My Diary 672 --- A Further Assessment to Japan; The Exit Ways of

 

My Diary 672 --- A Further Assessment to Japan; The Exit Ways of Sovereign Crisis; China Tightening to Extend; More Headaches vs. Rising Food Prices

 

 

 

 

Sunday, April 03, 2011

 

 

 

“Quarter End & Japanese Year End vs. Data & Earnings” --- The past week buried me with all sorts of data through which I tried to figure out the activity levels of major economy entities and investors alike. My general observation is that lingering concerns over Japan, the NATO-led assault on Libya and the continuing peripheral European debt saga did little to dent the risk appetite. Macro wise, March data flow indicates a building tension between improvements and drags, particularly on IP and consumer spending. Although ECRI WLI fell to 129.3 from the multi-month high of 130.9 recorded two weeks earlier, the index remains firmly in positive territory. That said, data also supports the fundamental improvements coming from business spending and hiring. Rebounding from a weak January, US NFP gains averaged 188K monthly gains last quarter. The UNE rate fell another 0.1% to 8.8%. Euro area economic sentiment was resilient in March, easing 0.6% to a still very elevated level of 107.3. The flash PMI (56.1) also held up pretty well and continued to signal a broadening regional expansion. In Asia, a rise in China’s PMI survey and healthy Korean trade flows underscore the solid position of regional growth on the eve of the Japanese earthquake.

 

However, a main drag on global growth comes from rising oil prices, which are taking a bite out of global consumption spending. This is evident in US where consumption gains slowed to about 1.5% yoy. Global auto sales also appear to be moving lower at the end of the quarter. This consumption drag will be reinforced by Japan’s demand shock. Another shock is laid in the aftermath of Japan’s tragic natural disasters as Asian regional performance is set to deteriorate. Major sell-side economists have further revised down Japan’s 1H11 growth forecast with IP dropping a huge 16% over March and April. Although it is impossible to gauge the severity of the blow at this time, the initial negative hits have been echoed by the two industry surveys (PMI and Tankan, see below) covering the post-quake period collapsed. As negative as the results appear, such surveys probably understated weakness due to the low reporting rate by the hardest-hit firms. In my own views, the impact of supply disruptions and weaker Japanese demand should be more apparent this month and felt most strongly in the Asian economies.

 

Policy front, the tension is registering in the inflation environment as food and energy prices are lifting headline inflation everywhere. In DM economies, though wage inflation remains subdued, there are significant regional issues creating financial vulnerabilities. Such environment complicates monetary policy setting and is pushing policymakers in different directions. There is a sharp distinction between ECB and Fed where the former’s B/S is being geared toward fostering financial stability while interest rates will be raised to contain inflation pressure. At the same time, Fed speakers continue to grab headlines in the context of rising headline inflation and increasing household inflation expectations. Last week, Minneapolis Fed President Kocherlakota's musings on the Taylor principle raised the specter of a rapid tightening by year-end. In a WSJ interview, Kocherlakota observed that modern monetary theory prescribes that policy rates should increase more than one-for-one with inflation. Given that in his view core PCE inflation will increase from 0.8% at year-end 2010 to 1.3% by year-end 201. Mr. Kocherlakota said when the Fed decides to tighten monetary policy, he favors raising short-term interest rates over selling assets by the Fed's portfolio, primarily because the Fed has a firmer understanding of how interest rates affect the economy. Two other regional Fed presidents with votes—Charles Plosser of Philadelphia and Richard Fisher of Dallas have also expressed concerns about inflation and suggested they would favor raising rates in the near future. Viewing the expansion of its B/S as an extension of traditional policy setting when interest rate policy is constrained by a lower bound, NY Fed President Dudley reaffirmed the Fed’s commitment to complete USD600bn APP and underscored that, while the economy is improving, there remain “several areas of vulnerability and weakness.”  I think, unless Chairman Bernanke comes out with a strong statement stating otherwise, the market may have started a re-assessment of the assumed duration of low rates for an exceptionally long period of time.

