My Diary 659 --- Does Asia Have An Option? The Bernanke’s Conce

My Diary 659 --- Does Asia Have An Option? The Bernanke’s Concerns over QE2; How to Bet on EMs and China; The Outlook of USD and Commodity

Sunday, October 24, 2010

[Note: This diary is served for some broader topics’ discussion because I believe, at this time point, it is more important to discuss the investment strategies for the year of 2011, instead of betting the QE-2 in 4Q10. I did not conduct the review of X-asset market performance as usual as they were essentially one trade latterly.]

“The engine of life is linkage. Everything is linked. Nothing is self-sufficient. ” --- This is essentially the key message delivered by the fascinating film --- Home, directed by Yann Arthus-Bertrand, one of the most popular movies in the YouTube website. I couldn’t agree anymore and for the same reason, the G20 finance chiefs pledge to avoid competitive devaluations and endorse market-based exchange rates in a fresh effort to defuse mounting trade tensions before they hurt each other. Before flying to Seoul, US Treasury Secretary Geithner told the WSJ that…” the US doesn’t intend on devaluing the dollar as a way to achieve prosperity… and he would use the G20 meeting as a forum to advance efforts to “rebalance” the world economy.”  Well, these comments sound nice but the core philosophy underlying such a policy framework opposes to the free movement of key economic factors such as capital and labor. As a consequence, it ultimately will lead to trade protectionism with all its negative consequences.

In fact, it is not difficult to understand the underlying forces behind the G20 meeting. Low interest rates in DMs are leading to asset bubbles across EMs, as money flows in search of higher returns. In contrast, intervention by China and others EM nations to keep currencies cheap is adding to trade tensions with DMs, where jobs are scarce. The result is inflation in EMs and deflation in DMs. Thus, something will have to give and we saw exchange controls, the fear of protectionism and talk of currency wars. To make things more complicated, China today is gaining more confidence as its economy develops, and Beijing is no longer willing to yield to American demand. Obviously, China’s FX policy will continue to be the focal point of contention. US politicians believe that China is using a cheap currency to steal American jobs. However, the Chinese believe that the country is the victim of American politics and RMB is not undervalued because a majority of export-oriented manufacturers are operating with very thin profit margins. To equity investors, in a world of low nominal growth and ZIRP, any country that can drive down its own currency can usually produce better economic growth, higher corporate profitability and therefore better equity performance. In short, under normal circumstances, the linkage between money creation and economic growth is interest rates. With rates being held at zero, the linkage has shifted to asset prices and exchange rates. This is why keeping a close eye on the currency and its related-policy is so important in today’s investment world.

That being said, I strongly believe that the coming years are the ideal environment for hedge fund managers and traders, who typically have the instruments and capacity to ride volatility, as the expected volatility of business cycle and the expected risk of policy mistakes are high. Looking at the broader picture, before the 2008-09 global crisis, US consumption and Chinese investment were two key engines of the world economy. With US consumers having entered into a B/S repairment mood, the world economy will go through a period of dislocations and adjustment --- 1) there is a surge in global savings. Beside the high saving rates and CA surplus in China, OPEC countries and Germany, the global saving pool is further expanded by the sudden addition of US household savings ( from near zero to 6% as of Sep2010). This implies that the relative abundance of savings will persist, keeping borrowing rates cheap; 2) on the other hand, there is a lack of private spending power, particularly in DMs. In Japan, there has been virtually no domestic private-sector spending growth over the last 15 years, and a similar situation is also developing in EU. In US, though private consumption has recovered somewhat BTE, the sustainability remains to be seen due to high UNE rate and the level of capital spending is 22% below its pre-crisis level.

