My Diary 673 --- Rate Hiking is Far From Over; The Firewall EFS

My Diary 673 --- Rate Hiking is Far From Over; The Firewall EFS is Working; Get Prepared for Renewed Pessimism; More Upside for EURO;

Sunday, April 17, 2011

“Inflation is like a Tiger vs. Growth is like a dog” --- The first part of this quote came from Premier Wen Jiabao who warned last month that “inflation is like a tiger --- once unleashed, it is very hard to cage again”. I tend to agree at the current stage of economic cycle and I have made my arguments in the last two diaries. Nonetheless, the story of 2011 is more complex than we thought. The world is never so divided than before --- 1) a division between EM and DM; 2) a division within Europe between the strong core and the weak periphery, 3) a division in US where big banks and large firms appear in good shape, while other areas such as housing are fragile; and 4) a division of policy path of which many DM countries unsure how to cope with the relative shock from energy prices, while many EM economies reluctant to tighten sufficiently for fear of curbing growth. Further down the road, the continuing rise in crude oil prices is now turning into a source of concern for EM, as it poses significant risks to global demand. In addition, the likely end of Fed’s QE2 in June may create significant volatility across asset markets in the coming months.

That being said, global growth in 1Q11 was WTE, along with D/G in US forecast to 1.4% (from an already downwardly-revised 2.5%). The rational is that higher gasoline prices eat into consumer spending. Based on UBS estimates, every 10USD/bbl increase in crude cuts US growth by as much as 0.3%. In the near term, some of the drags to global economy in 1Q11 have carried over to the current quarter --- 1) energy price stand nearly 20% above its 1Q average; 2) there will be continued fiscal tightening in Europe; and 3) the earthquake and tsunami in Japan will deliver a blow to global growth this quarter. All told, global GDP growth in 1H11 would be a significant disappointment. The softness in global growth is focused in DMs, where the level of activity is depressed and UNE rates and government budget deficits remain very elevated. Looking forward, the drag from the oil shock could fade by midyear if oil prices have peaked as anticipated, while the impulse from Japan will turn strongly positive as domestic activity normalizes and the rebuilding effort gets under way. Consequently, street is looking for a decisive strengthening in global growth to a 4% pace in 2H11. However, such call bears some risks, including --- 1) Uncertainty about the trajectory of China’s economy. Some key economic indicators turned soft in 1Q, suggesting a sharper slowdown might be under way. As IMF pointed out lately that “an abrupt slowdown of economic activity in China, perhaps following a credit and property boom and bust cycle, would adversely affect the whole region”; 2) Uncertainty about the global inventory cycle. Global IP surged at a double-digit annual rate in 1Q, boosted by global stock building. But a key issue is whether the rate of inventory accumulation might have gotten too high, which might lead to a more pronounced downshift in production; 3) Uncertainty about business outlook. Although hiring was impressive in 1Q, US Capex fell short of expectations and contributed to the weak GDP outcome.

Even many economists have lowered their numbers of global GDP growth in 1H11 (largely due to the purchasing power hit), CPI inflation is spiking in response to unexpectedly strong increases in commodity prices. The latest data from major economies point to the same direction. Inflation in Euro region accelerated MTE in March, quickening to 2.7% and breaching ECB’s 2% limit for the fourth month. The rise in headline CPI was driven by energy price inflation which rose 2.5% mom and 13.0% yoy. Inflation in China and India also accelerated by more than economists forecast in March as rising commodity costs and inflows of capital threaten to overheat economies across Asia. In China, CPI climbed 5.4% yoy, the fastest pace since 2008. Indian WPI jumped 8.98% yoy as fuel costs rose, according to a commerce ministry statement. These results make me somewhat nervous as the past four interest-rate increases in China since the start of 2010 and eight in India have failed to tame price pressures in the two fastest-growing major economies. Looking into 2Q11, the price of oil could easily match or exceed its +20% increase in 1Q11. At the same time, agricultural commodity prices, which jumped another 13% last quarter after surging 44% in 2H10, are not seemed likely to retreat before the harvest season. In all, global consumer price inflation is projected to leap to at least 3.6% yoy in 2Q11 (with upside risk).

