My Diary 677 --- The Asian Tightening Ongoing; The European “Leh

My Diary 677 --- The Asian Tightening Ongoing; The European “Lehman Moment”; Range Bound for Longer; About Crude Oil, USD and Grains

Sunday, June 19, 2011

“The Risk of USD Collapse vs. The risk of Hard Landing” --- During my two-week trip to mainland China, there were so much noises around the economy prospect of this country and its implications to the financial markets. Many smart investors, including George Soros and Dr. Roubini, talked about hard landing, but few had a clear-cut definition. Meanwhile, concern that some US-listed Chinese companies may have issued fraudulent financial statements is also weighing on Chinese equities. CNBC even timely pointed out that the last time the stock market began a month with 6 down days was 11/08. Adding to that, the US-based major rating agencies were busy with downgrading the credit worthiness of European peripheral sovereign’s ratings and European banks’. All seemed like that the sky is going to fall. However, in my own views, all the dirty tricks behind the market movements are intended to delay the collapse of USD. Historically a weak US economy would have been seen as negative for USD. Since the crisis, the market has had to come to terms with new rules. One of them that seem to go against the "fundamentals" is that a weak US economy is not necessarily USD negative. This has changed in the post-crisis world, when an increase in the debt ceiling helps reflate risky assets at the USD's expense. The "fundamentals" used to say that the USD had primacy, but now the USD behaves like a residual currency. The world understands now that the miracle of ‘American Dream” is largely based on the USD’s reserve currency status, in particular since 1971, which provides the free lunch for this super power country to grow without constraints to resources. Now, with the waning prospect of growth recovery and the traps of debt ceiling and high UNE rate, there is reasonable to believe that the American is using its muscles (either in the financial markets or in the geopolitics) to drag down Euro by downgrading the peripheral sovereign ratings though Moody’s, S&P and Fitch, as well as to pull Southeast Asia into wars by silently encouraging US’ small alliances like Vietnam and Philippines to itch Chinese PLA through the challenging of China’ sovereignty in South China Sea area.

My doubt is not coming from groundless guess. U.S. has reached its debt ceiling in May and would be in default by Aug 2 if the limit is not raised. Like Greece, U.S. needs new borrowing to pay his old ones. As such, I look at much amusement at Chairman Bernanke's comments (14June, 2011) that failure to raise the debt ceiling on time "…could cause severe disruptions in financial markets and the payments system, induce ratings downgrades of US government debt, create fundamental doubts about the credit worthiness of the United States, and damage the special role of the dollar and Treasury securities in global markets in the longer term…". I think Chairman is not getting the point. It is not the failure to raise the debt ceiling that will "create fundamental doubts about the credit worthiness of the United States", it is the rapid expansion of debt and spending more than the American earn that will do that. According to current projections, US debt will grow by another USD10trn over the next 5 years. In fact, fiscal stresses are in no way confined to the periphery of Europe. In US, the federal deficit is projected to be 9.5% of GDP this year, a larger shortfall than in 2010. In the other hand, my own observation tells that China is not as bad as external investors think. China May macro data suggests growth is stable and not collapsing. China's IP, FAI, and retail sales have all expanded some 1-2% mom for four months in a row on the s.a. basis.  Inflation is high but many economists expect it to peak in July-August. 

That said, from the global perspective, the growth slowdown has become increasingly evident, with the latest US NFP (+54K vs. exp.=+165K) following on from a broad range of weaker global PMIs, as I discussed in the Diary 445. With a full slate of April activity data now in hand, I saw global output ex-Japan fell 0.5% in April. Japan’s footprint is evident in the generalized output declines, although we are still above the average level from 2005-07. The distinction between a decline from a high level and an outright negative print is important for global markets. But there is risk that global PMIs will fall further, in particular a sub-50 PMI in China. But outside DMs, the slowdown is a welcome in many emerging economies, especially in Asia, of which were already facing demand-led inflationary pressures due to continued high labor participation rates and consequent wage pressures. With manufacturing growth now slowing, demand pressure should ease. The focus now appears to be whether China faces the risk of a hard landing. I do not think so, and see growth bottoming out in 3Q11as the 1H slowdown is policy-guided in nature. Once credit controls are softened, growth will pick up.