The lack of private demand indicates that deflationary pressure will continue to be felt and that both monetary and fiscal policy will have to stay very accommodative. The supply side of the world economy will face enormous competitive pressure. Pricing power has greatly weakened and will likely stay weak. All of this means that trend of profit growth could be reduced to around 5- 6%, down from 8.3% in 1990s and 10% in 2000s. Moreover, with interest rates near zero, monetary policy has become much less effective than before. Although central banks can control money supply via QE, they have limited means of altering the demand side of money. The dramatic divergence between exploding central bank B/S (Fed, BoE, and ECB) and the stubborn stagnation in broad money is a classic case of the diminishing ability of central banks to influence money supply and their underlying economies. Through most of post WWII history, this world has been able to mitigate the pain of economy recessions by taking countercyclical monetary and fiscal actions. Going forward, the ability to do so has been greatly reduced or limited. As such, the expected volatility in the real business cycle could be much higher than before. In the same token, G7 fiscal policy is also constrained by large public-sector debt and deficits with little room for maneuvering. Many DM governments have embraced orthodox fiscal conservatism and are actively engaging in fiscal retrenchment at a time when private demand recovery remains fragile. The risk of policy mistakes is high.

Having discussed the broader market environment, the October FMS sees resurgence in risk appetite of equities due to the prospect of a further dose of QE in US. However, such a crowded trade seems more likely a ST relief rather than a LT drive as most investors have little consensus over their growth outlooks, with only 9% expect above trend growth in the coming 12mos. Inflation expectations moved sharply higher (a net 27%, up from 9%) and with only a net 11% expect stronger corporate profits (vs. 2% in Sept). Position wise, hedge funds raised gearing levels to 1.44, the highest since Mar2008. A net 45% of investors see USD as undervalued, but only net 12% think it will appreciate over the next 12mos (down from 38% in Sept). Asset allocators raised weightings in equities (+27% from 10%) and commodities (+17% from 4%). Bonds fell to a net 24% U/W and cash to 6% O/W (vs. 18%). By region, a net 49% are O/W EM, the highest since Nov2009, and EU is the only other O/W (+3%).

Looking forward, the global economy will demonstrate ever-increasing divergences in terms of the strength in growth, cyclical patterns and monetary policy across countries, in particular the EMs vs. DMs. In my own views, the widened gap between low rates and high growth has inevitably created massive overstimulation to EM economies, which will cause several consequences in the coming quarters --- 1) a period of hyper-growth in some EM economies, such as China (10%), Indian (9%), Brazil (8%) and Russian (5%); 2)  high CPI or asset price inflation or  some combination of the two, due to the huge overhang of excess money and credit, together with fast nominal income expansion. So far, we have seen double-digit inflation (Food WPI=16.44%) in India and SENSEX (20687 on October 13) has close to record highs. Chinese property prices have soared, prompting the government to clamp down on speculation (Sept. 29) with new policies; and 3) an increasingly evident policy divergence with EM central banks to lean towards the tightening side, while G7 policy preoccupied with promoting growth, managing the deleveraging process and stemming price deflation by extending ZIRP environment.  Similarly, the overall fiscal status in EMs is relatively balanced, while G7 will likely go into an extended period of retrenchment with higher taxes and lower government spending.

In general, DM economy will slowly recover, but the overall environment will at best be described as --- reduced growth, weak pricing power, periodic threats of deflation and lingering debt crises. In contrast, major EM nations should undergo a strong recovery, with rising asset values, strengthening business activity and even budding inflationary pressures. Such very different structural/ cyclical background and policy tendencies between DMs and EMs will be reflected in asset markets. For equities, the combination of modest growth, very low inflation and highly accommodative monetary policy is supportive for equities. Emerging market equities will continue to outperform, while European equities could be negatively impacted by a strong EUR. For bonds, the path of least resistance is for yields to slowly go up. In 2011, it should not be surprised to see 10yr UST yields back to 4%. For currency, I continue to look for competitive devaluation and rotational currency weakness in USD, EUR and JPY, with key level of EUR at 1.40 and of JPY at 80.

Does Asia Have An Option?

