My Diary 639 --- The Increasingly Uneven Paths; The Bets on Trea

My Diary 639 --- The Increasingly Uneven Paths; The Bets on Treasury Bonds; The Guess of A-Share Bottom; The EURO Bear vs. Oil Bull

Sunday, June 06, 2010

“If you feel lost, look at jobs” --- This is my very first supervisor, Paul Thomas, the former present of Merrill Lynch Canada, taught me when I joined Cornerstone. It explains well the risk markets’ reaction to the poor US NFP figure. S&P plunged to a 4-month low, commodities slid with CRB Index sank 5% to the lowest level since Feb. 26. Oil fell 4.2% to $71.51/bbl and EUR slid below 1.20USD for the first time since Mar 2006. The Dollar Index jumped 1.2% to 88.195, its highest level since Mar2009, as a result of LTE US job growth and a widening govt debt crisis fueled concern the global economic recovery will slow.

Macro wise, US May payrolls rose by 431K after a 290K increase in April.  The gain was smaller than the 536K median forecast in a BBG survey and reflected a 411K jump in govt’s temporary hiring for the 2010 census. In short, the quality of job growth is very low. Meanwhile, the latest data reveals that unemployed Americans are facing the longest wait on record to find work. The average duration of unemployment jumped to 34.4 weeks in May from 33 weeks the prior month and 16.5 weeks in December 2007, when the recession began. In my own views, this “no job recovery” is likely to persist for quite some times as last week, Chairman Bernanke said SME lending in US is still declining, along with the persistent problem of high unemployment.  To the global economy, US job market growth is the single biggest driver during this household B/S repairment and economy recovery process. That being said, Friday’s NFP numbers suggest that the corporate sector as a whole cannot rely on top-line growth to drive profitability. If this is the case, then the next question becomes whether earnings estimates for 2H10 are too high?  As of June 4th, the profit forecast for S&P500 is USD81.34/sh (+17% yoy) in 2010, according to Bloomberg. The implied PE ratio is about 13.1X vs. an average 20X over past 20 years.

Cross the pond, CDS of European sovereign bonds jumped to a record after Hungary Govt saying that default talk is "not an exaggeration". Hungarian sovereign CDS rose 63bp to 371, along with France, Austria, Belgium and Germany sovereign credit spread, sending iTraxx SovX WE to a record 174.4bp. This is once again putting pressure on equities and currencies, especially in Europe. Importantly, EURCHF has plummeted below 1.4000, which is indicative of the concerns about the European banking system. Meanwhile, EUR/HUF has surged to the highest level in a year. At the same time, WSJ reported that European banks continue to face a difficult funding environment. The debt refinancing schedule for peripheral Euro area banks, at USD20bn per month over the next year or 5% of outstanding loans. In particular, Greek bank borrowing from the ECB rose by EUR18bn to EUR85bn in April. Greek banks now fund 16% of their b/s at the ECB, up from 8% in January and 1% two years ago. It is obviously that political risk and policy errors remain the key risk for the risk markets and the world economies going forward.

X-asset Market Thoughts

The stock market took a hit on Friday after the release of a WTE NFP number. Major market indices dropped average 3-5% with MXWO -2.82% and S&P -3.44%. 10YR UST yield tightened 16bp. Copper lost 3.75% and oil declined 4.15% on the single day. On a weekly basis, global equity markets lost 1.85%, with US -2.24%, EU +0.21%, EM -0.39% and Japan +1.19%. Elsewhere, UST yield curve flattened with 2YR down 4bp to 0.726% and 10YR down 9bp to 3.20%. 1MWTI oil fell $2.46 to USD71.51/bbl. EUR closed at USD1.167 (-2.5% wow). JPY climbed against all 16 major counterparts with USDJPY strengthened 0.92% at 91.90. 3M LIBOR held at 0.54%, another 10-month high, while TED spread rose 1.3bp to 41.6bp, +9.13% wow……Looking across asset markets, S&P500 has tumbled 13% from a 19-month high in April as slower US job market recovery, Europe’s debt crisis and the concern growth slowdown in China overshadowed global recovery. Meanwhile, the surge in most credit spreads to their widest levels of 2010 has mirrored movements in other assets. Equities have made new lows, volatility (VIX =35.48 +20.43% wow) has surged and commodity prices have fallen. EUR has weakened sharply on renewed concerns about the peripheral economies of southern Europe and Ireland, with Spain becoming the latest sovereign to suffer a ratings downgrade (by Fitch). Nevertheless, spreads are considerably tighter than their worst levels seen in the middle of last week. The world economy seems once again trapped deflationary worries.

