My Diary 399 --- The Fed is at the Crossroads; The Disagreed Con

My Diary 399 --- The Fed is at the Crossroads; The Disagreed Consumers and TIPs; The Cost-Demand Squeeze; Has the World Gone Mad!

May 21, 2008

Today is the last national mourning day and the market saw a sharp rebound in the PM session for both A &H shares…… 2008 is so far an eventful year for China (Snowstorm, Tibet riot and earthquake) and let's pray for China and all the victims.

Overnight, US equities were all in the red with a slew of negative data, including high core PPI & crude price and weak Home Depot earnings and USD, helping to keep the pressure on. The biggest driver is that 1MWTI contract price of oil climbed another $2 more to a record high $129.07/bbl, a $12/bbl hike MoM and +$33/bbl ytd. Accordingly, global stock prices fell 1.1%, their biggest one-day fall in more than two months, with S&P500 and Nikkei both dipped 0.8% and EU markets dropped 2.0%. Elsewhere, UST yields saw a classic whipsaw on the release of PPI for April which was tame on the headline (0.2%) but a concern in the core (0.4%). 2yr sank 9bp and 10yr receded 5bp. The 2yr and 10yr yields have declined 21bp and 14bp, respectively, since their highs last week. The USD weakened, falling 0.9% against EUR and 0.6% vs YEN.

In general, recent days I find myself in a market where no trend lasts and sentiment swings wildly due to a great deal of macro uncertainty. Given globally consumer prices are moving higher, the market is now attaching a high probability to a US hiking cycle and unchanged rates in the UK and Europe…So it seems stocks and risk trades are under pressure again…I do notice that there is an argument that good data, momentum around financials, possible help from US Congress, too much cash on the sidelines # # # are all reasons to ignore the weakening economic fundamentals…but I also want to call people’s attention on the intra-day volatility, weak trading volume and bad breadth. My another counter argument is that after the stimulus check and no more monetary dose from the Fed, the world might still face growth scare given oil, credit, housing, crash in China/Asia etc...

The Fed is at the Crossroads

This week, the data flow is largely back-loaded with eyes on tonight’s Fed minutes for the April 29/30 FOMC meeting. The minutes are of particular interest for two reasons: 1) to have an in-depth look at how the committee's thinking evolved from risk to growth over the previous five meetings to likely going on hold following the most recent 25bp cut; 2) to see the committee’s macroeconomic projections. My best guess is that the Fed is at the crossroads --- the growth outlook for 2008 will likely be revised down modestly, while headline inflation outlook will no doubt be revised up sharply, with the only comfort being that the core rate of inflation appears in check.

Such a guess has been somewhat reflected by Mr. Kohn’s overnight speech, in with he e xpects 1) economic recovery could be relatively moderate; 2) housing unlikely to rebound much after downturn ends; 3) gradual improvement in financial markets and some risk aversion reversed, but spreads still wide; 4)consumers likely to see boost from tax rebate; 5) headline inflation to rise but core should ease, while rise in long-term inflation expectations a concern; 6) rate cuts played only small role in commodity rise, USD drop helps exports but boosts inflation worries.

Talking about inflation, a rising PPI continue to threaten both consumer prices and/or corporate profit margins. Core PPI rose 1.2% SA MoM in April, bringing the %3M SAAR to a 28-year high of 12.4%. In Germany, total producer prices surprised on the upside, rising 0.9% SA MoM last month, although core producer prices decelerated some to a still-elevated 4% pace (%3M SAAR). In additional, with inventories still high, I do not expect the housing market to find a bottom until mid- to late-summer. Last week’s surprising move up in US housing starts/permits were likely an abnormality given that financing is still difficult to come by, house prices are still falling, and US housing sales have yet to bottom.

Outside the US, a clearer picture of global slowdown will be emerged after a number of key business surveys for the EU are released this week. Despite its robust 1Q GDP reading, activity has slowed considerably more recently. In German, ZEW (Tuesday) and IFO (Wednesday), as well as the PMI, should point to further moderation. Similar to the Euro zone, Japan showed considerable resilience to the US slowdown through 1Q but has been on a weak trajectory more recently. Private consumption, which zoomed last quarter, likely contracted in April, according to the most recent Cabinet Office index. Moreover, the reported further deterioration in nationwide department store sales in April suggests rising food and energy prices are continuing to damp household purchasing power and consumer sentiment. Meanwhile, according to Reuters Tankan survey, large-business sentiment continued to slide in May amid rising input costs and a strengthening YEN.

The Disagreed Consumesr and TIPs

Despite warning by Federal Reserve officials on the risk of rising inflation and oil price that pushed down US treasury prices, Asian credits continued to trade with a constructive tone. The iTraxx AxJ HY Index closed at 433bps today. Comparing with the recent wide, the HY index has tightened at 143bps. The iTraxx IG closed at 90bps. However, both the iTraxx AxJ HY and IG high-grade indices are still 100bps and 17bps wider than their levels at the beginning of the year, respectively.