Indeed, the lion’s share of the increase in commodity prices appears to be supply-driven. I expect prices to stabilize or pull back somewhat in 2H11. However, resource utilization is rising in many countries against a backdrop of above-trend growth. This will push up core inflation, though the level of core inflation varies widely. More importantly, the major central banks are set to embark on a policy renormalization path, but the pace at which rate hikes occur will differ. Recent speeches by policymakers confirm the diverging trend --- Dovish at the Fed and BoJ, hawkish at the ECB, and mixed at the BoE. That said, core inflation is rising slowly and from a historically low level in G3 economies, reflecting negative output gaps. Ongoing concerns about the high costs of persistently low resource utilization will keep the Fed on hold, a view reinforced by this week’s soft core inflation reading and the weak growth outcome in 1Q11. Although Friday’s report of an unexpected jump in Euro area core inflation is of some concern, it is expected that ECB will only gradually remove accommodation. Economists forecast two more rate hikes, bringing BM rate to 1.75%, a BBG survey shows. Policy normalization also is occurring slowly elsewhere in DM countries. Bank of Canada signaled this week that it would leave rates on hold a while longer as currency appreciation tempers inflation concerns raised by FTE growth. In UK, the MPC looks likely to delay the onset of rate hikes as it struggles to balance the conflicting signals of rapid inflation and sluggish growth.

In contrast, core inflation is rising rapidly in EM economies, where it already has reached the levels seen in the overheating phase that began in 2007. This observation is underscored by the March data out of China, whereby non-food inflation reached a 13yr high of 2.7% yoy. Equally troubling is in India March inflation accelerates to 9% yoy, significantly above market expectations, from 8.3 % in February. January inflation also revised up by a whopping 112 bps to 9.3 % from the initial estimate. Non-food manufacturing (core) inflation surges for a second successive month and is now running at 11% yoy on a sequential basis. With March inflation printing 100bp higher than the twice-revised estimate of the RBI target (8%) and core inflation now in double digits, RBI is likely to engage in more aggressive monetary tightening. March data in Brazil confirm that core inflation also continues to spiral upward. For all the emphasis on the need to anchor inflation expectations in the DM world, the risk that elevated headline CPI begin to dislodge expectations is much higher in EM world where slack is tight and societies have much more limited experience with low inflation and inflation targeting. Indeed, real policy interest rates remain at the recession low in the EMs, with hikes so far matched by the rise in core inflation. Clearly, EM central banks are under pressure to tighten policy further, with the IMF arguing that greater exchange-rate flexibility would help.

X-asset Market Thoughts

On the weekly basis, global equities ended 1.2% lower with -0.6% in US, -1.55% in EU, -1.6% in Japan and -1.1% in EMs. From March 15, when NKY plunged to a 2yr low, until the end of the month, the index recovered 13.4%. Since that time, however, it’s fallen 1.7%. Currently the benchmark stands 8% below its March 10 close. Elsewhere, UST yields fell sharply with 2yr fell 11bp to 0.69% and 10yr down 17bp to 3.41%. Both returned to their late March levels. In the European space, the 10yr yields of Portugal, Irish, Greek and Spain government bonds moved +43bp, +58bp, +107bp and +25bp, respectively. Both yields are record highs. In the commodity space, Brent crude dropped 2.11% to USD124.06/bbl. Gold and Silver saw new highs of USD1479/oz and USD42.4/oz respectively, while the DXY drifted to a new recent low of 74.68. EUR weakened a bit-0.37% to 1.4430USD and JPY gained 1.92% to 83.13USD.

Looking forward, investors should be prepared for softer economic data in the coming months. While gathering momentum in US jobs market has fed a growing confidence toward the economy, investors may be confronted with some disappointments on US growth expectations in the near term. Inflation concerns persist in EM Asia due to sustained increases in food and energy prices, but the same dynamics are a drag on US economic growth. The tragedy in Japan could also weigh on near-term global industrial production, although the subsequent reconstruction could be inflationary. As a result, while risk assets can handle a few disappointments, the big question is whether a longer-lasting soft patch will develop due to the Japan disaster and geopolitical risk. Bear in mind that a similar scenario occurred last year which caused SP500 tumbled by 16% from the end of April to the beginning of July.