 

In Asia, BoJ is facing a crisis and is responding to the earthquake and tsunami by easing monetary conditions through several channels. In particular, BoJ is supporting the government’s rescue and rebuilding operation by expanding its B/S JPY22.5trn (USD280bn). Asset purchases will include JGBs, corporate bonds, and equities. Additionally, the government may examine the possibility of BoJ debt monetization as one measure to finance the fiscal package. The BoJ is expected to expand its asset purchase program at next week’s board meeting. For the rest of EM Asia, growth and inflation risks remain skewed to the upside. Policymakers are likely to move quickly to hike interest rates further. The RBI)raised its inflation target for March to 8% from 7%, adding to expectations for further rate hikes there. Chinais expected  to hike rates by 25bp this month after the recent 50bp increase in RRR, and to follow with another rate increase of 25bp later in 1H11. In Taiwan, I saw another 12.5bp rate hike this week. BoT is expected to raise rates by 25bp at each of its next four meetings, taking policy rates to 3.50% by year-end from 2.50% currently. Finally, in Philippines, Bangko Sentral ng Pilipinas is to raise rates by 25bp at its next meeting. On balance, these aggressive hikes could be seen as negative for asset markets and dent some of the optimism that is currently built in.  

 

Market side,  global equities rallied this week to within touching distance of the cycle peak reached only a month ago, confirming that the selloff caused by Japan earthquake was merely a correction. It seems clearly now that Japanese earthquake is expected to only cause a down-and-up V-shaped move in IP and GDP and that within the year. I tend to agree, but what makes me nervous is that in coming months, sticker shock to the dramatic impact on global and Japanese IP and PMIs might lead investors to question whether something more persistent is at work. US consumption is running soft versus production, and oil prices keep rising. The above observations raises a question to me --- whether the 2Q11 will turn into a repeat of last year when weaker activity data raised fears of a double dip and pushed global equities down 15%, punctuated by the flash crash in May.

 

Turning to fund flows, both DM and EM equity funds recorded outflows in excess of USD8.5bn for the week ended 23 March. The market saw a big reversal from 2009-10 as 1Q11 sees inflows of USD36bn to DM equity funds versus redemptions of USD18bn from EM equity funds. Investors are keen to position for Inflation & Yield, witnessed by commodity funds as the big flow winner in 1Q11 along with floating-rate debt (massive 20% of AUM), TIPS (3.3% of AUM) & gold (3.5% of AUM). As these are inflation hedges, showing that retail desire for yield. That said, the latest equity market’s rally has caused the SP500 VIX to collapse sharply, from highs of around 29% in end-June 2010 to 17% currently, suggesting that investor pessimism has taken a backseat. In contrast, in Europe continued disagreements about the size of the emergency aid fund for distressed sovereigns have further undermined sentiment towards the peripheral European markets of Portugal, Ireland and Greece. Adding to the continuing uncertainty have been the lowering of Portugal’s credit ratings by S&P and Fitch, the collapse of the Portuguese government following its failure to agree on spending cuts, and electoral defeats suffered by German Chancellor Angela Merkel. For the moment, these factors have not adversely impacted the credit risks, but they could do so if the situation drags on with no resolution in sight.

 

 

X-asset Market Thoughts

On the weekly basis, global stocks jumped 1.185% with US +1.51%, EU +1.5%, JP +0.5% and EM +3.6%. Elsewhere, UST dropped with 2yr yield raised 7bp to 0.79% and 10yr up 1bp to 3.44% %. 10yr Portuguese sovereign bond yield hit 8.5% for the first time, with spread the 10yr bund  (+64bp), hitting its new high of 514bp. 1M BRT gained 2.5% at USD118.94/bbl. CRB index was largely flat at 360 level. EUR picked up 1.06% to 1.4237USD and has risen more than 10% since its early year low. JPY index plunged 3.3% to 84.06 and is down more than 7% since its post-earthquake high (78.99). 

