My Diary 649--- Reading behind the Truckload; To QE or Not to;

My Diary 649--- Reading behind the Truckload; To QE or Not to; Property and Agri in China; Where USD would Go?

Sunday, August 08, 2010

“Are we close to the Judgment Day?”  --- In the 1984 movie of “Terminator”, the Judgment Day refers to the day that the artificial intelligence “Skynet” becomes self aware and started a nuclear strike on the US, Russia, and other regions, killing over a billion people. I think what investors should be aware now are that financial markets and the real economy continue to move in opposite directions and that X-asset correlations have completely broken down. On one side, I have seen equities on the verge of making new YTD high, with MXFEJ just 2.06% away from April peak and many Asian countries like Korea, India, Thailand and Indonesia all broken to new highs recently. In contrast, 10yr UST yields are at year lows. Credit markets are doing similarly well with Junk bonds are getting close to par (98.99), based on Merrill's high-yield index data. The LME metals index has rallied 22% since early June and is marching to retest the April high. However, the rally in USTs is very confusing to me given the selloff in USD (-9.05% since early June). On the other side, US economic numbers were mixed with BTE ISM Manufacturing (+55.5), Construction Spending (+0.1%), ADP Employment (42K) and ISM Non-Manufacturing (54.3) while Personal Income (0%), Factory Orders (-1.2%), Pending Home Sales (-20.1% yoy), ICSC Chain Store Sales (2.8%) and NFP (-131K vs. cons=-65K) fell short of estimate. Moreover, the fear on further deterioration in the economy was highlighted by the renewed talk of QE and the surge in USTs which caused 10yr yield decline to 2.818%, the lowest level since April2009. As a result USD fell with DXY -1.39% to 80.40, breaking below its 200D MAVG.

That being discussed, I think there are three abnormalities in the markets worth for some thoughts and further judgments. The first one is -- Can the divergence between financial markets and the real economy continue its trend? In the real economic terms, the best of this 18-month expansion is behind us, evidenced by the soft data from US factory orders, consumer spending and housing sales, along with China PMIs. Beside the headline macro data, though corporate profits are surging, payrolls are stagnant (one of widest divergences between profits & payroll since 1960). As of Friday, out of the 443 companies in S&P500 that have reported, ~76.3% managed to surprise the market on the upside while 8.4% were in line. However, US initial jobless claims rose unexpectedly to 479K (cons=455K), up from 460K previously. The change in NFP for July was -131K, lower than consensus (-65K), with previous monthly data revised to -221K from -125K. This development worth for a closer monitoring, as any breakout of initial claims above 500K level would be an early warning sign of higher unemployment.

In addition, US personal income report underscores this point. The PCE deflator has risen just 1.4% in June yoy, a full %-point below the average during 2002-2007. Last week, the market focus on the Fed's balance sheet diverts attention from the real issue. In my own view, simply printing more Dollars cannot improve the economy. The expansion of the Fed's balance sheet was useful when liquidity in the financial system was constrained, but that is no longer the case. As the BoJ demonstrated over the past decade, pumping more currency into the financial system is not the answer. Real growth is only possible when the creators of wealth (investors and business owners) have confidence to invest and to hire. Over the weekend, Goldman Sachs has downgraded a number of US macro forecasts. The bank is now looking for a return to unconventional monetary policy in late 2010- early 2011; expect slower growth in 2011 @ 1.9% from 2.4% largely as a result of congressional resistance to further fiscal stimulus; expect the unemployment rate to tick back up to 10%; expect core PCE and t core CPI to slow to 0.5% yoy by year-end 2011; forecast 5yr UST to reach 1% in 4Q10 and 10yr UST at 2.5% (from 3.25% previously).

The second abnormality is the threat of inflation against the fear of deflation. As Milton Friedman correctly identified-- Inflation is always and everywhere a monetary phenomenon. That means that for US, inflation is always and everywhere the creation of the Fed. Indeed, at the core level, most G7 countries have not yet seen deflation, with Japan being the exception. Most importantly, monetary and fiscal stimulus has already been pumped into the system, and private sector demand is slowly recovering. It is premature and simplistic to believe that US is following Japan and will inevitably plunge into price deflation.  In addition, the recent spike of global agriculture price has added fuel on the inflation smoke, with Chicago wheat prices going up ~54% since June 9. However, the market does not believe in the stories as 5yr TIPs’ yield closed below 0% for the first time since Mar2008. Judged from the latest speeches from District Fed presidents, most policymakers behind closed doors must be getting increasingly nervous about the prospects of deflation in CPI. Since Core inflation is already <1%, US economy is struggling to attain a trend pace, and LT inflation expectations can no longer be described as stable. The 10yr CPI swap rate has fallen by about 33bps since June and by 53bp since the end of April. The 5Y5Y FWD rate has dropped by 108bp from its peak in April 05. In comparison, ECB president Trichet repeated numerous times that inflation expectations remain “firmly” anchored according to all indicators, despite the fact that 5Y5Y inflation swaps have fallen sharply of late. This is somewhat strange.

