My Diary 683 --- The Long-Term Equity Valuation; Debate over Inf

My Diary 683 --- The Long-Term Equity Valuation; Debate over Inflation/Deflation; How to Solve LGFV Debt; The Alternatives of USD

Tuesday, July 19, 2011

[Note: Given many inks have been put down to address the European sovereign debt crisis, I will skip the Rates/Credit market section in this diary piece, while add the discussion over equity valuation.]


“From Muddy Waters to Moody’s Waters” --- Moody’s/S&P/Fitch, the rating agencies are back! They really would place the whole world on review, wouldn’t they? Last week, I saw Moody's downgrade of Portugal and Ireland has brought the question of sovereign ratings back to the forefront of investors. 48 hours later, I observed the 3^rd largest global govt bond market (Italy with EUR1.6trn or USD2.25trn outstanding) in meltdown, and late Moody’s placed the largest (US) on review for downgrade as they suggested they would if the debt ceiling discussions weren't resolved by mid-July. Before the end of the week, Moody’s red-flagged 61 Chinese liscos based on a new rating framework designed to assign scores to corporate governance and accounting practice. With the repeated warnings from such vocal rating agencies, it seems that risk markets remain in the dangerous times. Why? The answer is simple --- if all financial assets are a pyramid, then the most risky assets are small parts at the top being supported by the huge base at the bottom that is the world's major Government bond markets.

Thanks to the “Always-In-Time” downgrade by the Moody’s, the risk-off sentiment was triggered --- note that the yield on 2yr Greek notes rose above 32%, and 10yr Portugal notes climbed to a Euro-era record of 13.27%, and pushed Portugal-German 10yr spread to a Euro-era all-time high of 1071bp. CDS on Portugal signals a 63% probability the nation will fail to meet its commitments within five years, according to CMA. CDS on Ireland, which is rated Baa3, imply a 58% chance of default and Caa1-rated Greece has 86% likelihood. As a quick reminder, back in 3Q08 corporate and financial credit spreads were acting in a not too dis-similar manner to sovereign spreads today and at that point it is said that credit markets were screaming warning signals to the equity market that there was huge stress in the system. So the reality is that we may again close to this point. However, anyone who has watched the agencies over the last two decades will also be aware that spread moves have increasingly influenced their ratings. Thus, one has to consider whether the likes of Spain and Italy actually have a probability of default of more than 8-9% over the next 5 years. If the answer is yes then the rating agencies would actually be within their analytical rights to consider a HY rating for all the peripherals. Some might say that the ECB could eventually monetize the debt before a default but given the ECB's current stance it's difficult to factor that into a rating.

Moody's moves are like a slap in the face to European policy makers, who have been devoting extensive effort and wire-time to curb the sway the rating agencies have over the markets. However, market attention has shifted rapidly to Italy, the region’s third-largest economy and largest sovereign debt market. In fact, European leaders are struggling to convince investors that they will agree on a second Greek bailout at a summit this week as record bond yields threaten to boost financing cost at sales of Spanish and Greek debt (totaled EUR 5.75bn bills). As noted by Suki Mann, the senior credit strategist at Societe Generale, that “Greece appears beyond repair, Italy is on the brink and the chances are that the Euro might be no more very soon.” As a result, I saw EU President Herman van Rompuy asked leaders last week to meet in Brussels to discuss “the financial stability of the Euro area as a whole and the future financing of the Greek program.”

The confirmation of the European leaders' summit on this Thursday may raise some hopes that a comprehensive and concrete solution is in sight but in reality plenty of work still needs to be done before a package can be tabled by the end of the week. Among topics for the talks is a potential overhaul of the EUR440bn rescue fund to enable Greece to better pay its bills. The fund, known as the EFSF, would need to be increased to near 2 trillion Euros and “and become a de facto common bond type instrument,” to solve the crisis, according to the RBS economist, Jacques Cailloux. Euro-area finance chiefs have revived the idea of allowing countries to use loans from the fund to repurchase and cancel their own debt in secondary markets. Chancellor Angela Merkel’s chief spokesman, Steffen Seibert, also said Germany is confident the summit will produce an agreement to fund another bailout for Greece, which received a EUR110bn rescue in May2011 from EU and IMF.