 

Looking forward, the economic outlook has become more uncertain over the past month. A sharp spike in oil and gasoline prices is sure to damp growth of consumer spending and business investment. The question is ---how much? The earthquake, tsunami, and nuclear crisis in Japan are disrupting manufacturing supply chains globally, but the extent and duration of the problem are unknowable at this point. Political turmoil in MENA is creating more uncertainty about future oil supplies. On top of all this, US Congress is debating how much and how quickly to cut funding for non-mandatory government spending programs. A sharp cutback could lower near-term GDP growth just as other downside risks are intensifying. Under such a background, policymakers are likely to maintain an accommodative stance for the time being. Even without an oil price spike, the current high level of UNE rate and low rate of core inflation would keep the Fed toward an easy monetary policy, given its current priority is to lower the UNE rate. The threat of a slowdown in activity coming from high oil prices should only serve to reinforce the Fed's concern about underutilization of resources in the economy. In the near term, consumer expectations will play a key role for the economy and for monetary policy going forward. The Conference Board’s measure of consumer confidence declined sharply in March from an upward-revised 72.0 reading for February to 63.4 in March. The current conditions rose 3.1pt but expectations fell 16.1pt.

 

That being discussed, even as 2Q10 looks to be bad, I want to keep long equities vs. bond, but reduce the OW in response to the risk that markets may react negatively to the weaker IP and PMI data over the next two months. Regarding EM equities, it could continue to outperform their DM counterparts – given that 1) signs that policy tightening is having an effect in slowing overheated EM economies and making investors more comfortable with the idea of a soft landing; 2) with growth indicators softening in DM, this growth differential between EM and DM will turn even more supportive for EM equities. In comparison, Bonds fell for the second week in a row, driven by another upside surprise in Euro area inflation, and generally more hawkish commentary from the Fed. Government yields have now largely retraced the March flight to safety. Inflation risks and impending central bank tightening are the main forces bearing down on bonds. Against that, the coming slowing in activity data as a result of the Japanese earthquake may provide near-term support, but I believe that the secular bull market in bonds is clearly over. The path for FX is more debatable as this major benchmark bond selloff has been tame by historical standards –– global rates have moved up only 20bp this quarter compared to +50bp moves when the ECB and/or Fed is tightening –– the trend for the rest of the year seems negative. Since actual rate spreads matter as much for deficit countries like US as shift in rate expectations, the dollar is very far from turning. Dollar forecasts are still bearish. Commodities are up another 2% this week as oil and agriculture produced strong gains, offsetting a 3% fall in base metals. Corn rallied sharply due to LTE US inventories, further highlighting the extent of the tight supply picture resulting from last year’s extreme weather. Thus I remain bullish on softs over the next few months, while oil is dominated by MENA situation and recovery signals,

 

 

A Further Assessment to Japan

The Japanese economy suffered both a demand and a supply shock. In terms of demand, many households and companies have been unable or unwilling to carry on with business as usual, resulting in a drop in spending. On the other hand, the economy has been hit by a supply shock whereby firms are unable to produce due to damaged facilities, transportation bottlenecks, power outages, and supply chain disruptions. This supply shock is the principal means by which the disasters will be transmitted to the rest of the world. Looking ahead, such shocks inside and outside Japan will begin to come into focus with the arrival of key March data reports. Concerning demand, investors should look to data on auto registrations and retail sales to gauge the hit to consumption. In fact, the registrations data reported Friday showed that vehicle sales plunged nearly 30% mom, the lowest level in the series dating back to 1980. Later, capital goods shipments data will provide guidance on Capex.

 

Concerning the supply side, the monthly business surveys will provide the first clues about how badly output has been hit. This week, market saw two survey data from Japan that covers the post-quake period. The survey window for the March manufacturing PMI was March 11-25 and for a flash manufacturing Tankan was on March 28. The PMI fell 6.5pts to 46.4, the lowest level since April 2009. The Tankan fell 36pts to -20, equivalent to a decline from 58 to 40 on a DI basis. In terms of impact to the rest of world, rather than IP, the disruption in Japanese exports i the main channel of transmission to other economies. The March report on international trade, which is due April 20, will tell how far exports fell that month. Market will watch for early signs of spillover in activity reports from EM Asia. China, Taiwan, and Singapore will report March imports by mid-month, well in advance of Japan. There also will be a set of reports on EM Asian manufacturing activity. Last week reported China’s PMI rose 0.1pt, while Korea’s fell 0.6pt and Taiwan’s fell 0.2pt. It may be too early to look for spillover in March due to EM Asian producers presumably have buffer stocks or some ability to procure substitute goods outside of Japan to cushion the shock. These factors suggest that the brunt of the spillover may be delayed to April or even May, or it may be more evenly distributed across all these months.