Under such a macro outlook, the growth/inflation trade-off will remain a dominant theme across asset markets. Inflation remains a major risk, supporting continued FX strength as a policy response. This environment is supporting sustained inflows back into EM, but the returns are likely from FX. For EM equities, this environment could be NEGATIVE as the rising food/commodity prices has pushed headline CPI  above target in most EM countries, compelling reluctant central banks to tighten policy. Even so, policy rates remain quite low by historical standards, suggesting the overall monetary policy stance is simulative. We should be aware of the tensions as inflation drivers remain very much alive here --- 1) strong domestic demands; 2) sharp rebound in exports; 3) oil supply shocks in MENA; 4) and sloe policy exits. I think that happens next depends on two scenarios – a) the possible lags in transmission from commodity prices to consumer prices, implying headline inflation might continue rising into the middle of the year; and b) commodity prices might rally further from their current levels, implying even higher tightening risk and potential downside risks of global demand. Beside the concerns over aggressive policy tightening ahead, the current pattern of earnings revisions does not support a continuation of the recent rally in MXEM and MXAPxJ for much longer, according to latest Citi Group research. Yet, FY2 earning revisions have now fallen below zero (more D/G to FY2 EPS estimates than U/S) for the first time since May2009. Hence, bottom-up analysts are starting to factor in the impact of slowing growth and rising input cost inflation. Meanwhile, Merrill Lynch FMS showed that real money investors raised their exposure to equities to a level typically seen during bull markets. A net 50% of asset allocators were OW Equities at the beginning of April, up from 45% in March, and close to the highs seen back in Jan-Feb. Average cash balances also fell to 3.7%, not far from the absolute lows of 3.5% for the history of this series since 2001. By having moved to a bullish stance, real money investors are unlikely to support the equity market. In addition, elevated positions make the equity market more vulnerable to bad news.

Rate Hiking is Far From Over

One feature of recent weeks is that, with so much headline news, it is easy to miss key events, including China’s 12th FYP and the annual Indian Budget, of which the latter disclosed its ambitious plans to move the Indian economy to be 1/4 manufacturing within a decade. Moving on to Europe, the ECB decided to hike rates. The ECB hike occurred the same day the BoE left rates on hold, a decision by the BoE that is fully justified. In my expectation, I was looking so much for co-coordinating exit strategies, as was the desire of central bankers only a couple of years ago. Also in the same week the ADB published its annual report, providing a positive outlook for the Asian economies. In contrast, IMF changed tack – in response to events and voting rights – and decided capital controls are not too bad, after all.

All discussed, we go back to data. US core PPI increased 0.3% in March and was up 1.9% yoy as a result of increase in energy prices. Over the six months through March, the prices of imported fuels shot up almost 90% while imported food prices jumped 31% (the largest six-month gain in the data history). Core CPI rose 0.1%, in line with expectation but a tick below cons=0.2%. Headline CPI went up 0.5%. The absence of continued acceleration in core CPI emphasizes that inflation pressures, while building, remain fairly tame for "underlying inflation”. The Empire manuf index showed continued momentum, rising to 21.7 in Apr from 17.5 in March. New orders surged. Shipments surged, Employment surged. This is encouraging given fears of Japan-related supply disruptions to manufacturing output. UofM consumer sentiment index improved to 69.6 from 67.5 in March. Within the Michigan survey, the outlook component improved, the current assessments index weakened a bit. However, the deterioration in the overall index in recent months had reflected a weaker outlook. Initial claims for the latest week rose to 412K from a revised 385K previously. In addition, US budget compromise includes a nearly USD40bn reduction in discretionary federal government spending, that is not incorporated in many sell-side forecast. This reduction is equivalent to ~0.5% of US GDP growth. More important, with the oil-price shock having been bigger and LTE, and with fiscal tightening MTE, IMF forecast that US economy will expand 2.8% in 2011, down from 3% projected in January.