Looking forward, there is certainly no shortage of risks in the macro landscape, which are helping to keep investors on edge. Imbalances in many countries are staggering, the threat of spreading contagion from the European debt crisis persists and Chinese authorities are attempting to cool the world’s primary growth engine. What is worse is that these are occurring at a point when the global financial system remains fragile and the recent surge in global growth is beginning to soften, making it difficult for investors to determine whether to expect a typical moderation or the beginning of a double-dip recession. For example, according to Hedge Fund Research Inc, hedge funds lost an average of 2.7% through May 27 and almost every strategy lost money in May. Even star managers like Paulson were down 7% in May (YTD -3.3%). Viking was down 3.4% in May and 2.9% YTD and Moore was down 7.7% in May and 4.8% YTD. Long-Only funds also had a tough time as well. In short, attempting to manage risk in an environment where everything that could go wrong does go wrong seems like a fruitless endeavor. This suggests that we could see redemptions kick in June or July (HFs have quarterly or semi-annual redemptions vs. LOs’ T+3 or T+5 settlement period).

With respect to the macro economy, I hold a view that employment lags the business cycle and offers no clues about the future course of the economy, which is the key to successful investing. Nevertheless, payroll data is important for short-term price action. The key point is, the creation of our wealth takes real skill and effort. It cannot rely on thin air either by government spending or the printing paper money. The apparent "superb" performance of equities since the bottom in Mar2009 was caused by a combination of factors – 1) an actual rebound in economic activity and the start of economic recovery; 2) the debasement of the value of money itself. That said, even after recent weakness, the S&P 500 is still up 13% from a year earlier and 57.4% above the closing low hit in Mar2009. As a result, I think, for the bottom to come, we need to see a few things: 1) redemptions and 2) the selling of defensives. Looking back, the 1st leg of the decline in this May was marked by the selling of the high-beta names and the small-mid cap stocks. I think that the 2nd leg of the decline in June will be marked by the selling of defensive stocks as redemptions will force equity PMs to sell. For a note here is that in 1Q09  (the last leg of the market decline for the Great Recession), the Hang Seng Index fell 5.6%, but the defensive stock like China Mobile was down 13%. Regionally, Singapore's STI fell 3.5% in 1Q09 but a defensive stock like Singapore Press Holdings (SPH SP) fell 19%...Stay Tune!

The Increasingly Uneven Paths

The past few days were heavy with economic news. According to JP Morgan, global services PMI activity index (aproxy for output) declined 0.5ppt to 56.3. This was a disappointment to their economist team as emerging Asia’s PMIs fell short of market expectations. In particular, China’s official PMI slipped to 53.9 from 55.7, while Taiwan’s PMI fell by 3.3ppts and Korea’s declined by 2.5ppts. Looking ahead, a sustained EUR weakness could hurt the competitiveness of Asian manufacturers and curb demand from the whole EUR area. In comparison, US ISM fell to 59.7 in May, and UK service PMI was slightly WTE at 55.4 (cons=55.7).

