My Diary 688 --- The Large Declines in Confidences; ECB’s Three

My Diary 688 --- The Large Declines in Confidences; ECB’s Three Interrelated Troubles; Pork Prices Keep Popping; USD Losing Safe-haven Status?

Sunday, August 28, 2011

“Who is the irreplaceable God: Steve Jobs or Warrant Buffet?” --- Speaking a joke to a friend that “when Mr. Jobs launched his newest product – iQUIT, the Japanese Prime Minister Naoto Kan bought one immediately”, he laughed and accepted the underlying message -- everyone knows, Steve Jobs is irreplaceable! But it seems Jobs has arranged everything for his resignation since he was indentified the pancreatic cancer in 2004. He has done 5 very thorough arrangements for Apple, covering Products, Team, Cash, Methodology, Legal and Business management. Let alone others, the product family with iMac, iPad, iPhone and iCloud is a strong portfolio, of which each one of them is a cash cow and enjoys certain competitive edge over the peers. In particular, so far in the areas of smart handset and mobile-internet, Apple is undoubtedly the flagship enterprise in this planet. However, even the most thorough plan has its limits to picture the uncertain future. If Bill Gates is the genius combination of technology and business, then Steve Jobs is the jointed-genius of art and commerce and even more irreplaceable as Steve has the ability to inject the artistic charm into industrial products and his deep insight into consumer needs is difficult to truly clone. If I can add one point is that Jobs is listed as either primary inventor or co-inventor in over 230 awarded patents or patent applications related to a range of technologies from actual computer and portable devices to user interfaces, according to Wikipedia.

In contrast, I could not raise my respect to Warrant Buffet, the so-called “The GOD of Investing”. In a month that similarities to 2008/09 have been drawn (short selling bans, bank funding pressures and capital concerns), Warren Buffet invested USD5bn in Bank of America through preferred stock and warrants. The warrants allow Buffet to buy 700mn BoA shares at an exercise price of USD7.142857/share. BoA shares rallied hard on the news, up nearly 26% before closing +9.44%. The initial excitement saw SP500 Futures briefly rally from 1171 to 1188 before the strength started to fade. Interestingly 1188 is where the index closed back on 23Sep, 2008 when the Oracle of Omaha struck his private deal with Goldman Sachs. The investment was a boost of confidence at that time but didn't prevent the index and GS shares declining around 24% and 33% for the rest of 2008. GS traded at USD120.78 the day before Buffet invested and it is now trades at USD109.84. Such observations are not the points I want to make -- that is, as a market opportunist, Warren Buffet indeed takes advantage of distressed market/companies and brings some returns to his investors. However, within the context of human history, Steve Jobs stands out as the winner based on his contribution to the advance of technology and the improvement of ordinary people’s life quality. Steve Jobs is the true GOD!

That said, the Friday’s Jackson Hole meeting was a non-event as Chairman Bernanke did not announced the bazooka a few were hoping for. On the other hand, he described the short and long-term factors behind a WTE US economic recovery but also explain the remaining challenges. He mentioned Fed has a range of tools to use and will use them when appropriate. He remains optimism on the LT growth potential of the US, but what would he expect otherwise? More importantly, he did not mention the risk of a double-dip. By doing so, he also established the Fed limits to act on LT growth drivers, acknowledging that monetary policy is constrained to turn things around by itself, particularly, it can do very little to solve the structural issues. However, he indicated there is scope for further Fed action to influence the cycle, and announced the September (21/22) meeting would be a two-day event, which would likely generate expectations that some new announcements could be coming out of it. An interesting observation is that Bernanke turned the attention to fiscal policymakers both to warn them against overly-hasty fiscal consolidation and to chastise them for the harm caused by the debt ceiling mess, stating that "the country would be well served by a better process for making fiscal decisions." The Fed, for its part, "will certainly do all it can to help restore high rates of growth and employment in the context of price stability," though it was clear from the gist of Bernanke's remarks that more could be done by other policymakers, both in Washington and in Europe.

