My Diary 730 --- Keep Your Eyes on Inventories; Likely Upside fo

My Diary 730 --- Keep Your Eyes on Inventories; Likely Upside for UST Yields; Big Govt Numbers vs. Sluggish Earnings; The Outlook of Gold Price

Sunday, August 26, 2012

“The Dysfunctional Yield Curves and Their Market Implication” --- My ex-boss, the legend bond trader and the ex-President of Merrill Lynch Canada, Paul A. Thomas, taught me that the yield curve covers all the information and secrets of economic conditions, markets dynamics and trading opportunities. To understand the curve will build one’s career and wealth. In addition, the Taylor Rule, a formula for setting interest rates depending on changes in the inflation rate and economic growth, is the most influential principle to evaluate the potential gap of policy rate setting vs. underlying real economic conditions.  Empirically, using this formula, it is clear that in the period 2002-04, the Fed kept interest rates too low. The low interest rate was a key factor (surely not the only cause) of a boom in credit and a boom in house price.

Having said so, during the past 12 weeks, global financial markets have been in a risk-on mode. The trigger for this ongoing rally has been expectations of bond purchases by ECB, renewed easing by PBoC and some form of QE3 by Fed. While PBoC obviously has much room to stimulate, it is much less clear on what sort of reflation measures may be implemented by ECB or Fed. At the time of 2-3 weeks ahead of ECB &Fed meetings, investors star to ask whether policymakers could disappoint market expectations. To answer this question, it is essential to read through the yield curve and to find out --- 1) what kind of policy easing is needed by the global economy, and 2) what actions have already been discounted by the market. In my views, the two questions are very tough to answer nowadays due to the dysfunctional yield curves as a result of uncertainty stem from ZIRP and QEs.

Prior to the 2008-09 GFC, it was relatively easy to understand what kind of policy change the market was looking for. The FF future curve could give out accurate signals on how large and when a change in interest rates was expected by the market. This is no longer the case. With short rates having fallen to zero, the information incorporated by the FF discount curve has greatly diminished. The forward curve can only tell us how much longer the ZIRP is expected to last. It cannot tell us when, whether or to what extent a QE program may be initiated by central banks. For example, with regard to the ECB policy, the forward interest rate curve has shifted downward a notch since Draghi’s comments back in July, suggesting some kind of policy easing is discounted by the market. But the curve still fails to tell investors when or what type of QE program the ECB will launch.

As discussed, the Taylor Rule measures equilibrium nominal interest rates based on the output gap and inflation expectations of an economy. The advantage of using Taylor Rule to gauge a particular policy stance is that the calculated equilibrium nominal rate can fall into negative territory, which typically suggests the need for QE. In other words, a sustained -VE nominal rate implied by the Taylor Rule calls for much more accommodative monetary policy than what the ZIRP entails. In fact, the equilibrium nominal rate implied by the Taylor Rule for US economy has been pretty consistent and hovered at -2% level since Sep2008. This accurately points out the risk of debt deflation as well as the need for large amounts of monetary stimulus, even though ST rates have fallen to zero. Not surprisingly, the Fed has taken extraordinary actions to stimulate the economy, with its B/S exploding up by +3X since then.

How about the Euro zone economy, if examined by the Taylor Rule? The Rule suggests that nominal rates should also be at around -2% as well. With EMU’s Taylor Rule falling to similar levels as in US, it is clear that the need for large scale QE programs in Europe is no less important than the need in US. If assuming, that the impact of QE programs and that of negative nominal interest rates can be interchangeable, suggests that ECB needs to expand its B/S by roughly EUR2.5trn in order to achieve the impact equivalent of a 2ppt rate cut from current levels, or a similar effect of a 10-12% fall in EUR. Of course, such estimations have many limitations as the conclusions suggest the impact of QE and that of rate cuts or of exchange rate depreciation can be economically interchangeable, which is not necessarily true. Interest rates impact the real economy by altering the relative incentive of savings and investment, while FX rate affects the economy by changing the competitiveness of exports and imports. These are well-defined relationships with strong empirical support. However, it is not entirely clear how QE affects an economy. Some say that QEs reflate asset values, which has a positive impact on spending via the so-called “wealth effect”. Others say that QE often triggers a fall in the currency, which in turns promotes exports. However, the linkage between QE and business activity is not easily quantifiable.

