My Diary 675 --- Oil is A Double Whammy; The USD14.25trn Debt Ce

My Diary 675 --- Oil is A Double Whammy; The USD14.25trn Debt Ceiling; Moral Suasion vs. Strict Control; Gain Here but Lose There

Monday, May 02, 2011

“Sell in May and Buy the iPad2” --- According to Steve Jobs was the year 2010 the year of the iPad. Over the weekend, I met a first-year undergraduate from Tsinghua University who flew to Hong Kong for the first time in his life and stood for the whole night in order to become the first group of iPad2 users. Underpinned by such young generations, I believe that the iPad frenzy will carry into 2011, which in turn makes APPL (14XPE11, BBG est.) the top buy in the era of the tablets instead of China Unicom (32XPE11, UBS est.) or Foxconn (2354TW, 15XPE11, DB est.). That said, according to latest IDC report, industry-wide shipments of consumer PCs dropped 8% in 1Q11 and netbooks dropped 40%, together with the trend that more consumers are choosing iPads over a new laptop with Windows. Interestingly, 10 years ago it was Microsoft announced the era of the tablets and put together with HP, Lenovo and numerous other Tablets on the market. The desired results they never had. At that time, Steve Jobs has said publicly that no one would ever buy a tablet. About a decade later, once can clearly tell the result turns upside down. So do the stock markets a decade later. Globally, most equity markets reached new cycle highs this week, with US small caps (RTY@865.3) reaching a new historic high. But credit and commodities were flat, and bonds actually rallied. All this after two months of weaker economic data that induced many economists to lower their growth outlook for the world economy. The question at this juncture is can this rally last?

Macro wise, latest Japan data showed WTE decline due to the Tohoku earthquake, including IP (-15.3% mom) and HH spending (-8.5%). That said, I have yet to see a clear signal on the extent of the spillover from the Japan earthquake to the rest of Asia. However, even abstracting from the direct hit to Japan, global IP in the rest of the world is set to decelerate sharply from an 11.4% (3mos annualized) pace as of January to a sub-trend 2.4% by July as growth in inventory building is curtailed against a backdrop of soft final sales growth. In US, 1Q GDP rose merely 1.8%. Looking ahead, one question is whether consumption growth will be maintained at a 3% pace in 2Q11 as rising oil prices are squeezing on real income growth and this effect is not being cushioned by a cut in withholding taxes like last quarter. In Euro area, though the magnitude was modest, economic sentiment also slid in April given fiscal tightening, currency appreciation, higher commodity prices and the Japanese catastrophe. The street analysts now forecast Euro area GDP growth to slow from 3% to 2% in the coming two quarters. Policy side, The FOMC as expected kept rate unchanged but the key focus was though the "extended period" language was left untouched, chairman Bernanke elaborated that the removal of this phrase from the statement could signal higher interest rates within "a couple of meetings". Moreover, QE2 will be completed by the end of June (as scheduled) and the Fed would continue to maintain its B/S by reinvesting proceeds of maturing MBS and UST holdings. When asked about the possibility of QE3, Fed Chairman Bernanke said "Why not do more? In my own views, the trade-offs are getting less attractive at this point --- US inflation has gotten higher and inflation expectations are a bit higher. It's not clear that US economy can get substantial improvements in payrolls without some additional inflation risk. In other words, if Fed wants to have success in creating a long-run, sustainable recovery with lots of job growth, they got to keep inflation under control.

