My Diary 647 --- The Unexpected Strength in Europe; The Bet of C

My Diary 647 --- The Unexpected Strength in Europe; The Bet of Curve Belly; The Two Camps in China; To Climb a wall of Worry?

Sunday, August 01, 2010

“The month of July is for ‘Julius’ and the August for ‘Augustus’ ” --- The history of Rome is built on the two great generals, Julius Caesar and his grandnephew Augustus, who defeated Marc Antony and Cleopatra and then became the first emperor. Under the names of the two battle men, it is no surprise that the summer months are typically choppy, trend-less and volatile. That being said, the passed July has turned out to be a pretty decent month after all with the S&P up 6.9%, MSCI World up 8.3% and MSCI FE ex-Japan up 6.3%. Across the asset markets, equities are up, EUR is flirting with 1.30, commodities are up, and more importantly, stress in bank funding markets appears to be abating according to the recent decline in the 2yr USD& EUR swap rates.

Macro wise, recent high-frequency data point to a slowing growth for global economies. Key data from US in June-July were generally disappointing and indicate a patchy recovery. Headwinds persisted in the labor, consumption and housing markets. Growth in EU remains uncertain in the face of budget austerity measures and lingering concerns over sovereign debt risk. In contrast, EM Asia's recovery continues, albeit with fluctuations. In short, the deflation risk will become a problem for some DMs, while inflationary pressures are gradually building up in EMs, driven by either demand or supply side factors. Some EM Asian countries are facing asset price pressure as well as rising wages and producer prices which are likely to feed into CPI eventually. As a result, EM Asia may tap on their brakes or hike rates at a measured pace without choking the recovery amid the external uncertainties. Given such a macro backdrop, I think the biggest question for next week is -- with the S&P up 6.9% in July, can the market hold its earnings season gains once the traders’ attention revert back to the macro? In HK, the same question is also applied after Hangseng Index has run up 4.5%. The latest China manufacturing PMI in July is trending lower with output index fell 3.1pt to 52.7, new orders index 50.9 (-1.2pt) and new export order index 51.2 (-0.5pt). US 2Q GDP (2.4%) is also below consensus of 2.6% yoy. The bond market has given its assessment of the Q2 GDP report: Negative. As a result, 10y UST has fallen by 7bps to 2.905% and 2yr UST is down 3bps to 0.546% on Friday close, which renews its recent low. In addition to US GDP and China PMI reports, next week brings several major US macro reports including ISM, auto sales, retail same store sales, Michigan Sentiment and next Friday’s payroll report.

Though these headwinds do not mean that US or China is headed for a double-dip, it is no doubt that both countries continue to battle strong structural headwinds that were the inevitable legacy of the massive credit overshoot and subsequent melt-down. Moreover, there is one more risk factor, which recently highlighted by Dallas Fed President Fisher -- Regulatory Uncertainty, is having a significantly negative impact on the economy.  He says that monetary policy alone cannot offset the negative effect of the regulatory uncertainty. Fisher's comments contrast sharply with St. Louis Fed President Bullard's statement that the Fed should consider additional debt monetization in order to avoid deflation. If tax and regulatory policies are negative for growth, as Fisher says, then no amount of newly printed money by the Fed will be capable of generating economic prosperity. Debt monetization is not the answer. In my own observation, the substantial amount of policy uncertainty has existed since the Bush Administration aggressively intervened in the financial sector with its TARP program back in Oct2008. The uncertainty multiplied under the current Administration with aggressive rhetoric, regulations, and legislation that make planning for the future particularly risky. For example, Barron's highlighted the fact that many entrepreneurs and business managers have effectively gone on strike rather than risk their hard-earned capital and efforts because regulations and legislation are increasing penalties for productive work and elevating the uncertainty about future policy changes.  Discussion of policy uncertainty is not limited to business circles. In his recent semi-annual testimony in Congress on July 22, Fed Chairman Bernanke conceded that “…uncertainty in general is a constraint on their activities and their expansion,” In a simple word, despite near-zero interest rates and plenty of access to liquidity, businesses are not spending money because they do not know how new regulations on everything from the financial system to healthcare will affect them.

Putting aside of macro talks, the recent US reporting season suggests that earnings have V-shaped, even if the economy has not. Question is whether it can sustain? According to Morgan Stanley, with 173 S&P 500 companies reporting (70% market cap), earnings are beating forecasts by 14%, a record margin. Much of this is due to a blow-out result by financials. But non-financials are also beating forecasts, by 8%. Cost-control remains critical to the positive surprise. The bad news is D/G to consensus earnings forecasts for 2011, which have fallen by 1.3% since the reporting season started. The D/G may reflect growing caution about the macro outlook. This also fits with the inflection point in LEIs. Recent data points indicate weakness in US – the US ECRI Weekly Leading Index growth rate fell below -10%, and the University of Michigan consumer confidence measure declined in July.  As a result, I am not convinced that the stellar US earnings momentum can continue.

