My Diary 633 --- The Bernanke Must-Read; The New Version of Japa

My Diary 633 --- The Bernanke Must-Read; The New Version of Japan ; The Hot Spots of China ; The Gold and AxJ Currencies

 

February 28, 2010

 

“What are we waiting for --- Beijing ’s NPC , US ’s exit strategy, EU’s bailout or else?” --- A HK colleague asked me this question before I left office in the Friday evening. Based on her chats with street analysts, there isn’t any risk factors that she has not though about. However, HK stock market’s average transaction volume in Feburary has dropped to ~HKD50bn ( same as last Mach and pre-Xmas level) from ~HKD70-80bn over the past three months. It seems that traders have not recovered from the cold weather during CNY. Having said so, ML’s China economist, Dr. Lu Ting, has appropriately coined today’s market environment --- Stable Growth, Uncertain Policy. I think the last two words explained the hesitation behind most investors’ mind as one can not fight with all government authorities after the unprecedent measures taken by the nations worldwide over the past 18 months. That said, my view over the markets is that there are 3 major uncerntainty capping upside in the near term, namely 1) a double-dip in US, 2) further tightening in China, and 3) intensified political fights of major currencies. In addition, the Greece/Euro issue will not go away soon and the outlook of EU’s economy is very comparible to what Japan had experienced in 1990s...So let me start with US, which I think is the single engine of global recovery  in 2010, instead of China.

The NY Fed President Dudley recently spoke cautiously about US economy, stating that the outlook was improving but that "significant downside risks" remain. In particular, he noted that small banks are still under pressure and credit conditions for households and SMEs are constrained. In addition, UNE rate remains unacceptably high. Echoed his concerns, the data flows, including falied banks (702, +27% in 3Q09), consumer confidence ( -10.5pts to 36), employment (Initials +22K to 496K), durable goods (core -0.6% vs. cons.=1%) and housing sector (existing home sales -7.2% & new home sales -11.2%), are all sending out worrying signals and questioning what the market’s consensus are --- US recovery is on track (EPSG=26.5% vs Jan22=10.6%)? Moreover, the correction in CRE market is not over and this poses a serious problem for smaller regional banks, of which their B/S have concentrated exposure to the CRE assets, a significant factor driving the pace of failures in US banking industry. The acceleration in small bank failures will make credit increasingly difficult to obtain for SMEs and could delay the recovery in employment growth. Meanwhile, the week saw Fed raised the primary discount rate from 0.5% to 0.75% (1st time in 3 years), but assured its policy outlook unchanged. However, this gesture of policy nomrlization indeed tested investors’ nerves as historically in the spring of 1937, Fed raised RRR twice (March and May) helping to send economy back into recession and Dow Jones to fall 49% in the 12-months following Mar1937.

Across the pond, recent efforts by the Chinese authorities to tighten will continue, given that policy settings in China remain highly stimulative. Though Chinese economy and real estate market are heating up, a lack of broad-based inflation pressure and a policy mandate to create employment, should ensure that authorities move gradually and do not jeopardize underlying fundamentals. Nonetheless, Chinese policymakers have not historically been very effective at communicating their intentions to the market, which will leave investor uncertainty elevated over the next few months. Moreover, China reduced UST holding by USD34.2bn in Dec2009 vs. total net reduction from O/S investors=USD53bn. China now holds a total of USD755.4bn in USTs. The reduction of UST holdings by China has caused a wave of media guess over the implication of Sino-US trade and political relationships, as well as the impact over USD assets, especially government and agency debt over the medium term. Coincidently, UST market appears to have lost some pillars of real money support in late December and early January. Yields once moved sharply higher for 10YR (3.82%) and 30YR (4.77%) and the curve hit all-time record steeps with 2/10 spread at 294bp and 2/30 touching 389bp. The move in UST is worth watching as 30YR yields are threatening a multi-decade trend line between 4.78% to 4.83%, dating back to the late 1980s and finishing off the 2007 highs.