Back to Asia, inflation remains a front-page story, together with the ADB meetings and inflation releases in Taiwan, Korea and Indonesia. As discussed in last two diary notes, I expect that inflation risks to go beyond supply-side shocks, with significant contributions from both strong wage and lending growth. In fact, in yoy terms, core and headline CPI inflation in EM Asia have risen to rates not seen since 2008, and they look set to rise further in coming months before moderating in 3Q11. In March, headline CPI in EM Asia stay at 7.2% QoQ. In HK, Mr. Norman Chan of HKMA warned that HK might raise interest rates ahead of US and that when the US raises rate eventually the USD77bn of net capital inflow into HK of late might leave the city. But I think this time the difference is that policy response does not need to come through interest rate as Bank Indonesia clearly showed. In other words, FX has finally emerged as an important channel of adjustment, albeit a much delayed response, suggested by the strengthening of KRW, CNY, MYR and SGD. Indeed the MAS recentered the SGD NEER band (from 1.2469 to 1.226USD) last month, which should on the margin help to keep a lid on price pressures. More importantly, RMB is traded through 6.5USD for the first time since 1993. During the G20 meeting in Nanjing, Timothy Geithner and Wang Qishan will again revolve around the question of RMB valuation, particularly as RMB is now depreciating on an effective basis, pegged to a weaker USD, and as China’s domestic economy is suffering heightened inflationary pressures. On the back of higher ADXY expectation, I saw continued inflows to EM Asian local currency bond funds. During the week ended 20 April, EM bond funds took in USD 487mn, while HY funds saw inflows of USD422mn. However, it seems there are few investors willing to position aggressively based on their short duration exposure. I think this is because the market's apparent recognition--that the Fed will reiterate its intention to continue QE2, rather than end it early, and that a dovish outcome is already factored into the USD's lower levels (DXY=73.25, YTD -7.28% or -20.24% on yoy equivalent basis)

X-asset Market Thoughts

On a weekly basis, global equities ticked up 2.03% with +1.97% in US, +1.2% in Europe, +1.19% in Japan and +2.34% in EMs. Elsewhere, UST yields fell a few basis points with 2yr down 4bp to 0.61% and 10yr down 8bp to 3.31%. 10yr Greek-German sovereign spread rose 78bp to 1242bp, while Irish and Portuguese bond yields were mixed, without any notable moves in any direction. Brent has moved up another 1.5% to $126.06/bbl. Spot gold price reached YSD1545/oz, +8.93% YTD. EUR rise 1.69% to 1.4807USD and JPY also strengthened 0.84% to 81.2USD.

Looking forward, investors should be prepared for softer economic data and certain market correction in the near-term. According to JPMorgan, global manufacturing PMI has showed the downshift in the forward looking components –– new orders/inventories, is a negative for cyclical sectors. The ratio fell with the March release for the first time since last October, and another fall is likely with the April release on May 1st. Indeed, with 4 of the 7 regional Fed surveys now in hand, the average ISM-weighted composite is down roughly 1% in April led by sharp declines in the indexes of new orders and production. While risk assets can handle a few disappointments, the big question is whether a longer-lasting soft patch in the data will develop, as occurred last year when SP500 tumbled 16% from the end of April to the beginning of July. In addition, the imminent end of QE2 is another event that was known well in advance. It is true that QE2 has had the effect of boosting equities and commodity prices, giving rise to inflationary fears globally. S&P 500 has surged 30% percent since Aug. 26, a day before Chairman Bernanke said in Jackson Hole and CRY index climbed more than 40% during the same period. Obviously, there are investors willing to take profit. Meanwhile, given the daunting task of unwinding unorthodox policies that have never been tried before, the potential for another spike in volatility is significantly higher (VIX=14.75, a 36-month low).  Another factor is more based on seasonal or empirical observation --- Sell in May.  Over the past 50 years at least, the stock market performed better between early November and early May of the following year than it did during the rest of the year. The “Sell in May and Go Away” trading strategy, which sells equities in May and buys them back at the end of October produced an impressive performance over the past 50 years with a success rate of 72%!