Clearly, Chairman Ben’s speech is bad news for those expecting a miracle from Jackson Hole. But in general he also puts a floor to the market kicking the can forward to September. In my own views, the Street is much more realistic now than before as the Chairman has previously noted two preconditions that are needed before undertaking further QE --- 1) persistent economic weakness and 2) the re-emergence of deflationary risks. There is growing evidence to support the first condition but the second conditions are unlikely to find support as long as prices are rising and remain elevated. Indeed the inflation report last week confirmed the continued strength in headline (3.6%) and core CPI (1.8%) in July. The 5yr BE inflation was 1.67% on Aug19, 2011 up from 1.13% on Aug24, 2010, according to BBG. Looking forward, one obstacle is that the economy is particularly hard to read now as "We don't know what's going to happen in the next two years," according to Alan Blinder, a Princeton professor and former Fed vice chairman. That makes it even more difficult than usual for the Fed to manage market expectations as it is trying to do. Another obstacle is the risk that inflation doesn't retreat as the Fed expects, or rises, which could force it to raise interest rates sooner than promised, damaging its credibility. Mr. Bernanke correctly predicted that commodities prices would retreat from highs earlier this year. Yet underlying inflation outside of commodities has advanced more than expected, a surprise to some at the Fed given the economy's weakness. Three key dates for the Chairman and the FOMC going forward are: 1) FOMC minutes released Aug 30; 2) Sep 8 Bernanke speech. This meeting will be post ISM and payrolls and, importantly given his comments on fiscal policy, post the President's jobs initiative; and 3) Sep 21 FOMC meeting.

Amid the diminished hope of further policy support, the week saw LO equity funds recorded outflows of USD2.9bn (7 straight weeks of redemptions), while ETFs saw bigger inflows (but most likely represent short interest). Bond funds received inflows of USD0.9bn after 3 straight weeks of outflows, and Gold had its biggest weekly redemptions (-$2.2bn) on record (since 2005) after CME announced a 27% increase in margin requirements (Initial margin rose to USD9450 from USD7425 per 100-ounce contract; maintenance margin rose to USD7000 from USD5500). Fundamentally, the past 3 weeks of financial market panic have cast fresh doubt on the economic outlook. Global financial conditions have tightened significantly in recent weeks, with global equity prices down about 15% from the recent peak, and interest-rate risk spreads having widened. Part of this sell-off is attributable to a sense of policy paralysis in US and EU, of which there is no cavalry to ride to the rescue. Fiscal policy has turned restrictive and an additional sharp tightening lies just ahead in US, while monetary authorities have exhausted much of their ammunition. In addition, I am also concerned about the sharp drop in business and consumer expectations in US and Europe in August (see below section). That said, although quantifying fully these downside risks is not easy, the possibility of a US recession may now be as high as 1 in 3, and that of an eventual (but not imminent) Euro area crisis may be as high as 1 in 2. Despite these increased risks, the story remains as it was before the latest volatility in the markets --- US is drowning in debt, Europe is imploding as problems in the euro area intensify, while, in contrast, Asia‟s economy is cooling, as growth rates moderate from a strong to a solid pace. It should be little surprise that there is increased uncertainty, greater volatility and heightened risk aversion across financial markets.

In fact, the two biggest risks as a result of the latest developments are --- a double-dip recession in US; and an escalation of problems in EU. The trouble is that either of these could trigger the other. Any collapse in confidence that leads to a US double-dip would likely feed on problems in EU; and any problems in Europe would likely trigger further market turmoil and possibly trigger a double-dip in the US. The risk of either of these events is non-negligible. Thus, these risks need to be taken seriously. That said, the world economy is still growing, and while this latest crisis will hit confidence hard in the West, there are some offsetting positives, particularly as lower oil prices, declines in bond yields and easing supply chain disruptions from Japan will provide some support to a fragile US and world economy. Indeed, I do expect these factors to allow US to grow, albeit at a sluggish pace in 2H11. The trouble is, there is little momentum! By early 2012, another round of Quantitative Easing (QE3) may be necessary. This will not do much to help US, but as last year, it is likely to trigger renewed flows into EMs.

With respect to the policy response, despite a few regional hawks, FOMC has already stated that policy will stay at full throttle until after the economy regains traction. This sort of open-ended support is lacking in Europe, which is the current source of greatest concern for investors. Worse, there was some backsliding in Europe again this week, with Germany (and Finland) remaining wary of proceeding further. Chancellor Merkel noted --- “The markets want to force us to do certain things. That we won’t do”. As has been the case since the spring of 2010, European policymakers will ultimately respond, although usually after the markets riot further and additional economic damage has been done.

