My Diary 662 --- Reading across Regional Economies, Comparing A

My Diary 662 ---- Reading across Regional Economies, Comparing Apple to Orange, Three Themes for China Ahead, Rotation from Metals to Oil

Merry Christmas and Happy New Year to all friends who have encouraged me over the years to write this market diary and to share their invaluable market insights with me!

December 27, 2010

“Christmas Gifts: American tax cut, European debt treaty and Chinese Rate hike” --- The Santa Clause has been busy delivering the presents over the X-mas week, of which it ended up with a surprising rate hike from China. PBOC on Saturday said that it will raise the 1YR lending rate by 25bp to 5.81% from 5.56% - the hike comes after Oct 19, the first increase in almost three years. As Fed is still priming the pump with QE2, the move for China to raise rates looks more reactionary as it attempts to get ahead of the inflationary consequences of Fed’s policies given the peg of CNY. However, overnight global risk assets and currencies performed reasonably well despite rate hike and the subsequent 1.9% loss of SHCOMP. In addition, President Obama signed into law last week an USD858bn bill extending for two years all tax cuts enacted during the administration of George W. Bush. The deal is being touted as a second fiscal stimulus, exactly what chairman Bernanke has said is needed to complement the central bank’s asset-purchasing program. Most of the provisions are extending the status quo, such as the Bush-era cuts in individual income taxes (max=35%). But the most important is probably a measure to allow businesses to depreciate new equipment investments at 100% in 2011 and 50% in 2012, which should help cash-hoarding companies to begin to invest and, ultimately, to hire. As a result, the yield slope between 2-10 USTs touched the widest (274.4bp) since February on speculation an extension of tax cuts will spur growth and increase deficits.

Across the pond, Spain was forced to pay a high premium in its latest auction, with the cost of borrowing for 10Y bonds up 80bps in just over a month. Spanish spreads over bunds (283bp) are close to their highest level in 14 years, taking the Euro area debt crisis to a new and potentially more risky stage. Meanwhile, EU leaders agreed to amend the bloc’s treaties to create a permanent crisis-management mechanism in 2013, with Germany refusing to boost the current EUR750b emergency fund for the most indebted countries. In fact, what really concerns me is that Europe’s most indebted nations, already struggling to find buyers for their bonds, will face more competition due to the refinancing needs of Ireland’s rescue package. The EFSM and EFSF will need to raise EUR34.1bn (USD44.6bn) for Ireland in 2011, the European Commission said Dec. 21. The other peripheral nations also will ask for funds against AAA-rated Germany and France, which plan to sell a combined EUR486bn of debt next year with Spain’s funding needs around EUR90bn and Portugal EUR19bn.

Looking back the economic expansion starting in June 2009 has driven an 85% surge in the S&P500 since it sank to a 12-year low of 676.53 on March 9, 2009, restoring about USD7trn of equity value. Moreover, US government and Fed spending to stimulate the economy, coupled with improving profits, drove the rally in equities. The index will end 2011 at 1370, according to the average projection of 11 strategists at Wall Street’s biggest banks, producing the biggest three-year rally since 1997-2000. As 2010 draws to a close, global policymakers seem quietly confident that the worst is over. Economic activity is booming in EMs and no longer declining in the Western world. UNE has stopped rising in most countries and, for the lucky few, is actually falling. Stock markets have rallied and bond markets have sold off, perhaps indicating a revival of animal spirits. And, whereas a year ago, many policymakers were worried about deflation, the bigger concern today in many parts of the world is the return of inflation. However, downside risks have not gone away yet. Although US economy picked up through the course of 2010, the pace of recovery has been disappointing, to say the least. In the first few years of recovery from deep recessions, the US typically grows at a very brisk pace. Following the Great Depression, growth rates hovered around 10% per annum. In the mid-1970s, after the first oil shock, growth rates were up at around 5%. And following the double-dip recession of the early-1980s, growth rates averaged between 4-7% for three successive years. For 2010, it looks as though growth will average around 2.8%. Following the 2.6% decline in GDP in 2009, this is simply not good enough. The pick-up in US growth has not been sufficient to lift inflation from remarkably depressed rates. With interest rates now at zero, the US economy is in danger of behaving very strangely. If inflation continues to fall - or indeed, descends into outright deflation - interest rates will, in real terms, be too tight. For an economy awash with debt, this will simply hamper the recovery even further, leaving the UNE rate too high and policymakers either scratching their heads or wondering whether quantitative easing will be able to weave its debatable magic.