In the mid-term, I think investors should stay Long Equities overall as the fundamental driver of strong earnings generation and profit margin expansion remains intact for the next year. The 1Q11 earnings reports from companies across the globe have generally beaten analysts’ estimates. Corporate as diverse as Apple, DuPont, Travelers and Morgan Stanley in US, Novartis and Fiat in Europe, and SABIC in Saudi Arabia have all reported strong earnings. According to the 298 companies in SP500 that have reported results since April 11, net income has grown 21% as sales increased 10%. Revenues look more impressive relative to recent quarters with the beat/miss ratio standing at 72%/28%. This is stronger than 2010 when the beats ranged between 58%-67% each quarter. In terms of European earnings it is still very early days with less than 50 companies having reported. In APxJ, the 3M ERR (0.89) fell but remains above LT averages (0.85) and the 1M SRR trend remains strong. It seems that inflation, central bank tightening and higher oil price are weighing on bottom-line expectations at a time when top-line expectations continue to improve. Looking ahead, though 2011 global growth has been downgraded from 3.6% to 3.2% over the past two months, largely due to D/G in US and Japan, such a growth pace is barely faster than the historic average. As a result, equity may see a short-live correction due to 1) the downside on the world economy is quite moderate; 2) equities remain very attractively valued against the alternative of low if not near zero returns on fixed income and cash; 3) global portfolio allocations remain near historic averages and are this far from stretched; 4) lackluster global growth hides stronger and weaker sectors and equities give global PMs access to the stronger ones.

Oil is A Double Whammy

Most economy numbers managed to beat expectation in the US with BTE Pending Home Sales (+5.1%) , Personal Income (+0.5%) , Personal Spending (+0.6%), New Home Sales (+11.1%)  and Durable Goods  (+2.5%) while GDP (1.8%)  Dallas Manufacturing (10.5%)  Chicago PMI (67.6) fell short of expectation and the Initial Jobless Claims (429K) were higher. In addition, house prices continued to edge lower (-3.33%) in Feb, according to Case-Shiller 20-city composite. That being said, higher oil price is a double whammy --- it increases inflation and reduces growth, posting the key risk of derailing US/global economic recovery. In fact, US economy suffered a very rapid pass-through of higher oil prices in 1Q11 through several channels --- 1) petroleum imports (>50% US trade deficit) and net exports are likely to be a drag on growth, since the price adjustment for trade is rarely adequate; 2) data so far suggest that inventories (key growth driver last year) looks unlikely and 3) higher gasoline prices are acting as a tax on the consumer, affecting both sentiment and consumption. It is important to note that gasoline prices kept rising during April, into Q2. As a result, though Conference Board consumer confidence edged up to 65.4, it is still below its February level (72) and well below the previous expansion peak. Moreover, cross-country measures also show consumer confidence equally depressed in the US, EU and Japan as of March.

Unlike in the US, data this week show that Asian economies remain resilient. The deceleration in activity in Taiwan, Korea and Singapore was moderate.  March IP in Taiwan stayed flat at 13.82% vs. 13.28% yoy in February. 1Q11 GDP in Korea could print 4.1% from 4.7% prior. Given that the Bank of Korea has already released its Q1 GDP flash estimates, the number should not cause a major upset in markets. Looking forward, I continue to expect production to lose momentum across EM Asia in 2Q due in part to the global inventory cycle and to the disruption in exports from Japan. Indeed data out of Japan showed a large hit in the immediate aftermath of the Tohoku earthquake. The Shoko Chukin survey showed a sharper fall in April (-13.4% mom). Industrial production fell by a record 15.3% in March. With regard to the demand shock, household spending fell 8.5% in March, indicating of further consumer weakness along with -15.2% mom in department store sales.

