My Diary 623 --- The Outlook of 2010; A Run for Bills; How to Play China; A Road Map to USD
29 November, 2009
“Dubai Shock, Banks Hunger, USD Rebounce and Equity Weakness” --- All these are the “thanks-giving” headlines for the media. If one’s memory lasts long enough, this time last year many people in this industry were applying for jobs like barbers or restaurant cashiers as Wall Street teetered on the brink of collapse. One year later, Goldman Sachs is set to pay every employee on average of USD711K in bonuses, as a result of the world has been pushed so far out the risk curve by the tidal wave of liquidity unleashed by governments globally. That said, it is unsurprised to see Fed and its counter-peers in Asia (Japan and China) expressed their concerns over “excessive risk-taking” and “asset bubbles” which could derail the global economic recovery. Such a concern is warranted as historically, whatever Tech bubble or Housing/Bank bubble was aided by Fed policy. It’s not unreasonable to suggest that some of the same characteristics are evolving. Obviously, smart investors, like Bill Gross, have bought into this theory. PIMCO, the world’s biggest bond fund, has increased its holdings of govt-related debt to 63%, the highest proportion since July04. Flows wise, YTD bond funds have benefited more than equity equivalents as money flows from deposits. Less hoarding of cash reflects the desire for greater return and higher conviction that rates will stay low for longer. It also suggests that bond and equity market rallies have been liquidity-driven in recent months.
Until Friday, global risk backdrop was favourable for risky assets and EMs in particular. According to Citi, liquidity continues to chase EMs with inflows of USD869mn, and USD542mn (>50%) goes to China in the week ended 18Nov, compared to previous 4WAVG of USD54mn. However, the room for complacency is squeezed after Dubai shook investor confidence sue to its proposal to delay debt payments risked triggering the biggest sovereign default since Argentina in 2001. Dubai 5yr CDS were quoted at 670.1bp vs. ~300bp before Wednesday. Its risk now ranks higher than Iceland. At this stage, it is too early to make a clear judgment about the potential repercussions for global EM of the Dubai developments. But the contagion risks have not disappeared. By way of illustration, European banks which exposed to Dubai World include Credit Suisse, HSBC, Lloyds and RBS have all down >5%. In Asia, all Korea E&C were hit hard, as they are often cited as Dubai/Middle eastern play. In HK, HSI drop 1075.9ppts or -4.84% on Friday, the largest single day decline YTD.
In a nut shell, I think the Dubai debt crisis is another classic example of excess liquidity creation feeding financial manias and asset bubbles, which ultimately end badly. Since details remain sketchy, it is difficult to make a full assessment. But I have a few preliminary observations and thoughts here --- 1) the size of the debt involved is relatively small with total estimated debt under Dubai at about USD80-90bn (100% of GDP, while Dubai Worlds alone at USD60bn). While the debt amount is large relative to the size of the local economy, it is rather small on a global scale and relative to the estimated USD2.8trn losses suffered by global financial institutions; 2) European banks have most exposure to DW. Therefore these banks will take a hit when the debt is restructured and this is why HSBC, RBS, ING and Lloyds fell by around 5-8% given they were among nine banks were book runners on an outstanding USD5.5bn syndicated loan to Dubai World in June 2008 (Reuters); 3) It is possible that Dubai will seek financial help from Abu Dhabi’s SWF, which has assets >USD400bn. I think that Abu Dhabi would extend help, although terms and conditions of a bailout are yet to be determined. So far, UAE’s political willingness to use its own reserves to bail out troubled Dubai will be tested.
Having discussed the DW crisis, it also seems that every banking crisis will end up at a currency crisis. Last week, I observed that Vietnam central bank permitted the Dong to decline 5% on 26Nov, bringing its losses in the past year to 8.3%. Vietnam is the outlier of Asian economies as the country devalued its currency in response to unique circumstances – 1) a CA deficit; 2) rapidly depleting FX reserves; 3) the accelerating inflation and 4) a 120% Debt/GDP ratio. The rest of Asia is in a very different situation, where currencies are appreciating against USD. If Thai’s experience is of a guide, Vietnam move won’t achieve much and it still has a long way to go. The baht fell 50% after debt/GDP rose from 60% in 1990 to 110% in 1996, while Vietnam's ratio has gone to 120% this year from 40% in 2002.
Another market shock is the rumour or debate around the mega-sized fund raising by Chinese Banks. Early the week, Reuters reported that CBRC is asking banks to raise CAR to 13% in 2010 and they were quoting that BoC was to raise up to RMB100bn (USD14.6bn). The CBRC then promptly denied the Reuters report. However, no smokes no fires and Chinese banks continued to get sold off into the end of the week. In my own views, the market reactions are a bit overdone due to 1) capital raising probably won't come till 2010-11 and won't be in big size; 2) even if the banks need additional capital, straight equity raising is not the only option. Other means include a) internal capital generation or dividends-cut; b) Tier-2 capital raising through sub-debts (max =25% of Tier-1 capital) or CBs or hybrid debts; c) even without capital raising next year, the current B/S can theoretically support 17-18% loan. I remain +VE to China banks and view this correction as a better entry point because the fund to-be-raised is growth capital and not B/S repair capita. It's important to differentiate between the two as raising growth capital is seen as a +VE thing by the market, as evidenced by the recent case of Industrial Bank.