The third complicated macro factor emerged after the recent HH/Banking crisis is that most part of world, inlcuding US, EU, Japan and China, have been very dependent on exports for economic recovery and job growth. This means many economies are more sensitive to the effects of FX adjustments and the expansion of domestic manufacturing sectors. For example, manufacturing now accounts for 23% and 22% of GDP for Japan and Germany, respectively.This highlights the importance of currency movement to the major economies, which is the backbone of renewed global barks against RMB valuation to its major trading counters. Beyond currency world, soverign credit stress connected with Greece has not seen any real substance for the past few weeks, though the weekend BBG news said that KfW bank may purchase Greek bonds (USD34bn), backed by German government guarantees, as Eurohypo and Hypo Real Estate, the two largest Germany  holders of Greek bonds have claimed not to buy the next issuance. At the end of the report, the key message stays the same --- NO Decisions have been taken yet. I think, that will test the markets patience in what are dangerous times. In a rule of thumb, information vacuum or ambiguity has a nasty tendency of breeding additional uncertainty which plays into the hands of the bears. Thus, the risk remains for further pressure.

To sum up, my general sense is that investors have unusually low conviction about the durability of the economic recovery. Consequently, any weakness in the LEIs would lead to unusual consternation. Moreover, sovereign stress, which could limit the ability of policy makers to respond to slower growth, is likely to exacerbate investors' concerns. As a result, the road ahead is rocky and each of the above threats to a sustained recovery warrants careful monitoring.

 

X-asset Market Thoughts

Global equities close nearly flat (-0.1%) the week with -0.47% in US, -1.78% in EU, +0.48% in Japan and  +0.28% in EM. Meanwhile, UST continued their recent rally, with 2yr and 10yr yields falling 10bp and 16bp to 0.82% and 3.61% (the biggest decline since Aug2009). 2yr has declined 32bp YTD and 10yr has contracted 22bp. 1MWTI oil price decreased USD15cs to USD79.66/bbl. USD finished the week -0.35% on a TW basis, lost 0.13% against EUR (1.3631) and slipped 2.79% vs. JPY to 88.97…Reading across markets, I saw globex stock future reacted negatively to Fed’s 25bp hike in Discount Rate. But later on Bernanke’s testimony saying that rates would remain low had given strength to the market at the beginning of the week but the looming Greece credit issue and the talks of being further downgraded by credit agencies led the sell down towards the end of the week. USTs viewed the Bernanke move as yield normalization and the latest UST auction received strong demand with USD32bn in 7YR notes at a yield of 3.078%, a lower level than expected. EUR rose a bit in reaction to the German’s bank rescue to Greece, accordign to FT. However, Greece could see a further downgrade in its credit rating, something that would complicate the debt-troubled nation's efforts to meet its financing obligations. The weaker USD did not help the commodity space which was still dragged by the poor macro data with CRB -1.09% and oil -0.19%. Oil price stay firm though crude inventory surged, but cushing stock drew for the 7th consecutive week, providing support for WTI price.

Looking forward, as earning season is kicking in, investors have to do more home works to generate alphas in such a tricky market environment. Sor far, >480 companies in the S&P500 have reported 4Q10 earnings and about 73% have beaten analysts’ estimates on the EPS basis, according to Bloomberg. However, the flaring of sovereign debt fears earlier this year along with more recent evidence that the US consumer is losing hope serves as a reminder that much of the easy gains in risk assets have been made. The world is gradually returning to a more normal state, where reward is wedded to concomitant risk......Guess what would be the top-performing asset classes in today’s environment? According to AsianInvestor's first online survey, voters chose equities/credit as the most likely asset class to perform best in 2010, with almost half (47%) responding this way. Next came volatility/high-frequency trading (21%), suggesting a belief that the markets will remain significantly volatile this year. In my own views, this year HY credits will continue to outperform the IG bonds because interest rates are on the rise, which could have a negative impact on IG valuations. Beside the interest rate factor, another major theme to consider is whether a strong USD would be very bad for Asian equities? Historically since the 1970s, a strong Dollar has been bad for Asian equities for ~70% of the time. But there is an important and prolonged exception at this time, which (similar to the late 1970s) is that monetary policy remains very loose. Given that the transmission mechanism of a strong USD to Asia is typically through monetary policy, any significant rally in USD might lead to quasi-tightening, thus local government is unlikely entirely unwind loose monetary policy from here, which is a key to sustain a good return for Asian equity investors.

