My Diary 600 --- Is the Recession Over; Consequences vs. Reality

My Diary 600 --- Is the Recession Over; Consequences vs. Reality; The Chinese Liquidity Wall; USD to Overshoot, Oil to Stay

August 09, 2009

“Taking away the punch bowl from the party, but not the rice bowl from the economy” --- Having stayed in low touch with the markets for +2 months, this is my general feeling after coming back for 2 weeks. I think this commentary well explained the recent market dynamics among investors, policy markers and the X-asset markets’ volatilities. On the macro front, Friday’s BTE US NFP, along with global PMIs, seems to indicate that a synchronized global upturn is taking hold. Business and household behaviour could make an early shift away from retrenchment, raising upside risks to growth outlook. As a result, the markets now expect a hike in FFTR in Jan 2011. That being said, I believe global central banks are likely to hold the easing mood in order to promote growth for some time to come, amid depressed utilization and gradual financial sector healing. Risk remains on consumers. In spite of the recent sharp increase in household savings, US consumers are still saddled with too much debt. PCE -- the largest component of GDP-- fell 1.2% in Q2 as savings rate surged to 5.2%. Retail sector results on Thursday indicated consumers are reluctant to spend, with Target and JC Penney both reported drops in July SSS (although still BTE). The focus next week is US IP and retail sales.

Coincidently, a trio of senior policymakers (PBOC, NDRC & MoF) held a news conference on Friday to discuss China's economy, after a 3 days straight decline in A-share market. The key message is that PBOC clarifies its statement of “gentle adjustment” as to maintain loose monetary policy to support the economy and said it would ensure sustainable credit growth without resorting to heavy-handed quotas to domestic banks. I think over the past week, market has been misled by local media. Just sit back and think, Premier Wen has spent trillions of money and efforts to restart the stock market & to stabilize the economy just for a few months, how could the govt reverse its policies at this early stage when export recovery is more or less a story? In my own views, PBOC has to deal with three important Qs at this moment – 1) Whether asset bubbles are forming in China; 2) How much the liquidity should be removed from the market; and 3) When to implement these financial stabilisation policies to avoid creating instability…Well, these are the central banker’s headaches and the market’s overhangs.

Having discussed the biggest data and event over the week, let us take a look of global asset markets. On Friday, equities moved up 1.5% in US and 1.2% in EU, along with modest gains in Japan (0.2%) and EMs (0.4%). On a weekly basis, global equity prices increased 2.0%. Elsewhere, USTs yields moved up considerably with 2yr by 19bp and 10yr by 37bp. 1MWTI oil rose $1.5 to $70.93/bbl.  EUR closed lower 0.5% at $1.418 and JPY weakened 3.1% to 97.6…In general, it was the BTE economic data that helped to bring about broad-based buying, which took the SP500 to close above the psychologically significant 1010 mark for the first time since Nov2008. Looking ahead, the question is how sustainable is the US market strength, as doubts over about the sustainability of the US and global recovery dominated the week, starting with the China share scare and later IMF report.

X-Asset Market Thoughts

As well perceived, the rally in higher-beta assets, including credit, equities, commodities and currencies, was mainly due to the massive liquidity injections via interest rates and QEs. At the macro level, the evidence is observed by soaring global MS growth, i.e. US M2 growth almost doubled to 10.0% yoy as of Jan09 (vs. 5.4% yoy in Aug2008), China M2 growth accelerated to 28.46% yoy as of Jun09 (from 14.80% yoy in Nov08) and even Japan M2 growth rebounded from 1.8% yoy to 2.7% yoy. The key characteristic of such a liquidity-driven rally is a sharp increase in X-asset correlations. From 1 January to 31 July, the correlations between the S&P500 and SHCOMP, EMBI Global, crude oil and gold have been 6.3%, 48.7%, 45.8% and -3.3% respectively. However, from 1 July to 1 August, the same correlations were 12.8%, 52.4%, 56.2% and 49.2%. In other words, liquidity-driven rallies at the beginning stage are typically broad-based, lifting the fundamentally sound along with the more fragile. However, a turning point seems to come under the considerations of 1) asset valuations relative to economy fundamentals and 2) the talks of “exit strategies” by central banks. This is why just the hint of liquidity tightening by China has been enough to cause sharp sell-offs across global markets. Meanwhile, price momentum of higher-beta assets over the last two weeks has looked tired, pressuring investors’ nerve. However, the fact that BoE chooses to expand its QE program shows that policy makers are well aware of the link between inflating asset prices and nominal GDP. Talk of “exit strategies” remains premature.