In contrast, since early March, US economy has surprised on the downside almost without exception, even as US growth forecasts have simultaneously been revised down. US growth expectations for 2011 have slowed from 3.2% at the beginning of March to 2.7% now, according to a BBG survey, while UST 10yr yields have declined from around 3.6% to 2.9%, a 70bps decline. Such a large fall in 10Y yields reflects a continuous D/G to economic growth expectations in 1H11 and now concerns that 2H11 growth will also be downgraded. As a result, it seems to me that it is too early to re-position for a growth rebound as we head towards late summer. Having discussed so, I still think the chances for QE3 seem not high due to 1) concerns about how QE actually works, and 2) last time around there were genuine concerns on deflation. This is not the case this time. To the global financial markets, the near-term risk overhang is Greece. While German is still pushing for a soft-soft approach --- fiscal adjustment, additional funding and voluntary restructuring --- ECB remains firmly against any restructuring. It is unclear to me how such a voluntary restructuring could work. The Vienna Initiative is a different model, as that was designed to provide coordinated funding from Euro-area banks to their Eastern European subsidiaries, and the risk of not co-coordinating action was a potential default for the banks themselves. In the case of Greece, the intent is instead to encourage a rollover of debt to unrelated entities. Thus, I expect Greece-related risk continuing for some time, again providing a risky backdrop to the market.

Furthermore, the timing of the growth trough will be critical in how base effects in food and energy inflation are interpreted. According to JPMorgan, the forward-looking global food prices in local currency terms show the base effects in food-price inflation remains intact. The yoy food-price inflation in EM local currency terms will start to decline sharply from around 25% in mid-July to 10% just two months later. If inflation consequently begins to decline sharply at a point when manufacturing activity is at a short-term nadir, there is a material risk that this combination will be interpreted as a severe slowing of the global economy. Consequently, I expect macro data leading market volatility as we head into the summer. That is probably already in portfolio managers’ mind. Based on the June Merrill Lynch’s FMS, investors raised cash, reduced risk asset exposure and rotated to defensive sectors. The % of investors OW cash rose to 21%, the highest since July09. Actual cash balances rose from 3.9% to 4.2%. Hedge funds cut gearing levels sharply to 1.27X from 1.53X. The June FMS also shows global investors trimming their overweight positions in EM as risk appetite is reduced. A net +23% of global investors are OW EMs, down from +29% in May. EM remains the favored region (ahead of US) but allocations are well down on the highs of last Nov (+56%) and below the LT average.

X-asset Market Thoughts

At the end of a volatile week, global equities dropped 0.61% with -0.1% in US, -0.35% in Europe, -1.48% in Japan and -2.22% in EMs. Elsewhere, UST yields fell a few basis points with 2yr down 2bp to 0.375% and 10yr down 2bp to 2.94%. Brent oil declined 3.8% to $113.49/bbl. Spot gold price reached USD1535/oz, +8.2% YTD.  EUR weakened 0.3% to 1.4306USD and JPY strengthened 0.39% to 80.05USD.  Moreover, it was a very dark week for European sovereign CDS with Greece, Ireland, and Portugal index all hitting new wides after having widened by +672bp, +58bp and +41bp to close at 2234bp, 771bp and 783bp, respectively. Looking back, asset markets in this summer are trading on a weak note, with global macroeconomic uncertainties returning to the fore and undermining market sentiment. In addition to Europe’s ongoing fiscal crisis, fresh evidence of a marked deterioration in US economy has contributed to a distinct souring of investor risk appetite. These factors, together with the imminent end of QE2, have focused market participants’ attention on the return of market risk. While -VE US economic developments will weigh on market sentiment in the short term, the longer the soft patch continues, the longer the Fed’s stance will remain accommodative. On balance, this will support markets in the longer term.

Looking forward, inflation has picked up further in EMs, in particular in China and India. This indicates that policy tightening in these two countries is not quite over yet. While the focus in Asia is inflation and the impact of policy tightening on growth, in US it is the absence of growth, while in Europe it is the ongoing debt concerns. I think concerns about Greece are unlikely to dissipate soon. Elsewhere in Europe, Moody's threatened ratings downgrades on 2 Portuguese banks and on 3 French banks. It's not a pretty sight out here. The base case is we could see a 20% decline from May to July.  As discussed above, the challenges for EM investors are whether the base effect in food and energy, should it bring down headline inflation from late July onwards, raise the risk that data will be interpreted as signaling an aggressive slowdown, and thus high asset-price volatility. So far, a number of technical indicators suggest that the corrective action in broad US equities has further to go. For example, the momentum is still falling from an overbought zone, and the 26WK rate of change of SP500 has still not retreated to zero or below zero which typically signals a complete unwinding of overbought conditions. Regarding to the USD outlook, the moderating US growth is sending USD at the bottom of “Dollar Smile”. In the near-term, rate differentials will continue to drive EURUSD, reinforced by ECB statement, while in Asia, I remain broadly constructive on local currencies. As a result, I believe risk/reward dynamics will encourage higher commodity prices in the near-to-mid term. The commodity space is on a firmer footing, with net positions generally declined materially from their recent highs, supply fundamentals remaining robust, and demand-side data is showing improvements. However, recent macro data has not been encouraging, even though the market has generally priced in slower growth. I expect this could change by Q4, when US growth turns stronger and global growth pick up by 2012.