 

Last but not the least, Japan’s fiscal response to the earthquake and tsunami will ultimately amount to about JPY10tn, or 2% of GDP. The first installment of this will come in April and amount to about JPY 2trn for the immediate costs of restoration, such as disposal of rubble. A much larger supplementary budget is expected to be announced in July. While the size of the spending increase is critical for the speed of the recovery in the affected areas, the financing of the fiscal stimulus measures is important for the outlook of the broader economy as well as for the impact on the JGB market.

 

 

The Exit Ways of Sovereign Crisis

The EMU sovereign credit crisis continued to simmer but not boil over this week, with markets appearing to have discounted much of the news out this week. According to the Central Bank of Ireland’s bank stress test, Ireland’s banking system will require EUR24bn in additional capital. Capital will be provided by the National Pensions Reserve Fund, the EU/IMF facility, subordinated bond holders, and private capital markets. Meanwhile, as expected, the Portuguese debt and deficit numbers were revised up this week, and the president announced that the election will take place on June 5. With bond yields continuing to climb, it seems only a matter of time before the Portuguese ask for external help. There is some uncertainty about whether this is possible during the interregnum. Moreover, the fiscal revisions announced by the Portuguese government highlighted two conflicting messages --- 1) excluding the impact of one-off changes in spending, the government largely achieved its objective of lowering the deficit by 2% of GDP last year; and 2) both the level of the deficit and of government debt are estimated to be higher, suggesting that Portugal's journey to fiscal sustainability is harder than previously expected. The budget deficit is now estimated at 8.6% of GDP in 2010 (1.3% WTE). Meanwhile, at 92.4% of GDP, government debt in 2010 was 10% of GDP HTE.

 

More importantly, next week ECB will likely begin normalizing policy rates with a 25bp hike. Such a move will not be beneficial to the periphery, where rising rates will slow financial healing and damp growth. But ECB council members have been adamant in highlighting that the central bank only has one policy instrument and it thus has to respond to conditions in the region as a whole. The central bank is helping the periphery via enhanced credit support and the collateral requirements, as illustrated this week when the ECB suspended the rating threshold for debt instruments of the Irish government.

 

The rate-hike determined ECB suggests that indebted countries should find different ways to rebalance their deficits and debts. Such a variety of ways that deficits and debt can be adjusted include --- the generation of primary surpluses, liability management exercises (debt buybacks at market prices), asset sales, the restructuring of official debt (lower borrowing cost and maturity extensions which are essentially fiscal transfers), or the restructuring of market debt (coupon reductions, grace periods for coupon payments, maturity extensions, and principal haircuts). Financial markets currently think there is a high likelihood that the exit path will involve a restructuring of market debt. In contrast, it looks to me that policymakers may choose to limit any restructuring to the official debt (bilateral and EFSF/EFSM loans) which would be equivalent to a fiscal transfer.

 

 

China Tightening to Extend

Chinese equities diverged with MXCN +3.2% while CSI300 pulled back a bit by 0.7%.  FY10 earnings are the focus over the week. As of end of March, +1300 or 80% of Chinese companies by market cap have reported FY10 results. Despite the concerns over policy tightening, credit crisis in Europe and the uncertainty over a recovery in US, total sales and net profits grew 35% yoy and 40% yoy, respectively. Margins have been stable at 6% on average for non-financials which is similar to 2009’s level, but operating cash flow declined 6%suggesting higher level of inventory which might be driven by material hoarding with inflation expectation, and tight liquidity. Overall, base on Credit Suisse’s report, >40% are above expectations and ~20% of them were below on both the top and bottom lines. Sector wise, Chinese property reported better results across the board. Local governments has also announced 2011 price control target which is to tie to DP/income growth at ~10%, except for Beijing. Such latest policy adjustment not only demonstrate how hard to cool down property prices in China but also create expectation of further price hike. In short, sell-side analysts are assuming 10-15% price cut. This may turn out to be excessive. In contrast, consumer sector looks mixed due to cost/margin pressure. One spotlight is luxury segment which continues to deliver solid growth and strong demand on China's wealth effect, benefiting companies like Brilliance. Cement sector results are mostly better due to proven supply discipline. Valuation starts to look expensive but China is entering into 2Q11 with seasonal pickup in demand and possibly rising cement prices.