Moving forward, I think the asset markets are likely to continue to be dominated by three uncertainties – 1) Uncertainty about the economy: the uneven quality of the US recovery hopes comes from the divergence between manufacturing (thanks to inventories, car schemes and global demand) and the services ( due to consumer deleveraging, credit limitations and Unemployment rate). The dynamics of US economy makes clear that export sectors and USD exchange rate becomes more important to US economy. Thus, it would be interesting to watch how other nations deal with a weaker USD via intervention, rate cuts, shifting of reserves, higher commodities, etc. 2) Uncertainty about asset market outlook: the range of expectations for almost all markets has never been so diverse, whatever in FX, oil, rates or stocks, leaving many concerned the present opportunities are not worth playing in the medium term; 3) Uncertainty about regulation and policy: the debate over health care, cars for clunkers and regulating financial industry --- what does it mean for markets? Are these opportunities or traps? In addition, the decisions of central banks remain critical to the debate over inflation risks or bubble creations with China being the prime driver but the on-going meetings with FED, ECB & BOE still a watch for moving from accommodative to neutral stance.

To the stock markets, so far beta has been concentrated in financials, industrials, materials and EMs. All of these sectors and markets have had a tremendous run and are up anywhere between 50% and 100% since the March lows. I think some corrective action is possible and maybe even necessary. But as long as the cyclical rally can carry forward, sectors and markets with high betas should continue to deliver above-average returns. Given the above uncertainties I mentioned, three key market indicators to be closely watched – 1) Yield curve, a good predictor of future growth and corporate profits. A flattening curve could signal the re-intensification of deflationary pressures in the economy; 2) Credit spread, important information on market expectations of corporate default risk. It is a measure of the general health of corporate B/S; 3) VIX, a coincident indicator of equity prices. It should be treated as a confirming signal of a market trend. For instance, the VIX did not make new highs in March, suggesting the March selloff was a false new low that should have been used as a buying opportunity.

Is the Recession Over?

This is a widely debatable question. In US, macro data are mixed with better NFP, home sales and GDP while consumer confidence, durable goods, chain store slaes and initial jobless claim were on the disappointing side. With Q2 GDP falling just 1%, the market feels that US economy hit bottom during 2Q and is already on the mend. Looking into the breakdowns, the BTE decline in GDP was due to +VE contribution from net exports (+1.38%) and govt spending (+1.12%). Net exports rose only because imports fell even more, thanks to the weakening USD & to consumers savings. In fact, PCE fell 1.2% as the personal savings rate surged to 5.2%. Ironically, the Fed becomes slightly more bullish about growth, but more bearish about employment (peak at 9.8-10.1% this year). I think good news is US housing market may have already bottomed. Both existing and new home sales have climbed 3 months in a row and inventories have fallen. More importantly, prices are beginning to firm, witnessed by the Case-ShillerPrice indexes posted MoM gains for the first time since mid-2006. Along with this weeks’ job market data, there is real hope that things are getting better now than the data suggest.

The economic picture from the rest of the world looks better than it did a few months ago. In EU, the economy is showing clear signs of recovery. The strong euro is a drag on the regional economy, but business confidence has improved quickly. The China economy continues to accelerate, with electricity consumption and IP having surged over the last several months. Although there is concern over an early policy tightening, I think this risk remains low due to deflation, weak external demand and most importantly, the political imperative to create jobs. Japan also shows some signs of life. Its inventory/shipment ratio is starting to fall and industrial capacity utilization is rebounding.