In Asia, Tankan's manuf DI fell by historical large 28pts in April. As a result, the index plunged into a negative territory indicating "bad" conditions (-13), after continuously posting positive readings during Mar10 - Mar11. The result reiterates the severity of the immediate impact of the Tohoku earthquake on corporate activity. Previously, the largest monthly decline in its history since June 1998 was a 22pt drop marked in December 2008, a few months later than the Lehman failure. My concern over the extent of the weakness is that the negative impact is showing up in nonmanufacturing activity, which point to a pervasive decline in the economy since March 11. Meanwhile, international trade reports from China, Taiwan and Korea show that Japanese exports for the first 20 days fell in excess of 10% mom for the month as a whole. In comparison, Singapore’s GDP surged at 23.5% yoy in 1Q11, far above expectation. Singapore’s strong growth is an indication of strong momentum in EM Asia. This implies that demand-side growth momentum is expected to create further price pressure in the months and quarters ahead. Wage inflation is already adding to this challenge. The low real rate environment is encouraging investors and consumers to borrow; this could combine with asset inflation to create asset bubbles. The HKMA has already stepped up its monitoring of commercial banks’ business plans amid rapid credit growth. Bank Negara Malaysia has also repeatedly highlighted the need to slow lending growth, especially to households. Out of the 3 Asian central banks that announced monetary policy this week, Indonesia and South Korea opted to stay put, while Singapore tightened by allowing SGD to have another one-off revaluation, though the magnitude was milder than the market expected. Despite the inaction from Indonesia and South Korea, I believe Asian central banks have a hawkish bias and these two central banks will continue to tighten monetary policy in the months ahead, while the rate-hiking cycle in the rest of Asia is far from over.

The Firewall EFS is Working

European sovereign credit markets saw another poor week with 5yr Greece CDS closing at another record wide of 1100bp. Comments from Germany's Finance Minister yesterday continued to hint of the possibility of a debt restructuring.  S&P also said that a Greek restructuring could see haircuts of between 50-70% for investors. On the other hand we are getting mixed messages from the EU and IMF officials as they continued to play down restructuring fears. EU's Olli Rehn said that a Greek restructuring is not an option and IMF's John Lipsky said the Greek program does not contemplate restructuring. Greece is expected to announce new deficit cut measures and plans to raise EU15bn by 2013 via asset sales.

In the same week, the decision of Portugal government to request liquidity assistance from EU Commission has been greeted with widespread indifference in both the peripheral bond and FX markets. The contrast to when Ireland requested aid (Nov 22, 2010) is quite striking. The average peripheral spread widened by +100bp in the lead up to the Irish request, and widened by another 50bp following it. This time around the average spread has been pretty flat over the past month, as Spain crucially has decoupled from the widening in the Portuguese spreads. This absence of contagion in peripheral bond markets is evidence that the EFS is working as intended as a firewall against non-fundamentally justified contagion and explains in part why EUR has been so relaxed about Portugal walking into the liquidity hospital. In the two weeks before Ireland requested aid, EURUSD fell by 4%, and in the week following the request it fell another 4%, before stabilizing once the bail-out was approved. This time around EUR has been on a rallying trend, as not only is there far less concern about contagion to a systemically much more important country such as Spain, but underlying monetary fundamentals are improving, not deteriorating (front-end rate spreads are widening).

To Sum up, the periphery credit/Euro price action indicate that sovereign stress is no longer a critical driver of EUR. Not only has Europe demonstrated its total political commitment to the cohesion of the EMU (eliminating whatever break-up risk may have existed in early 2010 when Greece became the first domino to fall). Going forward, I  believe that the catalysts for substantial credit spread widening, so called tail risks, have retreated for the time being – The Irish stress tests and Portugal asking for help along with strong economic data have put a lid on some of the immediate concerns for risk assets, especially credit. The risks have moved from systemic funding issues to macro events – like inflation and commodity prices for now.