X-Asset Market Thoughts
Over the past two days, equities fell 1.8% in US, 2.1% in EU, 3.8% in Japan and 2.2% in EM as markets reassess credit risks following developments in Dubai. However, on the weekly basis, global equities slipped only 0.8%, finishing 2.5% higher than Oct’s close. Elsewhere, 2yr and 10yr USTs yields ended at 0.68% (3bp from last year’s low) and 3.21% (the lowest yield since early Oct). 1MWTI ended USD76.05/bbl, three cents above the November’s low. Consistent with its recent 2-days trend, USD moved inversely with equities, rising 1.1% against EUR at 1.4986. Meanwhile, USDJPY ended at 86.56, the weakest since the mid-1990s. Gold touched an all-time high of USD1174/oz. Ytd, the metal has the longest rally (+34%) since 1979....Looking across asset markets, equities seem to be suffering from some lethargy here but it's just a matter of time before we head for the punchbowl, if my judgement of the Dubai debt crisis is correct…So Buy on the recent Dip!...However, I continue to expect short-end yields to drop as many investors have been hiding out in the front end, waiting to see how this economy turns out. With respect to USD, although the currency is approaching a 14yr all-time low against JPY, I still prefer the upside to the downside in EURUSD. Furthermore, fundamentals in oil are still weak as demand from refiners remains low with utilization rates below 80%. And it is the first time since August that WTI/Brent spread narrowed to 3c/bbl from 24c/bbl.
Looking forward, I am inline with most private sector economists who believe in low inflation and damaged labour markets will deter Fed from lifting interest rates until 2H10. Currently, US real GDP is 8% below its 30yr trend line at near 3% and the consensus forecasts for 2010 and 2011 are 2.6% and 3%, respectively. Thus, the GDP gap is unlikely to close soon. This argues for a low for longer view of the Fed funds rate, lower long-term rates, a latter curve and continued top line pressure for companies. As a result, I think returns from risk assets are unlikely to be as stellar in 2010 as in recent quarters, but risk assets will continue to outperform govt bonds and cash. Historically, SP500 rose an average 8.4% in the 6mos before the last 5 increases in FFTR and added another 82% in the bull markets that followed, according to BBG. It is expected that S&P will finish 2009 around 1,100, which implies 15.5X 4Q09 annualized EPS of about USD70. This makes current 10yr UST yield undemanding. With respect to EMs, fundamentals remain strongly supportive despite the current market shock. The growth outlook for EMs is quite favourable and exit strategies will be on the agenda but for a large part the accommodative bias will remain in place for some time. With respect to energy, Oil could climb to USD85/bbl in 2010-11, owing to strong demand growth from Asia. For debt markets, the recent themes driving US bond trading will continue into 2010 - too little growth, too much supply, and the wall of money/carry story.
The Outlook of 2010
Macro side, it was a mixed but busy calendar over the week, including Oct existing home sales (6.1mn vs. cons=5.7mn, +10.1%mom, -7.1% yoy), 3Q revised GDP (2.8% vs. 3.5%), personal consumption (2.9% vs. cons=3.2%), home prices (-9.36% vs. cons=-9.1%), and Nov consumer confidence (49.5), durable orders (-0.6% vs. 0,5%), jobless claims (466K vs. cons=500K ) and Oct new home sales (6.2% vs. cons=0.4%). The bad data is US consumer spending, which falls short of economists’ estimates. I think this is due to 1) consumers continue to face tighter terms and less available credit. 2) According to IMF’s Mr. Strauss-Kahn, banks have revealed only 50% of their losses from the financial crisis. Thus, consumer loans held by US banks fell to USD846.7bin in Oct, -0.7% yoy. On the economic outlook, FOMC minutes indicated that risks are balanced around Fed’s forecast for moderately-above trend growth. FOMC raised its 2009 growth forecast (-0.3% vs -1.3% in June) but the revisions to growth and inflation in 2010 and 2011 were small (Growth: 2010=+3.0% vs +2.7% in June & 2011=+4.0% from +4.2%). Core PCE inflation is expected to stay at 1.5% for 2009, 1.3% for 2010, 1.3% for 2011. UNE rate is expected to move lower to 9.5% in 2010 and to 8.4% in 2011. In short, US GDP will need to grow by 4% to make a meaningful dent in joblessness. Inflation over near-term should remain “pretty low”, although government deficits and Fed policy increase the risks of rising prices in the coming 2 to 4 years.
