My Diary 700 --- China’s Risk Premium: Systemic Risks vs. Growth

 

My Diary 700 --- China’s Risk Premium: Systemic Risks vs. Growth Risks

Sunday, October 30, 2011

“The Systemic Risks vs. Growth Risks”--- Tired after the 7 days trip and thus I would keep this diary short! The week saw global risk assets had the strongest weekly run since 1974 on the back of the announcement of EU leaders’ rescue plan, BTE earning results (SPX 324/500 reported & 70% surprised on the upside) and better market sentiment (VIX -21.68%) as a result of more M&A news including Oracle buying RightNow, Google buying Yahoo and Cigna buying HelathSpring. On the other hand, US macro data was in a mixed bag with BTE durable goods ex-transportation (+1.7%), new home sales(313K), personal consumption (+2.4%) and UoM (60.9) while consumer confidence (39.8), housing price index(-3.8%) and pending home sales (-4.6%) fell short of expectation and the initial jobless claims (402K) was slightly HTE. The 3Q US GDP was in line at 2.5%. The focus of last week was of course on the development in EU debt solutions --- 1) the boost of EFSF from EUR440bn to EUR1.4trn; 2) 50% haircut on Greece debt; and 3) a boost of banks capital to 9%. The key to watch next week will be --- 1) Nov 2^nd FOMC meeting during which the policy makers will clarify benchmark they want to reach before it is ready to raise borrowing costs; and 2) November 3^rd-4^th after the G20 meeting.

In China, the market optimism was triggered by Premier Wen’s first time comment that the government would “fine tune” economic policies at an “appropriate time”. This gesture was a follow up action after Huijin announced buying the big five SOE banks (which based on history should signal a bottoming of the market soon) and the government’s recent reiteration of encouraging lending to SME (though this is nothing new). Then towards the end of the week, MoF said they would change business tax to VAT for the service and transportation sector in Shanghai starting January next year. The impact of this is unknown but the message is clear and that is the Government is leaning towards more easing than tightening on the economy. In addition, Jiang Weixin, Minister of Housing and Urban Rural Development said that the government was forced to impose the limit on home purchases that was rolled out in 40 cities this year and will eventually replace them with a housing data base that will gather information from banks and tax offices. On the economy, HSBC PMI came out above 50 (after the previous two times under such critical level) which gave relief to the market on the chance of hard landing in China. Earning wise, A-share market is in the middle of reporting season and so far 640 out of 917 companies have report with an average of 23% growth yoy which trailed analysts’ estimate by 4.2%.

That being discussed, I think the latest rally of China markets is due to the decline of excess risk premium, which was caused by the dominating views of “systemic risks” among the global investors’ minds since early September. Bases on my last week’s trip to China, of which I visited a few dozens of companies and industry experts in the most distressed sectors like Railway, Property, Construction Equipments and Textile Export, I believe that those China bears with a view of “systemic risks” seemed clearly overdone or they do not see the reality under the media reports in the WSJ or Financial Times. As a whole, China has ample financial and revenue resources to resolve or control the current idiosyncratic risks emerged in some sectors or regions. For example, the solvency risk of the railway sector has been gradually resolved if one noticed the 16.87X Bid/Cover ratio of the RMB20bn railway construction debt issued in the past week. Before the year-end, through the RMB100bn of railway debt issuance and RMB50bn bank loan arrangement, the whole sector will resume its normal operation. In fact, the railway sector is currently under the close watch from two of Vice Premiers (Li Keqiang and Zhang Dejiang) since the national meeting on September 23^rd. The government related trust products (about RMB1.5-3trn) were largely guaranteed by the local government’s budget revenue, which essentially carry the same credit risk as the central government. It is widely known that the total amount of fiscal revenue of China in FY2011 is expected to reach RMB 10trn, which in turn explains well why the government has the confidence to hold up its tightening policy stance in general. Meanwhile, in the city of Ningbo, another hub of China export manufacturers, business owners look quite calm as they have experienced many up & down cycles over the past 20 years. They have learned ti keep their balance sheets quite healthy. Given that NingBo had USD82.9bn merchandise trades in 2010 (vs. Wenzhou @ USD17.09bn), I think the journalists from WSJ sound “’penny wise, pound foolish”.