The USD14.25trn Debt Ceiling

Credit markets are at a point in the cycle where the all-in yield is becoming a more important driver of their performance than any changes in credit quality or the simple spread vs. government debt or swaps. This is because the spread is just numerically smaller vs. the overall yield and because credit quality is not improving a lot more dramatically relative to what it has already since the start of the recovery. One implication is that spreads will become more negatively correlated to underlying government yields. Turning to Europe, the recent U/P in sovereigns led by Greece has brought the focus back on sovereigns. There is significant market debate about the possibility of a restructuring for Greece with many thinking inevitable. Of course, European politicians were defending their positions --- France's Finance Minister said that a Greek restructuring "is not envisaged or envisageable", and ECB's Governing Council Member Wellink said that “a Greek restructuring is not in the interest of the Eurozone”. However, I would like to demonstrate how does the market think --- Greece CDS (1300bp) is implying a 72% probability of a credit event in the next 5 years. In fact the first 2 years imply a 46% probability showing the front ended nature of Greece risk. The nation’s 2yr yields have jumped over 500bps in the past week, topping 25%. Greece last week issued EU1.625bn 13wk bills at a yield of 4.1% vs. a previous auction rate of 3.85%. Interestingly, Greece banks’ 5YR CDS trades ~500bp tighter than the sovereign. This is somewhat out of my expectation because it’s hard to imagine a restructuring of Greek government debt that wouldn’t have a quite profound impact on the banks. Arguably there are many possible reasons for these relative price actions between sovereigns and banks ranging from simple liquidity arguments to the relative size of the countries bank debt and sovereign debt.

Furthermore, a D/G of US sovereign-rating outlook by a major rating agency is not a common phenomenon. According to the UST Department's forecast the USD14.25trn debt ceiling could be reached as soon as 16th May. Thus fiscal policy cannot remain so accommodative for much longer, which makes it even more important for the Fed to get the timing of its first hike right. Even though there is no pressure for immediate fiscal tightening, US will have to come up with a credible exit strategy. All said, it is important to note that the market impact has been limited as markets are giving the US the benefit of doubt. Practically, I think Japan serves as a good reference as S&P has cut Japan’s rating outlook as well. So is Japan on the verge of a debt crisis? Not Yet! The rising stocks and bond prices show investors aren’t buying the despair about Japan’s finances. They are focusing on the nation’s USD15trn of household savings, the government’s latitude to raise taxes and the fact that about 95% of public debt is held domestically.  Yet Japan’s day of reckoning will arrive at some point, and the longer it’s delayed, the worse it will be. This is an ideal moment for the bond traders, who from time to time take matters into their own hands and boost yields, to teach Japan a lesson. Looked through this lens, traders are even less perturbed by Japan’s debt load --- 10yr JGB yields at 1.2%. One explanation for why markets are ignoring S&P is that credit rating companies, wrong on just about every major crisis of the last 15 years, have lost all credibility in Asia. In my own views, Japan is in bizarre economic territory. BoJ Governor Masaaki Shirakawa isn’t exaggerating when he says the economy faces “strong downward pressure.” That dynamic, coupled with the cost of rebuilding Tohoku, means issuing lots of new debt. As a result, one would think that with Debt/GDP (already 200%) is set to widen, traders would be wary. However, nothing of the sort is happening!

Moral Suasion vs. Strict Control

The weeks saw A-shares falling five days in a roll, down 6% in a week and B-share down even more on the back of heavy rumors, such as one-time appreciation of RMB, IR hike, imminent launching of the international board, and redemption on overseas investors. So far, nothing turns out to be true. Macro side, China’s NBS manufacturing PMI eased modestly in April to 52.9 (cons. =53.9 and 53.4 in March), but still above the expanding threshold of 50. However, PMI components on new orders, new export orders, imports and input prices fell >1% in April. Looking ahead, softer US economy and PMI export orders component suggests that export sector likely show moderate growth in the near-term. Domestically, slower auto sales growth and housing-related spending may contribute to weak retail sales, offset by solid overall employment growth and broad-based wage gains. FAI will maintain fast pace due to public investment projects, especially at the local government level, as the 12th FYP kicks start. As a whole, Chinese economy to continue with steady, trend-growth pace in the coming quarters, with FY11 real GDP growth forecast at 9.5% yoy