Perhaps the most compelling sign of a return to growth is the breadth of the improvements in global PMIs. According to JP Morgan, 76% of the countries reported a rise in output index and 86% reported a rise in new orders index. Such consistency across countries is a powerful signal that a robust IP rebound is underway. Geographically, US ISM manufacturing index climbed 4.1ppt in July to 48.9, with production index + 5ppts to 57.9 & new orders index +6.1ppts to 55.3. The EU PMI for manufacturing also gained, +3.6ppts to 46.3. Japan, PMI strengthened to 54.7 but has yet to register the surge in factory output already underway. In EMs, the output PMI of China and India are well above 50…Without underestimating the downside risks, I think the manufacturing recovery itself have an important +VE feedback onto payroll and business confidence, consumer spending, retail sales and thus financial markets.

Consequences vs. Reality

The coordinated global policy reflation is unprecedented and has two consequences --- 1) the rise in govt deficits, debt, and contingent liabilities; and 2) the expansion of the Fed and other major central banks’ B/S. according to CBO, US federal govt debt is likely to reach ~100% of GDP over the next 8-10 years, as a combined result of anemic growth, falling tax revenue, increased govt spending, and bailouts of indigent states, households, businesses, along with an aging population. Having said so, in the short run, huge deficits and growth in govt debt are necessary. They will continue to play a crucial role in deleveraging the private sector and in helping to fill the black hole caused by the sharp increase in household savings. I agree that govt deficits will put upward pressure on interest rates. However, much of the economy, particularly housing and commercial real estate, is far too weak to absorb an interest-rate shock. Therefore, the Fed will have to monetize much of the rise in govt debt, making it extremely difficult to unwind the explosion in the Fed's B/S and consequent rise in bank reserves - the fuel that could be used to ignite another money and credit explosion.

Despite the worries over debt monetization, govt bonds have remained well bid over the past few months. As I discussed, partially it is because major central banks want to keep policy rates on hold for an extended period in order to lend support to the recovery. The only exception is the RBA. Meanwhile, policymakers are focusing on talking down inflation expectations and the term premium in the yield curve by reassuring investors that they have well thought through the “exit strategies” when the economy is on firmer footing. That being said, 2-10yr USTs curve spread reached 258bps, along with 10yr yields soaring 38bps, the most in a week since 2003, to 3.86%, as job reports indicating the US economy is recovering and spurred investors toward riskier assets. Long-end treasuries remain vulnerable to rising inflation risks and the weight of supply. On TIPs front, 10yr BE increased to 201bp, from near zero at the end of 2008. The market-based inflation measure has averaged 220bp for the past five years. On the back of better macro data and rising confidence, the NA IG Index fell 5.5bp to 105  the lowest since May 30, 2008, CMA data show. HY spread over USTs fell 65bp this week to an 11-month low of 857bp, according to Merrill. In EU, iTraxx Crossover fell 11bp to 584bp, JPMorgan prices show.

The Chinese Liquidity Wall

The SP500 has rallied 49% since 09March, the steepest surge since the Great Depression. Based on the 2Q earning announcements, BTE earning results are largely due to cost cuts, not because of higher revenues. In fact, in many cases the YoY revenue declines were simply frightening. That being pointed out, while profits at SP500 companies are falling for a record 8 straight Qs, results have surpassed projections by 10% on average, with 447 companies seeing their earnings estimates are ratcheting up. The market is forecasting EPS=$74.49 for SP500 in 2010, according to forecasts compiled by BBG as of Friday. Overall profits are projected to rise 21% yoy, led by +85%  at chemical and mining, +54% at financials, and +47% at energy.

Back to home markets, liquidity is on the very top of market attention. Historically, the A-share market liquidity always came from three sources -- 1) Export surplus, 2) Hot money and 3) Bank loans. In 2007, 1 and 2 are the key drivers, but today is more related to 2 and 3.  The key difference is bank loan are more policy sensitive, while export surplus and hot money are more constrained by capital account control. That being said, it seems the retail investors are being waken up again, witnessed by the recent locked-up of RMB1.9trn in CCSC IPO and of RMB1.4trn in Ever-bright Securities IPO, as well as the renewed surge in new trading account openings and n mutual fund launches. YTD, A-share mutual funds raised RMB186.4bn, already exceeding that of 2008. On average, every new fund raised about RMB2.5bn. 44 of the 75 new funds are equity funds. The question is when will this momentum be gone? I don't know but  to keep an eye on 1) CPI MoM changes; 2) GDP growth over 9%; and 3) Govt warning on asset bubbles seem to be the right choice.  In the near term, market consensus remains bullish. Based on the 17 brokers surveyed by SH Security Journal, most remain bullish on ST outlook, believing the market will continue to go up in August & calling liquidity remains robust and the trend will not be changed in short term.

