My Diary 603 --- Santa Is Not Coming, Bonds Dont Buy Optimism,

My Diary 603 --- Santa Is Not Coming, Bonds Don’t Buy Optimism, What to Expect from China , USD at 3500 Metres Height

September 6, 2009 

[Note: I have not put down any inks during the past two weeks when my parents have their first visit to HK. Remember, family is always the first priority. Paul Thomas, the former President of Merrill Lynch Canada and the founder of Cornerstone Asset Management, once told me. Btw, tomorrow is my birthday. I present this diary as a gift to share with friends.]

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“The September Myth: Bear Fears vs. Better Economics” --- Obviously, bulls won the Friday, but not yet the month. Based on the data of S&P from 1957 to 2008, the worst sell-offs usually happen in Sept/Oct, making this the time of fear. In other words, the seasonality studies show that September is a down month. But similarly many incredible rallies have started in the fall as well. Before I step into my birth month, let us have a review of market performance in August as the seed of a lost month must be laid ahead of time.

The month of August saw DMs (+4.2%) outperformed EMS (-0.3%) and EU (+6.2%) outperformed US (+3.4%). It was the concerns over end of easing / tightening affecting the pace of recovery in China hurt EMs’ performance. In AxJ, regional market registered losses (-3.8%) and marked the first monthly underperformance since March. China (-7.0%) and HK (-7.1%) were the worst performing markets. Within them, materials sector had the hardest hit after China’s decision to impose capacity curbs on key commodity related sectors including steel, cement, coal and power. Style wise, I saw Growth outperforms Value, and SMCaps outperform LACaps. On the other hand, the global economic recovery remains on track with continued signs of improvement in most LEIs and sentiment indices. The missing peice is that Western consumers’ demand and job markets remain in deep troubles. Monetary policy remains loose (except for +25bps by Bank of Israel), but a stabilizing global economy has led the markets to price in a rate hike. In Asia, macro data remained mixed, witnessed by the continued improvement in domestic demand offset by a weak external demand. Industry production showed significant improvement in South Korea, India, Singapore and Taiwan. Retail sales continued to improve in China, Singapore and HK. Exports in major countries (South Korea, India, Indonesia, and HK) continue to surprise on the downside. It seemed that the market finally realizes this rally could be shaky as economy is still struggling in th mud. As of this August, a 86% rally in MXAxJ since Oct2008 has led to significant re-ratings, with FWPEs are now trading at 2007 levels. Thus something has to give away.

Entering into September, markets and risk appetite have stalled in the last week or two as investors fret over whether they have got ahead of the recovery. In particular, US banking sector appears the most vulnerable (-4.78% wow), even as major banks contemplate repaying government funds. Interestingly, liquidity measures, such as LIBOR-OIS spread, continue to grind lower. I think what caused the correction of equities is mainly about China as nearly everyone now wants to know what is going on here. Some fear that A-share has shifted from bubble to burst as SHCOMP dips 22% in August into bear markets technicals. The magnitude of such a fall was enough to panic the govt which then got NDRC to clarify that they weren't backing away from oil price reforms, Premier Wen to call for sticking into the supportive policies, and CSRC to raise the QFII quota by another USD1bn. Put it together, it’s clear that market optimism has begun to wane, signalled by 1) A-shares off 20%; 2) JPY-crosses strength and 3) the stickiness of SPX at 1000 level. But the fear factors seem to be less popular as global economic data continues to improve, if compared with the dramatic slump in last winter and spring. That said, the econ data were mixed last week while Chicago PMI, ISM manufacturing, pending home sales, chain store sales, non-farm productivity, NFPs were all BTE, while ADP, factory orders, jobless claims and UNE were all disappointing. And in particular, pending home sale (+3.2%) jumped suggested more strength in housing sectors may be seen going ahead. However, risk ahead is that the recovery remains BTE but insufficient to restart jobs hiring, so markets and moods bounce around without direction. Historically, the last time when US UNE rate >10% was in 1983, following the recession of 1981-82. Cuts in the FFTR from 20% to 8.5%, combined with deficit spending by the Reagan administration helped push the jobless rate down to 7% by the end of 1985. The problem this time is that the target rate is near zero already.