The Asian Tightening Ongoing

The week’s US economic data were not pretty, with June Empire Manuf. unexpectedly plunging to -7.8 (cons=12.0) from 11.9 in May. The NAHB housing survey also fell to its lowest level since Sep10. The CB consumer confidence index fell to 60.8 in May (cons=66.5) from 66.0 in April . The details showed a sharp drop in the expectations (75.2 after 83.2) component. In addition, the UNE rate unexpectedly climbed to 9.1% last month. Moreover, the headline PPI was +7.3% yoy (cons=6.8%) while core PPI (+2.1%) was in line. CPI also increased a LTE 0.17% in May. More worrisome was the 0.29% rise in the ex-food and energy core CPI, the largest such increase since May06. The 3M annualized core CPI is now a robust 2.5%.  With such inflation data on hand, it is not surprised to see Fed officials are discussing whether to adopt an explicit target for inflation, a strategy long advocated by Chairman Bernanke and practiced by central banks from New Zealand to Canada.  In Europe, Eurozone HICP is currently running at 2.7%, well above ECB's 2% target. The risks that higher commodity prices will fuel 2^nd round effects and de-anchor inflationary expectations should ensure Trichet sounds as hawkish as ever. Further adding to the hawkish tone, upward revisions to the ECB's growth and inflation forecasts seem likely, currently 1.8% and 2.3% for 2011 respectively.

In contrast, I think the current slowdown in Asia, has been somewhat exaggerated by supply-chain distortions following the Japan earthquake on 11 March. Near-term, the risk is that markets may see this slowdown as a broad-based demand shock, which could trigger another corrective wave across assets into Q3. The exact impact from the Japan earthquake on Asian economies is hard to quantify. But the correlation of Asian industrial cycles with Japan should provide an indirect idea of the relative degree of that impact, particularly on manufacturing. Across Asia, IP rates in Malaysia, the Philippines, Taiwan and Korea have correlation coefficients of 0.81, 0.78, 0.77 and 0.73, respectively. In contrast, China’s IP correlation coefficient is only 0.34. The composition of imports from Japan could also show a clearer picture of the supply-chain impact. Japan constitutes around 20% of the total imports of electrical machinery and equipment for China and Korea. With a high value-added component, imports from Japan may not necessarily be substitutable by other Asian producers.

The problem to Asian authorities stays with Inflation and strong growth. In India, May WPI rose 9.1%, more than the 8.7% expected. In Singapore, April retail sales came in strong at +8.1 yoy (cons +3.6%) in nominal terms vs. +1.1% in Mar. The rebound was broad-based. Chinese May data also showed a sticky headline inflation. In Korea, BOK hiked rates by 25bps to 3.25% against market expectations of no move, as core inflation (3.5%) has continued to trend higher. Overall, there expects a number of EM central banks to tighten again this week, putting June on track to deliver the biggest increase in EM policy rates (on a GDP-weighted basis) so far this cycle.

The European “Lehman Moment”

Earlier this week, ECB and the German government have clashed over how much investors should contribute to alleviating Greece’s debt load, which reached 143% of GDP in 2010. While German has argued for an extension of the maturities of Greek bonds, ECB has said it’s against anything that could be interpreted as a default. ECB is in favor of a plan for bondholders to agree to roll over their debt voluntarily. The approach is modeled on the Vienna initiative, where banks agreed to roll over loans to units in Eastern Europe at the height of the financial crisis in 2009. Later on, Standard & Poor’s slashed Greece to CCC from B, handing the nation the world’s lowest credit rating and noting it’s “increasingly likely” to face a debt restructuring. 2yr Greek notes exceeded 28% for the first time and 10-r bond rates jumped to 17.73%. In fact, EU’s failure to contain the Greek debt crisis is sending fresh shockwaves through currencies, money markets, equities and derivatives. The EURO tumbled almost 2% once in the week. The credit-default swaps anticipate about a 74% chance that Greece won’t pay its debts.

