five times to 1.5%. So far, financial markets and the underlying economy have weathered the central bank’s “exit program” rather well:

 

o    The Swedish economy has softened somewhat from its recovery peak, but there is no sign of a “double dip” or any major growth slump ahead (from 4.5% in 2Q10 to 7.3% in 4Q10).

o    The KRONA has strengthened +23% against USD (from 7.7694 to 6.3371) and +9% vs. EUR (from 9.5236 to 8.7407), respectively.

o    The Swedish equity market (OMX STOCKHOLM BM -3.5% ytd) has underperformed the European market since Jan11. But adjusted for current, it has maintained +ve absolute return.

o    10 yr bond yields actually fell sharply (from 2.75% in July 10 to 2.52% in Sep10) when the Riksbank began to shrink its B/S. The bond market has only weakened recently in tandem with the global selloff in government bonds.

 

To investors, tt seems the Swedish case is quite encouraging. The economy, equity prices and the bond market have all withstood monetary normalization rather well. For sure, Sweden is a small open economy and to what extent this experience may apply to large economies like US and UK remains to be seen. At the minimum, the experience reminds that an exit from quantitative policy by a central bank does not necessarily mean that asset market must suffer.

 

 

To put all the above discussion together, one conclusion is clear that China is a dominant factor for overall EM market performance. In my own view, there are several developments that could mark the end of the tightening campaign – 1) a meaningful slowdown in the Chinese economy, likely around 8%; 2) Tier-one cities’ property prices need to stop rising; and 3) the rate of CPI momentum is broken. Given this tightening cycle is still in its early stage and the overall environment remain highly simulative, we need some patience before the economy and property prices could cool off a notch. And that will pave the way for a resumption of the bull market in Chinese stocks and perhaps EM equities in general. The risk to this forecast is that both money supply and inflation come down faster than most believe.

 

 

 

 

 

Good night, my dear friends!