Based on the latest global high-frequency macro data, it seems a larger growth rotation is now underway in 2H10, with GDP growth in DM projected to slow by 1% from 3Q10 to 4Q10, and EM growth projected to pickup by an equal magnitude. The rising growth divergences are fuelling policy tensions between the DM and EM. A slew of DM central bank rhetoric this week generally raises conviction that Fed and BoE will restart QE in November. Their actions are one reason why Asian regional FX reserves have risen USD172bn in 3Q10 compared with USD26bn in 2Q10, according to JPMorgan. The shift to an easing bias in the major DMs has complicated EM policy setting in recent months. The already very gradual removal of policy stimulus has come to a halt across EMs/Asia and numerous measures have been enacted to slow the pace of currency appreciation. Many governments are thinking of ways at least to slow their currencies’ rise against USD at a time when “any quantitative easing will go straight out of the US and into the rest of the world which doesn’t need quantitative easing”, said by El-Erian at PIMCO.

Over the past few weeks, I saw China surprised markets with a 25bp hike in the 1-year lending and deposit rates. China’s rate hike does little to change the global policy landscape, in which policymakers elsewhere to halt rate normalization, intervene in the FX market, and to consider more aggressive steps to contain capital inflows. Brazil raised taxes on foreign inflows into fixed income investments once again from 4% to 6%. South Korea said measures are being prepared to stem inflows and action will be taken to stem FX volatility. Following last week’s increase in capital controls, the Bank of Thailand surprised by going on hold. Taiwan central bank warned it would intervene in the currency market if TWD overshoot. The RBA October meeting minutes revealed that officials left rates on hold in a close decision because currency gains represented a tightening of domestic financial conditions.

In real world, the game between DM and EM isn't quite so easy to play --- monetary and financial conditions are already far too loose across the Asia, and with the Fed poised to pump liquidity yet again, the “Impossible Trinity” has now become a real constraint to Asian policymakers, even though they were able to maneuver in the past.  Ideally, to absorb inflows, Asian countries should deepen and broaden their financial markets. However, that should be a long-term solution across Asia as it also helps economies switch from export-led to domestic-driven growth. There are a few options left in the table – 1) to dangle protectionist tariff in various forms; 2) to accept the consequences for economic instability should the US turn the printing press on; 3) to prevent excess liquidity from the West feeding through to Asian economies through the adoption of "mopping-up" policies, including fiscal tightening, higher collateral requirements on loans, counter-cyclical capital ratios for banks and, most obviously, the imposition of capital and exchange controls.  Obviously, none of the single strategy will work. Only a mix will do. This means rising policy risk!!! Despite this, I still favor capital and exchange controls, if such policies deter speculators, who have caused massive loss of Asian national wealth during 1998-99 Asian Financial Crisis. The only difference is, if last Asian crisis was caused by greedy private speculators, this time they are teamed with Western governments which are armed with thirsty for return to fill their bottomless debt holes.

The Bernanke’s Concerns over QE2

Both BoE (to increase emergency bond-purchase plan by USD160bn) and Fed (refer to Bernanke speech on October 15 and the FOMC minutes) have made another round of quantitative easing a “done deal” in November, unless the economies suddenly perks up or core inflation moves up toward the Fed’s comfort zone.  As a result, market participants have been pushed into a corner with all the debate and uncertainty about QE2. So far, the bigger unknown is what will happen next and it has caused increased market volatility until investors find out more about what’s going on.