X-asset Markets Thoughts

On the weekly basis, global stocks went up 2.47%, with +4.75% in US; +1.01% in US; +0.53% in Japan and +0.64% in EMS. The volatility index has had a volatile few weeks, hitting 48% at the start of the month before falling as low as 30. Elsewhere, 10yr UST yield slipped to 2.19%. This is 13bp above the low set on the 19th, but more than 50 below its level at the start of the month. Over the past 6 months, the 2yr (0.19%) and 10yr yields shrank at a astonishing speed, -52bp and -122bp, respectively. In Euro area, 2yr Italy, Spain, Greece and Portugal bond yields widened substantially (+163bp, +111bp, +2816bp, Portugal +891bp, respectively) on the back of market talk of Greek banks running short of collateral. 1M Brent climbed 2.16% to $111.9/bbl, while CRB index up +1.75% to 335.25. EUR strengthened 0.71% to 1.4499USD. JPY was largely flat at 76.64. DXY dropped below 74 and closed at 73.81.

Looking forward, the danger for the risk markets is clear --- if there is no growth, then asset prices will keep eroding, which undermines bank capital and business/consumer confidence. A downward spiral could develop à la the 1930s, or at least a Japanese-type of near stagnant economic outcome. The lesson from these episodes is that a debt deflation can take hold if policy reflation arrives too late. Although the financial markets seem to be reacting harshly, confidence is fragile, and once broken it can take a long time to repair. Rumors of bank funding problems have appeared, with CDS spreads for some European banks up to levels seen in the autumn of 2008. Various markets and sectors are reaching valuation extremes, which are either very worrying or very enticing if a grim economic outcome does not occur. I think investors should proceed cautiously until there is a resolution to the European debt crisis.

That being discussed, central bank hawks in the major countries continue to sound out of step with the times. Worries about new excesses, including stoking an inflation spiral, are misplaced if economic activity does not improve (lessoned learned in Japan in the past 20 years). These attitudes are reminiscent of the “liquidationists” of the 1930s, who acted as if America had sinned, and the country had to cleanse itself with wholesale bankruptcies and massive unemployment. Meanwhile, German Finance Minister Schaeuble was quoted this week as saying… “We cannot have a uniform interest rate level (across Europe). The different rate levels are the incentive to run a solid economy or the punishment if you are not running it properly”. I am sympathetic to this view over the long term, but the time for such orthodoxy was 10-30 years ago. Absent growth, even Germany will go down the tubes. Although inflation tends to be stickier in Europe than in US, headline inflation is set to decelerate and there is plenty of labor slack in most countries. Europe should not be preoccupied with inflation since it is fighting a debt deflation problem.

While the above discussion is gloomy, one must keep in mind that asset prices already reflect considerable economic pessimism. For instance, 10yr UST yields are at levels reached during the depths of the last recession at the end of 2008. At that time, deflation fears were rampant and the banking system had seized up. The economy is not in great shape today, but is certainly much better than late 2008. Inflation is not in negative territory, and banks are at least functioning again. USTs have been downgraded and pessimism on USD is more entrenched, yet UST are well bid, indicating high risk aversion. In fact, the current 2yr Swiss bond yields are negative, which investors are paying for the privilege of ensuring the security of their capital! This kind of risk aversion can’t last. Regarding to asset markets, equity and corporate bonds are attractive unless profits contract sharply in the coming year. Profits have performed strongly despite the anemic economic performance since 2009. Valuation wise, stocks are at multi-decade inexpensive levels compared with government bonds. Dividend yields are higher than government bond yields in many countries, underscoring that if Armageddon can be avoided, then excellent opportunities loom in. In terms of strategy, investors could start o UW stocks voer bonds, given three conditions --- 1) concrete action by Europe to provide open-ended support for all member sovereign debt markets; 2) reassuring US economic data, especially in the form of jobs and consumer spending data; 3) PBoC announcement of a shift in monetary policy to support growth.