Economy wise, Asia countries keep their growth pace with Aussie Q1 GDP beat expectations at +2.7% yoy (cons=+2.4%). India’s 1Q10GDP rose 9.1% yoy. Trade data in Asia continued to be strong with India, Indonesia and Korea all reporting strong export numbers. Clearly, the global economic recovery is proceeding but is increasingly uneven across countries, with strong momentum in EM economies, some consolidation of the recovery in US, Japan and other industrialized economies, and the possibility of renewed weakness in Europe. The required rebalancing of global growth has not yet materialized, which has led to very different policy normalization path. In G7 world, Bank of Canada becomes the first G7 central bank to raise rates, hiking by 25bps to 0.5. In the BRIC countries, the Central Bank of Russia eased 25bp and signaled it was going on hold. In Asia, the RBA kept rates unchanged at 4.5% as expected even with retail sales surging ahead by 0.6% mom in Apr (cons +0.3%) from an upwardly revised +0.8% in Mar (prevs.=+0.3%). In India, street economists continue to see upside risk to core inflation and think the RBI will raise rates by 25bps before the July policy review followed by another 25bps rate hike at the review. Meanwhile, the lacks of inflation pressure plus external uncertainty have keep Bank of Thailand (1.25%), Bank Indonesia (6.5%) and the BSP (Philippines, 4%) stay put, respectively.

The Bets on Treasury Bonds

Last week saw several hawkish comments from regional Fed governors – 1) The Atlanta governor, Lockhart said “… the time was approaching to recalibrate rate policy - economic recovery in the medium to be neither jobless, nor job rich.” This was a bit of a surprise to me only because the Street has become complacent regarding Fed policy in light of the Euro debt crisis and recent Fed speaks suggesting the Fed's hands are tied. In addition, Kansas’ Fed President, Hoenig said that he believed the Fed should raise rates to 1% by the end of summer. Clearly, the upcoming FOMC meeting on June 23rd could see diverse opinions. But many economists point out that Fed has historically not embarked on a rate hike cycle with unemployment rate above 8%

Having discussed the US rate outlook, the recent drop in 10YR UST To 3.20% caught economists and investors by surprise. While economists are revising their predictions, many investors have been a little slower, continuing to post near-record bets that UST yields will rise, according to CFTC data. Looking through the broker house forecast, has the lowest forecast at 3%, followed by Goldman Sachs’ year-end forecast of 3.25%. Morgan Stanley on May 10 slashed its outlook from 5.5% to 4.5%. I think, from this point forward, the inflation outlook is really the biggest uncertainty to bears. While the risks for bulls include BTE economic growth and a cooling of the European debt. These two factors would help remind investors that US Treasury Department is still borrowing heavily, a situation that could bring higher yields, as it does in Europe now.

In my own views, over a longer-term horizon (3-5years), US government bond yields will rise substantially due to several factors – 1) Fair Value: the fair value of LT UST yields should be roughly equivalent to long-run nominal GDP. For US, this is around 4% (2% real growth and 2% inflation, consistent with the Fed’s target); 2) Crowding-out Effect: a rising govt bond issuance will gradually put upward pressure on bond yields, as private sector demand improves and competes with the government sector for domestic savings; 3) Term Premium: This premium represents extra compensation for uncertainty regarding the outlook for inflation, output growth and the future expected path of short rates. The credit crisis along with the unprecedented explosion in central bank B/S and budget deficits has increased uncertainty related to the outlook for inflation, growth and the exit strategy. The premium is expected to shift back into the range that existed in the mid-1990s, roughly 75bp above current levels.

The Guess of A-Share Bottom

SHCOMP corrected by 3.85% last week on concern of LTE China PMI, big IPO financing plan and tightness of liquidity. Meanwhile, investors are worrying the rising labor cost will hurt the company earnings in the future after Foxconn added the employees’ salary by 30%. In addition, Beijing (from 800/mo to 960/mo) and Shenzhen (+10% in July) governments increase the minimum wage. Macro wise, the next week is a heavy data week with the release of Export/Import and Trade (June 10), M1/M2 and New loans (June 10) and CPI/PPI/FAI/Retail Sales and IP (June 11). The key to watch is CPI as SH Securities Journal reported that China's CPI may reach 3% in May, exceeding 2.8% growth in April.       