X-Asset Market Thoughts

On the weekly basis, global equities were 1.5% lower with -3.3% in Japan , -1.8% in EU, -1.2% in US, and -0.5% in EM. Elsewhere, 2yr and 10yr UST yields decreased 9bp and 8bp, respectively, to 0.93% and 3.44%. 1MWTI oil moved down $4.72 to $68.02/bbl. Since the end of July, the price of oil has ranged from $66.75/bbl to $74.37. USD was flat vs. EUR@1.430 but decreased 0.6% against JPY to 93. Gold continues to shine and now is flirting with $1000. Everyone has a theory but none is satisfied– reserve managers buying, technical buying, inflations worries, renewed risk aversion and so on…Based on the relative performance; I think the markets look completely confused. On the one hand, I saw UST rally (low @ 3.28%) suggesting that FI investors are expecting deflation while gold is rallying back $1000 again suggesting that investors are expecting inflation? A seasoned analyst even pointed out that last time EUR/Gold had a move like this, SPX subsequently dropped 300ppts in a hurry…Wow, it sounds like a Red Alert!...In general, the traditional correlations among equities (up), USTs (down) and USD (down) have not held over the recent weeks. Part of the reason is that the basing of US economy isn’t sufficient to lure foreigners to buy more USD assets – particularly bonds without a yield premium putting the USD correlation to rates back in play. In addition, I saw oil ended below $70 bbl – a bellwether that suggests the pessimism on A-shares extends beyond to many other assets. Also, weaker USD suggests risk aversion trades have dominated, and the move in USTs shows that the move in gold isn’t about inflation fears but about currencies (I will discussed later).

Looking forward, I notice that the recovery has started, but the current global recession is far from normal. In DMs, their financial systems are still partially dysfunctional. It will take a long time to form a new balanced system, along with regulatory reform. In EMs , capital inflows may not fully come back in the next few years, along with the changes in the structure of global demand/ production. In nearly all countries, the costs of this crisis have added to the fiscal burden, and higher taxation is inevitable. In the medium term, the major challenge is that economy growth is not strong enough to reduce unemployment. The “green root” theory is largely based on a combination of a fiscal stimulus and inventory rebuilding by firms, rather than on strong private consumption and investment spending. All this means that we may have to accept a lower output than it was before the crisis.

The implication to equities is that the overall backdrop in the near term remains favourable --- 1) recent economic data and earnings releases have beaten expectations; 2) Fed has reinforced that it will not rush to implement its exit strategy because 9.7% UNE rate represents a significant output gap that should help limit inflation pressure over the foreseeable future. Federal funds futures are pricing in < 50% chance of a rate hike before March2010; and 3) 10yr UST remains well below 4%, despite mushrooming issuance and a clear improvement in consensus estimates of global growth. That being said, these are not enough to ignite a sustainable rally of equities until some signs that corporate sales are improving or consumer spendings are warming up. In US, the latest report revealed that US consumers continued to sit on their hands in July as wages and salaries lost 4.7% yoy, the biggest drop since 1960. In Asia , given the outlook for profits remains rather dire as excess capacity and rising raw material costs squeeze margins. Thus, leverage remains the main source of cash for asset buyers as Asia is among the few regions in the world able to lever up. That’s why bubbles are more likely to occur in this land.

Santa is not coming

Several macro trends worth for a note based on August macro data. First of all, the global PMI clearly said that growth is strengthening, although perhaps LTE. While manufacturing output index reached 57.5 last month, the level of service output remains a relatively low 50.5. These index points to a sluggish expansion in the rest of the economy, while many broker houses are looking for a 4% growth in 3Q09. Secondly, it is about US housing market. While Case-Shiller index bottoming out in the last two months, I am sceptical that any significant recovery can take place due to 1) UNE is rising (NFP still weak, ADP indicating layoffs and initial claims at 570K and continuing claims rose); 2) the delinquency rate are still rising with prime mortgage delinquency rising from 6.06% in 1Q09 to 6.41% in 2Q09; and 3) sales volume surge is mostly stimulated by the USD8000 Federal housing tax credit…You can call me bearish, but this is the fact, not my opinion…As for CRE, it is worth reminding that the earnings season saw numerous large regional banks in US posting further losses, many due to CRE exposure. The real estate problem is not over yet. A new loss of confidence in these sectors (CRE & Bank) could generate a fresh wave of risk aversion and volatility in the markets.