Back to home market, EM Asia has registered a sharp USD2.6bn outflow last week (YTD -11.5bn), as macro concerns triggered a flight to safety among investors. While this down-move could persist, I expect that Asia will, on balance, outperform DMs during this period given its inherent stronger fundamentals. The other angle is to look at relative valuation or whether the current situation would be as bad as 08 or not. While this debate will continue, it is appropriate to look at the current market valuation vs. 2008. MSCI AxJ’s PB is currently trading on 40% premium to its trough value during 2008. Also during 2008 earnings were downgraded 44% but we have only seen downgrades just started in Asia. Thus, should we apply the same magnitude of earning cut to the current valuation of 9.6X PE 12 for MXASJ, then the valuation would get boosted to 14.2XPE which is at a premium to its historical average of 12.7X PE, implying downside risks as well.

The Large Declines in Confidence

This week’s economic data confirmed the sharp slowing in economic growth (without yet pointing to recession) and large declines in consumer and business confidence (which could yet lead to recession). In terms of confidence, the problem is not so much the level, but the steepness of the declines in August are the focus of concern. In US, the August UoM consumer sentiment index looked pretty lousy. The headline index tumbled from 63.7 to 55.7 (previously 54.9) between July and August. A sharp decline in sentiment regarding government economic policy was the main factor behind the large drop in sentiment, but several of the survey’s components weakened substantially between July and August. The current conditions index fell from 75.8 to 68.7 (previously 69.3) and the expectations index dropped from 56.0 to 47.4 (previously 45.7). The headline index and these two main subcomponents reported for August were all at levels generally seen during recessions. This is in line with the first revision to Q2 GDP (+1.1%) which sees a slip from the originally-reported +1.3% on weak trade and inventories data. Looking ahead, consumer confidence of Conf Board (Aug 30) and ISM (Sept 1) could confirm we are already in recession if they come under 44 and 46, respectively.

Across the ocean, Euro area consumer confidence dropped 5.4pts, the second largest monthly decline since 1985. The German IFO index dipped for a second straight month in August. The headline business climate index dropped 4.2pts to 108.7. This was caused by a near-record drop in expectations (-4.9pts) and a large fall in current conditions (-3.3pts). In contrast to the sharp drops in confidence, the more narrowly output-focused PMI survey actually surprised a bit on the upside—rather than declining, the composite output index held steady at a low level of 51.1 in the Euro area. Also, one must not overlook risks from what might call left-field. These include countries with large deficits. Turkey, with its large current account deficit equal to 9% of GDP, is the biggest worry. Vietnam is a large concern too, as are some eastern European economies such as Hungary, where the surging Swiss franc (CHF) poses key financial stability issues, given the volume of CHF-denominated mortgages and their close links to western Europe. In a volatile market environment, a shock in any one country could have far-reaching consequences.

Despite the subdued outlook for US and Europe, I am looking for somewhat stronger growth in EM Asia in coming months as the region’s manufacturing sector begins to grow again following an aggressive inventory adjustment. China’s PMI did not give a clear signal in this regard; on the positive side, the indexes of output and export orders bounced, while the index of finished goods inventory declined. However, as noted above, the index of total new orders retreated 1pt to 49.2, implying a sizeable drop in domestic orders. Elsewhere in EM Asia, Taiwan reported that output rose 1.4% mom in July. This is an encouraging sign that the severe, nearly 25% annualized drop in output in 2Q finally realigned production with sales. However, the risk of a technical recession (two consecutive Qs of sequential GDP decline) for Singapore in 3Q11 has risen because of WTE manufacturing output last month. The monthly MPI rose 0.3% mom SA or 7.4% yoy, below consensus of 7.8%. Meanwhile, though EM central banks are moving to the sidelines, there is residual tightening taking place. Bank of Thailand hiked policy rates 25bp to 3.50% last week.