 

The Bernanke Must-Read

Chairman Bernanke testimony came at a significant juncture in terms of the monetary policy cycle, but few surprises emerged. His base case remains that the Fed will continue to prepare the ground for an eventual tightening of policy in a very methodical fashion, but that this tightening still remains some way off. I think Chairman must have read the broader US macro figures, of which can be classified into 5 categories – 1) banking sector: FDIC had 702 banks on the troubled list at the end of FY09, +27% vs Q3. Lending declined 7.5% in 4Q09, clearly not boding well for the economy. FDIC set aside additional USD17.8bn for bank failures fund, and now deposit insurance fund at negative USD20.9bn. 2) Consumer: the Feburary Confidence Index fell a whopping 10.5pts to 46, along with credit card debt dropping at 20% yoy at the end of 2009. Job security is still an ongoing concern. Given consumer spending is used to be 72% of the economy, a sustainable recovery is being questioned. 3) Job market: initial claims shot up 22K last week to 496K, the highest level since Nov09. Looking at the 4WK MAVG, it has risen by 30K to 473,750 in the last four-weeks. Thus, the recent trend does not suggest an imminent change for the better in the next round of data. 4) Durable goods: headline is bullish, but core capital equipment and machinery orders, the determinants of the direction of economy, lost 2.9% and 9.7%, respectively. FY09 durable goods fell a record 20%. 5) Housing sector: Applications for home purchases have just fallen to a 13-year low. New home sales fell to the lowest level on record in Jan. FRE reported it lost another USD7.8bn in 4Q09, a whopping loss of USD25.7bn FY09. Meanwhile FNM is seeking addtional USD15.3bn in aid after 10th loss. All the above data supported the Bernanke’s testimony that an expected backdrop of low rates of resource utilization, subdued inflation, and stable inflation expectations is consistent with a low for long stance on policy interest rates. In fact, US rates in 1930s & Japanese rates in 1990s show interest rates should stay low for an awfully long time after a B/S recession/credit crunch...

That being said, Germany’s 4Q GDP suggested the divergence between the recovery in domestic demand in US vs that in Europe. Gernmany’s domestic demand fell at 8.5% yoy (-3.1% from final demand). The lifeline for the economy was net trade, which boosted GDP by 9% as exports continued to rebound while imports contracted in conjunction with final domestic demand. One of the other notable features of the GDP report was the decline in German labor productivity (-1.2%  yoy) vs. US (+5.1%). This divergence makes for a strikingly different foundation for corporate profits and, thus, future spending. In Asia, things are still relatively better.Taiwan and Thailand reported BTE 4Q09 GDP at 9.2% yoy and 5.8%, respectively. This continues to support the region’s momentum in exiting the recession. On balance, there seems to be stronger desire to exit loose monetary policy before fiscal policy. Some central banks in the region have begun speaking more hawkishly in recent weeks, notably BOT and BOM, while BOI and PBOC have already embarked on liquidity withdrawal. Meanwhile, Asian governments are taking a mixed approach to fiscal tightening. In India , the case for fiscal consolidation is strong, as rating agencies are closely watching the country’s fiscal discipline. Moody’s has indicated that a narrowing of the fiscal deficit would be helpful in securing a higher sovereign rating. To the regional growth, question is whether we can maintain teh current momentuum as the +70% yoy in Taiwan export orders and +40% yoy in Singarpore IP is hard to keep pace.