The third one is a tremendous divergence running between bonds and stocks. USTs seem to be pricing in a potential double dip, while stocks are threatening to break above the June 21 high (S&P=1131) from where a near 11% sell-off. In fact, S&P has climbed 64.9% since Mar2009, while 2YR UST yield has been declining from 0.95% to 0.50% as of late. Long time readers know that I believe in the theory of transference in markets where, over enough time, usually currencies lead followed by rates and last to find out are the equity markets. One explanation could be that the markets are focused on different time frames with USTs looking further down the road. However, the Bond King Bill Gross of PIMCO, investment manager Jeremy Grantham (GMO) and hedge-fund managers David Tepper and Alan Fournier are among the best-known investors who are bracing for a possible bout of deflation, a development that could cripple global economies and world stock markets. "Deflation isn't just a topic of intellectual curiosity, it's happening," said Mr. Gross in WSJ.

X-asset Market Thoughts

On the weekly basis, global equities closed up +2.44% with +1.88% in US, +1.35% in EU, +1.48% in Japan and +1.97% in EMs. Elsewhere, 2yr UST yield fell 4bps to 0.50%, another all-time low, and 10yr fell 9bps to 2.82%, a 16-month low. In the currency space, EUR surged 1.74% to 1.328USD, while the Dollar fell 1.11% against JPY to 85.45. 1MWTI oil went up 2.26% to USD80.7/bbl. Wheat prices have risen 56% to USD755/bu since of June 29.

Looking forward, the key to Asian equities is the trend of USD. The latest weakening USD had helped MXASJ +2.37% for the week -- its 3rd consecutive weekly increase with improving volume. Currently, there are two schools of thoughts here. The bulls think that this could be a repeat of 2009 with a strong inflow into EM led by the USD carry trade, but the bears would no doubt say it was an indication of a double dip in the economy. Nonetheless, the key is relied on Fed and the US labor market. The WSJ suggests that the Fed will discuss buying more MBS and treasuries when they meet next week, instead of shrinking the Fed's portfolio as expected. In the language of law, Fed is a systemic mediator whose agenda is to balance the interests of Capital vs. Labor (or inflation vs. employment). However, history has proved to us that the balancing act between inflation and employment resulted in what many economists and the Fed refer to as economic "imbalances." Today’s Washington insists that the Fed keep policy accommodative because the common wisdom is that the Fed can somehow generate employment by the mere act of printing up more dollars in order to monetize more debt. That view is misguided. At the end of day, the Fed keeping rates near 0% and printing up more paper money will not change the mind of business decision-makers who have bigger concerns over future changes in taxes and regulations. In that senses, growth is still clouded along with a huge amounts of public-sector debt and deficit. Thus, it seems to me that further upside in the equities seem to be capped, along with the three unsolved market abnormalities discussed in the above sections.

Reading behind the Truckload

Truckload of economic data out last week, let me start with the US. July ISM manf was not as bad as feared, coming in at 55.5 (cons 54.5). New orders fell 5pts to 53.5, the lowest since Jun2009. Export orders index rose to 56.5, suggesting that the slowing new orders demand is largely focused in domestic orders (not good). Construction spending also much stronger than expected at +0.1% mom (cons -0.5%), a good sign given the bad data we've been getting from US housing recently. In addition, personal spending, personal income, factory orders and pending home sales were all disappointed. There were no significant data out of Europe.

In Asia, the big focus was on the China PMI number. The official number came in at 51.2 but HSBC's PMI fell below 50 at 49.4. The main difference between the 2 numbers has to do with the survey size. The HSBC series surveys 400 SMEs while the official one surveys 1000 SOEs. HSBC PMI has historically led the official PMI, something to watch out for in future China PMI numbers. In HK, Jun retail sales value rose 15.3% and volume rose 12.1% (both much lower than expectations), growing by double digits for the 7th straight month. However, on a sequential basis, retail sales fell for the 2nd consecutive month. In Indonesia, CPI was surprised on the upside for the 2nd consecutive month, coming in at 6.2% yoy in June. As widely expected, the Bank of Indonesia kept its policy rate unchanged at 6.5%, noting that underlying growth continues to remain positive, despite the uncertainties stemming from the recent moderation in growth in China and US. The RBA also left rates unchanged.

