My Diary 728 --- Slowing, Slower, Now What?; We are Not in Defla

My Diary 728 --- Slowing, Slower, Now What?; We are Not in Deflation!; More Downside to MXCN’s Earnings?; The Reversal of RMB Bet

Sunday, August 05, 2012

“Expectation &Surprises vs. Disappointment &Tears -- It is not the Olympics!” --- Yes, I am talking about financial markets. At the 2 August meeting, ECB completed a trio of disappointment following the meetings of the Fed and BoE this week. Indeed, all these central banks now find themselves in a similarly frustrating situation. This may not what markets want to hear. But this is not a problem that can be fixed with monetary policy. If HHs and consumers do not know what their taxes will be next month, what good is it the policy makers telling them the central banks will keep interest rates zero until 2015? Monetary policy is operating against headwinds of fiscal policy that are simply too strong. Meanwhile, all central banks dfind themselves stuck in the political crossfire, but nowhere is this more clear than in the Euro zone. The challenge is how can ECB decide whether the Spanish government “deserves” interest rates to be capped at say 6% and the Italians 5%? It is not the ECB's job to monitor and pass judgment on economic and structural reform and distribute rewards accordingly. ECB have and must surely continue to make clear that some other “policing body” must play this role. Only when this is done can the ECB increase the money stock in a way that is required to stop the system deleveraging.

The lack of immediate action unnerved markets on Thursday. The trading session saw EUR spanning four big figure handles (1.2134 - 1.2405) in less than 30 minutes as the market tried to digest the implications of the meeting. By the close Spanish 10yr yields (closed at 7.165%) had spiked 43bp which is the biggest one day rise since the daily data starts on Bloomberg in Jan1993. The Spanish curve steepened though given the ECB's focus on the front end in any potential market intervention. The Italian curve moved in similar fashion with the 10yr (+40bp) recording its biggest single day spike since Dec2011 to close at 6.327%. The reaction away from peripheral fixed bond markets was equally violent.  Spanish and Italian equities were off -5.16% and -4.64%, respectively.

In my own views, Mr Draghi could have fired his surprise bullet too early and even then was probably guilty of subconsciously guiding expectations too high. But to be fair to him, how the media and financial pundits interpret what he's says is not his responsibility. If we re-read his speech --- the two key quotes were "within our mandate, ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough." and "To the extent that the size of this sovereign premium hampers the functioning of the monetary policy transmission channel, they come within our mandate." It was his "whatever it takes" comments that overshadow the mandate part.

Overall the basic message from ECB was a more sober we're happy to intervene but only if countries activate support from the EFSF/ESM. But I think even ECB delivered the intervention as promised, it will not be the much-needed bazooka. The problem is that EFSF/ESM EUR500bn firepower is simply insufficient to simultaneously backstop distressed Spanish and Italian bond markets and re-capitalize troubled banking sectors. To end the crisis, the firewall needs to be 2-3X its current size to meet Spain’s and Italy’s funding needs for the next few years. There are several ways of achieving this but all involve the ECB’s balance sheet either directly or indirectly. For example, the central bank could commit to buy theoretically unlimited amounts of distressed bonds; it could set an upper limit to distressed yields; or the EFSF/ESM could become a bank and expand its firepower with full access to the ECB’s liquidity operations.

At the end of day, the ultimate resolution to Europe’s crisis hinges on a very simple concept. For EUR to succeed, risk in sovereign bond markets and banking systems has to be sufficiently shared across Euro zone. Without such a risk sharing, EMU is an inherently unstable system. Risk can be persistently overpriced, making economies, financial markets – and ultimately the monetary union itself – vulnerable to self-destructive feedback loops. So where are we left? The good news is that ECB does seem prepared to intervene in the secondary market. The bad news is that they won't do this until Spain and/or Italy request official support and they enter a MoU. So we now enter a waiting game for Spain. But as a minimum, we know that ECB will likely be involved which gives Europe more time than if they weren't going to intervene. The ESM banking license issue seems to be also off the table as Draghi repeated a legal opinion last year that such a construct is illegal and the ESM (in its current form) would not be a suitable counterparty for the ECB.