Therefore, investors should interpret our estimation results with care and reservation. Regardless, the key message is that ECB lags far behind in terms of required QE, a key reason why “tail risk” has flared up from time to time and the financial crisis is still festering.  The Fed’s B/S as a share of US banking sector assets has soared to ~22%, while the ratio is only 12% for the ECB. Another way to look at current monetary policy in Europe is that if the ECB wanted to bring the ratio to the US level, ECB would need to increase its B/S by around EUR2.5trn. Ultimately, I believe that ECB will get the size of its own QE programs right, but it will not do so in one shot as the resistance to ECB monetization is only slowly waning as Mr. Jens Weidmann still objects to ECB monetization, but he has increasingly become an isolated voice. Therefore, the odds of a sizable QE program by the ECB are fairly high. That said, several of the upcoming meeting schedules to be watched --- 1) August 31: Bernanke's Jackson Hole's speech; 2) September 6: ECB meeting; 3) September 7: US NFP / UNE Rate; 4) September 12: Germany's Constitutional Court decision on ESM; 5) September 13: FOMC meeting; 6) Sept 14-15: ECO FIN meeting.

X-asset Market Thoughts

On the weekly basis period, global equity declined -0.37%, with -0.49% in US, -1.79% in EU, -1.13% in Japan and -0.11% in EMs. In Asia, MXASJ and MSCI China closed -0.57% and -1%, respectively, while CSI300 also -1.63%. Elsewhere, 2yr USTs yield shrank 2bp to 0.26% and 10yr’s narrowed 12bps to 1.68%. With a 7bp increase to 6.42%, the Spanish 10yr sovereign bond yield has increased +20bp since Tuesday. The yield remains well below its late July peak of more than 7.5%. The 10-year Italian BTP yield was about unchanged at 5.71%. 1MBrent crude was largely unchanged at $113.30/bbl. The benchmark is up + 25% from its June trough but has fallen modestly over the past week. The USD weakened 1.44% @1.25121EUR and stayed relatively stable to 78.67JPY. CRY index was boosted by 0.87% to 306.4, while Gold price were up 3% at $1671.5/oz.

Given that how much EM stocks (MXEA=+3.99%) have underperformed the global (MXWD=+15.44%) and US (MXUS=+32.9%) equity benchmarks over the past 24 months; their latest rebound in share prices has been not been exciting. Looking forward, a question is --- does such downbeat performance present a buying opportunity, or is it indicative of a generally poor EM backdrop and more weakness to come? Furthermore, what will be the key factor that investors should bet on? Based on the X-asset market moves, industrial metals remain in the doldrums and there is no strong message from commodity markets that the selloff is over. Meanwhile, it is impossible to know whether the latest selloff in USTs and the softness in USD are simply technical relapses that have occurred amid overbought conditions or something more lasting and fundamentally driven. However, the moves in USTs and Dollar markets will be of paramount importance, as these markets are no longer overbought and their next move will be primarily driven by the global growth trajectory rather than their technical positions. Investors should watch these markets for any clues to confirm the momentum of global/EM growth.

Technically, EM equity bourses are facing triple technical resistance. EM materials stocks have fallen by 40% while EM consumer staples are making new highs . Remarkably, materials stocks’ PE and PB ratios are 10.6X and 1.5,X while the same multiples for EM consumer stocks are 24X and 4X, respectively. In a nutshell, expensive sectors have been getting more expensive while “cheap” ones have dramatically underperformed. Similarly, EM stocks as a whole have been languishing, even though US consumer discretionary stocks have surged to multiyear highs. Such clashing share price patterns are particularly evident in Asia. China's bank share prices have been extremely weak while their Malaysian and Indonesian peers have done very well. The same divergence has also occurred between the Chinese large- and small-cap indexes and those in Malaysia and Indonesia. This divergence is not contained solely within Asian equities. Interestingly, bank stocks in Brazil and Colombia have also posted extremely divergent performance. This is despite the fact that the Brazilian central bank has been cutting rates much more aggressively than the Colombian central bank.