Meanwhile, liquidity condition in China remains healthy with M2 growth stayed at 16.6% and negative real rate widened to -2.4%, driving demand deposit to 41% of household deposit at end 1Q11. Looking forward, commodity prices should remain high for longer but market reaction to a QE3 should not be as robust as with QE2 last year because that will bring a risk to China’s inflation scenario should oil/commodity prices get out of control. For now, I expect headline CPI could stay elevated in the near term, hopefully peaking around June or July at about 5.6-6%. Thus, I expect one more RRR hike and potentially two more IR hikes (to boost the current –VE real rate) for the rest of the year, as well as further RMB appreciation (6.3USD). That being discussed, in order to mitigate inflationary pressures, Chinese policymakers have adopted price interventions that have sent mixed signals – on one hand attempting to hold the basic food costs in check for retail consumers, while on the other, allowing price increases of petroleum-based products as well as on-grid electricity tariffs. The current episode of controls began last November when the NDRC instructed producers of edible oils and flour to refrain from hiking prices. This time around, the government is relying more on moral suasion rather than strict price controls. In the last several weeks, meetings between NDRC and both domestic and MNC F&B producers have resulted in announced postponements in price increases for instant noodles, milk and personal care products by companies including Tingyi and Unilever.

Broadly speaking, it is the mid-stream companies that are being asked to shoulder the burden of higher input costs. In the oil refining space, for instance, profitability now appears more elusive than expected after PetroChina reported a 1Q11 refining loss of RMB6.1bn. Similarly, rising coal costs (domestic spot prices +26% yoy) have crimped IPP’s profits, with Huaneng reporting a 76% yoy and 43% QoQ decline in earnings (despite revenue +25% yoy). Certainly, these are the sectors to be avoid in the coming months, should CPI stay high…...Lastly, regional wise, MSCI China is now traded at 11.8XPE11 and 19.4% EG11, CSI 300 at 14.1XPE11 and 24.9% EG11, and Hang Seng at 12.1XPE11 and 20.4% EG11, while MXASJ region is traded at 12.8XPE11 and +15.1% EG11.

Gain Here but Lose There

Commodities are flat this week with oil unchanged and precious metals offsetting a sharp fall in base metals. Supply remains tight in the oil market as OPEC appears to have failed to cover the loss of supply from Libya and preliminary data for March suggest that they have actually lowered production. Without an increase in supply from OPEC, the market will remain tight and prices will continue to move higher. Precious metals moved up sharply this week with gold breaching the USD1500/oz mark for the first time ever and silver approaching USD50/oz. Precious metals have been benefiting from a combination of rising inflation expectations and rising downside risks to the recovery. I think Investors should also stay long gold as demand is to increase further as investors hedge against both inflation and downside tail risks to risky assets.

A more interesting observation is that YTD oil shock does not yet appear severe enough to trigger deflation fears in risky assets or cost-push concerns in UST. Thus my question to oil prices is --- how high is too high? In fact, Singapore gasoline prices have risen almost 160% in USD terms, and the retail price of US transport fuels has almost doubled from 1Q09 recession lows. But Asian pump prices, weighted by the relative demand for diesel and gasoline, had only risen by about 21% through March. Despite Brent crude rising by about USD74/bbl over this 26-month period, the actual pain born by Asian consumers has been more muted. There are three main drivers behind Asia’s limited pain --- 1) Price subsidies, although the mechanisms vary widely. China requires state refiners to run at a loss, while India divides the loss between upstream and downstream. Malaysia, Indonesia, Thailand, and others all subsidize selected oil products to varying degrees. The Korean government recently seems to have pressured domestic refiners into “voluntary” wholesale price cuts of about USD15/bbl (100 won/ltr); 2) Currency appreciation, which minimize the pass through to retail prices in domestic currency. For example, RMB has appreciated by 4.7% since Jan09, despite central bank efforts to rein in appreciation against USD; 3) Slow adjustment, when oil prices collapsed during the recession. After asking the refiners to bear a major loss for every barrel run at the height of the oil price peak in mid-2008, Chinese refining margins rose to about USD14/bbl as Brent crude saw lows of about USD40/bbl in 1Q2009. By making few adjustments to retail prices in 2008 as oil prices were on the way down, governments did not feel immediate pressure to adjust retail prices upwards as prices began to rise. In short, you gain here but lose there.

Good night, my dear friends!