Having said so, the underlying risks of Chinese economy come from two fronts --- the export slow down in the short-term and the demographic trend in the long-term. During the trip, I got to know a 65-year old business man, who is acting as a container shipping agent between China and Taiwan. Mr. Yip Kok Chong started his business in 1993 and has been in the shipping industry for more than 18 years. He commented that “… the 4Q11 is even worse than 4Q08 … To me, this year is over and I am going back to Australia for vacation…” He shared with me that his Ningbo clients have not seen much orders from US and Europe, which is same to what Miss Clinton said early in Shenzhen that US is not likely to buy more this year. Mr. Yip thinks the worst time will arrive in 1Q2012. In addition, the labor shortage is being mentioned a few times by local business owners as a monthly salary of RMB3000 (saving RMB1000/month) is not attractive to a migrant worker who earns RMB2000 but also save RMB1000 per month in his or her hometown in the inland area. Staying with family vs. having a higher pay is not a difficult choice any more for young workers when they face a job offer. This reflects the change of “value” in one’s life among the 80s-90s generations in China compared with people born in 1970s or earlier.

To the macro policy markers, the migrant workers’ life and pay dilemma seems not as big as the demographic issue, In fact, the speed of Chinese population turning older is 3X as fast as that of US population, and this demographic trend would definitely raise more concerns on growth and more pressure on inflation in the future. In my own views, the inflation pressure is clearly going up, and the policy makers will have to carefully utilize their tool-kits going forward. However, the growth of China economy may not slow-down as much as the China bears expected in the coming years. There are a couple places to help sustain the 8-9% of GDP growth, based on the economists’ views --- 1) the labor productivity in China is still low. Currently, China’s average labor productivity is only 62% of American’s in 2009; 2) China’s retired population has strong willingness to work. Currently, China has about 55mn retired labor at 60-65 years old, and this pool will reach 75mn by 2020; 3) China has 83mn of handicapped population, which could be trained and help contribute to the economy. I think the point 1) and 2) are doable and there is international examples of best practice. In 1983, the US government raised the retirement age from 65 to 67. But the problem is the actual implementation of this policy has to wait for another 10 years. Thus, Chinese government has to act a bit earlier before the economy runs out of labor dividend. All in all, given the expected growth risks in the coming quarters, I would think the current “bear market rally” is worth a caution here.

X-asset Markets Thoughts

So much for the updates for China, and let us take a look of asset market performance latterly. On the weekly basis, global stocks jumped 5.01%, with +3.81% in US, +4.14% in EU, +4.01% in Japan and +9.79% in EMs. In Asia, MXASJ closed up 9.67% and MSCI China +13.5%, while CSI300 +8.02%. Elsewhere, 2yr USTs yields added 2bp to 0.29% while 10yr +10bp to 2.32% and 30yr +11bp to 3.38%. Excluding Greek bonds, yields across the Euro area periphery were largely flat with Greek, Portugal, Spain and Italy 2yr yields -117bp, +22b,-6bpp and +30bp, respectively. The 3M Euribor-OIS added 4bp to 78.2bp. 1M Brent crude was flat @ $119.91/bbl. The USD weakened 1.81% to 1.4147EUR and 0.60% to 75.82 JPY, the highest level since WW2. CRB gained 3.85% to 323.07, while Gold price was up 6.44% to $1742.2/oz. Regarding the valuation, MSCI China is now traded at 9.9XPE11 and 18.0% EG11, CSI 300 at 12.5XPE11 and 22.4% EG11, and Hang Seng at 10.2XPE11 and 21.3% EG11, while MXASJ region is traded at 12.0XPE11 and +6.4% EG11.