It has been natural to explain away the underperformance of EM stocks as a by-product of Europe's debt crisis and the historically high-beta nature of EM assets. However, a detailed examination of various markets suggests that EM underperformance has not been driven by tail risks from Europe or US but rather it has stemmed from worsening of both top- and bottom-line growth in EMs. The point is that if EM stock performance were primarily being dented by tail risks stemming from the European debt crisis, these divergences would not have occurred. Any macro tail risk would have affected share prices and multiples of all countries and sectors similarly. What has rationalized various EM countries’ and sectors’ diverging performance to a significant extent has been profit performance. In other words, it is profits rather than valuations will be of critical importance going forward. In short, unless the market can foresee a bottom in earnings in the months ahead, a meaningful multiples expansion is unlikely.

Keep Your Eyes on Inventories

Global growth is expected to remain below trend through the end of this year. Rates have fallen less than 50bp from their 2011 peak levels and are forecasted to fall only about 20bp more through the end of this year. For DM policymakers, the zero bound has effectively eliminated room for conventional action. For the EM, the part of world retains rate flexibility, stubbornly high inflation and a desire to unwind strong credit growth limit action? Faced with these constraints, important decisions await the Fed and the ECB at their September policy meetings.

In US, though economy continues to expand, its performance is disappointing to Fed, which has been trying to deliver growth materially above trend. Thus, this week’s FOMC minutes point to further action fairly soon unless there is a “substantial and sustainable strengthening in the pace of economic activity.” Even with better recent reports on employment and retail sales it looks likely that Fed is poised to lower its growth forecast at the Sept meeting, opening the door for further action.  That said, as food and energy prices move higher, a new headwind for consumer spending has emerged. And there remain important uncertainties relating to global business behavior. For growth to be materialized, the rebound in consumer demand must promote sharply lower inventory gains this quarter. It must also bolster business confidence sufficiently to contain a slowdown in global capital spending and hiring growth.

With latest activity data available, global PMIs suggest that finished goods inventory positions remain stubbornly high. A sharp divergence in the flash PMIs is important to recognize --- with the US finished goods inventory index dropping 1.7pt while the China index rose 3pt to a record high. With the flash readings pointing to a modest rise in the global orders and employment readings in August, and knowing that Chinese manufacturing recently has expanded even as output contracted across the rest of the globe, many economists viewed China’s survey results as an outlier. In fact, the signal from the recent slide in G3 capital goods orders and shipments --- with weakness accelerating around midyear --- raises legitimate concerns that global business demand may be disappointing, just as the latest consumer indicators have delivered a positive surprise. To sum up, it seems that inventory is the key barometer to observe global growth momentum into year-end. The next important test will come with the unveiling of the global manufacturing and services PMIs, along with data on US payrolls, in two weeks’ time.

Likely Upside for UST Yields

As discussed in the above sections, there are various commentaries on reasons for the run-up in UST yields. Prevailing thought appears to be that a change in expectations regarding the probability of QE is to blame. But I think the answer needs more elaboration. It is not the absolute amount of Fed stimulus that drives UST yields, but rather the expected amount of stimulus relative to what is judged necessary to preserve economic growth. If more QE is discounted than required, then UST yields should rise as investors discount higher growth and inflation. Conversely if the amount of expected monetary stimulus is judged inadequate relative to what is required to return domestic growth to potential, then yields will fall as the deflationary tail risk comes to the fore.

The sell-off during the past few weeks was caused largely by a jump in the real component of yields, a reflection of improved growth expectations and hence less required stimulus. The inflation component has also edged higher, and this reflects the combination of the Fed’s easing bias against a slightly improved growth backdrop. The turning point came early in the month on two key developments --- 1) The economic data began to beat expectations that had become depressed following a long run of disappointments; and 2) ECB opened the door to unlimited sovereign bond purchases at the short end of the curve.

Considering the successfully combining EFSF/ESM lending facilities with ECB backing would have a larger positive impact on risk tolerance, thus further upside in yields to 2-2.25% is possible in ST if economic data continue to firm, but this does not mark the start of a sustained Treasury bear market. The FOMC minutes were unusually explicit in their dovish tone with move towards additional easing – suggests QE is on the cards for Sept but since this last meeting on the 1st of Aug we have had a “better than expected” NFP and retail sales. I believe that eventually the Fed will need to announce some additional policy stimulus, but it is unlikely to do so while data are improving. Chairman Bernanke’s opening remarks at the Jackson Hole conference next week will be a good opportunity to update markets on the Fed’s latest thoughts. In the meantime, stronger domestic data and a soothing message from ECB have delayed the need for further easing measures. The Fed is more likely to steer expectations for additional stimulus lower in the coming weeks. Moreover, the string of positive economic surprises by definition cannot last indefinitely. Under the framework outlined above, such a combination would cap the rise in UST yields. It would also cause inflation expectations to decline and therefore may provide a signal to close our overweight allocation in inflation protection.