So what are the things to watch out from here? Clearly all eyes will be on when/if Spain requests for a full program. One of the biggest pending question marks for timing of aid is perhaps Germany's Constitutional Court's approval of the ESM on the 12 September. Also important is Moody's potential downgrade of Spain's rating to HY. Another hurdle is Greece's Troika review which will be out in September. So clearly there are plenty of potential risks still ahead. Against this backdrop, the market expects ECB to deliver a 25bps rate accompanied by another LTRO. Furthermore, ECB could announce collateral changes in September, key to ensuring a decent take-up at the LTRO. This could also pave the way for Bank of England-like “funding for lending”.

X-asset Markets Thoughts

Something very unusual happened during July. The prices of European equities, safe-haven government bonds and gold surged simultaneously. But the star performers this past month were soft commodities. Indeed Wheat and Corn were the big winners (+20%) in July due to the drought in US. YTD, Wheat and Corn are up the most, at +36% and +25% respectively. If these continue to remain elevated, headline inflationary pressure will likely start to mount which may complicate monetary policy easing when needed. Away from the crops, core European equities have performed well with DAX and  Stoxx600 +5.5% and +4.1% respectively. Elsewhere SP500 and FTSE were also up by +1.4% and +1.2%. In fact, SP500 is up 11% for the year and has yet to fall below where it ended last year - a feat that was last seen in 1979.

Moving on to Credit, the monthly excess returns were somewhat more mixed given the mid month stresses and the solid performance in core rates. Germany Bunds and USTs gained +2.1% and +1.1% in July vs. the total returns of +1.7% and +1.5% seen in US & EU HY. The "losers" in July were SHCOMP (-5.1%), IBEX (-4.6%) and Nikkei (-3.5%). Spanish bonds lost -1.5% and the FTSE MIB lost -2.7% --- all impacted by the renewed wobbles in Sovereign Europe. Currency wise, EUR/USD depreciated 2.9%, while JPY appreciated 2.1% against USD. Gold went up 1.1%.

It is very rare to see such strong synchronized gains from all three asset classes. And the lesson from history is that at least one of the three rallies is in danger of unraveling. Looking back, the ECB’s latest and eagerly anticipated policy announcement is not the game changer that can single-handedly end Europe’s debt crisis. Historically, July 2012 was the only month out of the last 400 in which equities, bonds and gold all rallied more than 2.5%. Even applying a lower hurdle of 2%, there have been just eight other months when this has happened, the last one being 15 years ago in Feb1997. Hence, on the previous eight occasions that equities, bonds and gold all posted strong gains in a month, at least one of the rallies subsequently unraveled. And in most cases, the sell-off was sharp – a decline of 4% or more in the following month.

Of course, the simultaneous gains have a good explanation – the prospects of more liquidity injections from central banks, and especially the ECB President’s promise to do “whatever it takes to preserve the Euro”. Equity bulls point out that a resolution of the debt crisis would liberate stocks, justifying a melt up from depressed valuations. They add that all previous liquidity injections boosted profits rather than wages. Bond bulls are focusing on the asset class that newly created liquidity will gravitate towards – presumably safe-haven bonds. They would also argue the need for more central bank liquidity shows the real worry is deflation, which is good for bonds. Meanwhile, for gold, the bull case is simple – the flight to safety as investors fear the creation of even more money and the apparent debasement of paper currencies. These three arguments might be inconsistent with one another, but the magic of central bank liquidity can raise all boats – at least for a while. However, for fundamental-driven investors, the synchronized rally is a red flag. Equities, safe-haven government bonds and gold have rallied by 5% this year but there are virtually no economic or financial backdrops that can keep pushing them up simultaneously. For example, a resolution of the debt crisis would be good for equities but bad for safe-haven bonds. The opposite is true if the crisis escalated. Meanwhile, deflationary forces are good for bonds but bad for gold. Inflationary pressures have the reverse effect.