Regarding the rest of world, European business sentiment surveys rose solidly in Nov, and EU composite PMI is at a 2yr high of 53.7 in Nov from 53.0 in Oct. In Asia, BOJ kept rates unchanged at 0.1% but upgraded its assessment of the overall economy for the 3rd month in a row. Taiwan reported export orders which rose 4.4% yoy but below the headline. However, there is some underlying weakness as +2.4% mom rise in Oct was below 3MAVG and shipments to China contracted for a 2nd month in a row. Taiwan Oct IP was strong at +6.6% yoy but this was due to base effect. In HK, Oct CPI came in at 2.2% yoy, much higher than consensus but once again due to the low base effect.
In general, almost all major economies exited recession in 2Q-3Q09. The initial bounce in output after financial crisis is likely to be quite solid and even, but I expect recovery to be uneven across regions going forward --- the strongest in AxJ vs. the slowest in EU and Japan. For US, a relatively solid recovery is likely in late 2010-11, but the mid-term fiscal outlook poses major policy challenges. As recovery strengthens, many EMs especially in Asia are likely to hike rates in 1H10, with the PBoC’s first hike forecast in 3Q10. In contrast, with subdued inflation and residual worries among policymakers over recovery’s sustainability, Fed is likely to hike in 4Q10 and ECB to hike in 1Q11.
A Run for Bills
St. Louis Fed President James Bullard said last week that he would prefer to have Fed buying MBS beyond the Mar10 cut-off date to give policy makers more flexibility as they seek to shepherd the economy toward recovery. As of 19Nov, the Fed held roughly USD847bn in MBS on its B/S out of the Fed’s USD1.25trn mortgage bond purchase program. The reality is that what happens to the Fed's APP will be a major issue for the market in 1Q10 and beyond. There is no doubt that the USD1.25trn in MBS debt purchasing is a key contributing factor to low market rates across the MBS and UST curves. And this is also a material factor fuelling the liquidity-driven risk trade. Thus, if the program sticks to the schedule, there is legitimate risk that it will be followed by higher market rates and diminished liquidity.
Interestingly, despite all the complaints about diversifying from USD, the US managed to sell a record-tying 44bn of 2yr debt at the lowest yield ever. Corporates are also trying best to utilize the historical-low rate and historical-high liquidity by selling USD1.171trn corporate bonds YTD in 2009, surpassing the USD 1.167tr sold in 2007. One thing to be noted here is that there is still tremendous demand for the front end of the curve despite the fact that investors are saying things like there is no yield there and that cash is trash, i.e. 3M bills have approached 0% (2bps), while 6M bills recently fell to a record low of 13bp. In short, while counterintuitive, negative rates simply reflect 1) B/S window dressing, of which banks adding the safest securities to improve B/S at year-end; 2) a drop in sales as the Treasury lessens its dependence on short-term financing and; 3) fewer alternatives as investment banks and companies, cut back on sales of commercial paper.
Having said so, strong demand for UST bills suggests that dislocation and fear still pervades the financial system as investors are willing to forgo interest income completely or even take a small loss to own securities considered safe. In fact, this is the first time in 7 decades, treasury bills are paying no interest while stocks continue to appreciate. The divergence in US Debt & Equity markets might be perilous based on the previous depression experience in 1938-39. During that period, S&P 500 climbed 25% while bill rates tumbled to 0.05% from 0.45%. As 1939 began, stocks began a three-year, 34% decline after the Fed increase borrowing costs prematurely to stymie inflation that never materialized. Today, while bond investors say, with UNE>10% and housing taking another downturn, they are willing to lend the US govt money for nothing to ensure their capital is preserved, Stock investors, meanwhile, say the worst is over and that low borrowing costs coupled with the USD12trn of fiscal and monetary stimulus will bolster earnings. All in all, I think the fundamental question remains the same --- what to do with all the money created?
Look at the credit market, it is obviously rattled by the surprising announcement of the intended restructuring of Dubai World's debt. The surprise crowned a week with other unanticipated developments --the opposing move of the central banks of Israel (+25bps to 1%) and Colombia (-50bps to 3.5%). With sovereign risk (Dubai) continues to be a driver for sentiment in credits, other sovereigns are also impacted, i.e. Saudi Arabia CDS was 18bp wider and EM peripherals were also negatively affected, with Vietnam widening by 35bp, Indonesia 25bp wider and Russia 14bp wider. In Europe, SovX index finished 1bp wider at 65bp. Greece 5yr CDS closed at new wide of 210bp (+10bp).
