My Diary 727 --- Policymakers behind the Curve; Keep your Eyes o

My Diary 727 --- Policymakers behind the Curve; Keep your Eyes on Paris; No Surprises in China; The LT S&D Function of Commodity

Tuesday, July 10, 2012

“The world is now ‘drug’ addicted or alcoholic” --- The Summer of 2012 is evolving sadly similar to that of 2011 in many perspectives --- 1) an EU leaders’ summit leaving more questions than answers, 2) a US economy slouching partly on Europe and partly on domestic fiscal neurosis, and 3) a Chinese economy unable to provide a meaningful offset. One of the major difference is that investors did not react proactively to the multitude of liquidity and structural boosts, including QE plus subsidized loans from BoE for amount to GBP150bn, interest rate cuts by ECB and PBoC, agreement expedite EUR120bn of structural funds by EU as well as tentative agreement to eventually directly capitalize Euro zone banking system, resumption and extension of operation Twist by Fed, and significant reverse repos by PBoC. The other material difference between this year and last is that investors enter this environment quite long of USD rather than short. That being said, for the most of time, investors were watching the same movie over and over again, given that the major central banks running out of the conventional armors in the policy toolkits, and that there were diminishing risk/reward benefits of unconventional measures. Eventually everybody gets tiring and the markets require larger and larger injection of stimulus to have an equivalent impact ……The same symptom as Drug Addiction!

Macro wise, global LEIs are still pointing down with JP Morgan all industry PMI index dropped 1.8pts in June and stands well below the level consistent with 2Q GDP forecast (+1.8% yoy). A significant fall in the manufacturing output index was expected, but the large drop in the manufacturing new orders and services PMI was a disappointment that raises concern that final demand growth might be WTE. Tempering this concern is the modestly upbeat signal from global consumers.  Regionally, manufacturing PMIs in US, Euro zone and China are all below the 50 boom/bust level. In short, global growth appears to have stalled and while policymakers are responding, they remain behind the curve.

Although there were several policy responses over the past week or so, more are needed. The June 28/29 EU summit made two important steps towards debt metallization, which I believe is a key component to ending Europe’s debt crisis --- 1) the recapitalization of Spanish banks will occur directly from the ESM, as opposed to indirectly through a loan to the Spanish government, and 2) the ESM will be able to buy government bonds in the secondary market. Despite these favorable steps, there are growing concerns that the size of the ESM will be insufficient. With EUR100bn already pledged to recapitalize Spanish banks, the remaining firepower of the ESM is only EUR400 bn. It will probably take another “market riot” to force their hand.  Across the Ocean, it is the second time in a month that PBoC cut interest rates. This is a clear sign that Chinese officials are worried about the economy. I think this is a positive development, but it is too soon to conclude that the easing in monetary policy is sufficient to boost growth.

Then in the US, economy is calling for more stimuli. GDP growth appears to have decelerated even further during 2Q12 to around 1.5%. Employment growth has averaged just 75K in the last three months. This is only half the pace needed to keep up with the growth in the working age population. Weakness in the labor market is decidedly pronounced as a condition that highlights the potential for weaker consumption going forward, which still represents something like two-thirds of total GDP. And the data followed disappointing readings in other indicators (ISM Manuf =49.7) which paint a gloomier picture for the broader economy. Meanwhile, nothing can be expected from fiscal policy ahead of the November elections. Therefore, the onus to support the economy is entirely on the Fed. The next step will be for Bernanke to announce QE3.

On the Euro zone front, the finance ministers meeting is a clear focus for the market following the deterioration in sentiment sparked in part by Friday's press reports indicating that Euro zone sovereign governments would be fully liable for any loans taken to support their respective banking system. That undercut the message and the apparent spirit of the EU summit the previous week, and clearly undercut an already struggling EUR as well. Indeed, it looks to the markets that many of the key players are implacably opposed to giving any impression of being pressured by market rioting into adopting policy decisions. The bearish sentiment in and towards the Euro zone was also evident in a German Treasury bill auction, where negative yields partly reflects intensified flight-to-quality concerns in the region. Germany auctioned EUR3.29bn in 6Mos bills at an average yield of -0.034% vs. the previous auction last month which drew an average yield of 0.0077%. I think the ultimate resolution to the crisis hinges on a very simple concept. For EUR to succeed, risk in sovereign bond markets and banking systems has to be shared across the whole Euro area. Without such a risk sharing, Europe’s economic and monetary union is an inherently unstable system in which risk can be underpriced or overpriced for long periods of time. And this makes economies and financial markets continually vulnerable to destructive positive and negative feedback loops.