One thing clear is a building consensus that USD will suffer on a trend basis if the Fed embarks on an open-ended policy of monthly debt monetization. As presented by St. Louis Fed President Bullard on October 21…"If we do decide to go ahead with quantitative easing, I think there is a good program we could adopt, one I like, which is to think in units of USD100bn between meetings. We could give forward guidance for the next meeting that would suggest how likely the committee thinks we would continue these purchases.”  Interestingly, Chairman Bernanke noted that "…one disadvantage of asset purchases relative to conventional monetary policy is that we have much less experience in judging the economic effects of this policy instrument, which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public"…Again, high policy risk here!!!...Another work that Fed governors have been working hard is to stop the decline in inflation expectations, which threatened to push up real yields in a replay of what occurred in Japan. Policymakers have been openly discussing ways of better anchoring long-term inflation expectations using an inflation target, a price level target or a nominal income target. These “open mouth operations” have been rewarded as 10yr BE inflation rate has increased by 57bp since the beginning of September, while the implied 10-year real yield has dropped to near zero. These are positive signs, suggesting that US will not fall into a Japan-style trap in which deflationary expectations and the zero bound for rates doom the country to persistently high real yields.

All said, there is still a risk of a repeat performance like QE1 as nobody knows how much more quantitative easing is enough. Under QE1, Fed purchased mostly non-UST in order to boost liquidity and lower credit spreads to bring down private sector borrowing rates. At the time, the economic data were beginning to signal that the end of the recession was in sight (marked by Bernanke’s “green shots”), helping to unwind a massive flight-to-quality that occurred at the end of 2008. In contrast, the Fed appears set to buy mostly Treasuries in November with the express purpose of flattening the curve and driving real government yields lower (and hopefully dragging along private sector borrowing rates). Thus, a key question to investors is whether QE-2 is already fully discounted in the bond market, implying that there is little further downside potential for yields. In my own view, there could see “buy the rumor, sell the fact”.  If so, then USD yields might continue to grind lower with each disappointing data release since investors will expect even more Treasury purchases in subsequent months. The open-ended nature of this policy approach would make it difficult to estimate how low yields will go. The yields will go as low as is necessary to stimulate growth.

How to Bet on EM Equities and China

Given that there is clear interest in EM equities and the broad investment climate in 1990s was very similar to today, I would like to do a comparison of the two time periods. In early 1990s (after S&L crisis), there had a badly damaged banking system, immense pressure for corporate US to delever, a chronically high UNE rate and a deep doubt over whether US recovery will be sustainable. Yet stocks kept climbing a wall of worries with SPX moving from 304 in October 31, 1990 to 1517 on August 31, 2000. Today, the world has half-decent economic growth, no inflation, a high jobless rate but solid profit growth.  In addition, with government bond yields at 2.4%, commodities flirting with pre-crisis highs and corporate spreads having narrowed dramatically, equities look cheap compared to all other competing assets. In the 1990s, global stocks were trading at much higher PE multiples than today. For instance, the trailing PE for emerging markets was 17X, normalized PE close to 40X and FWD PE at 20X. In comparison, EMs today is trading at 14.3X trailing PE, 16.9X normalized PE and 11.7X FWD PE. Therefore, solely comparing relative valuation, stocks are genuinely cheap.

That said, through almost all of the 1990s there were massive, cumulative distortions in EMs -- foreign debt/ GDP was high and climbing, the entire EM had a fixed exchange-rate system, budgetary deficits were large and Asian companies were hugely leveraged with very thin or no corporate profits. All of these distortions culminated into a series of major financial crises and debacles for all of the 1990. Today, almost all EM countries have adopted floating exchange-rate systems, with the exception of China and Hong Kong. I think the biggest difference between today and the early 1990s is that we are close to price deflation and short rates have already been slashed to zero. The overall indebtedness of US economy is much higher than it was in the 1990s. The transmission mechanism for monetary policy is profoundly different. Budgetary conditions are severely strained in Europe and the US and the uncertainty surrounding fiscal policy is also very high. Neither of which is equity friendly. Looking forward, accommodative monetary policy, very low interest rates and decent corporate profitability will limit the downside risk for equities, but there will be a lack of a positive story creating a new secular bull market. In addition, most G7 markets will eventually encounter either fiscal or monetary renormalization, Not to mention that global QE, together with the rapid escalation of public-sector debt, has introduced enormous uncertainty with respect to the long-run outlook for global inflation. All of this means that a “buy-and-hold” strategy is no longer adequate. Active portfolio management is needed to obtain and increase alpha.