 

The New Version of Japan

As briefly discussed above, the policy actions taken by Japan during 1990s and EU since 2008 have many similarties, of which investors should be cautious about the outlook of European continent. 1) Monetary policy -- BoJ kept increasing interest rates until Sep1990, even though asset prices had already begun to collapse. BoJ did not ease until 1991, and it took 4 years to drop rates to below 1%. In comparision, ECB made a similar mistake. It raised interest rates in July2008, when share prices had already collapsed by 30% and the world economy was sliding into a severe recession. This rate hike, in hindsight, represented a gross misjudgment and policy mistake made by the ECB. To their credit, ECB reversed course much more quickly  than BoJ did in the 1990s. By, or only 10 months after the last rate hike, ECB’s policy rates were brought down to 1% from 4.25%. 2) Quantitative easing: Arguably, ECB’s balance sheet expansion came in much timelier than BoJ’s. It took ECB 19 months to expand its B/S by 72%, while it took 8 years before BoJ seriously ramped up its QE. However, it is also true that the size of quantitative easing by the ECB has been very timid, especially when considering that the euro zone economy is much bigger than Japan’s. 3) Fiscal policy: Same as monetary policy. Japan’s policy was a drag on the economy by running a surplus until 1992, when it became clear that the economy was falling into recession. It took about a year after the stock-market collapse for the Euro area authorities to implement a fiscal stimulus package.

4) Currency appreciation: JPY rose about 90% between 1990 and 1995. This appreciation was lethal for the Japanese economy as the strong yen suffocated exports and therefore cut off an important economic escape route for debt deflation. The strong yen also added deflationary pressures, strengthened contractionary forces for the economy and quickened the debt-deflation process. In a similar vein, EUR’s strength since 2001 has been extremely painful for exporters. The expensiveness of EUR has weakened the export recovery, hampered the economic rebound and added tremendous deflationary pressures. The strong EUR has also contributed to the intensifying financial crises in the peripheral countries that are in urgent need of a cheaper currency to alleviate debt-deflation pressures. 5) Banking Sytem: the Japanese crash of 1989 and the great recession of 2008 both severely damaged banking-sector B/S. As a result, a period of intense credit contraction followed.  However, the path of adjustment somewhat differed. The collapse in the money multiplier during the 2008 global meltdown was quicker, reflecting the ferocity of the crisis. Whereas, the decline in MM in Japan took place over a long period of time, suggesting a low-grade but persistent credit contraction.

In short, it is true that the actions taken by the European authorities during the great recession were much more aggressive than Japan’s stimulus efforts, but this has to take into account that the 2008 recession was much worse than Japan’s in the early 1990s. So judging by the severity of the great recession, it is not obvious whether the stimulus in Euro zone has been aggressive enough at all, especially when part of the member countries are already in the deep hole of fiscial deficit.

 

The Hot Spots of China

The continuous outflows from China equities (7 out of 8 weeks with a total amount of USD1.08bn YTD) highlighted a reversal in sentiment towards China, as global PMs are now worried about – 1) an overheating economy; 2) structural issues on property market & excessive lending; 3) a sharp deterioration over the Sino-US relations; 4) consensus EPSG (22.4%) on MXCN too bullish. In addition, Chinese listed banks have openeD their lion mouths for capital in oder to meet the new regulatory requirements. China Merchants Bank said on Monday that it was planning to offer 1.3: 10 in a rights issue that will allow it to book USD3.2bn. On Tuesday, BoCom asked for rights issue to offer 1.5:10 to existing holders of its HK and SH stock. BoCom is expected to raise around RMB40bn based on its current share price. With BOC, BoComm, CMB largely clarified, all eyes are now on the big 2. Executives at CCB said on Wednesday that the lender had a very satisfactory Tier-1 ratio, which reached 9.7% as of Sep2009, and had no immediate plan to raise money from the equity market. However, the bank will "be more carefully managing credit risk". In fact, according to latest domestic media, CBRC has further raised the CAR for large banks ro 11.5% from 11% in the end of 2009. This would be translated into funding needs of RMB40bn for ICBC (12.7%), RMB50bn for CCB (12.6%), RMB80bn for BOC (12.5%) and RMB42bn for BoCOM (13.8%).