That said, policymakers will need to repeatedly re-affirm their commitment to preserving the global economic expansion if the recent bounce in risk assets prices is to be sustained. These conditions will keep policy initiatives and potential policy initiatives very much in the market's focus. For financial markets, a key concern is that any potential policy initiatives are perceived lack of effectiveness. Indeed, Fed funds has been near the zero rate bound for 3-1/2 years, the Fed has already purchased USD2.6trn in assets (mostly USTs and some MBSs), and operation twist has been in place since late 2011. And none of those substantial policy measures have been sufficient to support a stronger economic recovery in US. While that does not mean future initiatives won't be more effective, the track record in recent years has understandably left the market skeptical that they can work.

X-asset Market Thoughts

Over the one-month period, global equity was up +3.02%, with +1.98% in US, +4.92% in EU, +6.25% in Japan and +4.36% in EMs. In Asia, MXASJ and MSCI China added 3.64% and 2.28%, respectively, while CSI300 -4.66%. Elsewhere, 2yr USTs yield shrank 5bp to 0.26% and 10yr’s narrowed 13bps to 1.51%. 10yr Government bond yields of Italy and Spain widened +24bp (6.19%) and +72bp (7.08%), respectively. 1MBrent crude was down 0.8% to $98.85/bbl. The USD strengthened 1.63% @1.2291EUR and strengthened 0.3% to 79.24JPY. CRY index was boosted by 7.3% to 292.7, while Gold price were largely flat at $1584/oz.

Looking forward, I think the slowdown in global growth is well known and should have been largely discounted. I believe the current market sentiment are too pessimistic about the global growth outlook and I hold a +VE bias toward risk assets on a 6-9 month horizon. Despite a recent soft patch, the US economy should stay on a moderate growth path. Meanwhile, I hold the view that a soft landing in China is the most probable outcome. In addition, global policymakers’ renewed reflation bias, assuming it persists, tilts the odds in favor of risk asset outperformance in the months ahead. Regarding to the risk side, among the key factors I will be monitoring closely for the next few months include --- 1) Euro area policy:ECB and the German government need to signal support for fiscal/sovereign policies in the periphery in the coming months, to ensure bond yields continue to decline. In particular, Italian and Spanish bond yields need to decline steadily to enable a risk-on phase to persist. A drop below 5% for Italian 10yr yields and to the 5-5.5% range for Spanish yields would be a signal that policy reflation is working, and would increase the odds of a more durable risk-on phase. 2) US NFP and ISM Data: Payrolls need to firm and return to the 100-150k (for the private sector) to stabilize economic expectations. The manufacturing ISM new orders index needs to rebound in the next two months to signal that the June data was an anomaly; 3) Chinese trade: domestic macro data will be somewhat dismissed as unreliable, so watch Chinese trade data to gauge whether domestic and external demand is stabilizing or continuing to weaken. Better trade data is crucial for risk assets to sustain any near-term bounce.

For equity investors, US earnings will dominate the asset market in the coming weeks. Indeed, the earnings outlook is contingent on global growth trends, but history suggests a major decline is unlikely unless the world economy slumps into recession. Using nominal IP growth (a proxy for global revenue growth) to forecast the yoy growth in FWD earnings expectations, we can find that a sharp slowdown in nominal economic growth is already discounted. Given domestic and financial sector weakness, a 25-30% decline in Euro area earnings (11% of global corporate profits) is probable will knock 2-3% off of the global total. Yet earnings growth should continue to expand at a moderate pace in US (48% of the global total, & Alcoa just announced earnings Beat) I would expect global corporate profits to be flat to fractionally higher this year, before growing at a solid pace in 2013. More importantly, equity valuations are compelling by historical standards, even if analysts’ earnings expectations are somewhat optimistic. Based on consensus earnings, the 12M FWD PE ratio for global stocks is just over 11X, with US trading at 12.6X, and the world ex-US at a depressed 10.6X. Thus, earnings yields translate to 8% in US and 9.5% for the world ex-US, implying exceptionally high earnings risk premium compared with government or corporate bond yields. As a result, it seems to me that, without Euro break-up, it could be a good time to pick up some high quality stocks for long-term investors.