In general, the latest readings suggest real consumer goods spending have softened broadly some into midyear. Global retail sales volumes look to have expanded at a subpar 2.3% yoy in 2Q10, a step down from the nearly 5% yoy set in 1Q10. Combined with the weakness in services spending, the recovery on total consumer spending remains lackluster. However, Capital expenditures continue to ramp up. As reported, orders for German capital goods surged 7% in June, bringing the annualized gain to 48% -- the largest gain on record back to 1992. Orders have seen a similar surge in US, while trailing off in Japan of late. In whole, G3 orders are pointing to gain in shipments of 20% yoy in 2Q, which would translate into a gain in global capital expenditures of just under 15% (QoQ,saar) following a strong 10% gain in 1Q. These moves mask considerable variation in outcomes around the world. The output gap in DM remains near record lows at -4% in 2Q10. Economic activities in EMs are now roughly aligned with potential.

To QE or Not to

The US corporate bond market is experiencing renewed interest among investors who are hungry for yield. Risk-taking is rising in the form of the acquisition of non-govt bonds, witnessed by corporate bond coupons hitting record lows amid surging demand by investors for supply - Debt sales reached USD35.9bn this week, the most since March 26, when issuance totaled usd39 bn. As an example, IBM sold a bond this week with the lowest coupon (1%) on record and books were multiple-times oversubscribed, according to Bloomberg

But to the rate markets, the major focus is whether the Fed will go to the 2nd QE or not? An article in last week’s Wall Street Journal said the Fed is considering reinvesting the proceeds it receives from maturing mortgage and Treasury debt back into Treasury securities. Such actions would be small relative to the Fed's B/S, as the article states that ~USD200bn will mature by 2011, relative to the Fed's portfolio of securities which is roughly USD2.3trn (8.7%). The market impact of the QE2 is worth -5bp, assuming a linear relationship between the size of QE and the market move. Nonetheless, it would be a symbolic step towards more easing rather than towards "normalization" in the Fed's B/S and monetary policy, and possibly a step to precede additional QE measures (QE2). Indeed, a Bloomberg article published after the WSJ article argues against additional Fed action, citing a series of private sector economists. Any change only four months after the Fed ended its massive bond-buying program would signal deepening concern about the economic outlook.

The market is a discounting mechanism and at present and there is an increase in the perceived risk of additional Fed policy action. While those sentiments are prevalent, it will keep downward pressure on US yields. But, there is a risk the Fed statement disappoints the market. The Fed likely has a high hurdle for any new QE program. And, a QE reinvestment program may lead to calls for more QE from investors, a distraction for the Fed. That said, pressure is building on the Fed to provide additional stimulus and the UST market is beginning to bet that policymakers will deliver. Indeed, short- and long yields in several of the major countries are plumbing new lows for the year. Meanwhile, US economic data have disappointed, at a time when there is plenty of slack, long-term inflation expectations have fallen sharply and a Fed regional bank President is warning that the US is in danger of falling into a Japanese-style deflationary slump. At the August 10 FOMC meeting, policymakers will surely discuss additional steps the Fed could take to support the economy and markets if the situation deteriorates further. Labor market and consumer spending data will be critical to the Fed’s decision, but investors should watch measures of LT inflation expectations as discussed above. A continued fall in such expectations would be a warning sign to the Fed, and would increase pressure on policymakers to crank up QE. The risk is that if expectations fall to near zero or below, as occurred in Japan, a persistent deflation could become self-fulfilling.

Property and Agri in China

During the later of this week, there are suddenly a lot of talk about policy, with 1) flood-related damage to crops and thus food price inflation. The street economists expect 3.4-3.7% yoy for July CPI, and 2) the bank loans rose to Rmb700bn in July. This is 45% higher than the market expectation of Rmb480bn. But based on my own observation, the real risk comes is a revival of the property market. For investors who worry about tightening in China should keep a closer eye on the property market rather than CPI. A sustained pick-up in property sales without a drop in price would be the pre-condition for a new round of tightening, in my views. Meanwhile, 2Q10 GDP deceleration was largely viewed +VE as it demonstrated the central government’s resolve on tackling structural concerns such as property sector bubble, local government debt problems, industrial overcapacity and energy inefficiency.