Having said so, the wave of risk aversion that has swept through credit markets since 2H07 appears to have peaked in mid-March. Everywhere the eye can see systemic risk premiums have shrunk, which has boosted the supply flows. In US Corporate markets, there was over $11bn in new issuance in April and May has seen over $107bn thus far and with significant tightening of spreads. The new issue corporate market was on deal fire again with over $10bn priced. The biggest deals included a $3bn 5s/10s from ArcelorMittal, $2bn 10s/30s from Kraft, $1.75bn 10s from Pepsico, and HSBC's $1.5bn 30-year. Indeed, it seems clear that the recent contraction in Asian spreads has been driven by the reversal in global risk aversion since the middle of March. This heavy macro influence on Asian credit spreads has a history: the JACI index spread has been tightly correlated to the UST 2yr yield since risk reduction began in earnest last July.

However, recent regional equity market performance has placed a shadow on the credit spread. Yesterday, Asian credit spreads were led wider by a 4.5% decline in Chinese equities, due to the expectations that a number of listed companies will see profits negatively impacted by the 12 May earthquake in Sichuan province. An interesting observation is that there is a disparity between the headline inflation and breakeven inflation rates. According to a monthly survey by the University of Michigan, American expects prices to rise 5.2% in the next 12 month --- the most pessimistic they've been since 1982. In contrast, TIP prices show traders anticipate inflation of about 2.9% by Jan2009, in line with its average of 3.1 percent the last 20 years. I think both figures are correct within their own context, but the long-term trend of inflation has an important role on the asset prices through discount mechanism.

The Cost-Demand Squeeze

As pointed out by Thomas Deng, the GS China strategist, if the inflation would not come down, then regional market should trade at 12-13XFWPE on the fair value basis, instead of 16XPE currently. I do share his arguments, but I still think the major risk to equity in the coming 6-9 months is growth. Witnessed by the recent skyrocketing commodities prices and the ample liquidity (the highest ratio of MMF/Equity fund), I expect inflation this year will largely move higher or at least stay high. In addition, with high cost and weak demand, corporate margin will be squeezed and nominal GDP growth may also slow down, which translate into a shrinking real growth rate… Remember, growth is the key risk for equities, and weaker growth probably is the most effective way to cap inflation risk, as repeated by Fed officers.

In fact, according to BBG, based on the 441 companies in the S&P500 that already announced results, earnings have declined by 18.3% yoy. If taking away Exxon Mobil Chevron and ConocoPhillips, profits of S&p500 tumbled 26% and 30.2% in the last 2Qs, he worst records in a decade. The divergence in the earnings of oil companies from the rest of corporate America indicates that the S&P 500's two-month, 12% rally may not be sustainable…Interestingly, such an cost-demand squeeze concerns seems also play in Chinese equity universe.

Beside earnings, I think we should also beware of the global slowdown in flows - Asian funds are not the only one challenged by decreased inflows, all country equity funds and GEM funds also reported falling inflows. The former dropped 20% WOW while the latter 89%, according to EPFR Global by the end of last Wednesday. By that far, net cash taken in by offshore Asian funds fell to US$496m, the 3rd week of weakening inflows and the amount is just one third of those received one month ago. In addition, when equity prices move up a lot in most markets recently, country picks become more difficult hence late comers may simply put money into regional funds. Last week, net inflows to these two represented 1.4% of their combined AUM, three times of those to China, India and Taiwan funds. As usual, we take a peak of v aluation; MSCI China is traded at 16.7XPE08 and 23% EPSG, vs. CSI 300 at 22.7PE08 and 26.6%EPSG, while regional market is traded at 15XPE08 and 12.4% EPSG.

Has the World Gone Mad!

Today, the market sees the release of US inflation data in the form of the PPI. This raises an interesting FX question. If the market bought the EUR on a higher PPI (1.1% in GE), will it sell the USD on a lower PPI (0.4%)? This would mean the market is happy to buy a slowing economy with sticky inflation, rather than an economy with improving growth-inflation mix? The world has gone mad? Yes, as EURUSD is move 0.71% higher now at 1.5758.

Another market wide observation is, as I write, crude oil price rose to $130/bbl for the 1^st time after at least five houses raised prices forecast in the recent weeks on expected supply constraints will persist. Looking forward, I think a falling oil price would be very USD positive at this stage. Usually such logics are based on the flow of Dollars held by foreign central banks, but there are also fundamental reasons; 1) help the US trade deficit considerably; 2) help on the import inflation and Fed make rate cuts decisions; 3) help EUR turn softer. In essence, the Fed is now more worried about inflation, while ECB seems to be more concerned about the growth outlook. A lower EUR/USD is in both their interests and a falling oil price would accelerate any such move.

Having said so, I think we should not underestimate central bank hawkishness, in particular at a time when inflation and growth priorities look more difficult to central bankers. If the USD recovery was in part sparked by the perception that the Fed has done cutting interest rates in this cycle, then the next USD down leg is not very far as an increased hawkish tone is now becoming more prominent outside the US. So far, for all the concern that US inflation is worsening, the US CPI and PPI data remain relatively mixed, failing to confirm any sustained pass through. Indeed, comparing US, German and UK core price trends, the US numbers are not only the lowest, but have shown the least variability over the past 12 months. What is more, US inflation expectations remain well anchored as showed by the TIPs. In sum, further sign of price stability outside of the US is also likely to create more instability for the USD.

Good night, my dear friends!