My Diary 402 --- G3 Outlooks Remain Weak; Bonds Turn Into Bears;

My Diary 402 --- G3 Outlooks Remain Weak; Bonds Turn Into Bears; Oil/Rumors Equal Advance; Dollar Has Another Test

June 1, 2008

My family felt very sad over the past few days as my dearest mom has been identified a terrible disease --- liver cancer, after her stomach cancer operation in 2003. She has to do 6 rounds of chemo treatment in the next 6 months after another operation. I am extremely worried about her health status, as she has not been able to eat like a normal person over the past 5 years. Going forward, I will spend as much my times as possible staying with her. As an investment professional, I will have the opportunity to catch up my performance, if I lost some. But if I lost my mom, I will never be able to get her back……

Back to the weekly market notes, GDP and oil prices are this week’s key drivers for the global equities which gained 1.2% vs. -3% last week. Regionally, the gains were made entirely in DMs (+1.4%), while EMs slid 0.3%. Within the DMs, US and Japan(+2%) outperformed EU (+1%). Elsewhere, UST yields jumped considerably during the week with both 2yr (2.63%) and 10yr (4.05%) yields are more than 20bp above last Friday’s close—each now sitting near 5-month highs, and ytd 10yr yield is above 4% for the 1st time. Consequently, USD strengthened, moving up 1.3% against EUR and 2.1% vs. YEN. Also likely affected by the strengthening USD, oil prices ran into some resistance this week, as 1MWTI price declined more than $4 to near $128/bbl, but the price is still $14 above the level in the end of April.
Worldwide, government bonds have been sold off sharply and yield curve flattened over the past two months, reversing the trend that took hold when the credit turmoil first erupted almost a year ago. An interesting observation is that contrary to the Financial Times, bond yields are not rising on the back of higher inflation expectation, but instead it is a sharp move higher in real yields. Inflation worries are fading as metals crashed and oil shed $4/bbl. These moves, if sustained, are equitant to consumptions tax Cuts and able to boost growth expectation. If that is the case, then long equities may be a better risk reward trade than selling bonds going forward……Well, let us start from US macro data released over the week….

G3 Outlooks Remain Weak
Last week, dataflow has continued to highlight the pronounced weakness in G3 countries and a rotation of market focus from US to EU and Japan. For the US, reports on durable goods orders, jobless claims, and corporate profits sent a message that corporates, while scaling back, are not retrenching in a way that is consistent with recessions. With the tax rebates now entering the system, the economy is positioned to maintain sluggish growth.

Digging into the details, 1Q08 US GDP was revised up from 0.6% to 0.9%, with core PCE revised down from 2.2% to 2.1%. It seemed that US macro metrics looks better now, but I don't think the improvement in that inflation metric is a sufficient condition to take a complacent outlook on inflation. Among major inputs to GDP, real final sales revised from -0.2% to +0.7%, while inventory contribution revised down from +0.8% to +0.2%. The later figure could act to boost 2Q08 GDP as inventories now have a better chance to boost growth, or at least be neutral. Net trade contribution revised up from 0.2ppts to 0.8ppts, but for the wrong reasons - exports revised down from 5.5% to 2.8% while imports revised down from +2.5% to -2.6%. Job market wise, 372K claims is consistent with falling payrolls. Continuing claims is at a new cycle-high, so unemployment likely to rise.

In contrast, growth is slipping in Europe and Japan. The EU business surveys show that activity is weaker in 2Q08 than 1Q. In German, job growth is losing momentum as in seasonally adjusted terms, the number of unemployed rose slightly by 4,000 people between April and May, while in UK, the nationwide survey indicates that the pace of house price declines is intensifying (-2.5% in May, largest one month drop in 17 years). The evidence of GDP growth slippage is even more striking in Japan. The business surveys are nose diving, in conformance with the loss of momentum in the official activity indicators (Tankan fell to 11 from 19)……The spill-over impact of Subprime/structure credit crisis is just like you throw a stone in to a pond …… It takes same times for people to realize the energy of water ripples, originated from the centre of the problems.