Looking forward, I still hold the views of asset reflation strategy, simply because of --- 1) low economic growth with a modest downside risk bias; 2) a tight fiscal stance in mature economies; 3) further monetary easing in both DM and EM; and 4) continued brinkmanship with neither an immediate resolution nor a blowup of the fiscal crises in US and Europe.  Most sell side economists’ projections are for the world economy to keep expanding at mid-2%, or about 0.5% below potential. This subdued macroeconomic growth suggests a structural rather than cyclical force depressing growth, echoing the financial crisis and the run up in public indebtedness. Much academic research, by the IMF and Reinhart & Rogoff, has shown that growth stays depressed in the aftermath of financial crises and when public debt/GDP exceeds 90% for at least a decade by an average of 1%.

The most plausible explanation is that the memory of a severe financial crisis and the loss in wealth simply makes both the public and the private sector more cautious and forces them into B/S restructuring. This was surely the case for Japanese corporate in the aftermath of the 1980s bubble. The economic agents who survived the recession were the cautious ones, while the big risk takers are not in charge anymore or have lost much of their wealth. Caution and risk perceptions will likely only fade very gradually, over at least a decade. As a result, risk premium (discussed in Diary 467) tend to rise across the world. On the US side, nothing is expected to be decided before the November elections, and it unfortunately appears that the campaign will not produce much of a true policy debate, let along any move to consensus. In the Euro area, policy makers and politicians seem to agree on only one approach --- they will do what it takes to prevent an imminent blowup of EMU, but will not commit to the surrendering of sovereignty required to salvage monetary union over the more medium term.

Given such macro environment, I think long duration assets are relative more attractive, including real estate, corporate and EM bonds, and equities vs. cash, FX carry and commodity. This is because easy monetary policy and asset reflation are the most powerful forces for “Long” risk premium. The logics are simple --- thinking of central banks in the world trying to boost growth and avoid deflation by injecting more and more liquidity, by cutting rates where they can, and buying bonds where they can’t cut rates any further. This injection of extra liquidity makes the world longer cash than they would have wanted and induces them to spend this excess cash on goods, services and other financial assets. The more confident economic agents are about the future, the more they will likely reallocate this extra cash to longer-term assets such as durables, fixed capital, real estate, and equities.

In addition, the current portfolio positioning also supports these views as most investors remain quite uncertain about the future and prefer to reallocate excess cash to relatively safer financial assets, such as bonds and bond-like equities. YTD, fixed income mutual funds have seen over USD350bn in inflows, compared with USD35bn of outflows from equity funds. The main flow into stocks comes from company buybacks that have reached USD294bn YTD in gross terms, and are primarily in US. Meanwhile, the share of equities in global portfolios remains no higher than it was mid-2009, at the end of the recession, but stock prices are up 30% over this period. Given very limited net new issuance of shares, this shows that equities can and do gain in price in a world that remains as uncertain as 3 years ago, simply in response to the reflationary forces.

Slowing, Slower, Now What?

Incoming data confirm that global GDP growth slowed to an expansion low in 2Q12. With last Q’s disappointment weighing on sentiment and setting in motion an inventory correction, growth is likely to remain weak for some time to come. The week’s flash manufacturing PMIs, a gain in China (49.3) was offset by declines in US (49.8) and the Euro area (44.0), while global manufacturing PMI continued to slide in July, dropping 0.7ppt to 48.4. The deterioration in the forward-looking indexes of new orders and finished goods inventory is also a concern. The ratio of the two series, a signal of the headline series’ momentum, fell to its lowest level since March 2009. However, the global proxies for retail sales and capex may provide a silver line on final demand. Overall retail sales volumes are estimated to have increased at a 0.5% yoy in the three months ending in June. The growth of capital goods shipments appears to have been similarly subdued near 1%. The demand data are somewhat noisy month to month and we would not put too much weight on the latest reading. Nonetheless, the soft results put important weight on upcoming July readings on demand and labor markets.

