My Diary 709 --- US is the Bright Spot; ECB Will Ultimately Act

 

My Diary 459 --- US is the Bright Spot; ECB Will Ultimately Act More; Listen to Top Leaders; Weaker EUR and Stronger Gold

Saturday, January 07, 2012

“Will 2012 be like 2011?” --- I bet this is the question casting shadow over investors’ minds. Looking back, from the Arab spring to Tohoku, extreme flooding, and two sovereign debt crises (Euro area + US), 2011 was a year in which geopolitics and natural disasters left a major mark on the global economy. Their imprint was felt in the spike of global commodity and finished consumer goods prices. They also contributed to a material slowdown in global growth. Following a gain of 3.7% (Q4 to Q4) in 2010, global GDP is estimated to have risen a subpar 2.2% in 2011.

That said, based on the latest macro data series, the global soft patch is not over and downside risks related to the Euro area crisis and a possible oil supply shock are unlikely to disappear anytime soon. However, this week’s December data releases represent one small step on the path toward a modest acceleration in the global economy into midyear. Following 4-month of broad stability, the all-industry output index rose to 53 last month, its highest level since March. The most interesting data release this week was global manufacturing PMI, which rose 1.1pt to 50.8 in December. Although the PMI remains depressed, the December reading was the highest since June. Moreover, the increase in the global PMI was broadly distributed across its major components, and both of the leading ratios of new orders to inventory rose decisively last month. The output index rose strongly, gaining 2.4pts to 52.1. The new orders and employment indexes posted more moderate increases of 1.3 points and 1.0 points. The global PMI’s increase also was fairly broadly based by region. PMIs rose in US, Euro area, Japan, and China. Certainly, the PMI is not yet giving an “all clear” signal on inventories. The global index of purchased inventory declined 0.8 points to 47.6, which is below normal for an expansionary economy. But the December global survey suggests that the weakness in global manufacturing is starting to diminish. The street now looks for global IP growth at near 2.5% annualized in 1H12, along with biggest national PMI increases in EM Asia, which accounts for about 25% of the global PMI.

On the other hand, the risks are that the European PMIs would stay flat or decline from their December levels. In other words, 2012 is unlikely to be any better than 2011 for the region as the market faces two huge uncertainties: the depth and duration of the recession, and the means by which sovereigns and banks will be funded on the other. These are of course interrelated. Data wise, Euro area economic sentiment declined five tenths to 93.3 in December, which was in line with expectations. Euro area retail sales fell 0.8% MoM in November, leaving the Oct/Nov average 2.6% yoy below the 3Q11 level. In addition, German industrial orders dropped 4.8% MoM in Nov, effectively wiping out the 5% MoM jump reported for Oct2011. The average of these two months is now 4.4% yoy below the 3Q11 level, and this decline comes after a 14% QoQ saar decline in 3Q11. Most of the sell side economists’ views are that the region will get through the year with only a mild recession in terms of the outright decline in GDP, and that sovereigns and banks will manage to fund themselves without a significant and sustained increase in the level of financial stress. If this view is correct, it will be due largely to a more active central bank. The ECB’s decisions in recent weeks regarding both the main policy rate and the liquidity support to banks suggest not only a more aggressive approach to supporting the real economy and the financial system, but also a more preemptive one. I will discuss the reasons for historical perspective that why ECB has no other alternatives.

Policy markers front, the December 13 FOMC meeting minutes show no major shocks in the assessment of US economy, though it is notable that a cautious view of the outlook persists despite visible improvements in some economic data, with risks from Europe clearly weighing heavily in the Fed's thoughts. But the minutes agreed to three new items that will be reported at the January FOMC meeting – 1) the projections of the appropriate level of the target FFTR in the fourth quarter of the current year and the next few calendar years, and over the longer run; 2) the current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions; and 3) an accompanying narrative will describe the key factors underlying those assessments as well as qualitative information regarding participants’ expectations for the Federal Reserve’s balance sheet. In addition, the Fed may also release a statement of the FOMC’s LT goals and policy strategy. This statement could contain an inflation target, but we would be surprised if the Fed were to overstep its Congressional mandate by overweighting inflation at the expense of its employment mandate.

Across the ocean, December inflation data in EM Asia show some divergence. CPI for Indonesia (3.79%), Philippines (3.53%) and Thailand (4.2%) surprised on the downside. The high base effect from end-2010, mainly driven by food prices, was part of the reason for the decline. Inflation is likely to continue easing in 2012, as I expect food and energy prices to average only modestly higher than in 2011. However, the trend is different in Korea (4.20% y) and Taiwan (2.03%), which are HTE. The combination of more benign inflation, rising real interest rates and a greater threat to growth from the West is pushing Asian central banks into a more dovish stance. After the December inflation data was released, Bank Indonesia Deputy Governor Sarwono said there is room to cut rates if needed (a 25bps cut in 1Q12?). The Philippines’ central bank governor also said there is room for rate cuts.

Having said so, the risks to global economy recovery are also emerging --- 1) Oil prices escalating over USD150/bbl. That would choke off the global economy and send it back into recession. With global growth on a softening path, a sudden upward explosion of oil prices could be particularly hurtful for the world economy. Obviously, geopolitical conditions remain very unsettling in the Middle East; 2) the untimely fiscal austerity in US. The Republicans are pushing for fiscal conservatism, and some have argued for draconian cutbacks in government spending. That could bring the US economy back to contraction, especially if the private sector remains weak and fragile. Stock prices would suffer badly; and 3) A miscalculation or inaction by the Chinese government to stem economic weakness. China is in a power transition next year. Could this transition hinder necessary policy actions? I do not think it will, but obviously there is a risk.