But some early -VE signals hit the nervous market lately with A-share down 5% over the past three days, due to some media reports on 1) The “mild adjustment of PBoC monetary policy; 2) People's saying SHCOMP 3400 is the defined line of more asset bubbles, and 3) Talks of more IPOs related to the return of  Red-chips (China Mobile, CNOOC etc) and international names (HSBC). But after the Friday jointed conference, it seems the subtle change of PBoC/CBRC's credit control policy is not the reversal point of monetary policy yet. Thus, the 3-day market run is more about the shift of market sentiments rather than others.

Sector wise, along with the tightening noise, Chinese property saw profit taking due to 1) comments by Shanghai mayor that local prices are too high and need to be cooled down, plus the implementation of Shenzhen property taxes, and 2) the confiscation of a land in Foshan due to R&F failed to pay Rmb4.5bn outstanding land premium. I think these are well known in the market and this year, government related ppty companies are for sure the top picks. Amid at strong domestic demand, Chinese steel mills' profit in July is expected to exceed Rmb20bn, as the monthly growth of steel prices rose to an 8-year high, according to MySteel. Net profits in HRC and CRC are estimated to stand at Rmb600-1,400/ton, as their prices gained by Rmb376 and Rmb473/ton in July, respectively. Meanwhile, iron ore inventory in China’s 19 major ports reached 73.29mn tons in July, 2.69mn tons higher than June and close to this year’s record high of 73.5mn tons. It seems BDIY may see further dip on the back of weaker China demand…Lastly, valuation wise, MSCI China is now traded at 16.9XPE09 and 7.8% EPSG, CSI 300 at 26.9XPE09 and 16.1%EPSG, and Hang Seng at 17.8XPE09 and -15.8%EPSG, while AxJ region is traded at 17.8XPE09 and +6.1% EPSG.

USD to Overshoot, Oil to Stay

Since the breakdown of Bretton Woods in the early 1970s and the move to floating FX rates, there have been only two major bottoms in USD --- The late 1970s and the early 1990s. These bottoms shared two common features – 1) USD had fallen to deep undervalued levels; and 2) US CA balance had improved markedly. These two conditions are not currently in place. While the US CA deficit has narrowed, it remains much wider than the levels seen in late 1970s and early 1990s. On the other hand, since the 1930s the US has never subjugated domestic concerns to external discipline. The USD role as the main reserve currency country is compromised by its persistent inflationary policies and CA deficits, a subject high on the agenda at the recent G-8 meeting and referred to frequently by China, Russia and others. As of 2008, foreign central banks hold +USD10trn (20% in China), the largest component of world reserves. They fear a large drop in the Dollar, thus they don't want more USD. But they also want to preserve their currency’s competitive position and thus have to buy more when USD is under pressure. In contrast, US Officials may talk of a strong-dollar policy, but their actions always speak differently. Thus, USD is not undervalued and due to the weak cyclical state of the economy, continued US policy reflation may lead DXY index to new lows in the months ahead.

Oil has stayed over $70/bbl for some times, mainly due to USD weakness and the sentiment towards a demand recovery in 2H09. This outlook sentiment may be right in the mid-term, but there are plenty of risks to monitor. In particular, the inventory overhang of oil and related products is massive in the wake of the economic and financial meltdown. Plentiful physical supply has left forward inventories near record levels. With refineries cutting runs on poor margins, it will take weeks for the situation to be resolved. In addition, although China, Latin America and Middle East’s apparent demand is growing yoy in 2Q09, according to IEA estimates, demand from DMs (70% of the global oil demand) continued to fall in 2Q and there is little indication that Q3 is any different so far. US inventory data this week continued to show a picture of weak demand and high inventories. Meanwhile, indications are that OPEC’s output is edging higher and this is likely to persist for as long as prices remain within the OPEC’s desired target range of USD 70-75/bbl.

Good night, my dear friends!