The positive news is global inflation continues to step down from last year’s spike. With most of the June data now in hand, global consumer prices look to have increased at a 2.8% yoy pace last quarter, a 1.3% ppt drop from the peak in 2Q11 and 0.5%-point down from 1Q12. The bulk of this move owes to the unwinding of last year’s jump in commodity prices. Global consumer price inflation is expected to just edge down to 2.5% yoy by yearend. The recent stall in global inflation has boosted household purchasing power and should translate into firmer spending. In addition, policy stimulus from China and Brazil are expected to kick in. If we are right, this mix should support inventory adjustments and calm business concerns, setting the stage for a modest lift in GDP growth into year-end. However, the risks to this forecast that incorporates better but still sub-par global growth remain skewed to the downside.

As downside risks linger, the response by policymakers should build, but easing should be modest. Over the past two decades, each extended period of sub-par global growth has produced a material easing in global policy of 150bp or more. Thus far, monetary authorities have delivered a very modest response. On average, global policy rates stand only 35bp below their year-ago levels. Half of this move has come from Brazil, whose central bank has lowered rates 450bp. With growth expected to remain subpar and inflation back inside most banks’ comfort zones, additional easing is in the pipeline. There is, however, an important divergence in policy easing. EM central banks have the flexibility to act, with rates standing at 5.7% at present. However, the case for aggressive easing in the EM is lacking. The modest acceleration in growth over the coming year largely derives from a pickup in EM economies led by China and Brazil. Moreover, the disinflationary impulses that have driven EM inflation back inside the target zone are dissipating as the backdrop for key global commodity prices has shifted. Oil prices have firmed while agricultural prices --- which are more important for the EM economies --- shot higher in July. All told, EM inflation is likely to reach bottom at a level that is near the midpoint of central banks’ target band.

The major DM central banks remain constrained by the ZIRP and the effect of additional QE by the Fed and BoE should be limited. Last year, the G4 central banks’ B/S expanded rapidly, by 26%. Nearly all of this expansion reflected the completion of the Fed’s QE2 program and the LTRO program initiated by the ECB, neither of which was designed as a response to slower growth in 2011. This year, G4 balance sheets have increased at a modest 6% pace. With that said, the situation recently has changed and the major DM central banks are preparing to undertake additional QE. The BoE already announced a GBP50bn expansion of its gilt-purchase program in July. The Fed is expected to unveil a new round of asset purchases at its September meeting, likely in the range of USD500bn. The BoJ is expected to announce a JPY5trn increase in the size of its asset purchase program in September. Although additional QE will have a positive influence on financial markets, confidence, and the economy, the magnitude of these effects is likely to be fairly limited. The wild card is the ECB, which is the one central bank that has power to provide a significant boost to growth. Over the coming weeks, the ECB will unveil the details of its new approach to dealing with the impairment of the transmission mechanism in the Euro area.

We are Not in Deflation

The week saw Ben Bernanke and Mario Draghi with words but not yet actions. Both central bankers demonstrated that they are on red alert about the global economy. However, for all the handwringing over the slowdown in US economy, the bond market shows there’s less risk of deflation now than before the Fed’s first two rounds of large-scale debt purchases. The Fed’s favored bond-market gauge of inflation expectations ended last week at 2.39%, above the 2%  levels in 2008 and 2010 that led the central bank to inject USD2.3trn into the economy by purchasing USTs and MBSs, the policy known as QEs. The 5y5y measure shows that Chairman Bernanke has persuaded traders that US will avoid the chronic deflation that has slowed Japan’s economy since 1995. It also complicates the central bank’s decision about starting more QEs to boost an economy that grew at the slowest pace in a year during 2Q12.