How to Play China
China markets suffered a series of negative shocks, including Dubai story, RBS issue new capital, USD bounce and A-share weakness amid news of Ping An unloading stock holding, which caused free-fall in both on-shore (-6.8%) and offshore domestic markets (-5.3%), the worst market in the region. On Friday, HSI lost 4.84% or 1076pts, biggest % drop since mid-Dec 2008, and turnover was huge at HKD107.5bn, the heavies since mid May this year. Standing at this moment, the key question is sustainability though China has led the world in the first year of recovery. However, its generous stimulus policies have created double-edged risks for the next step in macro policy, as the negative side-effects of stimulus are intertwined with lingering uncertainties over growth.
Looking into 1H10, I expect liquidity conditions to remain supportive with >20% yoy in bank loans and M2. Rate hikes may kick in during 2H09, if inflation becomes a real threat. RMB appreciation is expected to be 3-5% yoy. Structurally, given the dominated market share of Chinese export in the global trade, export would support GDP growth in 2010 at near 10%, but at a small pace. FAI and consumption growth should continue to drive economy growth along with political and policy support. In terms of macro risk factors, inflation faces upward pressure next year with CPI estimated at 3% because of abundant liquidity, rising asset prices, imported inflation, and domestic resource price reforms. Overcapacity might not yet hold back inflation, as China is still in the process of heavy investment. In the longer term, the real risk is a delay in structural reform that could lead to a greater correction. Thus the current global recession has presented the top authorities a golden opportunity to rebuild China economy via industrial consolidation, rising consumer purchasing power, service sector investment, financial industry development and continued privatization. All these could be investment themes in the years to come.
Market wise, the current HK market valuation is lower than peak valuations made in the last three decades and may have another 15~20% to go. A comparison between now and 2007 shows that cheaper valuations in heavyweight sectors, such as Financials and Telcos, which kept the market from being too expensive, while valuations in other sectors have been higher than their respective levels in mid-2007. This means that the current valuation will only be sustainable on the premise that China economic fundamentals and global liquidity will remain supportive. Sector wise, Banks are beneficiaries under rate hikes and rising inflation expectations. As discussed in the beginning, even if banks were to need to raise CAR to 13%, they can raise the incremental capital needed through sub-debt. Under this scenario, BoCom and CCB would need to raise the most equity capital at RMB28.9bn and RMB 49.7bn respectively. This works out to about 6.7% dilution for BoCom and 3.2% for CCB. CMB would suffer dilution of 2.4% with almost no impact on BOC, ICBC or Citic. Asset allocators should O/W Insurance, Consumption, Energy, IT and Property related sectors, while U/W Infrastructure, Telecom and Utility... Lastly, valuation wise, MSCI China is now traded at 13.5XPE10 and 21.4%EG10, CSI 300 at 19.4XPE10 and 26%EG10, and Hang Seng at 13.6XPE10 and 21.0%EG10, while AxJ region is traded at 13.3XPE10 and +26.4%EG10.
A Road Map to USD
The underlying theme for currency into 2010 is the global recovery will face challenges in 2010 as favourable base effects ebb and policy makers begin to unwind the massive easing put in place from 2008. In this context, investors will be increasingly watching to see if individual economies are able to make the transition from stimulus to private sector-generated growth. In my own view, USD could see a bounce in 1H10 as investors reduce beta” (equities and credits) in anticipation of weaker growth prospects, especially in DMs. However, I also expect the Dollar rebounce to be temporary on the assumption that 1) the global recovery trend will continue, as any unwinding of policy easing will be gradual and measured; 2) US budget deficit reached a record USD1.4trn in the fiscal year that ended Sept. 30. Its debt amounted to 9.9% of the economy, up from 2004’s average of 3.5%; 3) ECB is considering the introduction of a variable interest rate at the central bank's 12-month repo fixed at 1.0%. Such a switch to a variable rate could be viewed as a step towards tightenin monetary policy. It is likely that DXY may retest its all-time low of 70.7 (last recorded on Mar08) at some time in 2010.
On the other hand, history show that USD shouldn’t start rising on a sustained basis until 12 months after Fed starts to lift rates. In the recent history, USD Index tumbled 10% and didn’t get back to where it had been before the first increase and stay there for more than a month until Nov2005. USD also dropped 16% the Fed’s 1994 move without regaining lost ground until 1997. The 2001 recession, induced by the crash of technology stocks, prompted the U. to cut rates by 5.5% to 1% in June03. The Fed stayed there until June 2004. USD started rallying after the rate surpassed the ECB’s 2% in Dec2004. If the apex of the crises were in 2001 and 2008, then USD weakness will last into 2011.
With respect to the counter-part, 1yr RMB forward rate is likely to move towards 6.5 levels as investors try to price in ~5% appreciation for 2010. Given China's positive GDP growth gap to US and the rest of world, interest rate differentials, strong FX reserves and fiscal position, and the sharp 80% rebound of China's exports to the US since Feb's low, Rmb is indeed very undervalued against USD.
Good night, my dear friends!