Back to Asia, the region led the global manufacturing recovery by at least one quarter, suggested by a surge in output and exports. But I am now on guard for signs that we are beginning to lose momentum as Christmas orders this year remind me that the world is not back to full strength yet. Again, this echoes the still weak service PMI and consumer demand in the west. So far, several reports have shown that western buyers are unwilling to commit their orders due to the economic uncertainty and the need to preserve cash flows. Another common complaint is that the hefty price discount demanded from these buyers. What this means for Asian corporates is that the business outlook (especially 4Q09 or ahead), remains uncertain, despite the recent improvement in regional PMIs. This implies that business confidence is unlikely to improve until our region sees a more consistent order book, either from DMs or from some new sources of demand. Consequently, private business investment will be constrained. The recent 2Q09 GDP data from most of regional economies have shown that private FAI has been the weakest link in this recovery story. And this is a crucial issue for the policymakers when considering their exit strategies, as Western Santa has not come back to Asia as it does before.

Bonds don’t buy optimism

UST market continued its rally with 10yr yields once touched a low of 3.28%. Catalysts for lower yields were weaker ADP and Factory Order reports along with a more dovish read on FOMC minutes released which showed policy makers concerned by the still weak labour market and "sizable risks" remaining for bank credit losses. As well "most anticipated that substantial slack in resource utilization would lead to subdued and potentially declining wage and price inflation over next few years; a few saw a risk of substantial disinflation". In short, the bond market isn’t buying all the optimism over the end of the global recession. According to the Merrill Lynch, yields on global GBs of all maturities average 2.27%, compared with YTD peak of 2.62% on 08June. As a result, bond investors profit 2.14% since the start of June. But looking ahead, I believe that the bond market is due for a mini-bear run as 1) incoming economic data was trending upwards and 2) a supply of UST is heavy with $38bn 3yr, $20bn 10yr and $12bn re-open bonds over the next two weeks.

Another point worth for a note is the real ST rate. Over the 3-year period before the crisis, the average nominal T-bill rate was 4% and inflation was 3%. That resulted in a real rate of 1%. Today, T-bill rate is roughly zero and inflation expectations appear anchored around 2%. That implies a real rate of around –2%, or 3ppts below its pre-crisis level. Negative real rate is likely to remain on the course as Fed can leave the policy rate at zero if it needs to and inflation expectations are more likely to increase than to decrease. An old rule of thumb is that a 1% lower real rate leads to roughly 1% increase in aggregate demand. Thus, the 3% decrease in the real rate may seem sufficient to sustain the current recovery. This may not be true in this cycle, as what matters for demand is the rate at which consumers and firms can borrow, not the policy rate itself. As of today, risk premiums on US BBB bonds are nearly 3% higher than before the crisis. Higher risk premiums could offset, at least in part, lower policy rates that US policy-makers count on to deliver a sustained US recovery.

Back to Asia corporate markets, September is typically a bad month for credit as well. Looking at Moody's Baa credit spreads since 1980, credit returns (due only to spread movement) has given a Sharpe ratio of -1.62. Furthermore, spread movements have been skewed to the wide side, with the 10th percentile move of a 19bp tightening while the 90th percentile of a 40bp widening. Thus, this also suggests a seasonality play given --- 1) the strength of risk market YTD and the natural tendency to lock in some profits after the horror of 2008; 2) the continued increase in default rates which will only peak during 4Q09; and 3) the evening out of news flow as expectations begin to catch up or even pass the recovery.