The current problems arise from the fact that it appears almost impossible that Greece will be able to access the market by Q1 2012 as originally planned. Greece funding requirements consist of bills, bonds and the coupons on the bonds. Of particular interest to the markets as of now are the July and August funding requirements. Greece has its first liability on July 15, a bill repayment of EUR2.4bn. The total amount that Greece needs by the end of August (before the next tranche) is EUR18bn of which EUR6bn are bills which are expected. Meanwhile, Papandreou needs to clinch a parliamentary vote on a EUR78bn (USD110bn) 5yr package of budget cuts and asset sales by July to ensure the country receives a new EU aid package to avoid the Euro-area’s first default.

That said, although Greece is a small country, the threat of the Greek debt crisis spilling over into the banking sector is currently the biggest risk to the region’s financial stability. In general, German lenders were the biggest foreign owners of Greek government bonds with USD22.7bn in holdings last year, data from BIS showed. French banks trailed their German peers with USD15bn. The figure for French banks was inflated by USD39.6bn in lending to companies and households. At the end of 2010, Greek government bonds held by banks in countries reporting to the BIS were totaled USD54.2bn, of which 96% was owned by European lenders. In addition, the ECB holds EUR80-90bn in Greek bonds of which EUR45bn are in purchases and the rest is through repo financing largely to Greek banks. This perspective helps to understand the ECB’s position on debt restructuring. When ECB council member Bini Smaghi spoke a few weeks ago of debt restructuring as political as well as economic suicide, he was expressing a concern that goes beyond the impact of debt restructuring on the ECB’s own B/S and the implications for financial stability in the region. As a result, ECB is one of the loudest voices around the negotiation table in deciding the likely outcome.

Given the gloomy outlook of Greek debt restructuring, Moody’s placed the ratings of BNP Paribas and Societe Generale SA and Credit Agricole SA under reviews. While on this subject a Fitch report published in March indicated that US money-market funds' exposure across all European banks (including CD, CP, ABCP, and repos) were significant at 44.3% of total assets as of February 2011. After seeing these data, I can't help thinking that these data points are a reminder that a European sovereign default could have very destabilizing effects on global and not just European markets given the interconnectivity of the global financial system. So far, it looks like that Europe could face its own ‘Lehman Moment’ as Greece unravels. Just a reminder here that Lehman’s collapse contributed to USD2trn in write-down and losses at the world’s biggest financial institutions, according to Bloomberg.

The market is nervous and focusing on the potential solutions could be reached by EU leaders. It has been agreed that there will be a permanent crisis resolution mechanism—the ESM—which can be activated in order to preserve the stability of the Euro area. But, the de jure control of fiscal, macro prudential, and structural policies remains in the hands of national governments, and the ESM is an inter-governmental agreement under the control of Euro area finance ministers. As of Friday night, there were two main obstacles to sealing a package for Greece: disagreement among European policymakers, and Greek politics. Following a meeting between German chancellor Angela Merkel and French president Nicolas Sarkozy, the first of these two obstacles appears to have been lifted. In particular, Germany appears to have backed down on its demands for a formal maturity extension of bonds, and opened the path for a solution along the lines advocated by the ECB and the French. More specifically, the two heads of state announced that private sector involvement in Greece would occur on a purely “voluntary basis”, through a “Vienna-style rollover” of bonds. They both remarked that the solution would be consistent with the ECB’s demands, and that it would avoid triggering a credit event. Technically, the term “credit event” is usually used in the context of triggering CDS contracts, but it could be meant to include rating agency downgrades in this context. As the rollover is voluntary, under current ISDA rules this option should not trigger CDS. Will it be a happy ending or a Greek tragedy? No-one really knows at this stage but everyone in every corner of global financial markets should be keeping a very close eye on upcoming Greek events. I do think the period resembles the build-up to the Lehman collapse where, although markets were increasingly nervous, virtually everyone expected a last-minute buyer. It’s likely that the relevant parties are now more aware of the consequences post-Lehman, but there are more people that need to reach an agreement than there were during the last days of Lehman.

Range Bound for Longer

The week saw HKMA announced new measures t to cool the property market, with intention to further limit leverage: the measures basically reduce LTV ratios for specific property segments, i.e., the non-luxury segment, flats valued below HKD 12m. This reflects concern among policy makers about the expected rise in the debt burden or middle-income households once US rates start to rise.  Meanwhile, inflation continues to trend upwards, with the main drivers being food prices and the rising cost of housing. This uptrend is likely to continue until late Q3 this year.