Big Govt Numbers vs. Sluggish Earnings

The week saw several local government announced RMB6trn stimulus plans, including Tianjin (RMB1.5trn), Guangdong (RMB1trn), Chongqing (RMB1.5trn), Guizhou (RMB3trn) and Changsha (RMB1trn).  Such a big number did catch eyeball, but lack of detailed action points as they generally gives the market a guideline on which industries that the local government will focus on in the next 3-5 years. Meanwhile, funding issue is still there. Local government debt in 2010 reached RMB10trn, +40X increase since 1997. China local governments see weak fiscal revenue growth this year and more than 40% of local govt haven't completed half of their full year target. Local governments can sell more land but the central government is now monitoring very closely on this. They can also issue new bonds but it will make the local government debt problem more serious and complicated. In addition, the central government will not buy the bill as the investment rush & consequence caused by the RMB4trn stimulus in 2008 is still huge and serious. The governments should have learned a lesson that stimulus is not the solution to solve the economic/social problem of China.

Growth wise, we are still very early in the reporting season. Up to August 17, 24% of total market cap of MXCN companies reported 1H2012 results. We see lackluster earnings so far, with overall earnings flat yoy and -1% if excluding financials, though the majority of companies (esp. banks) are yet to report. 1H earnings so far have reached 46% of annual consensus forecasts, weaker than the 53% achieved in 1H11. For sectors with meaningful % of market cap reported, software (+20%) and property (+11%) saw solid earnings growth yoy. Healthcare, property, telecom, and utilities are tracking yoy growth in line with or ahead of FY12 consensus growth expectations. In contrast, building materials and mining are down significantly in 1H12 and tracking well below full-year consensus.

In the A-share market, 83 CSI300 companies  released results so far and overall 2Q earnings growth (+8% yoy) rebounded from 1Q (+4%), but still slightly lower than the FY12 consensus of +9%. However, excluding financials, 2Q earnings growth (-12%) stayed sluggish and is worse than the FY12 consensus of -1%. For sectors, property and healthcare are tracking at higher growth vs. FY12 consensus, while materials and IT are tracking weakly. So far, the aggregated bottom-up CSI300 earnings growth in FY12 is 11.4% vs. 14.9% in FY11 and 14.4% in FY13..….Lastly valuation wise, MSCI China is now traded at 9.2XPE12 and 5.1% EG12 ( vs. 18.1% on Feb 18), CSI300 at 10.3XPE12 and 12.1% EG12, and Hang Seng at 10.5XPE12 and -0.1% EG12, while MXASJ region is traded at 11.7XPE12 and 7.9% EG12.

The Outlook of Gold Price

The price of gold in EUR is also holding steady while gold in dollars is challenging its 200D MAVG, currently at $1620/oz. Meanwhile, the gold/silver ratio has lost upward momentum, similar to early 2012 when the ECB previously showed its willingness to act. Finally, gold shares have survived their first test of the May lows and are tactically attractive. No doubt, these developments are tied tightly to European policy. Historically, gold prices were a massive beneficiary of the secular decline in real interest rates, and corresponding mushrooming in central bank B/S, especially since late-2008. This period also coincided with an intensifying aversion to the major currencies, as fiscal problems soared and the economic backdrop worsened markedly. The flip side of these positive trends was that prices have become progressively more overvalued.

The secular positives are not likely to reverse quickly in the coming years, as it will take time before real rates rebound meaningfully (there is no equivalent of Fed Chairman Volcker about to arrive and massively lift real rates, like in 1980-1982. From a ST perspective, gold prices should stay firm until USD recovers and/or a risk-off phase develops, if the ECB fails to follow through and significantly bring down bond yield spreads in Spain and Italy.

While gold prices have recovered from oversold conditions, an ominous technical pattern has been developing, in marked contrast with the period preceding the all-time price high reached last September --- rates of change have failed to rebound to levels seen during the bull market, underscoring that a flat trend is underway, or even a mild bear phase.

Good night, my dear friends!