Regarding to Chinese equities, I think the medium-term investment themes are clear now after the Chinese Congress approved the 12th Five-Year Plan on Oct 15-18. In general, the action plan is to raise labor’s share in the initial income distribution, and to raise the share of residents’ total income in the overall income distribution with domestic consumption now recognized as the NO1 growth driver. To market participants the focus is on the strategic emerging industries, of which the government is aiming at increasing the proportion to 8% of total GDP by 2015 (from 3% in 2010) and 15% by 2020.  If the past investment cycles in Chinese equities are still valid reference, the seven industries are surly the golden mines, including 1) Renewable Energy; 2) Machinery Industry (+17% cagr with USD20bn sales in 2015, plus industry consolidation and M&As); 3) Alternative Energy Automotives (10mn levels by 2020); 4) Biotech Industry (medical and agricultural); 5) New Material (20% industry growth in the next five years); 6) High-end manufacturing/Aviation Industry; and 7) Information Technology. .Lastly, regional wise, MSCI China is now traded at 14.7XPE10 and 28.7% EG10, CSI 300 at 19XPE10 and 27.7% EG10, and Hang Seng at 15XPE10 and 29.1% EG10, while MXASJ region is traded at 14.0XPE10 and +39.3% EG10.

The Outlook of USD and Commodity

Every single country now seems to fight for a softer local currency, which offers two benefits --- 1) it makes export more competitive, boosting both economic activity and inflation; 2) it raises the value of GDP relative to existing deficits and debts. In other words, the debt burden declines. That said, with USD short now replaced EUR sell as the consensus trade, the top question is how long can this trade be sustained? By many measures, this leg of the USD sell-off is beginning to look stretched. According to the latest IMM Commitments of Traders report, total net short position USD has reached USD 30bn, the highest since Nov 2007. Net shorts have increased by almost USD 24bn since the end of July. Compared with May (when net longs in the USD were greatest), the net change is more than USD 50bn. Market positioning is looking increasingly one-sided.

In addition, the magnitude of the USD sell-off is approaching the limits of previous sell-offs over the past 18 months, which could trigger a sharp corrective retracement.  For example, the DXY index weakened by 9.2% between its high in early Jun2010 to early August, before making a brief bounce of 3.7% in August. Prior to this, the DXY index sold off by 9.8% from late April to early June 2009 before bouncing 3.6%. And in March 2009, during the Federal Reserve’s first round of quantitative easing, the DXY fell 7.6% over three weeks before correcting 4.0% in April. Moreover, the next round of quantitative easing is likely to be more open-ended, with the Fed determining how much and when purchases will be made by discretion, enabling them to remain ‘data-dependent’, as the Fed has often publicly emphasized. This lack of clarity could be a trigger for USD short-covering in the run-up to the FOMC meeting, especially in light of the heavy positioning against the USD already highlighted.

On the other hand, commodity markets continued to respond to specific factors – 1) floods in Pakistan drove up cotton prices; 2) grain and other food prices were pushed up by weather-related crop failures; and 3) gold prices flirted with new highs (in USD terms) over concerns about the Fed conducting additional QE. Superficially these might look like the pre-cursors of higher inflation in 2011 or 2012. In reality they are simply speculative or knee-jerk reactions by investors who have learned to fear inflation following from low interest rates, whereas the most likely outcome in DM economies undergoing B/S is low interest rates and near-deflation conditions. Looking forward into 2011, continued strength in commodity prices will require demand from China and India to fully counterbalance the relatively weak recoveries in G7 economies. Nevertheless, in DM economies, inflation fears – in turn driven by very low interest rates, QEs and weak currencies - are helping to drive speculative funds into commodities. The combination of inflation fears in DMs and strong, real demand in EMs is driving commodity prices higher. As long as these two primary forces remain intact the bull market trend in commodities seems likely to continue.

Good night, my dear friends!