Get Prepared for Renewed Pessimism

China released its March data. Both 1Q11 GDP growth and March CPI inflation were above street consensus. 1Q GDP growth was at 9.7%, slightly below 9.8% in 4Q10, higher than consensus at 9.4%. Inflation data takes center stage as CPI rose to 5.4% in March from 4.9% in February. This is higher than the market consensus of 5.2% and brings the series to its highest since July 2008. The PPI was 7.3% and broadly in line with. In terms of the other releases, Industrial Production (14.4% vs +14.1%), Retail Sales (17.4% vs +16.5%) and FAI (+25.0% vs +24.8%) were all firmer than forecasts polled by BBG. In particular, real estate FAI (25% of total FAI), the swing factor for growth, grew 34.1% yoy in 1Q11, up from 32.6% in Jan-Feb and 33.5% in 2010. Export growth rebounded to 35.8% yoy in March from 21.3% in Jan-Feb; while import growth declined to 27.3% yoy in March from 36.0% in Jan-Feb. After the release of March data, Chinese government stressed that inflation is the No. 1 target. Premier Wen strengthened his tone on inflation fighting, and he prodded local government to step up enforcement of existing tightening measures to bring home prices under control. Monetary policy should remain prudent, and – interestingly – Wen dropped “proactive fiscal policy” in his speech (though he highlighted 10mn units of social housing in 2011). As a result, we should expect more RRR & rate hikes. In addition, the government could step up intervention in the pricing of consumer staples, though it may avoid outright price cap. I do not expect many further new property tightening measures, but enforcement will be strengthened until the government see clear sign of falling prices in top-tier cities and stabilization of home prices in other cities. Moreover, China has allowed RMB to hit a 17-year high of 6.53USD last week.

Looking ahead, the prominent problems for the country are faster inflation, heightened inflation expectations, declining real estate market transaction volumes and still rising property prices in most cities. These all imply greater pressures for macro control. China should be well prepared to deal with various difficulties and risks, and strike the balance between maintaining stable and rapid economic development, adjusting its economic structures and managing inflation expectations, further consolidating the positive momentum of economic development and paving the way for a good start to the 12th FYP. In fact, street equity strategists in most banks are calling to buy Chinese stocks by citing the coming decline in CPI inflation in 2H11 and the coming lessened intensity in tightening measures. But I want to stay cautious even though these fellows turn bullish at the same time period. We all agree that Chinese government’s inflation fighting will be carefully engineered in order to not derail growth. However, as a market practitioner I have low conviction on street economists or strategists’ inflation forecasting, not mentioning the still-mysterious CPI basket and calculation methodology in China. Thus I want to price in enough risks before turning into bullish due to significant uncertainties associated with disruptions in MENA and Japan's quake. Investors should also get prepared for a new round of pessimism on China’s “hard-landing”, along with the very bullish position in EM equities…...Lastly, regional wise, MSCI China is now traded at 12 XPE11 and 18.9% EG11, CSI 300 at 14.9XPE11 and 24.3% EG11, and Hang Seng at 12.3XPE11 and 20.2% EG11, while MXASJ region is traded at 12.7XPE11 and +15.3% EG11.

More Upside for EURO

EURUSD has gone up 11.8% since January low at 1.2907 and the cross is breaking through an important resistance level toward 1.45. Looking ahead, I think EURO could strengthen further against USD given widening interest rate differential; the fire-walling of the European sovereign debt crisis and China’s accelerating FX reserves accumulation. First, ECB has taken the lead in normalizing policy ahead of the Fed. What is more, the ECB may deliver a few more rate hikes before Fed starts raising rates in 2012. Second, the market is gradually becoming assured that the lingering debt crisis in the periphery will not spread to larger Euro area countries, such as Spain and Italy, as I discuss in the above sessions. The perception of having contained the debt problem is positive for EUR because it may begin driving down the fiscal risk premium. Finally, China’s economic policies will place upward pressure on EUR. Specifically, China’s accelerating reserves (> 3trn USD as of late) growth and its diversification away from USD will push EUR higher.

From EM equity’s point of view, my concern is how much downside DXY has going forward. Based on JPMorgan’s FX model, the trade-weighted dollar is currently 5% undervalued, which at face value suggests a potential trend reversal as USD approaches its 2008 lows. However, it is worth noting that the DXY’s 5% undervaluation is far from historical extremes. Since 1980, the average USD misalignment in the time series is 5%, while the model estimated a 14% undervaluation in 2008 and a 10% overvaluation in 2002. In this context, a further Dollar decline based on the US policy environment (Fed rates at zero, fiscal outlook unclear) has ample precedent, particularly judged against previous extremes.

Good night, my dear friends!