For the EMs, additional US monetary stimulus is making life more difficult. With global interest rates already very low and with investors sensing that emerging growth is the only game in town, the danger is that capital inflows into EMs lead to overheating, the creation of bubbles and excessive inflation. Indeed, while US inflation heads down, inflation in the emerging world, most obviously in China and India, is heading up. For Asian countries which don't have Western-style debt problems and are not suffering from the associated headwinds, they're mostly unwilling, however, to raise interest rates and to allow their  currencies to appreciate, fearing either even bigger inflows to take advantage of currency appreciation or, instead, a severe loss of competitiveness. Instead, many EM nations are pursuing what can best be described as quantitative tightening; raising collateral requirements on property loans, changing reserve requirements for banks and, increasingly, imposing capital controls. They are throwing sand into the works of global capital markets in a bid to protect their own sovereign interests.

X-asset Market Thoughts

On the year-to-date basis (in USD terms), global equities closed up to 8.94% along with +13.14% in US, +0.25% in Europe, +10.28% in Japan and +11.99% in EMs. Elsewhere, USTs climbed with 2yr yields dropped 44bps to 0.69%, 10yt slid 51bp to 3.32%, and 30yr shed 25bp to 4.39%. In the European space, the 10yr yields of Portugal, Ireland, Greek and Spain government bonds went up 259bp, 381bp, 652bp and 141bp, respectively. 1MWTI oil went up 14.62% to $90.96/bbl, while CRB index also had a good run to 329.11, +16.13% yoy. Many metals break their new height with Copper closed at USD9346/ton and gold at $1390/lb. In the currency metrics, EUR (1.3219USD) has fallen 9.7% this year in a measure of the currencies of 10 developed nations, according to Bloomberg. JPY (82.4USD) has gained 10.9%, while Dollar Index was up 2.68% on the yoy basis.

Looking into 2011, what I can describe the world at best is modest growth, gentle inflation, low interest rates and a gradual improvement in UNE. Given the BTE profitability and FCFs generated by companies, investors agree that equities are relatively attractive to bonds and to real assets. This is true worldwide and there are 3 assumptions underpinned the bullish views --- 1) expect 3% US growth and 4% global growth; 2) switch from  bonds into equities, and 3) increased confidence over policymakers’ ability to prevent further major disruptive events. However, there is increasing pressure over the potential outperformance of EM equities relative to DM equities in 2011 --- a) Relative valuation: high-quality US blue-chips seem to offer the most compelling valuations (12XPE11). They are cheap and not only benefit from sales into emerging markets, but are also positioned to exploit domestic growth.  Moreover, MSCI EM is now trading at 20% premium to MSCI World on the P/B basis.  b) Margin and earnings growth: if US economy and global growth accelerates next year, commodity prices, especially oil, could trend higher & be the major headwind for emerging markets, given the much lower level of output gaps, triggering higher inflation and/or pressure on current accounts. Earnings disappointments in terms of margin compression (CPI-PPI) will erode the bottom line growth. That said, FWD earnings growth seems strong for EM equities in 2011 with median EPSG of global EM at 18.2% vs. EM Asia at 17.1%. c) Policy risks: given the expectation of high commodity prices and inflation, EM equities are entering the more dangerous point of the rate hike cycle, along with quantitative restrictions on lending & other measures on the way. I continue to expect more rate hikes in EM space. In that sense, Asia's "growth alpha" is declining but it's "growth beta" seems as high as ever. Asia will continue to struggle to manage the post-crisis realignment of currency valuations. d) Fund flows:  2010 sees the highest ever annual flows recorded by GEM funds with YTD flows to GEM funds reached USD61.2bn (68% of dedicated EM funds). As of last week, the global weighting of EM has already gone up from 2% in 2002 to 11% currently. It is still slightly underweight, but a lot closer to benchmark of 13%. Thus, there is not much space for Asian outperformance, if considering YTD local currency performance of which Asia has just seen the best year ever! Meanwhile, if US assets, including the Dollar, are strong, then investors would anticipate some unwinding of the carry trade to the detriment of emerging market assets.