Policymakers behind the Curve

Clearly, global growth appears to have stalled and the weakness in the world economy is widespread. Manufacturing PMIs in US (49.7), Euro zone (44.7) and China (48.2) are all below the 50 boom/bust level. Industrial production in India (0.1%) and economic activity in Brazil (-0.35%) are flat on a yoy basis, indicating economic stagnation. Although there were several policy responses over the past few weeks, more are needed. European policymakers are moving in the right direction. However, despite some favorable steps, it will probably take more pressure to encourage policymakers to adopt further measures toward risk sharing. On the other side of the Atlantic, the US economy is calling for more stimulus. Since nothing is expected from fiscal policy ahead of the November elections, the onus to support the economy is entirely on the Fed. As for China, it is a positive development that the PBoC stepped up easing efforts, since complacency would mean greater downside risks to the Chinese economy. However, it is too soon to conclude that easing in monetary policy is sufficient. 

The only silver line is consumer. After sliding steadily from mid-2007 to early 2009, global consumer confidence mounted a modest recovery before plateauing in 2010 at a level well below the pre-recession norm. The dual debt crises in Euro area and US in 3Q11 delivered a considerable shock to this already depressed level of confidence before recovery late in the year. More recently, global consumer confidence appears to be flat-lining, with aggregate index printing -0.8 stdev from its historical average in June.  Even with Europe continuing to fall, global auto sales look to have recorded their second consecutive increase last month, led by gains in US, Japan, and Brazil. And while US job growth remained soft in June, rising hours and wages reversed some of the recent weakness in labor income gains. Combined with a sharp fall in inflation, real disposable income growth accelerated to an estimated 3% pace in the past three months—its fastest gain in nearly two years. On balance, the more mixed message emerging from June releases is consistent with midyear stabilization, but risks remain skewed to the downside.

Policymakers are responding to slowing global growth, but they remain behind the curve. Investors should monitor several signposts to determine if reflationary forces are winning --- 1) global LEIs are pointing down and (at a minimum) they need to stabilize to suggest that reflationary policies are gaining the upper hand, 2) the gold price is worth monitoring since it is a real-time monetary indicator. Last week’s combined easing by the ECB, BoE and PBoC failed to push gold higher, suggesting that central banks are still behind the curve. As in early 2009, a sustained rally in gold will signal that the world is in reflation stage.

Keep your Eyes on Paris

As discussed in my other articles, France’s perceived safe haven status will not last long. The French bond market has been reasonably calm with spreads over German bunds staying at 100bp. But the French public sector is not in good financial health and is in worse condition than that of Italy in many respects. Italy has run large primary surpluses through much of the last two decades, while France has run large deficits. The Italian debt/GDP ratio was rather stable, while France's has been rising sharply. In fact, France has accumulated 60% more debt than Italy since 1999, and its debt service costs are rising. More worrisome is that France’s combined private and public sector debt load is higher than that of Italy, putting the French economy in a perilous situation. The only variable where France looks better is economic growth, but even this has mostly come from larger government spending, and in turn at the cost of escalating debt. France is currently headed toward mild recession. On the positive side, the domination of the French Socialists in recent legislative elections gives French President Francois Hollande the necessary flexibility to pursue structural reforms once market focus inevitably turns to Paris. However, pushing structural reform in France will be difficult because of electoral commitments to do otherwise.

Looking ahead, beside the concerns over economy growth, political concerns will resurface soon and there are several issues are noteworthy --- 1) the Germany’s general elections in September 2013, which has already begun to weigh on Merkel’s decision making; 2) the proposals raised by French President Francois Hollande, which will be implemented to pursue structural reforms; 3) Italian President Mario Monti’s popularity is sagging ahead of April 2013 general elections.

That said, I remain bearish views on G7 government bonds given their depressed yields should have already discount a very poor economic backdrop. Indeed, cyclical economic and policy factors remain neutral or supportive, for now. Slowing global growth, falling inflation expectations and prospects of additional monetary stimulus (both lower rates and additional QE) should temper any upside for yields in the short run, even in a risk-on climate. Global growth will need to pick up significantly before a sustained rise in yields will occur, especially as central banks are committed to lagging the economic cycle in order to ensure recovery. Even the Fed seems intent on suppressing yields through next year at least. However, valuation is poor, and underscores that G7 government bonds are no longer a low-risk asset. Even a moderate upgrading of medium-term global growth expectations would trigger at least moderate losses for G7 government bonds.