Honestly I would only keep my fingers cross and wish EU leaders to come up with a solid solution by the coming Friday morning. In fact, this summit was originally mulled for last week before being postponed amid German fears it would backfire without a pact on private-sector involvement (PSI). EU leaders are at odds with one another and with the ECB over demands by Germany and Finland that private investors bear some of the burden of a new Greek rescue. The summit also comes after European bank stress tests (only 8 banks failed, and mere EUR2.5bn of new capital needed) on July 15 failed to allay investor concern that lenders were prepared for a Greek default and that euro-area governments had the ability to bail them out. The stress tests results add to the impression that politicians and regulators do not realize how serious the situation in peripheral Europe has become, after Euro concerns spread to Italy last week (23% of Euro-area debt and 17% of its GDP). That said, despite several structural vulnerabilities, Italy has a more favorable fiscal situation (4.6%), CA balance (USD-58bn), and growth profile (1.1%) than most other peripheral states.

On the other side of the Atlantic there has been no major progress on the debt and deficit talks in US. As we edge closer to the deadline Republican Senate leader McConnell's “Plan B” seems to be gaining momentum behind the scenes. According to BBG, the “Plan B” involves allowing Obama to unilaterally lift the ceiling by USD2.5trn with support of just over 1/3 of the members of each chamber. It seems unlikely to me that politicians will take on the risk of causing a US default, even temporary. The bond market seems to agree to some extent as the UST10yr yield actually fell 12bp last week despite the Watch Negative by Moody's and S&P. One could also make the argument that if more aggressive fiscal cut backs are eventually forced through, even if the was a selected default first, the appetite for USTs may increase due the increased recession risk for 2012 due to the lack of sustained aggressive deficit spending. Within the same week, Moody’s published a report on July 11, 2011 discussing red flags for Chinese companies. Equity markets reacted quite negatively to this report. While some of the methodology is in the right direction, such as highlighting risky or opaque business models, poor quality earnings and cash flow, I disagree on several parameters, such as short listing history and concerns over the quality of financial statements. Moreover, based on the track records over the past several cycles, rating agencies are seldom the first in spotting fraud. This is partially because of their rating process. Moody’s acknowledges it lacks access to due diligence reports and auditors. It conducts no direct interviews with major customers or suppliers. Sometimes it confirms ratings before analysts conduct a site visit. As a result, many dedicated HY investors only use rating reports as a reference for their own credit analysis.

X-asset Market Thoughts

On the weekly basis, global stocks dropped 3%, with US -3.3%, EU -2.4%, Japan -1.9% and EM -2.8%. Elsewhere, USTs yield stay flat with 2yr @ 0.375% and 10yr @2.91%. The Irish and Portuguese 2yr sovereign yields shot up to 23% and 19% respectively. The Greek 2yr yield rose to more than 33%, while 2-year Italian sovereign yield rose to 4.22%. 1M Brent has traded within $1 range and ended at USD117.26/bbl. Euro strengthened a bit to 1.4157USD on the rate differential ad QE3 talk, while JPY climbed to 79.06USD from 80.64USD last Friday.

Looking forward, from macro perspective, the lack of clarity about where the global economy is heading is particularly worrisome. Events in the US and Europe remain the biggest market focus. Two years into the start of the most anemic US recovery in post WWII history, as measured by employment performance, the Fed is showing a willingness to discuss the options for more easing as well as tightening. Chairman Bernanke in his Testimony to Congress laid out the details of both options, taking markets by surprise over his willingness to bring up the possibility of more easing being warranted. That said, the major impediment of growth and financial market performance remains the policies of the respective governments around the world. European governments' management of the debt crisis, the ECB's refusal to be an active participant in the periphery bond market, new and higher regulatory capital requirements imposed on banks around the world, monetary policies that have been geared toward printing up money in response to real economic weakness, and tax and regulatory uncertainties are among the major obstacles. Even the Fed, which is one of the major entities adding to the uncertainties, stated in the FOMC minutes released last week said growth was sub-standard because of "the effects of uncertainty regarding the economic outlook and future tax and regulatory policies on the willingness of firms to hire and invest."

