My Diary 398 --- Two Headwinds and One Surprise; Bonds

My Diary 362 --- Two Headwinds and One Surprise; Bonds Remain Downside Bias; An Implied V-Shaped Recovery; From USD to Gold &Oil




27 April, 2008



Having seen quite a few sea-changes over the past week, including another recorded oil prices (US$119/BBL), China Stamp Duty Cut (3% to 1%), further deteriorating of Housing market (17yr low of US Starts), and a weak consumer confidence  global-wide(US, German, UK)...... All of these deserve some inks in today’s note, and let me start with stocks.

Friday, equity markets ended the week on a positive note, as markets broadly moved higher. The Nikkei ran up 2.4%, EU markets increased 1.1%, S&P500 rose 0.7%, and EM markets firmed 0.4%. Globally, stocks rose up 0.9% for the week. Elsewhere, UST yields moved up again with 2yr +3bp@2.41% and 10yrb+5bp@3.87%. Judged by 2yr yield, the markets have taken a considerably more optimistic view on the US outlook of late, adding nearly 70bp in 2 weeks. Currency wise, helped by the expectation of higher interest rates, US Dollar strengthened a bit this week, gaining +1% against EUR(1.5617) and 0.8% against YEN(104.52). Accordingly, oil prices finally declined on Wednesday and Thursday with 1MWTI price finished the week at $118.71. Meanwhile, metals and agriculture prices ended down for the week.

My gut sense is that equity is turning a bit positive on the back-to-back gains, but the broader picture is not very convincing. Although the level of concern about financial markets and the economy is abating, global growth seems to be quite sluggish through at least 1H08….. And I will start from here……


Two Headwinds and One Surprise
The headwinds to global growth remain the fiercest in the US (if no income tax rebate), and at the same time, there are important drags weighing on growth in the rest of world. Not mentioning to how large extent that US consumer will spend the refunds, this concern over global economy growth also includes the purchasing power squeeze from higher inflation, tighter credit conditions, weaker housing markets and higher FX rates vs USD, in particular the EU area and Japan. In fact, recent economic numbers are starting to deteriorating, witnessed by Japan’s export volume growth slowing to 2% yoy in March from 9% in Feb and Taiwan export order slowing to 13% from 18%, while credit indicators remain worrisome as TED spread is back to 170bp despite further intervention from central banks.

This is suggesting that even as the US economy bottoms out, a moderation in growth should become more evident outside the US. This has been manifested by a widespread slow-down in manufacturing activities and exports, but also in sluggish consumer confidence across G7. Going forward, there is an important sign to watch for --- how the corporates (with healthy balance sheets and high profit margins) respond to a more prolonged downshift in consumer spending.

In addition, the biggest change of economic picture is the inflation forecast, based on the upside CPI surprises coming out of the DMs and EMs and the continued rise in commodities prices. In US, people are looking for 3.4% yoy CPI in 2Q08, while ECB has consistently expressed its concern over regional CPI (3.3% yoy). So far, global CPI revision has been primarily focused on the DMs, leaving upside risks to emerging market as EM central banks are probably most sensitive to the shifting inflation outlook as local economic growth remains robust and inflation already is about targets. The revisions means there is greater squeeze on current quarter household purchasing power than previously anticipated, which probably will weight on the real consumer spending. Having been discussed, in US, consumer prices rose at 4% yoy on March and inflation expectations have risen over the past month. 10yr TIPs now yields 239.5bp less than regular UST vs 225bp on March 25. The difference reflects the pace of price increases traders expect over the next decade.

One “surprising” observation is that the non-financial sectors in the US has so far performed very well, measured by Dow Jones index, which has fallen merely 3.78% ytd. This should be related the two points I put down on the first paragraph ---healthy balance sheets and high profit margins. Overall, during this cycle, firms are less dependent on debt or borrowing for their expansion, while prior to the 1990 and 2001 recessions, non-financial firms were extremely overleveraged. As a result, we see default rate has stayed at very low levels (1-2%), even though credit spreads have spiked up.  Moreover, there is an interesting macroeconomic and policy issue related to an overleveraged financial sector and the underleveraged non-financials. That is, the former sowed the seeds of a systematic failure due to its devastating deleveraging activities, which requires the Fed to act aggressively in order to stop the self-fulfilling prophecy of deleveraging ---Fed has clearly done so with 300bp Rate Cut, TAF, etc --- while the later has been benefiting from the stimulation through interest rate reductions.


Bonds Remain Downside Bias
US Treasuries fell, with 2yr notes (+72bps) headed for the biggest 2wk decline since at least 1982, as traders bet the Fed will stop cutting interest rates after a 25bp reduction on April 30, sending 2yr yields above the Fed's rate for the first time since 2006.  At the same time, 10yr yields gained 7bp to 3.87%, climbing for a fifth week. The 2-10 spread has also narrowed to 143bp, the least since January. However, the gap between 3M UST yields and the 3M LIBOR, showing credit costs are still rising, widened to 166bp from 156bp a week ago. The TED spread averaged 42bp in July 2007 before borrowing costs suddenly surged in last August…... Such a movement definitely reflects the unwillingness of banks to lend to each other, even through major US bank CEOs kept expressing their optimistic outlook on the sub-prime credit crisis.