No Surprises in China

The surprising rate cut by PBoC, effective 6 July 2012, now seemed no surprise to the markets. Latest data show that June CPI inflation eased to +2.2% yoy (cons=+ 2.3%), pulled down by softening food prices and a favorable base effect. The PPI inflation dipped deeper to -2.1% yoy (May = -1.4% yoy). It has fallen into deflation territory for four months. Today’s June trade statistics indicated that export growth was BTE at 11.3% yoy (cons=10.6%, Jan-to-May=8.7%). Import growth was WTE, at 6.3% (cons=11.0%, Jan-to-May=6.7%). Trade surplus in June came in at USD31.7bn, well above USD18.7bn in May and the market expectation at USD24.0bn. More interestingly is to look at the details. By destination, exports fell 5.4% mom to US (+21.4% QoQ, saar), down 3.9% mom to EU (+39.8% QoQ), down 6.2% mom to Japan (-0.5% QoQ) and down 1.2% mom to EM Asia (+17% QoQ)

The trade data suggest that the situation of China's exports in 1H12 was still much better than the case of 4Q08 and1H09. That's why we may not see huge stimulus from Beijing. Import growth continues to witness the China hunger for commodity and energy (1H12 imports of Oil, Iron ore, Coal, Copper, Aluminum were up 11%, 10%, 66%, 47%, 33% respectively). Imports of consumer goods also rose 25.6% yoy in 1H12. While the recent export dataflow has been in line with expectation, the outlook of China’s export sectos could be under pressure given the sluggish external environment, namely uncertainties surrounding the euro area and soft labor market and business surveys in US.

Looking forward, Inflationary pressures will continue to abate in light of the large drop in industrial commodity and food prices in the global marketplace. Rising prices are no longer a binding constraint for Chinese policymakers. Over the weekend, Premier Wen Jiabao has called for more aggressive efforts to preset and fine-tune economic policies, as the economy is running at a generally stable pace, but there is still huge downward pressure. Policy focus should be on structural tax reduction measures and resolving structural problems between credit supply and demand, and to make government policies more targeted, forward-looking and effective. The sell side economists are expecting two additional interest rate cuts in 2H12, in addition to RRR cuts, in order to keep abundant liquidity to support the growth recovery. Property policy will continue to support the first-time home buyers, while the restrictions on speculative purchase will remain in place at current juncture.

I hold my view that, barring an extreme external shock (probably emanating from Europe), the Chinese economy should be able to remain relatively robust. Although PMI readings in early June were weak, several recent data releases suggest that the economy is quite robust. Imports of key commodities are making record high, the labor market is still tight, retail sales remain very strong and car sales are accelerating at a 23% rate....….Lastly valuation wise, MSCI China is now traded at 8.9XPE12 and 9.4% EG12, CSI300 at 10.9XPE12 and 15.3% EG12, and Hang Seng at 10.2XPE12 and 1.9% EG12, while MXASJ region is traded at 11.1XPE12 and 12.1% EG12.

The LT S&D Function of Commodity

For commodities, I think there is near-term upside given they are oversold by late-June and should benefit from additional reflationary support from the major economies, despite slowing global growth. The outlook for energy is more favorable. Oil remains oversold and well below the low-end of the trading range that has prevailed over the past year. Fundamentally, oil demand will remain soft in the near-term, but should gradually firm assuming global growth picks up in the year ahead. Concerns about increased non- conventional oil output potential in NA are not a major issue in the short term. Meanwhile, most if not all of the unwinding of the geopolitical risk premium has already occurred, which should provide downside protection for crude prices.

Beyond the near-run, the key uncertainty for commodities is the supply side. Demand conditions should remain supportive of commodity prices, but to a lesser extent than in the past decade, as China downshifts to a more sustainable 7-8% growth rate from 10%+. For instance, China will not repeat the five-fold increase in steel output of the past decade that fuelled a twelve-fold increase in iron ore imports. Gauging the supply side is more challenging. The mining industry has dramatically increased its investments over the past decade in order to meet demand. As an example, new capital expenditure in Australian mining has risen roughly 10-fold since 2000, in real terms. The impact on future commodity supply remains uncertain, but past commodity bull markets typically faltered as companies added output capacity. The supply-demand balance is simply no longer as favorable as it was a decade ago.

Good night, my dear friends!