It is not a surprise to see Citi group’s global economics team cutting 2011 global GDP growth forecast from 3.4% last month to 3.1%, and cutting 2012 global growth forecast from 3.7% to 3.2%. This is the seventh biggest monthly cut in Citi’s global growth forecasts over the last 10 years. As a result, they now expect a long period of ultra-low and stable policy rates for the US, Euro Area, Japan and UK. In addition, the ECB's liquidity assistance program will probably continue to keep overnight rates well below its policy rate, perhaps for the next 2-3 years. At present, no further QE is expected from the Fed, but this could come into play if deflation risks re-emerge. Despite the UK's above-target inflation rate, the BoE might well set a lower hurdle for QE, requiring just the expectation of sustained economic weakness and inflation undershoot rather than the re-emergence of worries of outright deflation. Citi also expects broadly stable interest rates in EM over the next year, and is not anticipating the widespread rate cuts that are currently priced into bond markets, thanks to inflation persistence and the scope for macro-prudential loosening. The shift in growth expectations has had a profound impact on equity, credit and commodity markets. Oil and copper are seen as the key plays on global growth, and have weakened; gold is seen as a safe haven and has rallied. Despite worries about its debt, US bonds are still a safe haven. How investors and funds react varies greatly, influenced by many factors. Often in such an environment, liquidity issues can be a driving influence, although leverage is far less of a concern now than before and asset destruction can force positions to be closed, adding to market movements.

ECB’s Three Interrelated Troubles

Staying on Europe, the latest update is that the German President questioned the legality of ECB's purchase of peripheral bonds. But ECB continues with its purchases of Italian and Spanish bonds, with amount rising to EUR36bn in the first week and a half of interventions. Moreover, the French PM announced a EU12bn budget deal by raising taxes but at the same time pulling back growth forecasts from 2% and 2.25% in 2011 and 2012 to 1.75% in both of those years. That said, the latest concern is the potential for Finland’s unilateral deal with Greece, which called for it to receive collateral against its EFSF lending, to derail the entire deal. Clearly, the demand for a 20% cash deposit held against the Finnish support is too penal to be generalized. Finland has indicated a willingness to seek a compromise. However, the details are unclear, and the squabbling in the meantime has created doubts about whether the support package can be delivered, pushing yields on Greek debt to a new record of 44.9%. While Finland may have asked for too much collateral, concerns are building that Greek banks have too little. Deposits continue to flee the Greek banking system. The banks are reaching the limits of their ability to replace that funding by borrowing at the ECB’s regular repo operations, as their pool of eligible collateral is close to exhausted. As in the Irish case, the National Bank of Greece is believed to be preparing Emergency Liquidity Assistance for the domestic banks, providing funding to them, albeit at higher rates than from the ECB.

Elsewhere in the region, elevated spreads between rates on funding to banks and expected official rates reflect ongoing solvency concerns, but funding markets continue to function with ECB liquidity provision acting as a key backstop. According to the Irish Times, a 41-page leaked draft proposal has apparently proposed to give the EFSF more authority. The proposal has been denied by a senior CDU member who said that passing parliamentary controls over bailouts to the EFSF would "definitely not happen". The July 21 package agreed to by Euro area leaders offered further support for Greece and extended EFSF powers in an attempt to limit contagion. However, a number of road blocks still lie on the path toward getting the package ratified by each member country. Divisions have become evident within ECB. Germany, in particular, seems unsupportive of the move to buy Spanish and Italian debt. Although the ECB’s move has helped ease pressure on bond yields in both those countries, it has added to political concerns in Germany. There, some politicians feel support for the euro project is justified, whatever the cost. However, the majority it seems, including the current leaders, fear it is a case of Germany throwing good money after bad. Hence, whenever help is offered, whether to Greece earlier, or Italy now, tough conditions are attached to it. Italy, for instance, is pushing through measures to balance its budget by 2013 and has announced that it has implemented the Germany-influenced “golden rule” of a balanced budget. But Italy’s main problem is not its budget deficit, it is the stagnating economy. Given all this, the risk of a Euro-area crisis cannot be overlooked, or ignored.

With Euro area governments still reluctant to enlarge the EFSF significantly or introduce Eurobonds, many are looking to ECB as the only institution capable of solving the region’s sovereign debt crisis. Some suggest that the ECB should simply ramp up its purchases of government bonds through its Securities Markets Program (SMP), which it could do by creating more reserves (i.e., printing money). However, this strategy would bear huge risks, and the ECB has little appetite for following it. Instead, the central bank sees clear limits to its policy tools—it is willing to act as a safety valve against short-term stresses in financial markets but it cannot solve what is ultimately a crisis of fiscal policy and solvency. As a result, the ECB will always force the ultimate resolution of the crisis back to politicians.