For fixed income markets, investors agree that it should do well for at least the early parts of 2011, notably high yield, as Asian central banks have no choice but to put their expanding FX reserves into the most liquid markets, while many pension funds in the US are now pursuing liability-driven investment strategies. However, the biggest risk is an unexpectedly sharp hike in US interest rates. This is a ‘when’, not an ‘if’, but the consensus expects this to be a problem in 2012.

Reading across Regional Economies

The week saw a run of upbeat data from US, including retail sales (1.2% vs. exp=0.6%), consumer confidence (UoM =74.5), LEI (1.1% vs. Nov=0.5%), mid-Atlantic factory activity (24.3 vs. exp=15) has warmed up the markets and prolonged the sell-off in USTs, taking 10yr yields to their highest level in 7-months. In particular, US initial jobless claims declined 3,000 to 420K, lowering the 4WMVG to 423K. The 4WK-average was above 450K as recently as the end of October. Moreover, existing home sales increased 5.6% in Nov to an annualized rate of 4.68mn units as single-family homes increased 6.7%, which offset a 1.9% decline in multifamily units. That said, household sector deleverage persists. Net household sector borrowing has declined for 10 consecutive quarters, driven down primarily by huge declines in net mortgage borrowing. Though household wealth rose by USD1.2trn in 3Q10, the difference between household assets and liabilities was reported at USD54.9trn at the end of Q3, up from about USD53.7trn at the end of Q2. On the back of weak economy fundamentals, House of Representatives approved USD858bn tax package, which would deliver a stimulus to the economy, but will hold the US deficit at close to double digits. As a result, I would expect FOMC to continue to emphasize low resource utilization rates and subdued inflation trends as well as to reiterate the need to foster maximum employment and price stability. To watch for the next key data point, it will be the 7 January payrolls report.

With regard to Europe, though composite PMI fell 0.5pt to 55.0 in December. But it is still signaling surprisingly rapid growth (at above a 2% QoQ saar) in the region overall. As in recent months, this growth is relying very heavily on Germany, where the PMI (59.7) hit a new recovery high in December, which is the highest level in this recovery and more than 6pts above the pre-recession average. Euro area inflation was also stable at 1.9% yoy in November, while core inflation held steady at 1.1%. In Asia, the past weeks saw a series of positive reports on China’s economy, starting with a strong set of economic data and pro-growth macro-targets for 2011, and culminating in a one-notch ratings upgrade (to AA-) by Standard and Poor’s. Comments by PBoC Governor Zhou suggest that there may be a need for more hikes in RRR, possibly before year-end. In my own view is that rising inflationary pressures will bring further rate hikes – 3 more by mid-2011. In India, inflation is already significantly above the central bank’s comfort level. Upside pressure from rising commodity prices and strong domestic demand could lead the bank to tighten rates sooner rather than later if data and WPI inflation continue to surprise to the upside. Taiwan’s central bank (CBC) is expected to continue to tighten policy, with a 12.5bps rate hike at end-December, the third successive move.

To sum up, the turn in the global data flow in recent weeks is impressive. US consumption is now tracking a 4% yoy this quarter, prompting an upward revision to GDP growth forecast to 3.5% for Q4. Consistent with this news, key high-frequency global growth indicators are falling into positive alignment. EM Asian exports are rebounding, US jobless claims are sliding, and the German IFO survey has reached a new cyclical high. There is no longer any doubt that global growth is picking up. With strong corporate earnings forecasts and the improved economic picture, if we don’t have any bad surprises from Europe, stocks will be the investment of choice at this valuation level.

Comparing Apple to Orange

For most part of the year, media commentators have compared the Fed’s policy stance and market operations with what the ECB has done, and urged ECB to make huge bond purchases. In my own views, such comparison is like comparing Apple to Orange as QE in US and UK is about adding more monetary stimulus in an environment where the nominal policy rate is zero. Those urging the ECB to make huge bond purchase are asking the central bank to monetize the debt of sovereigns who cannot access capital markets due to concerns about their solvency. These two situations are not the same, by any sense of the imagination.