That being said, we saw commodity prices surged during QE1 and QE2 in 2008 and 2010. The problem is higher inflation caused by a spike in commodity prices will result in a tax on consumers and slows the economy down. Thus, have the QEs done more harm than good? Looking back, S&Poor’s GSCI Total Return Index of 24 raw materials rose as much as 85% during the past two easings, pushing CPI to 3.9% in Sep2009, above its LT average of 2.5% since 1992. While the Fed can ignore its target, traders’ outlook for consumer prices “could be a sticking point for more QE. Since Nov2008, the Fed’s QE programs commit to buy USD500bn of mortgage securities and USD100bn of debentures of Fannie Mae and Freddie Mac. Policy makers raised the purchase targets in Mar2009 to USD1.25trn of mortgage bonds, USD200bn of agency debt and added USD300bn of Treasuries. In November 2010, the Fed announced it would acquire USD600bn of USTs. The programs created about USD2.3trn dollars, sparking criticism by Chinese Premier Wen Jiabao, who said in March 2011 that QE2 boosted prices for commodities traded in USD. Representative Stephen Fincher, a Republican from Tennessee, said this month during Bernanke’s testimony to Congress that “there is so much money out there” that “inflation is going to be a huge problem.”

However, the expiration of tax cuts started by President George W. Bush and spending reductions to take effect at the start of 2013 would pull USD607bn from the economy, according to the CBO. If Congress doesn’t act, those events would “pose a significant threat to the recovery,” Bernanke told lawmakers in testimony on June 7. Chairman Bernanke has studied policy errors in the Great Depression and during Japan’s rolling recessions of the 1990s. He said in 2000 that the Bank of Japan should pursue faster inflation to curb the risk of deflation, adding earlier this year that the Fed’s stimulus programs have averted that fate in US. “The very critical difference between the Japanese situation 15 years ago and the US situation today is that Japan was in deflation,” he said in response to a question at a press conference after policy makers met April 25. “We are not in deflation, we have an inflation rate that’s close to our objective.”

Expectations are now high that Federal Reserve will act soon to address those worries. But the Fed faces immense tactical and political challenges. Chairman Bernanke has only 17 months left before the end of his second four-year term, likely to be his last. The US economy is growing, but too slowly to bring down high unemployment—and the elected politicians aren't offering much help either. Unlike the ECB Dragh, Fed Bernanke faces different economic challenges. If Mr. Bernanke buys more mortgage bonds, as many expect, he would be aiming to lower mortgage and other private-sector borrowing costs to help spur economic growth. He would also be hoping to give the stock market a boost. The US government is borrowing heavily at record-low rates and doesn't need the Fed's help.  The problem is Chairman Bernanke is stuck with inconvenient timing --- a national election that is three months away. Democrats are urging him to act quickly. Republicans are doing the opposite. If Mr. Bernanke moves at the Fed's Sept. 12-13 policy meeting, as many investors expect, he will surely be accused by Republicans of trying to goose the economy and markets to help President Obama's re-election.

More Downside to MXCN’s Earnings?

Investors saw a divergence of Chinese macro data with July HSBC PMI 49.3 (up from 48.2% in June), contrary to China official PMI 50.1 (down from June 50.2). The official PMI is a bit weaker than consensus 50.5 and continuing the pullback from April's 53.3 peak. The data indicate that China's economy is still slowing in 3Q12, although the pace of the slowdown is moderating. Nonetheless, the slowdown has yet to be fully reversed and most economists continue to expect further easing measures in the coming months. Political wise, the CCP's politburo met for economic policymaking in 2H12. No new messages, but official languages always need some interpretation. The key policy views remain intact --- Beijing will ramp up pro-growth policies in H2 to ensure a small rebound in growth to around 8.0%. But without a major external shock, there is no big bang stimulus. 