The Long-Term Equity Valuation

At this juncture, it is important to have an assessment over whether the equity as an asset class in cheap or expensive, or whether it has priced in the uncertainties enough or not. Indeed, as some equity strategists argued that equities look cheap based on the past 25 years. But based on pre-1980 valuations, they are not. Looking back, the period since 1980 was very unusual for DM economies --- sustained, benign decline in inflation; generally declining real interest rates; and trend increase in leverage. There were also major, largely investor-friendly, surprises --- the Cold War ending; widespread economic and financial deregulation; globalization broadened and deepened; and IT become ubiquitous. At the same time, valuations for risk assets stretched to levels rarely seen before. The average trailing PE since 1985 has been almost 24.5X, an 80% premium to the 13.75X average seen over the prior 110 years. Excluding the write-downs of the financial crisis, the average PE has been just under 21.5X. These ratios are based on headline, or GAAP earnings. Alternative earnings measures - operating earnings or forecast earnings - show lower multiples, but these earnings series are only available over the past 30 years.

The higher valuation of equities is difficult to justify by a fundamental improvement in equities as an asset class. In particular, equities did not participate in the so-called “great moderation” in many macro variables - the fall in volatility over the 25 years after 1983. The reverse happened: equity earnings have become more volatile, based on reported earnings. Likewise, the variability of US equity returns (5yr rolling for 12M returns) is now at its highest level since the 1940s. The key point, however, is -- based on the recent past, equities now look cheap on some absolute valuation measures relative to the averages of the past 30 years. Based on long-run, or pre-1980, averages, equities look expensive. They do not look cheap on every absolute measure: US equities are now 23.5X Graham-Dodd earnings vs. a post-1980 average of 21.5X and a long-run average of 16.5X. Relative valuation can give a guide to relative performance, but can often send the wrong signal on absolute performance, i.e. Yield Gap -- Equity DY vs. LT UST Yield. This is a badly constructed measure (confusing real and nominal yields), but it’s popular. It’s a poor guide to absolute returns, as equities were, on this relative measure, at unprecedented expensive levels in the early 1980s, yet were apparently ‘cheaper’ in 2000. Whoops.

In fact, the most pervasive influence on risk asset valuations over the past 30 years has been the rise in leverage. The problem is most debt was not used to fund consumption or physical investment. Most debt in the credit super-cycle was used to buy pre-existing assets. Consequently, the most pronounced effect of rising leverage was not on economic growth, or on the mix of growth, but on the level of asset market valuation. That in turn means that we would see an extended period of leverage reduction, so does the asset valuations. Some strategists have talked about 10X forecast PE, which is consistent with the trailing PE reverting to its long-run average. Excluding the big write down-driven PE ratios of the financial crisis, since 1985 the trailing PE has averaged a 50% premium to its long-run average. The forecast PE averaged 15X since 1985. If that was also a 50% premium to its (unobserved) long-run average, then the mean-reversion level is a forecast 10XPE. Such a de-rating would also be consistent with the Graham-Dodd PE reverting to around its long-run average. To sum up, if risk asset valuations revert to long-run norms then developed world equities are not cheap in absolute or relative terms. Paying an above-average price for an asset typically leads to below-average returns over the medium-term.

Debate over Inflation/Deflation

As the Great Recession came to an end, views on inflation split into two camps: those who saw simulative monetary policy creating runaway inflation risks, and those who saw resource slack possibly leading to deflation risks. So far, high frequent macro data seemed supporting both side of arguments. In the US, the latest dismal payrolls report shows that we are indeed in one of the weakest US recoveries on record. June's NFP (+18K vs. +105K) and Private payrolls (+57K vs. +132K) both printed sharply below market consensus. The UNE rate ticked higher for the 3^rd consecutive month to 9.2% (cons=9.1%) which brings us back to the highest since Dec 2010. Meanwhile, the UoM sentiment index fell 7.7pts to 63.8 in the preliminary July data, reaching its lowest level since March 2009. The current conditions (76.3) and expectation (55.8) both hit multi-year lows in July. The Fed Chairman also said that "the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might re-emerge, implying a need for additional policy support".