Having discussed so, FOMC said that the pace of economic growth is “insufficient to bring down unemployment,” as it affirmed its bond-buying plan and renewed a pledge for an “extended period” of low interest rates. Lately, Fed was the dominant player in the bond market, conducting two more purchase operations. The first round of purchases removed USD7.79bn (42.8%) of 5.5yr-7yr paper from the marketplace, while the second took out USD1.6bn (34.3%) of TIPS ranging from 7/12 to 2/40 in various maturities.  Market critics pointed out that the Fed’s effort to achieve the stated objective of pressing long-term yields lower has been a dismal failure as the benchmark 10yr UST has climbed to 3.42% from 2.64% on Aug., 27. Political side, Republican leaders in Congress also claimed that they have “deep concerns” about Bernanke’s second round of quantitative easing. On the flip side, Former Fed Governor Lyle Gramley said it’s “too early to make any definitive judgment” on the Fed’s bond purchases. I agree with his views as what the Fed is trying to do is reflate the economy and the most important way QE works is the provision of liquidity. To the extent, QE policy has prevented expectations of outright deflation and encouraged an increase in the stock market. In fact, the Fed’s policies have led inflation expectations to increase. The 10yr BE inflation has risen to 231bp from 163bp on Aug. 27, according to Bloomberg. Thus, it seems to me that the Fed policy is a success. And looking only at the long-term rate is a misinterpretation on this policy.

In contrast, the case with Euro Zone is much more complicated. At the meeting in Brussels last week, EU leaders agreed on a modest treaty change to enable a permanent crisis resolution mechanism to be established. The amendment to the treaty will have to be approved in each member state and the intention is that the permanent mechanism will be put in place in June 2013, when the legal authority of the current EFSF expires. Given that the peripheral sovereigns are unlikely to have reached a position of debt sustainability by 2013, the transition from the current regime to the new regime is of critical importance. The end-November agreement by finance ministers suggests that the transition will run as follows. Any Euro area sovereign which needs liquidity support after the middle of 2013 - to cover its gross funding needs - will be subjected to a debt sustainability analysis.

Looking in details, this proposal rests on the recognition that solvency is itself a function of the rate at which sovereigns can borrow. Debt dynamics are highly sensitive to borrowing rates. For example, if Greece and Ireland were forced to borrow at market rates after 2013, the level of debt would grow rapidly, reaching 184% and 155% of GDP by 2020, respectively. By contrast, if borrowing rates were subsidized to, say, 100bp above German rates, debt ratios would quickly stabilize and start to move down, reaching 125% and 113% of GDP by 2020, respectively. A similar calculus applies to Portugal and Spain. At the moment, liquidity support is being provided at a borrowing rate of around 350bp over Germany. Sustained at this spread, it is unlikely that all periphery countries will achieve debt sustainability. The cost of the large improvement in debt dynamics at borrowing rates 100bp over Germany represents a fiscal transfer. However the cost is modest. It is estimates the present value of the implicit cost of such a subsidy, if used to completely fund Greece, Ireland, Portugal, and Spain through 2020 to be EUR111bn, or just 2.5% of the combined GDP of Germany and France.

That being said, the ECB still cannot save the Euro area. What we see in the Europe is a fiscal crisis which should be solved by the fiscal authorities. A fiscal solution has two dimensions: fiscal consolidation across the periphery and liquidity support provided by a sharing of fiscal capacity (e.g. the Greek bilateral loan package and the EFSF). While some bond purchases by the central bank are appropriate to deal with market dysfunctionality, it is not appropriate to draw the central bank in further to compensate for a failure of the fiscal authorities to live up to their responsibilities. The ECB cannot risk being drawn into a situation where sovereigns become addicted to central bank liquidity, in the way that some banks have. In such a situation, the central bank would lose its independence in the most fundamental way possible: it would become subservient to the fiscal authorities. The risk of such a development would be monetary instability and elevated inflation. The easiest way for the region to move forward would be a slightly greater sharing of fiscal capacity. In short, it’s likely that we haven’t seen the worst of the crisis in the region.