It is not hard to see why some may argue that ECB could expand its B/S much more aggressively in response to the sovereign crisis. The total size of its B/S has increased around 50% since 2007, which compares to an increase of around 200% for Fed. In addition, around 80% of the increase has been driven by the more obscure and inactive B/S categories, such as valuation gains due to the higher price of gold and increases of the investment portfolios, which are held partly for operational reasons and as counterparts to the central bank’s capital. In contrast, the EUR110bn of government bond purchases make up just 5% of B/S at present. And despite providing as much liquidity to banks as they demand, the aggregate amount of lending is not a lot higher than it was in 2007. There are three interrelated reasons for the ECB’s caution. The first is moral hazard. The ECB wants troubled banks to restructure their balance sheets and raise capital so that they can quickly return to private funding markets. And it wants governments to deliver the difficult fiscal adjustments and reforms that will allow them to regain access to market funding. The second constraint is the risk of inflation. Recent experience in US and UK does not suggest any mechanical link between such balance sheet expansions and broader money aggregates, or a destabilizing impact on inflation expectations. But the context in which ECB is acting is different. The ECB does not see a need for B/S expansion to deliver price stability. And with markets questioning sovereign solvency in the region, the ECB’s purchases of bonds may increasingly resemble monetary financing of deficits, which EU Treaty forbids and which Germans fear. If people abandon the euro and move into real (e.g., property and gold) or foreign assets (e.g., Swiss francs), rising asset prices and a falling exchange rate could lead to higher inflation.

The third restraint is political legitimacy. To some, the ECB’s bond buying is a neat way of bypassing the political process that is slowing the fiscal response to the crisis. This ignores the fact that Germany is dragging its feet for a reason— its population and government think that the bailouts make sense only if the periphery “does its homework.” The ECB does not have the political legitimacy to purposefully undermine this position by purchasing ever larger amounts of the peripheral bond market, a point made this week by the German President Christian Wulff. The SMP purchases (EUR110bn so far) and the liquidity support to peripheral banking systems (around EUR325bn so far) already imply a huge socialization of liabilities across the region. Should this result in losses for the ECB, the central bank would need to be recapitalized or retain future profits. Politicians in the core countries know that their taxpayers are already on the hook for the ECB’s exposures, and are unwilling to sponsor them increasing indefinitely. The ECB’s actions remain a huge source of support to the region, and the central bank is justifying them with reference to its mandate: ensuring financial stability by supporting banks, and delivering price stability by improving the functioning of the monetary policy transmission in the bond market. Its independence, however, is strongly rooted in European treaties, which means politicians cannot coerce it to ramp up or even continue with its SMP purchases against its wishes.

Pork Prices Keep Popping

The most eye-catching news for China last week is that People’s Daily comments China still face great difficulty to achieve its inflation target of 4% in 201, citing reasons, including 1) high inflation expectations; 2) input inflation pressure remains; 3) rising labor cost persists; 4) uncertainties about supply-demand for the autumn crops and pork prices; 5) price conflicts of resource elements. In fact, NDRC reported that pork price continued to rise last week, with piglet ex-factory price +0.8% wow and piglet wholesale price +0.6% wow. Since corn wholesale price was up by 0.83% as well, pork/feed price ratio remained steady at 8.14X. Given the breakeven level is about 5.5x, I am looking for more supply coming in the next few months.

Entering into Friday, markets are whispering about an RRR cut over this weekend. There are two different versions – 1) the first one says that a globally coordinated response could be formulated at Jackson Hole. According to this version, China will participate in this global effort by cutting RRR and releasing liquidity; 2) It says that the PBoC plans to broaden the base for reserve requirement (especially corporate’ cash deposits for obtaining bankers’ acceptance). But to offset the liquidity squeeze of this broadening base, the PBoC will cut RRR simultaneously. The second rumor turns out to be true as PBOC broadened lenders’ reserve requirements to cover margin deposits, a move that may drain RMB900bn from the banking system over six months. Reserve requirements will now cover margin deposits paid by banks’ clients to secure issuance of bankers’ acceptance, LOG and LOC. Such deposits were RMB4.4trn at the end of July. The net effect of the reported rule change, if everything else was unchanged, would be to tighten monetary policy and have an effect equivalent to a 120-130bp increase in RRR. In fact, Since 2008, China has already raised RRR to record levels to counter inflation running at the fastest pace. RRR for China’s biggest lenders stand at 21.5% as Premier Wen seeks to cool consumer and property prices and limit the risk of asset bubbles after record lending.