While the markets are being affected by the above mentioned comments, what's apparently overlooked is his other remarks about Fed research suggesting that QE2 may have made LT interest rates 10-30bp less than otherwise and that last autumn Fed research suggested that additional QE would raise jobs by 700K over 2 years or by around 30K per month. That said, I do not expect QE3 coming soon as the Fed's forecast a better 2H11. In one of his most famous speeches about monetary policy, Bernanke has claimed that "…Deflation is always reversible under a fiat money system follows from basic economic reasoning.” As such, I think inflation risk is the right point to be concerned. Indeed, US headline CPI eased in June, dropping 0.22% (+3.6% yoy) largely due to declines in energy prices. However, the core CPI firmed 0.25% (+1.6% yoy). This strong reading comes after last month’s increase of 0.29%, bringing the annualized 3M run rate up to 2.95%. Beside US, other G3 countries also saw inflation pressure. Euro area CPI ticked down to 2.7% yoy in June. Core CPI inched up to 1.6% yoy against expectations @1.5%. In Japan, the latest Tankan survey for July was consistent with a V-shaped recovery, along with the manuf. and non-manuf. indexes moved up nicely on the month.

For non-G3 markets, the primary challenge remains one of rising core inflation. In India, WPI accelerated to 9.4% yoy in June, below the 9.7% expected. Core inflation is showing tentative signs of moderation, but there is a strong pattern of upward revisions in these data. In addition core prices are highly susceptible to pass-through from the recent increase in administered fuel prices. As such, I continue to expect the RBI to raise its repo rate 50bp this quarter. In China, the primary question has been whether inflation could be managed downwards without generating a hard landing. Last week’s China data showed little sign of even a soft landing, let alone a hard one. The BTE Q2 Real GDP (9.5% vs. 9.3% expected), IP (15.1% vs. 13.1%), and Retail Sales (17.7% vs. 17.0%) reports are offering some relief for those concerned about a China hard-landing. Interestingly, China has brought forward its June CPI release following PBOC's +25bp hike on Wednesday. The July inflation data whispers of a 6.5% print (vs. cons= 6.2%). The fact that the key global growth engine is in such good shape provides some hope, but is likely to shift the debate back to inflation. This dilemma is particularly acute in the rest of Asia as well, where food and energy form a significant share of CPI baskets (generally higher than in other regions), and domestic demand and loan growth are also strong.

How to Solve LGFV Debt

The Wednesday’s macro data showed that 1Q China GDP growth reached 9.5%, lower than 1Q 9.7%. Some street economists were cheering for the growth slowing down. However, such number looks misleading as seasonal adjusted GDP (3M annualized, used on most countries) is about 9.1%, much faster than 8.7% in 1Q. I believe this figure reflected the economic truth of China, witnessed by other signals, i.e. June IP reaching 15.1%, the fastest growth since May 2010. If investors look through the frog of these official numbers, the biggest concern remains on inflation outlook. Most China economists believed that inflation has peaked in June, after Premier Wen Jiabao claiming the confidence to put inflation under control. However, my observation over the past 8 years tells me that the economists have not much credibility in forecasting the CPI of China, especially under the variables of weather conditions, the lack of pig supplies and the increasing influence of global commodities prices. In short, it is nearly a mission impossible. At the same time, the real economic portion of China is running into trouble. Based on CLSA CRR SME survey, the portion of SME which found it hard to access to funding surged from 52% in 1Q11 to 76% in 2Q11. Most SME are cautious on re-stocking and capex and said profitability continued to deteriorate due to higher wages and RMB appreciation. Note that SMEs do play a significant part and account for much of the employment in China.