However I don’t see the match between the talks of senior management and the trend of underlying figures. Over the past few quarters, what we have seen is the increasing amount of bank losses and capital being raised from fearless investors (2Q08=US$84.9bn, 1Q08=US$72.8bn, 4Q07=US$44.4bn, vs total write-offs amounted to US$305.9bn). In fact, RBS has recently announced that the bank will raise US$24bn at 35% discount to it s recent closing price and this is a testimony on how difficult global banks are dealing with capital funding, not mentioning credit rating agencies are considering downgrading banks due to their large scale capital raising activities by using preferred shares and hybrid instruments.

As a result, a question to be asked here is whether the fixed income markets overreacted? I think to some extent, the direction of the move could be partially explained the drop in jobless claims and the ex-transportation durable good report, plus a WSJ article saying that the Fed is expected to pause after April 30th. But this is still hardly to justify such a magnitude of sell-off on Treasuries as 1) Michigan consumer confidence shows a sizeable net drop-off in recent months; 2) ISM new order index suggests on-going deteriorating trend, failing to grow for the fourth consecutive month (46.5 in March); 3) the monthly supply of new homes for sale continued to rise (To 11 months from 10.2 months in Feb); and 4)  the unemployment rate may continue to climb in the coming months, say 6% in Q308.


An Implied V-Shaped Recovery?
Judging form the recent stock market reactions, it seemed that although the conventional wisdom still assuming a “U-shaped” recovery, there are investors look for a possibility of a “V -shaped” recovery…Certainly, various indications are pointing to a return of the bull run --- improved valuation (MSCI USA = 15XPE08), pessimistic sentiment and a “wall of worries” ranging from housing to credit to inflation. In addition, Fed funds rate has already plunged far below the level set by the so-called Taylor Rule. Historically, since the 1980s, a “V-shaped” rebound in economic growth has occurred every time the Fed funds rate has dropped below the Taylor Rule…..Will it happen this time? I do not know the answer, but I think it is time to add some risks but not big.  Stocks do look less expensive than Bonds and I continue to think “Buying Oil” as a reflation bet and a hedge trade to stocks, if the oil prices cause troubles for economic growth.

Regarding our local markets, I think Hong Kong still enjoys the best of both worlds --- Chinese growth and US monetary reflation, plus low tax rate. However, after 9.2% wow hike in H share (14221), pushing HangSeng Index (+3%) to 25561, tactically it is not the best entry point to buy HK and H shares now. In the near term, two other reasons for downward momentum are 1)  the forecasts remain buoyant with 2008EPS for MSCI AxJ been revised down only 4% since its peak last November, while regional GDP growth has fallen to 6.2% from 6.9% in last October(India from 8.6% to 7.7% & China from 10.2% to 9.9%). In addition, as a contrarian’s indicator, the current % buy Rating is still high for the Chinese analyst (68% BUY vs 8% SELL), while the past 10-year average buy rating is only 48%.

Having said so, fund flows has improved a bit as, inflows to Asian funds reached US$1.5bn in the week ended April 23, according to EPFR Global. China fund took 64%, followed by India and Taiwan (15% each). However, consensus regional weighting in Asia has fallen to 47%, the smallest in since 2001 (45%). Sector wise, Telecom get the most weight hikes last months, while Materials (-113bp, biggest since 2002) and Energy (-15bp) were reduced the most. Valuation wise, MSCI China is now traded at 16.7XPE08 and 24.7% EPSG, vs. CSI 300 at 21.8XPE08 and 27%EPSG, while regional market is traded at 14.5XPE08 and 14.1% EPSG.


From USD to Gold &Oil
The Dollar Index recently rose to 73.03, the highest in a month, from a record low of 70.698 on March 17. Such a currency rally is buttered by a strong of “not-too-bad” 1Q08 earnings, instilled a rare sense of confidence that perhaps the worst of the credit crisis maybe behind us. This seemed some what too optimistic to me and I expect the USD continues to underperforms, not only because of there maybe another credit/liquidity-driven stress around the corner, but also there remain considerable adverse shocks to fight with, including sky-rocketing Oil and food prices, aside from the US credit crisis and a vulnerable economy.

But, the US Dollar decline is no longer a one-way bet on US deflationary pressures, as nobody will be surprised by a mild US recession, and markets, including currencies, have been discounting the need for massive US policy reflation since last summer and are now starting to scale back rate cut expectations. This is why USD headed for its biggest weekly gain in a month against EUR.

As a result of stronger USD, gold prices plunged to a 4-month low on Thursday. But the long-term outlook for gold remains bullish given record high oil prices and expectations of further interest rate cuts in the US, plus the world’s 2nd largest producer of gold --- South Africa has seen its out put dropped 17% and 28% yoy in January and February, respective sue to on-going shortage of power.  In the ETF said, StreetTRACKs has its holdings increased 47% from 453 tons at the beginning of 2007 to 663 ton in March 2008…..This is the same amount of Chinese gold reserve….

Same impact on Oil due to USD and it is heading for its first weekly decline since March 21 as dollar strength seems to be offsetting the fundamental business on Oil, including the unyielding OPEC remarks, concerns over Russian supply and struggling US inventories. In fact, from a USD perspective, the current record of nearly $120/bbl price for crude oil is above its historical 1980 peak of around $105/bbl. Thus, it is no surprise that current prices are causing major pain for US oil consumers. However, the picture is different in EM countries, where appreciating currencies and fuel subsidies have provided an offset to the rise in the Dollar price of oil.