X-asset Market Thoughts

On the weekly basis, global equities were slightly up (+0.67%), with -0.11% in US, -0.27% in EU, +1.1% in Japan and +1.02% in EMs. EM equities broke a nine-day winning streak, dipping 0.3% on Friday. Elsewhere, UST yields shot down, testing the multi-year lows set in the past few weeks. The 2yr yield dropped by 3bps to 0.546% and 10yr by 9bps to 2.90. In Europe, the spread on 10yr Greek bonds vs. German Bunds rose 13bps to 763bps and 10yr Portuguese spread widened by the same amount to 252bps. 1MWTI closed flat to $78.94/bbl. EUR strengthened 1.1% to 1.305USD, while USD fell 1.12% to 86.47JPY.

Looking forward, with weak macroeconomic conditions on the one hand, and very supportive July technicals on the other, it appears that investors are caught by the dilemma --- given the global economic uncertainties, particularly the slowing US economy, does it make sense to go long markets at current levels. In my own views, it worth a cautious stance at this stage, given the dominance of macro data next week, which could show -VE surprises. Though some investors argue the possible policy loosening from Chinese government, the market should be realistic with expectation of government policy loosening. There are no signs of loosening so far, and investors should not expect such to happen as long as GDP growth > 8%. That being discussed, there are a few other signs of fatigues in the markets -- 1) though equity fund inflows USD8bn (> bond fund inflows=USD3bn) shows risk appetite may come back, inflows of USD7.8bn into MMF prevents a conclusion that investor risk appetite is surging; 2) the impact from US earnings season is poised to fade as already 70% of S&P 500 market cap has reported results; 2) Merrill Lynch fund flow data just triggered a SELL signal (4WK inflows >1.5% of AUM) and usually results in a 15% pullback over coming month. With >90% success rate, be aware!

The Unexpected Strength in Europe

There are two developments in recent weeks worth for a note here. The first is the downshift in the global IP boom that is now underway. Of the 6 countries to have already reported, manufacturing in June declined in all cases, including US, China, Taiwan, Singapore, Russia, and Argentina. The 2nd development is the degree to which the European sovereign credit crisis and the 2Q10 pullback in risk appetites would damp the recovery. That said, an interesting topic for the markets was the strength of the European data -- UK 2Q GDP (1.6% yoy) surpassed expectation at 1.1%, and both the IFO (106.2 vs. cons=101.5) and INSEE surveys (+9.52% mom) were far BTE.  Since historically, EU growth follows that in US with a lag, this strength probably won't last long.

Having said so, the latest Beige Book appears to be more downbeat than it was in June. Several districts noted that manufacturing activity had slowed or leveled off. Retail sales are still in an uptrend, but gains seemed to be limited to necessities. Big ticket items, especially motor vehicles sales, were described as weak. The best that could be said about residential real estate activity was that it was "sluggish," as opposed to commercial construction which was simply "weak." Loan demand was generally soft or declining, while credit standards remained tight in most Districts. Simply put, the overall report presents a picture of an economy growing at a very modest pace, with some slowing in the growth of final demand. In contrast, there is a clear divergence between the continued improvement in Germany, which is receiving considerable lift right now from a strong jump in manufacturing output, and a less upbeat assessment elsewhere in the region. That Germany is in an upswing was underscored by the labor market, adding 25K jobs and retail sales, + 3.1% yoy in June. Moreover, as highlighted by the Spanish monthly budget data, the peripheral European budgets have largely performed BTE year-to-date. The data show a cumulative deficit of 2.8% of GDP in 1H10, significantly better than last year and in line with market expectation.

In Asia, Japanese data were disappointing with June IP fell 1.5% mom vs. cons. 0.2% gain, unemployment rose to 5.3% from 5.2% whilst core CPI fell for the 16th straight month. In India, the RBI raised repo rate by 25bps to 5.75% as expected but unexpected raised reverse repo by 50bps to 4.5%. Cash reserve ratio kept unchanged at 6%. RBI states preference for continued tight liquidity for better monetary transmission and narrower policy corridor for greater policy certainty. The FY11 GDP growth projection is raised from 8% to 8.5% and March 2011 inflation from 5.5% to 6%. The market expects another 25bps rate hike at the next review on September 16.

The Bet of Curve Belly

Risk markets finally received some clues last week after the release of the stress tests by the European Banking Supervisors. A number of valid complaints had been voiced regarding the tests – 1) the focus on Tier-1 as opposed to core Tier-1 capital; 2) the lenient haircut assumed on sovereign debt and 3) the reliance on the banks’ own profit projections. These overly optimistic parameters threatened to defeat or at least to soften the objective of a credible test of the resilience of bank B/S under duress. If eliminating this above-mentioned bias, there are 54 banks would have failed a more stringent stress test, generating a capital shortfall of EUR60-75bn.

Still, the broader market conclusion appears to be that the stress tests have proven that European financial systemic risk is limited. Certainly, the ECB believes the main risk has passed, judging by the steady drop in the amount of sovereign debt purchases under its Securities Markets Program. Average CDS spreads for the strongest banks have steadily narrowed, but so too have those that just barely passed, while the share price of one of the worst-off Greek banks has also gained ground. The EU authorities could not include a major haircut for government bonds in the tests because it is politically unacceptable to acknowledge that default by any of the Club Med countries is even a remote possibility. But the authorities at least provided enough details at the bank level that investors could do their own stress tests (except for some German banks). The details will allow markets to differentiate relatively safe banks vs. those more at risk. At the end of day, the outlook still depends heavily on whether governments can successfully walk the fine line between supporting growth and reducing the budget deficit.