 

Policy wise, Beijing has been stepping up cooling measures since last October, when inflation trended up and concerns about a US double dip faded. Instead of relying on any single policy tool, the authorities have been using a basket of instruments, including supply-side measures, quantitative tightening, rate hikes and specific property cooling tools to combat inflation. There are clear signs that this basket approach is working: While CPI is still rising, food prices have been increasing more slowly than expected. M2 money supply growth has declined for three consecutive months, to 15.7% yoy in February (vs. the 16% target for this year). Meanwhile, the HSBC China manufacturing PMI has also been slowing since last December. Despite the initial success, I do not think this is the time for policymakers to take a break, given local governments’ huge appetite for borrowing in the first year of 12^TH FYP. Moreover, concerns about over-tightening are unwarranted because the current rate of credit growth is still more than sufficient to support 9% GDP growth. As a result, China is likely to keep tightening in the coming months, mainly through a mixture of the following measures -- another 100bp RRR hikes and a 25bp rate hike, a monthly loan quota, fiscal subsidies for farming and oil refining, the releasing of state grain reserves, and restrictions on property purchasing.

 

That said, MSCI China valuation appear reasonable, but dissecting across sectors reveals that equities are not cheap. For example, excluding the low multiples for Chinese banks and some other industry groups or ~15% of cheapest and most expensive industries are excluded, Chinese stocks are traded at 14-15XPE11 or about 10% higher than DM equities. Though it looks undemanding (IBES consensus EPSG @ 15.4% yoy for 2011 and 15.7% yoy for 2012), such a valuation premium over the medium term looks risky as the premium could contract due to multiple compression and/or negative earnings surprises as a result of monetary tightening .....Lastly, regional wise, MSCI China is now traded at 11.8XPE11 and 17.8% EG11, CSI 300 at 14.3XPE11 and 25.4% EG11, and Hang Seng at 12.6XPE11 and 14.8% EG11, while MXASJ region is traded at 12.7XPE11 and +13.5% EG11.

 

 

More Headaches vs. Rising Food Prices

The prices of many global commodities softened in March. This included agricultural prices, which retreat about 2.5% mom, their first decline since June 2010. Even so, the March average stands 63% above the level in last June and the risks are skewed toward additional gains through midyear. Any relief on agricultural prices is especially welcome in EM economies. Raw commodities make up a significantly larger share of value-added in EM food prices compared to DM economies. Moreover, food comprises about 30% of the average EM consumer basket. With this sort of pipeline pressure, it is not surprising that EM food inflation has escalated since mid-2010. The aggregate EM food prices increased at an average 1.1% monthly rate from July 2010through Feb2011. This lifted YOY rate of EM food inflation from under 6% to 8.9% in February, adding about 1% to headline EM inflation over the same period.

 

Rising food prices have been a headache for EM governments, stirring social tensions. They also have been a headache for central banks as resource utilization is high and core inflation is rising. The added pressure from rising food prices has pushed headline inflation above target in most EM countries, compelling reluctant central banks to tighten policy. Even so, policy rates remain quite low by historical standards, suggesting the overall monetary policy stance is simulative. Investors are well aware of these tensions. What happens next depends on several factors – 1) the possible lags in transmission from commodity prices to consumer prices, implying headline inflation might continue rising into the middle of the year; 2) Commodity prices might rally further from their current levels, implying even higher tightening risk and potential downside risks of global demand.

 

That said, Copper is down almost 5% this week as a further hike in China’s RRR, a slightly WTE Chinese PMI and uncertainty around the impact from the Japanese earthquake raised fears of a slowdown in demand. My own view remains that China will be able to bring its economy under control without adversely effecting demand. The impact of the Japanese earthquake is less clear but it is likely to be a significant near-term negative impact on the supply chain, especially in Asia. However, the rebound in growth, as reconstruction gets underway later this year, should bring back at least to where we were before the disaster. I remain bullish copper on a medium-term view.

 

 

 

 

 

Good night, my dear friends!