Such a 50bp increase in the minimum capital ratio came out on the back of market watchers predicting that Chinese banks may have extended RMB600bn to RMB1trn of new loans in February. The amount of new loans in 1Q10 stimated to reach RMB3trn, which is 40% of the 2010 government target of RMB7.5trn. As a result, it not unlikely that China will hike RRR further to as high as 18% (vs 17%) for large banks in the near term. Moreover, the latest NingBo bank earning results sent a early signal of NPL risk. For Ningbo bank, problems in asset quality surfaced as both NPL balance and ratio rose QoQ and overdue loans soared 63% QoQ. As of end-2009, the NPL balance climbed from RMB40mn QoQ to RMB644mn while the NPL ratio jumped to 0.79%. In addition, many investors are trying to understand just how much of last year’s property boom was fueled by bank lending. But one thing for sure is that the tightening policies introduced in early 2010 are -VE for sectors leveraged to FAI growth. The property sector has temporarily fallen out of favor due to policy uncertainty, while the overhang of potentially huge capital-raising plans by Chinese banks has momentarily driven investors to the sidelines. The outlook remains bright for the consumer, healthcare and internet sectors, which should benefit from strong secular growth and the Chinese policy tilt toward promoting private consumption.

Looking ahead, a few early signs of export recovery can be found in rising container shipping rates, reported labor shortages in coastal manufacturing hubs and in renewed political pressure for RMB appreciation. Friday news says that MOC and MIIT are conducting stress tests for various export related industries under a RMB appreciation scenario. The industries include textile, shoes, toys and other manufacturing industries. The newspaper also interviewed industry associations in the various sectors and got similar confirmations that the test is happening. According to people in these industries, the net margin at the moment is 3-5%, and the RMB sensitivity is around 1 to 1. The impact is more severe in SMEs where cost structure is less efficient and pricing power is weaker. In addition, China’s annual NPC conferences will start from March 6-7th, and the government will focus on the topics on development-model shift, on industries relocation into west and on new strategic industries. I expect those regional themes (especially for Chongqing, Tibet and Xinjiang) and consumptions and technology names would have chance to outperform.… Lastly, valuation wise, MSCI China is now traded at 13.1XPE10 and 22.4%EG10, CSI 300 at 18.3XPE10 and 31.1%EG10, and Hang Seng at 13.2XPE10 and 21.7%EG10, while AxJ region is traded at 12.9XPE10 and +31.3%EG10.

 

The Gold and AxJ Currencies

Gold falls to USD1100/oz after IMF plans to sell the remaining 191.3tons of gold to the open market under a program launched last year to raise new resources for lending. Although the IMF said its sales would be phased in over a long time in order to avoid disruptions to the market, the announcement still caught the market off guard. It is noted that the IMF's announcement implies that central bank demand for gold is not as robust as the market have believeD Hence, this may have the psychological effect of keeping downward pressure on gold, at least in the short-term.

Having said so, USD traditionally is negatively correlated to gold and, other things being equal, a further decline in gold prices would be bullish for the greenback. Although that pattern may well develop, correlation does not necessarily mean causation and given the huge disparity between the size of gold market (small) relative to that of FX market (large). Thus, there is not too much between USD's fortunes over that of gold prices.  In this regard, I have already argued that the principal forces behind USD rise this year (a carry unwind and concerns over Greek) are different from those seen last year (liquidity/safety demand). However,the relative USD strength in 1Q10 does seem to be genuine as seasonal patterns (35 years data) in TIC data does not suggest unusually strong net portfolio inflows in the early part of the year, while non-seasonally adjusted CA data suggests that the trade and CA deficits are, on average, smaller in Q1 than in the rest of the year.

Interestingly, it is now the consensus view to be bullish on AXJ currencies based on --- 1) while DMs is likely to face weaker growth later in 2010 as fiscal and monetary stimulus fades, the global recovery remains on track. This is bullish for AXJ currencies given the region’s dependence on exports...Really, who to buy then?; 2) Capital inflows into AXJ should continue on growth outperformance and fundamentals. From a short-term perspective, this will outweigh any deterioration in AXJ CA surpluses; 3) AXJ central banks is to gradually raise interest rates in 2010, while most major central banks in DMs are likely to maintain current ultra-low interest rates until 2011. This should support AXJ currencies, as it will drive further capital inflows.

 

 

Good night, my dear friends!