Regarding the rising labor costs and implications for the economy, Deutsche Bank’s economist conducted a simulation on the economic impact of a 10% wage increase in 13 low-end labor-intensive sectors. The results are CPI +0.4%, real GDP growth +0.12%, real exports -0.6%; real consumption +0.2%. In my own view, this represents a redistribution of social wealth as in the past decades the distribution of wage income and profits have been extremely favorable to employers due largely to China's demographics. Now, the demographic effect is petering out and approaching an inflexion point which is estimated at 2015.

Sector wise, property tax turned to be focus again and for the first time State Council formally said government would gradually push forward the implementation of the property tax. This triggered broad based sell down in A-share property names. In addition, China Tax Bureau require East China provinces to set min 2% LAT tax rate, mid and northeast China provinces to set min 1.5% LAT rate, west China provinces min 1% LAT rate to pre-charge developers LAT taxes. Currently the prepaid LAT tax rate is lower than 0.5% for most provinces.  As a result of increasingly tightening policies, I have seen street analysts revising down assumptions and NAVs for Chinese property stock since mid April. Current "static" valuations look compelling but I still question on whether the NAV revisions (~10% on average) are sufficient enough, since property price correction has not happened in full force.

Liquidity was another hammer last week and BoC’s CB issuance was at the center of market movements. Over the week, BoC announced to kickoff its Rmb40bn of CBs plan while BoCom/MSB/Bank of SH also announced their financing plans. The market rumored that ABC will launch its IPO and will raise USD20bn via A+H share markets. Meanwhile, PBOC issued RMB15b 1yr CBs on June 1, with auctioned rate edged up by 8.32 bps to 2.0096%, the highest in 19 weeks. 1-day Repo rate jumped sharply in the early of the week with the rate level (2.10%) well above that by the end of April (1.40%), indicating that domestic market may face a structural tightness. Looking forward, financing plans and liquidity may remain as the market major concerns…Looking forward, I think 2400 is a fair value level under the assumptions that China economy will slow down to around 9.0-9.5% of GDP growth and lisco earning maybe further adjusted down by 10-15% during the 1H10 result season......Lastly, valuation side, MSCI China is now traded at 12.8XPE10 and 25.3%EG10, CSI 300 at 15XPE10 and 32.7%EG10, and Hang Seng at 13.0XPE10 and 25.0%EG10, while AxJ region is traded at 12.2XPE10 and +37.0%EG10.

The EURO Bear vs. Oil Bull

The recent market movement in EURUSD is quite disappointing to me, as whenever a risk-off trading day, EUR tends to weaken. On a risk-rally day, the best that EUR can do is holding steady. This asymmetry warns that it is still too early to expect a sustained turn around in EURUSD.  At the same time, southern European sovereign CDS spreads for are widening anew, with which most worryingly, spreads for Spain (269bp) and Italy (244.7bp), the two larger euro area economies, are back near the highs of early May. This means that the ECB must continue to act as the lender of last resort. The ECB loathes referring to its purchases of government debt as monetization or QE. But in the end, the key point is if ECB’s B/S expands relative to the Fed’s, then EURUSD will remain under pressure. In the near-term, another factor will add impact on currency movement is the monthly end effect. This suggests that the global liquidity providers, US and Japan, will repatriate funds, implying more strength for USD and JPY. Within G10, the EUR should weaken further, given fiscal woes and relative growth expectations for EU and US.

In the energy space, though the latest volatility for oil price is very high. I still believe in the bullish story of crude oil in the long term basis. My rationales are based on several observations --- 1) oil price pullback driven by “Cushing issues” at the front end and “risk-off” at the back end, both of which are showing signs of stabilizing; 2) oil prices are increasingly correlated to S&P 500 as long-term oil supply growth is increasingly questioned; 3) the summer turn in US crude oil inventories coming soon, with inventories expected to draw in coming weeks/months; 4) Demand recovery now evident in US in addition to non-OECD strength. 5) Non-OPEC supply ended 2009 HTE but it could level off over 2H10.

Good night, my dear friends!