Three Themes for China Ahead

The ultimate goals of China have been set during the Central Government Work Conference. In priority, the New Year resolutions are listed --- 1) to strengthen/improve macro controls, to ensure a stable and healthy economy; 2) to develop modern agriculture and ensure supply; 3) to ensure economic restructuring; 4) to provide better public service; 5) to encourage change in growth model and 6) to look for more global cooperation. Other broader economy goals including new loan and M2 are set at Rmb7.1trn & 15% yoy, respectively. Though the market has increasingly paid attention to the headline news of Chinese CPI figures, there is no compelling evidence that the Chinese macro story is about to be hit by an outbreak of 1970s style inflation. The view of the authorities is that headline CPI should peak at about 5% by the middle of next year at the latest, and decline back to below 4% in the second half of 2011 as the pressure from food prices goes out of the system. On the latest Sunday, Premier Wen said Chinese govt has all the tools needed to control overall price level and housing price, even though NDRC officials said a few days ago that it’s a challenge to keep 2011 CPI at 4%.

On the back of this policy tone, it is nothing unexpected about the latest China rate hike as real interest rate continues to fall. Given policy bias is still pro-growth and inflation, the current market is comparable to 2007, when Chinese equities had lower PEs and negative real rates. In particular today’s markets is far cheaper (~12XPE) than in 3Q07 (20X and more). Under such market and economic environment, I think there are three themes will do well --- 1) inflationary play: insurance (liability) and upstream materials & energy; 2) Consumption: consumer discretionary, capital goods, internet and technology, and 3) policy favorable: new material, alternative energy, healthcare, and environment protection-related industries. I think investors should U/W utilities, infrastructure operators, Telecom, consumer staples, shipping and export-related sectors, which will either suffer from rising material costs, narrowing margins or product price regulation by the government...Lastly, regional wise, MSCI China is now traded at 12XPE11 and 16% EG11, CSI 300 at 14XPE11 and 27 % EG11, and Hang Seng at 12.2XPE11 and 15% EG11, while MXASJ region is traded at 12.2XPE11 and +12% EG11.

Rotation from Metals to Oil

EURUSD continues its consolidation pattern on the speculation of European banks and nations will need to raise more funds, adding to signs the region’s debt crisis may be prolonged. Newspaper said that ECB will lend local banks EUR149.5bn (USD195.9bn) for three months to meet their liquidity needs over the year-end period. 5yr CDS on Greece, Ireland, Portugal, Italy and Spain have gone up from 9-16bp over the past few days. These movements come amid continued negotiations among EU policy makers on matters such as expanding the size of EFSF and the possible issuance of common EU bonds to fund future bailouts. Press reports indicate that France and Germany will not agree to such measures. And while officials also reiterated their commitment to defend EUR, those types of comments are not supportive the currency. My own bias on EUR has got to be on the downside and the upside for USD in 2011. And a prolonged debt problem in Europe creates uncertainty and volatility in the financial system that could make investors risk averse.

In contrast, as talked above, improving global growth prospects should sustain gains in oil price. In fact, the past quarters saw a clear rotation strategy throughout the commodity complex, based on macroeconomic conditions --- First gold, then copper, and finally oil. The rationales are gold typically benefits most from aggressively anti-deflationary liquidity impulses, especially from US, which bring down real interest rates and USD. That backdrop may be fading for now. Copper benefits when China is booming and/or restocking. Lately, the demand exacerbated over the short-term by the launch of two ETFs (one each for copper and nickel). However, copper prices have surged since breaking above the psychological $4/pound (USD8000/toN) level and may need to consolidate recent gains. Finally, oil outperforms when the growth impulse broadens to US. This is what appears to be currently underway: Recent economic releases suggest that the recovery is becoming more sustainable. Moreover, physical demand is starting to draw down inventories, even though several OPEC countries have been producing well above quota. The bottom line is that oil and related product prices are well positioned to benefit as firmer US growth reduces expectations of the need for quantitative easing, while boosting physical demand for crude.

Good night, my dear friends!