From macro perspective, there is more downside risk in global equities, but Asian countries, in particular China, have the ability to reflate their economies and look attractive. MSCI China is currently trading at 8.2x PE12. If using a 10% CoC, the market is pricing in negative growth. This is not sensible unless market is oversold or pricing in large cut in earnings as in 2008. So far, 1H11 earnings are likely to be strong with 55% of stocks having reported. 58% of companies beat expectations and 22% disappointed. Sector wise, consumer, cement, power equipment, property, and banks reported strong 1H results while consumer staples, steel, IPPs reported disappointing results. Using 2008 for guidance, earnings were cut by 34% from mid 2008 to mid 2009. The earnings revision was led by industrials, materials, property, and consumer discretionary. 2009 earnings cut overshot and was eventually marked back-up by 8%. 2010 earnings was marked-up by 30% due to policy response. Given the belief that the outlook is as dire as in 2008 and China is better prepared, I think 8% GDP growth remains the line in the sand. ……Lastly, regional wise, MSCI China is now traded at 9.6XPE11 and 19.8% EG11, CSI 300 at 13.1XPE11 and 25.1% EG11, and Hang Seng at 9.9XPE11 and 23.1% EG11, while MXASJ region is traded at 10.9XPE11 and +10.7% EG11. 

USD Losing Safe-haven Status?

What is the next stage of this crisis? Could it be problems for USD? Even though USD is still seen as a safe haven by many, benefiting from heightened risk aversion – it is not clear-cut that this will remain so. LT concerns about the USD must surely have risen. For instance, debate within the Gulf about the tie to USD has surfaced again. More questions have been asked in the last few weeks about its status as a reserve currency. Yet, there are few alternatives for now. Some currencies are benefitting in the current turmoil, including JPY, CHF, SGD and some commodity currencies (AUD, NCD, CAD and NOK). Japan and Switzerland have already intervened in their currency markets, and could do so again, while Singapore has pushed its interest rates sharply lower.

That said, based on the recent performance of USD, the market may send a sign that USD is losing its safe-haven status. Since the bursting of the tech bubble in early 2000, USD has been inversely correlated with risky assets. However, the recent weakness in USD is at odds with the historical relationship. Despite the sharp sell-off in global equities and spike in volatility, USD has not strengthened with DXY near multi-year lows. In the past, there are three key reasons why USD strengthens during times of financial stress --- 1) global capital flocks to the safety of USTs; 2) US investors stop sending their savings abroad (and even repatriate capital; and 3) US trade deficit narrows during recessions. This time around, however, the safe-haven factors have not turned in favor of USD thus far, even though it is premature to make definitive conclusions due to data lags. US macro policies are the obvious reasons for the Dollar’s diminishing role as a refuge --- fiscal policy is a mess and Fed is committed to devaluing USD. While economic policies outside of US are hardly picture perfect, FX is a relative game. Policies only have to be "less bad" than US to win. Overall, the risks to USD are becoming increasingly asymmetrical. Reflationary US policies will weaken USD with diminishing support coming during periods of “risk off”.

In contrast, fundamentally, there are many reasons to argue that Asian currencies should be stronger. This may well become the focus, perhaps next year. Indeed, the firmer RMB recently, particularly ahead of the recent RMB bond issuance in Hong Kong by the Chinese authorities, naturally caught the market’s attention. The combination of low US rates, plus the possibility of another round of QE in the New Year, may encourage asset diversification away from the West, towards the East, as we enter 2012. This is likely to bring a repetition of the problems of last year, with increased asset price inflation in Asia, as equities and real estate prices rise. Given this prospect, controlling capital flows and intervening to stem currency moves may be an ongoing issue across emerging economies over the coming year.

Good night, my dear friends!