Sector wise, China property stocks faced some profit-takings with major names like Vanke (-7.4%), CR Land (-3.4%), Shimao (-4.8%) and Agile (-3.2%) dropped 3-7% after the stress test announced by the Government with assumption of 60% decline in prices. Same as before, the official had come out and clarified the purpose of the stress test and the sector managed to recover some of its losses on Friday. Looking forward, the China property sector will remain policy-driven with 2 things to be watch for -- a) the NDRC Housing Index released next week -- remember the rally was triggered by the fall in such index; and b) developers’ guidance on sales target at the interim results. For banks, the street should not worry too much as they are adequately capitalized and will raise a combined USD55bn of new equity capital in 2010. Under the previous assumption of 30% price fall and a 108bps hike in interest rates, NPLs would rise by 2.2 ppts and pretax profits would fall 20%. In comparison, the agriculture sector rallied by 8.9% in A-shares last week due to the expectation that the recent flooding and rainy weather would trigger agriculture product price rally, pushing up the CPI in the next few months. In addition, the local market also noticed that the global wheat price extended a rally to the highest price in almost two years on concern other nations may follow Russia’s export ban of wheat shipment. As a result, there was rumor on RRR hike on the back of HTE CPI and the renewed RMB appreciation. The PBoC has resumed liquidity withdrawal lately and also hinted that a RRR hike is still a possible policy tool to control inflation.

From the macro perspective, the good news for China markets is that we have probably seen the bottom because a double-dip is unlikely in 2010. At the same time, policy is shifting to more neutral stance and valuation is reasonable. But investor should not expect the bull market to return any time soon due to the challenging economic transformation, continuing liquidity stretch and leadership transition in the coming years. What we should pay attention is the upcoming release of the 12th Five-year Plan in September and the National Economic Working Conference in November. In the near term, a couple of important events to watch out next week: 1) China will release July’s major economic data on Tuesday and Wednesday, and market will pay more attention to trade data and CPI; 2) Fed’s monthly meeting on Wednesday and it may consider whether or not resume mortgage bond purchase program; 3) On Friday, it is the last day for ABC’s green-shoe program..….Lastly, regional wise, MSCI China is now traded at 13.9XPE10 and 24.5%EG10, CSI 300 at 16.1XPE10 and 29%EG10, and Hang Seng at 14.2XPE10 and 26.7%EG10, while MXASJ region is traded at 13.3XPE10 and +36.7%EG10.

Where USD would Go?

The USD has weakened sharply on reduced growth expectations and the resulting unfavorable move in interest rate spreads. .As a result, DXY closed to 80.40, breaking below its 200DMVGline --- But beware that 79.50 is its triple bottom support. Looking closely, a stubbornly high UNE rate has received a lot of attention in the press and in financial markets, which sent US interest rates drop measurably across the curve, putting 10yr yields below 2.9% and 2yr yield at record lows. At the very front end of the curve, the implied yield on the Dec2010 Eurodollar interest rate future fell a whopping 70bp from late-May through this Friday. The spread of Euribor-Eurodollar has widened from -7bp in late-May to +60 bp, as well. The spread widening is entirely consistent with the rebound seen in EURUSD over that same period.

Given my thought that the decline in US yields has been a key contributor to the rebound in EURUSD, the question now is whether yields can continue lower. In that regard, I think the current, low level of yields reflects a reasonable amount of the D/G of US growth, as well as at least some market expectation for a dovish statement from the next Tuesday's FOMC meeting. As such, it would probably take a notably worse reading from tomorrow's data, or an even more dovish Fed, to extend the USD's recent fall. Thus, I think investors should use the current USD weakness as an opportunity to renew U/W positions in EUR and GBP. Debt rollovers in the euro area from September, coupled with the start of UK fiscal tightening, may reduce the market’s singular focus on the US.

A side note here is that global wheat prices have already gained over 50%, from $4.9 to $7.8/bushel. Russia’s domestic prices rose even more within the last 30 days. In addition, on August 5, Russia announced a ban on grain exports through year-end, effective August 15. This should help contain further domestic price gains, but may send global prices even higher. According to JP Morgan’s commodity team, it expects that any meaningful decline in prices is unlikely to occur before late 2010, but wheat prices are forecast to recede to below $6/bu in 2011, as higher prices now are likely to promote increased global planting…… Well, that is good or bad?

 

Good night, my dear friends!