Policy side, PBoC in July disappointed the market by not cutting RRR but instead conducted a total of RMB501bn reverse repos to ease ST liquidity tensions. The major barrier for cutting RRR is the concern that cutting RRR will be taken as a signal of further policy easing which will trigger further rise of home prices. The ST interbank rates went higher in the month – 7Day repo fixing rose to an average of 3.49% from 3.12% in June and 2.96% in May. As interbank rates remained high, I expect the PBoC to cut RRR in the near term, along with other measures to keep liquidity relatively ample and deliver stable interbank rates. That said, PBOC says in a quarterly monetary–policy report that “China will conduct policy fine-tuning at an appropriate time and consumer inflation may rebound after August”.  However, it seems to me that August is a good time to cut RRR, given that 1) it avoids the July which PBoC has cut interest rate once; 2) and July CPI ( to be released on August 9^th) is expected to decline from 2.2% to 1.7%,

The difficult question is how much has the Chinese equity markets priced in the overly pessimistic scenario of an economic hard landing. Both Shanghai and Shenzhen A shares have de-rated and now trade at a nearly 50% discount to their 5YAVG PB. SHCOMP valuation is now 15-20% cheaper than in October 2008. Fundamentally, the dismal performance is because of 1) floatable market cap has far outgrown demand deposits owing to non-tradable share reform and new issuances, and 2) retail investors have lost confidence and over 11mn accounts have become inactive since 2011. In addition, how much more downside to consensus earnings forecasts? The short answer is not much, as the Chinese economy continues to stabilize. Sell-side analysts have been revising down 2012e and 2013e MXCN earnings forecasts by 12-15% in the past year, while many hedge funds have been shorting Chinese stocks, particularly cyclical, into the August interim results season. I think these trends may be coming to an end. HSBC China manufacturing PMI is a strong leading indicator of the earnings trend, with a 4-month leg and with a correlation coefficient of as high as 85. The index rebounded considerably in July to 49.3, and is expected to establish an uptrend in the coming months……Lastly valuation wise, MSCI China is now traded at 9.0XPE12 and 7.0% EG12, CSI300 at 10.5XPE12 and 13.5% EG12, and Hang Seng at 10.3XPE12 and 0.6% EG12, while MXASJ region is traded at 11.3XPE12 and 9.6% EG12.

The Reversal of RMB Bet

Two recent developments about RMB are worth noting. First, RMB has depreciated by about 1.3% against USD in the past three months, compared with its stop-and-go one-way ascendance against the Dollar ever since the currency peg was dropped in 2005. Second, the onshore spot rate is now allowed to fluctuate much more freely within the floating bands set by PBoC. Interestingly, in April the central bank widened the range within which the RMB is allowed to fluctuate around the official RMB/USD, fixing it to 1% from 0.5%. In the past, the floating band was no more than symbolic, as the onshore spot and the official rate had almost always been identical. Over the past few weeks, however, the lower limit of the bands has been constantly breached. This means that PBoC has significantly reduced its intervention efforts in the foreign exchange market.

The Chinese authorities may have intentionally held back its currency against USD as part of their growth-boosting package. Still, RMB has appreciated by about 7% in the TW terms since the beginning of the year due to the sharp rally in USD. In other words, the rising trade-weighted currency still weighs heavy on Chinese exporters who are already struggling with falling external demand. Therefore, I think the recent move as a sign that Chinese policymakers are testing a new mechanism to allow for more exchange rate flexibility. The authorities have long made clear that the RMB will eventually become a free-floating currency. However, markets seem concerned over the reversal of one-way RMB appreciation bet prevalent in recent years.

There have been alarmist reports about massive capital outflows having a potentially devastating impact on the China economy. Some are even suggesting that China is facing a dollar “shortage”. It seems to me that these concerns are misplaced. China’s USD3trn holdings of FX reserves offer more than enough of a buffer against capital outflows. Furthermore, in order to sterilize foreign capital inflows, PBoC requires commercial banks to park massive amounts of reserve deposits with the central bank. In other words, capital outflows are a necessary precondition for a more flexible RMB. In addition, with years of development, the RMB market has become increasingly established. Not only has the onshore market become much more liquid than in the past, but the offshore markets have also been thriving. This means there are many more market-driven signals PBoC can observe to guide the onshore official FX rate. Furthermore, since June, RMB and JPY have been allowed for direct trading without using USD as an intermediate currency. The direct trading arrangement is expected to spread to other currencies soon

Good night, my dear friends!