Bonds Turn Into Bears
In terms of timing, US rates were on the rise after Dallas Fed President Richard Fisher said that rate hikes could come sooner rather than later, the US could face prolonged economic anaemia but inflation is the bigger risk, and that the Fed could hike even if the economy is still weak. In the following trading sessions, fixed income markets continue to weaken under the weight of the growth/inflation news and central bank commentary. Curves are flattening on a widespread basis, but the most extreme move has come in the US consistent with the growth/ rotation story. I think the recent move of price-in 2H08 tightening for central banks including Fed, ECB and BoE appears too much, as I still believe weakening growth is going to be the dominant concerns again for central banks to act over the medium term

Having said so, in the short-run, the rising inflation expectations have overtaken the on-going pressures in credit markets as the number one worry for central bankers. Until recently, the bond market had been willing to accept the view that rising food and energy prices would be largely contained, leaving central banks free to ease policy to fight the credit crunch and falling home prices in US and UK. However, bond investors are losing their patience as economic growth looks held up reasonably well in the face of soaring commodity prices, and the measures of G3 long-term inflation expectations (5y5y BE) in the bond market have increased. The rise in inflation expectations is unsettling central bankers, and their tone has become increasingly hawkish. The lesson from the 1970s is that it is much more difficult to return inflation to a low rate once inflation expectations become unanchored. Investors appear to have decided that central banks will be forced to attack inflation at the expense of growth, resulting in a sell-off in money markets.

However, I think, at least in the US, the sluggish economic growth, plus the declining housing prices (1/3 of PCE) will constraint the leakage from PPI into CPI, and the key is still the movement of energy prices going forward, which will set the tone of bond market.

Oil/Rumors Equal Advance
The recent advance of AxJ regional markets are largely driven by oil and food prices, which showed signs of stop advancing and move into a trading range, as well as a hack of rumours around China markets, plus MSCI rebalancing.

In general, rumour means volatility, and we have seen many times of big intra-day swing in A&H shares. Over the past week, rumours on the possible broker listing in June, May CPI number (8%, or lower), more bank M&As and government policies to electricity tariff and refinery product price have been played once again. But if we look beyond this fancy stories, CSRC is still urging local long money to stabilize A-share markets with below average market turn over, implying market direction and sentiment have not been changed.

Regional wise, with inflation becomes more a widespread phenomenon in Emerging Asia. Asian funds have increased their exposure in F&B and consumer staples sectors by 50bps in the last 2 months, according to EPFR. Relative to the MSCI, funds are 194bp overweight Food, the 2nd largest weighting after Materials. In addition, the consensus survey remains overweight HK and ASEAN, while underweight China. On average, cash levels at Asian funds are around 2.5% over last three months, same as the historical mean if the 1997/98 crisis period is excluded.  Regional markets seemed less favoured recently, as Asian fund flows turned negative with redemptions from offshore Asian funds totalled US$228mn in the week ended 28 May. Valuations largely stayed flat with MXCN ended 15.6X 08EPE vs. 23.3% 08EPSG, CSI 300 at 20.7X 08PE vs. 26.4% 08EPSG and H shares at 15.1X 08PE vs. 24.7% 08EPSG……Hong Kong listed Chinese shares remain on the top of valuation and growth mix.

Dollar Has Another Test
The most important theme in the currency market over the week was the USD rally on the back of rising US yields. As mentioned in the above sections, the upward revision to US 1Q GDP growth and strong US April Durable Goods data, together with further hawkish Fed comments have weighed further on US interest rate markets, causing yields to extend higher. Looking forward, the coming week will set another important test for the USD as there are a number of key data releases including the ISM surveys, and the Non-Farm Payrolls.

In addition, although Richard Fisher made some unusually hawkish comments regarding the rate hikes, which reflected the increased concerns of Fed officials over, but I do think  actually raising rates is an entirely different matter, because of 1)  the economy and financial system  is still fragile; 2) rate hike will offset the stimulus effect from tax rebate. All that said, there is no question that US market interest rates are on the rise, with 10yr yield rose above 4% for the fist time since January. Not surprisingly, EUR-USD yield spreads have narrowed (22bp wow) over the same period, a development consistent with EUR/USD (1.5554) slippage this week. Near-term, I don’t think there is so much risk from Fed side, it could be that inflation and inflation expectations (EU May CPI) alone could continue to push market interest rates higher.

Finally, oil prices remain a key focus but as market participants have undoubtedly
recognized, the price action this week has not correlated too well with developments in the USD.  The perceived de-linkage is important, particularly if it persists, as it would potentially allow other   factors--like interest rates--to exert greater influence over the USD.  Having said so, YEN has been staying on strong side in recent days due to the recovery of carry trades, but this may not last for long as rising oil prices usually weigh on the TW value of YEN, given it is still a major net importer of oil…..Watch out the Japanese currency…

Good night, my dear friends!