In US, PIMCO’s Bill Gross highlighted that a prolonged period of zero interest rate policy would benefit the belly part of the curve.  Besides that, Mr. Bullard noted that there was no imminent need for further easing, but should conditions deteriorate, further then UST would the first choice for extra QE, in a bid to lower term rates. He also iterated that deflation remains a definite threat to US economy. This is certainly the view of large bond funds such as PIMCO with its total return Fund holding a 115% duration weighting. Put another way PIMCO is long an extra USD35bn 5yr notes more than its total asset base of USD234bn. Also, if one is buying into the deflation story then it's best to look at the Japanese market experience to see where to be best positioned. Here too was it the belly and not the long-end as the latter meaningfully lagged. So the bond king seems betting on the right direction!

The Two Camps in China

Chinese growth expectations have been a key driver for the equity markets. In particular, the Chinese stock market and Chinese steel prices peaked on 15 April and 23 April, respectively, leading the subsequent downturn in global equity markets. Weakening US data from the start of June added to the mix, weighing on equities and credit and helping to drive government bond yields sharply lower. With that in mind, the NBS of China estimated GDP to grow at 11.1% in 1H10, but the market is concerned that China’s growth is petering out. GDP growth rate slowed to 10.3% in 2Q, from 11.9% in 1Q. IP growth fell sharply to 13.7% in June, from 18.5% in average 5M10, the lowest growth since Aug2009. 

Growth deceleration is expected as a result of base effects, the government’s structural tightening policies, and the new wave of external shocks. Most leading indicators, including the PMI, newly started investment projects, and import growth, clearly suggested the deceleration was coming as early as May and June. But the magnitude of the 2Q deceleration is greater than market consensus. Policymakers in China have divided opinions on the slowdown. One side urges the government to ease the current structural tightening in order to prevent a hard landing. In contrast, others point out that decelerating growth is desirable and a natural result of macro-policy rectification. Premier Wen lately attributes the growth slowing mainly to the structural tightening policy (apart from the base effects). It seems the Premier is suggesting that the growth deceleration could be eased by adjusting the current tightening policy.

In addition, weekly data from the MoC show that the prices of edible agricultural products rose 1.6% mom in the first 3WK of July vs. a decline of 1.6% in June. Such changes suggest that CPI inflation could jump to 3.5% yoy in July from 2.9% in June, the highest reading in 20 months. The jump in food prices was caused by severe flooding in many provinces in July, which will likely be followed by price declines in Sep or Oct when the flooding season ends. Therefore, Chinese CPI inflation is likely to peak in July. That said, the government has claimed that going forward, wage growth may be pegged to local CPI while companies in monopolizing industries have to receive govt approval for compensation increase. Market over the weeks has been focusing on the CBRC news on LGFV lending (Rmb7.7trn in 1H10), with 23% of that in higher risk zone. Overseas investors are scared by the number—“23%”! Actually this number has been mentioned in A-share market since last Tuesday, but A-share investors do not hesitate to buy banks even they know this data. What’s behind? Listed banks have much lower risk exposure. The portion of “risky LGFV lending” is just about 10%-15% for large bank, which in worst scenario is equal to 10bp increase in credit costs or 5% impact on bank earnings.…Lastly, regional wise, MSCI China is now traded at 13.6XPE10 and 25%EG10, CSI 300 at 16XPE10 and 28.7%EG10, and Hang Seng at 13.9XPE10 and 25.6%EG10, while MXASJ region is traded at 13.1XPE10 and +36.9%EG10.

To Climb A Wall of Worry?

Despite worries over US & China’s slowdown, a number of commodities have begun to rebound, such as copper (+3.8% in 5D), Nickel (+3.9%) and Aluminum (+7.1%).  Looking back, there were several news in the past week boosted commodity sector performance ( CRB +7.8% in a month) – 1) In aggregate, the EU economy was on firm footing in June and early July, with stress tests increased the transparency of individual bank exposure to troubled sovereign and private debt; 2) USD softened against a wide array of currencies as US inflation and growth expectations continued to grind lower; 3) IMF Article IV on China suggests that July PMI is likely to confirm moderating growth.

Despite these developments, it is still far from clear whether a policy catalyst will be necessary before a broadly-based rally can emerge. Commodity prices still are up year-on-year, even though they are well off their 2010 highs. Business cycle indicators and market positioning data are ambiguous, consistent with either a mid-cycle correction or bear market. At the same time, futures market speculators have barely taken profits with net spec positions are 10% of open interest, a level close to its peak, even though bullish sentiment has fallen back into the neutral zone.

It is a tough call whether commodity prices can now “climb a wall of worry” or whether they will need to briefly riot to mobilize policymakers to offset the “window of deflation risk”. The easier judgment is that the end point is higher commodity prices, regardless of whether a policy catalyst is necessary to trigger the break higher.

Good night, my dear friends!