I disagree with Moody’s on its recent Chinese banks report, both on its guesstimate on the size of local government debt and its assumptions on potential delinquencies. I believe that LGFV debt issue can be solved through China’s growth in coming years -- 1) politically, the central government will prevent such a crisis, equipped with the capacity of China economy and central govt’s B/S (I talked about it in diary 447); 2) strong fiscal revenue growth expected in coming years to boost debt affordability. The latest data from MOF showed that central govt income was Rmb2.9trn (50.8% of total), up 27%, and local govts collected Rmb2.8trn, up 36% in 1H11. Budget revenue (ex. land sales) may still increase by 20% CAGR in the next five years. 3) No trigger for uncontrollable liquidity crunch, thanks to largely closed capital accounts and huge liquidity inflow locked in China.

If the above macro/debt outlook is agreed, then Chinese banks will eventually benefit from a better liquidity environment, clearer LGFV resolutions and the removal of share overhang by strategic shareholders. In particular, upcoming 1H results may exceed expectations, as ABC just issued profit warning with NP up >45%, better than expectations of 40%. SZDB also said its 1H profit could be up by 50-60%. Analysts expect other banks will also post strong growth with small NIM improvement qoq and provisions and expenses under control, including CMB (+45%), MSB (+40%), CCB (+30%) and ICBC (+30%). Valuation wise, China banks' sizeable discounts of 35% to their average mid-cycle 11XPE and 2xPB of suggest that fundamental weakness in the form of rising NPL pressure and CAR deficiency may already be largely priced in……Lastly, regional wise, MSCI China is now traded at 11.1XPE11 and 19.8% EG11, CSI 300 at 14.1XPE11 and 24.9% EG11, and Hang Seng at 11.1XPE11 and 21.8% EG11, while MXASJ region is traded at 12.3XPE11 and +12.9% EG11.

The Alternatives of USD

FX markets have been highly volatile given concerns about the US soft patch, the Euro-area debt crisis and a possible hard landing in China. However, EUR was supported in 2Q11 by three factors: broad USD weakness, German growth out-performance and widening interest-rate differentials. However, from here, two of those supportive factors are turning less positive --- 1) risk/reward in the USD against G10 currencies is turning more mixed; 2) the economic out-performance of the core Euro area appears to be moderating. But the level and the direction of interest-rate differentials remain supportive for EUR for now. With ECB President Trichet having stressed “strong vigilance” at the last policy meeting, a 25bp rate hike appears all-but-guaranteed this week.

With more and more investors are concerning the long-term prospect of USD, it is interesting to have a look on what could be the alternative of USD? According to IMF data, beside USD, four currencies – EUR, GBP, JPY and SWF – have accounted for the vast majority of FX reserves. For most of the last decade, it was the Big-4 currencies (especially Euro) that benefited from USD’s relative decline in global reserves. While Euro is the default alternative to USD, central banks are increasing their allocation to the commodity currencies. Indeed, there has been a new development to central banks’ diversification strategy. Since early 2009, central banks have been looking to what the IMF simply classifies as “other currencies”. From 2% in early 2009, “other currencies” now account for almost 5% of total reserves, with total amount increased by USD300bn over a two year period. While the IMF does not provide any further information, it is speculated that it largely consists of the commodity currencies: CAD, AUD, NZD and perhaps the SEK and NOK. For these relatively small economies, USD150 n of annual capital inflows is an enormous amount to absorb. But the bottom line is central banks in EMs will continue to shift a portion of their new reserves into non-dollar currencies.

Precious metals, especially gold, have benefited from a “perfect storm” in recent months: falling real interest rates, a weak USD, fears of US recession and/or debt default, and European stress. These concerns will be recurring themes in the coming years. But expectations of another liquidity impulse could prove overblown as US economic surprises shift from negative to positive without much change in the underlying mushy backdrop. In this environment, growth plays like copper and oil could moderately outperform liquidity plays like gold and silver.

Good night, my dear friends!