Move to the North border, China’s May data suggests that economic growth has held steady, while inflation accelerated a little from April. According to NBS, CPI rose to a 34-month high of 5.5%, in-line with consensus. On that back of that, China hiked RRR by 50bps, the 6th for the year and the 12th in the latest cycle (since Jan 2010), taking the RRR to a new record high of 21.5% across big banks and 19.5% for smaller banks! The other bits of the data was actually more encouraging as it showed that retail sales (+16.9% yoy), IP (+13.3%  yoy) and FAI (+25.8% yoy) were all running strong, suggesting that growth may not be slowing down as much as feared. However, investors have been focusing on the latest “hard-landing” risk factors, such as power shortage, auto sales deceleration, weak PMI, property market corrections, and monetary tightening. In fact, several established China economists has just revised down their GDP forecast in Q2. Dr. Ma Jun expects GDP growth (saar) to slow from 8.7% in Q1 to 7.7% in Q2, before reaccelerating to 8.5% in Q3 and 9% in Q4. Dr. Tao Dong cut GDP target from 8.8% to8.7% for 2011 and 8.9% to 8.5% for 2012 on the back of persistent inflation and softening growth momentum. The street expects conditions to stay together for longer, into 2012. SMEs are facing severe liquidity crunch and it is increasingly causing concerned about its impact to the entire economy.

As a result, Investors should pay attention to early signs of macro policy easing in the coming months. These signs include senior policy makers’ field trips, NDRC/CBRC concerns on over-tightening, default by a few developers, tougher negotiations between LGFVs and banks, a rise in curb market funding cost to 30%, some SME closures, and a fall in yoy IP growth to 12%. That said, we would see some trading opportunities --between cyclicals and defensives. Nevertheless, I think the market will likely remain range bound for quite a long time until both of the following two issues are resolved: inflation and banks' B/S. There is also a chance that, if either of these two goes terribly wrong, we will see a bad break on the downside in the market…...Lastly, regional wise, MSCI China is now traded at 10.7XPE11 and 20.3% EG11, CSI 300 at 12.7XPE11 and 25.7% EG11, and Hang Seng at 11.0XPE11 and 22.3% EG11, while MXASJ region is traded at 11.8XPE11 and +14.9% EG11. To sum up, equity valuations is now at a neutral level, but EM stocks are trading at a premium to DMs. MXCN on the surface commands low multiples because banks, materials and property stocks have very low PE ratios. However, excluding cheap sectors, China is above its historical average.

About Crude Oil, USD and Grains

Despite the recent correction in oil prices, the uptrend in WTI crude is intact. Numerous currencies stand to benefit from rising oil prices, but channels through which the price of crude affects exchange rates can differ across countries. The reason is that though oil prices affect FX rates via the monetary policy channel, but central banks react differently to accelerating inflation depending on their mandates. For example, Fed explicitly targets core inflation rather than the headline measure, and for this reason could lag other major central banks in a rising oil price environment. Overall, when all factors are taken into consideration, commodity currencies should benefit from rising oil prices, especially AUD, while USD should underperform.

Having said so, USD’s backdrop remains unsettled, based on recent weak job. In addition to the jobs data, the ISM Manufacturing Index underperformed already-downbeat expectations, falling to 53.5 in May from 60.4 in April, suggesting a more pronounced slowing in the factory sector. With only weeks left before QE2 expires, the downgraded growth expectations indicated by the recent run of data have kept downward pressure on already-low US yields, with t 10yr note dipping below 3% for the first time this year. The yield declines were also a function of the sizeable contraction in risk, as US equities fell sharply over the weeks. In that regard, Eurozone-US 2yr swap spreads have continued to widen in the past week and stand at 153bp, up a full 10 bp from last Friday's close.

Meanwhile, grain prices have rallied since last July because of widespread output shortfalls and shrinking inventories. This supply tightness will not ease until at least the fourth quarter when most of the global grain harvest occurs. Despite high grain prices, global demand is likely to stay robust. Positive macro factors for grain include rising oil prices, a weakening dollar and cheap shipping costs. On the negative side, more favorable weather leading to an exceptional harvest represents a risk to the bull case. Also, there is risk associated with potential financial liquidation as both open interest and speculative positions are high. Finally, declining ethanol production could put downward pressure on grain prices. However, most of these risks are unlikely to materialize over the next three-to-six months.

Good night, my dear friends!