What to expect from China 

According to David Cui’s (ML China Strategist) analysis, A-shares 2Q09 results shows that earnings are recovering, with REV growth at -8.5% yoy (vs. -11.9% in 1Q09), OPM 10% (vs. 9.3% in 1Q09) and NP growth at -2.4% Yoy (vs. -24.8% in 1Q09). CFO was healthy with 1Q09 and 2Q09 saw operating cash flow of RMB316bn and RMB352bn respectively, vs. 3-yr average of RMB248bn. However, Capex remained weak at -9.6% yoy vs. +4.3% in 1Q09 and +46% in 2Q08, indicating a continued weak private sector investment appetite. Earning wise, the sector mix changed significantly with materials’ profits down to near neglectable, while major contributions are from banks (45.9%), energy (24.1%), consumers (6.8%), capital goods (6.4%), insurance (4.3%), and others (12.6%). Valuation wise, SHCOMP is trading at consensus 18.5X 12M FRD PE (24% EPSG) vs. 23X average since 2005.

Having discussed so, given the on-going market concerns about potential aggressive policy tightening, Chinese policymakers have reiterated that any change in policies will be fine-tuning rather than a major shift to tightening. Looking ahead, the macro development in China will keep global investors alert. In general, the market is expecting GDP growth at 9-10% in 2H09, with retail sales accelerate and exports stabilize, while FAI growth ease. While July CPI has dipped further to -1.8% yoy, headline CPI are expected to rise to 3-4% by mid-2010, due to 1) fading base effects; 2) continued resource price liberalization and 3) food price increases, such as pork and grain prices. Policy wise, as the central government remains growth-biased, it is widely expected that PBOC to keep the RRR, interest rates, and FX rate steady in coming months. But I do believe PBOC will continue to rely on open-market operation to manage overall liquidity. The key event to watch for a shift of policy gesture is the central economic work summit in Nov-Dec 2009. If there is a change, PBOC could start by implementing an M2 growth target and a credit quota early next year, and using window guidance to curb bank loans.

Sector side, PBOC said it will take years to implement stricter capital requirements for banks, through reduction of sub-debt. I think the next loan data would still likely be negative for asset markets as some believe that as much as 30% of the DBs found its way into stock markets. I think the market has priced in a lower loan growth. It is the indirect impact on sentiment has been significant so far. In addition, I would expect more targeted/sector-specific measures could be employed to curb inflation expectation and prevent a potential asset bubble. According to E-House data, SH/SZ/BJ property price hit record high in August with ASP in SH at Rmb18500/sqm & SZ at Rmb18380/sqm…Lastly, valuation wise, MSCI China is now traded at 15.9XPE09 and 12.5% EPSG, CSI 300 at 22.8XPE09 and 18.6% EPSG, and Hang Seng at 16.5XPE09 and -9.9% EPSG, while AxJ region is traded at 17.3XPE09 and +11.9% EPSG.

USD at 3500 metres height

USD fell over the week with DXY down 0.3%. The weakness in USD did not help commodity space (CRB -3.97% and WTI -6.49%) as the force of worry on China slowing down had overwhelmed. The only commodity that outperformed was gold (+4.23% to US$995/oz) as market/currency uncertainties had prompted investors to hide behind this defensive metal. Talking about gold, m arket suspected that China ’s SWF are dumping dollar and buying gold. The conclusion is that China recognises that USD is going to tank and it wants to convert as much of its trillions of dollars of holdings into strategic assets as possible before the collapse really takes hold. The trouble is there is too much money available chasing too few assets - and too little time available - or such is the conclusion. As a result the Chinese government seems to be doing its utmost in trying to persuade the Chinese public to buy gold and silver by relaxing the restrictions - it's now easier to buy precious metals in China than in US. If this continues the likelihood is that China will permanently overtake India as the world's biggest buyer of gold and silver, while the country's store of wealth will help shield it against further western economic collapse.

Personally, I am inline with the veiw that weak USD is the main driver of gold strength going into 2010. In an interesting footnote to the Thunder Road Report written by Paul Mylchreest, he comments that in Latin America, where he has been living for 25 years, for the first time he can remember, locals are now preferring their own currency to USD. He goes on to finish with this comment: "If a fellow with no education, a poor diet, and inadequate medical treatment living at 3,500 metres above sea level can figure out that USD is undesirable as a store of wealth, how much longer do you think it can last as the world's reserve currency"…Think about that point, my fellows.

Good night, my dear friends!