In terms of the specifics of thee area Plan, not all of the details were announced. A specific ring-fencing of the major banks didn’t occur, although investors may now believe that such a move would happen if a bank run took hold, i.e. there may not be a definitive Lehman-type event, just a near miss. Bank capital raising will be a challenge and may increase credit strains. Still, while not complete, the Plan was specific and, unlike the past 18 months, the politicians didn’t say “we have done enough and will stop”. While the financial sums on offer were not open-ended, there is a commitment to continue the process. Investors have to decide whether the politicians will see the project through to completion, or come up short. Gold prices say they will succeed --- prices held at their moving average and are rebounding, indicating reduced concerns about debt deflation and a shortfall of liquidity. Gold prices were far weaker in 2008, and indeed US made some big blunders in the autumn of 2008. Perhaps, in the end, Europe did learn from the US mistakes and Euro area politicians are finally on the right track to contain the crisis. They have positively surprised the markets by agreeing to a broad package that should help stabilize their sovereign bond markets and the banking system, as well as provide a more realistic haircut for Greek debt. Indeed, Europe still faces a long economic and financial workout, and the Plan could yet derail, or at least get bogged down. However, the risks of global economic and banking contagion have been significantly reduced (or in other words, the system risks declined). As a result, I think this means it is time for investors to return to those asset markets which offer good long-run growth opportunities, primarily EM, commodities and related currencies.

Looking ahead, the path of US markets in 2008 and early-2009 is likely to replay in Europe. There will be considerable skepticism in the coming months with regards to Europe, especially given the complex and frequently dysfunctional political process. The Euro area still faces many serious challenges. European equities and EUR have had a nice bounce this week, but may yet suffer setbacks given prospects for a recession – much as hit US equities in the opening months of 2009. The investment plays on the healthy parts of the world diverged from the SP500 from late-2008 until March of 2009, as banking contagion fears eased while US stocks continued to be shunned because of earnings uncertainty. A replay of sorts, with Europe replacing the U.S., would not be surprising. In other words, the European economy is likely to suffer a prolonged period of weakness, a muted subsequent recovery with periodic setbacks, and persistent political squabbling. Conversely, the EM world and the healthy DM economies rebounded strongly in 2009, and I expect solid growth in these countries in 2012. Macro wise, this week’s Q3 GDP report confirmed that US economy is not sliding into recession. But what concerns me is the massive gap between survey sentiment readings and economic activity. Both consumption and business investment are holding up better than expected. An improvement in confidence should at least allow the US to maintain a muddling recovery. If so, then risk assets will rally, especially if the soft landing outlook for China pans out. The key is for global economic confidence to revive after the sharp souring in sentiment in recent months. Moreover, if Fed and other central banks keep government bonds yields pinned down, and prevent a rebound in yields as occurred in early 2010 and early this year, then this will provide economic insurance and further increase the allure of equities and commodities

With respect to currency, neither EUR nor USD is attractive from a global perspective, and both should depreciate on a TW basis over the long haul. In relative terms, it is a toss-up as to which is the "ugliest horse in the glue factory". That said EUR/USD cross rate bounced this week on the news of a Plan, and should settle into a trading range now that interest rates between the U.S. and the Euro area have almost converged. Looking ahead, In terms of the variables that drive currencies, there is no clear winner --- 1) US economy has outperformed Euro area in recent quarters, and should continue to do so; 2) The political backdrop is grim in both. Europe has grabbed the headlines in recent months, but Washington is also paralyzed and unlikely to move forward until after the Presidential election; 3) USD is somewhat cheap relative to EUR based on most traditional measures, but the US has larger and more intractable CA and trade deficits; 4) Going forward, neither central bank is likely to move sufficiently to effect the EURUSD cross rate. The Fed is talking about QE3 if the economy struggles, whereas the ECB may soon lower rates (although the policy rate is only 1.5%). Both central banks are far away from the next tightening cycle.

Good night, my dear friends!