X-asset Market Thoughts

2011 was marked by the European crisis and global growth concerns, which resulted in most equity benchmarks (notably EM) and commodity markets recorded negative returns in 2011. Consistent with this trend 2011 proved to be a spectacular year for core DM Government Bonds (Gilts, USTs, Bunds). Elsewhere, USD High Yield, S&P 500, Oil and Gold also emerged as the key relative Winners while EU peripheral equities, BRIC equities, EUR High-Yield, Financials Credit (notably Sub), EURUSD, Greek and Italian government bonds, Copper and Silver were some of the relative underperformers last year.

Beginning with equities the divergence between EM and DM performance was a highlight. The SHCOMP, Nifty, Hang Seng and Russian Micex were down -20%, -24%, -17% and -15% respectively for the year. In comparison, total returns for S&P500 and FTSE 100 were +2.1% and -1.5% on the year, respectively. The S&P 500 reached a 2011 low of -12.6% on the day after the US sovereign downgrade but the index managed to finish the year virtually flat in price terms (its first 0.00% annual price return since 1947), largely helped by an impressive Q4 rally (+12%). It was overall a negative year for European equities (Stoxx600 -8.0%), especially for banks (-30%), but the overall performance was also affected by the significant weakness in peripheral markets (TR: Italy -22%, Greece -51%, Portugal -20%, Spain -9%). Turning to bonds, total returns for USTs, Gilts and Bunds were 9.9%, 16.7%, and 9.7% respectively mostly driven by strong performances in Q3 and Q4. In terms of yields, USTs, Gilts and Bunds 10yr fell by 142bp, 142bp and 113bp respectively. The UST, Gilts and Bunds 2s/10s curve were -106bp, -65bp, and -41bp flatter on the year. In terms of peripheral sovereigns, the 10yr bond yields of Portugal (+676bp), Italy (+229bp) and Greece (+2,249bp) were all sharply higher.

Moving on to credit, cash credit benchmarks were mostly positive on a TR basis but this was largely a reflection of the strong performance in core yields that helped offset the negative excess returns across most cash indices. The relative strength in non-financials and USD HY (TR=+5%) versus the weakness in European HY (TR= -3.3%) and Financials Sub (TR= -8.71%) was also a main highlight. Global credit derivative indices were net wider for the year. In Europe, Main and Xover were +71bp and +319bp wider in 2011 closing at 177bp and 760bp respectively. European Financials Snr and Sub indices were well through their Lehman-wides but managed to end the year around 70-90bp below their all time wides of 350bp and 600bp seen in late November (vs. post-Lehman wides of 209bp and 406bp, respectively). In other regions, the US CDX IG was the relative outperformer in 2011 with (+35bp) while Asia Pacific indices underperformed. The Asia IG, Aus iTraxx and Japan iTraxx finished the year +103bp, +78bp and +84bp, respectively.

Commodities failed to repeat the spectacular returns of 2010. The CRB Index, Copper and Sugar were down -8.5%, -24.2%, and -26.8%, respectively. Silver finished the year -10% lower after having risen +80% in 2010. Gold is around 18% off the highs of USD1900/oz in early September but still managed to gain +10% in 2011. Brent Oil is +13.6% this year, helped by the geopolitical tensions in Libya in Q1 (+21%) and Iran in Q4 (+9%). Turning to currency markets, JPY (+5.47%) was the best performing G10 currency this year relative to the USD. In fact it was also the only G10 currency that is up against the Greenback. EUR (-3.16%) was the worst given the European sovereign volatility. The YTD ranking of the other G10 currencies as follows: AUD (-0.23%), CHF (-0.31%), NZD (-0.38%), GBP (-0.44%), CAD (-2.28%), SEK (-2.55%), NOK (-2.57%), DKK (-2.89%).

Looking forward, it looks likely that the tail risks facing the global economy and financial markets will hang over markets in 2012, making it another difficult year for investors. While monetary policy will remain extremely easy, low rates by themselves do not guarantee that risk assets will perform well, especially since profit margins are extremely high. But at least valuation is reasonably attractive (equity DYs= +2x higher than bond yield & AxJ 12xPE is below 1990, 2001, SARS period). Over the mid-to-long term, the TR to equities should easily surpass bonds, even factoring in very weak growth. For example, if assuming extremely pessimistic nominal earnings growth of 3% over the coming decade and a compression in PE ratio to 10, equities would still deliver returns above current bond yields. A more reasonable expectation for global equity returns would be something between 7% and 8% a year.

Meanwhile, there are several key investment themes emerging and could dominate world financial markets in 2012 – 1) Policy reflation; this new reflation cycle will be led by EM countries in general and China in particular. Within DMs, BoE and SNB will be the leaders of a new round of QE. ECB will be a passive participant, but nonetheless has started its own version of QE via LTROs. The Fed will only react if growth slackens or USD becomes too strong. In short, the policy priority around the world is shifting from containing inflation to preserving and promoting growth; 2) Fiscal tightening; the entire DM is embracing fiscal austerity. This is untimely in an environment of very low nominal growth, high private-sector saving rates and ZIRP. Policy coordination is the key to sustained growth. The only offset to fiscal austerity is easy money; 3) Competitive currency devaluation; the countries with the strongest currencies have already fallen into deflation. Japan and Switzerland are two classic examples. In a deflationary world saddled with debt and ZIRP, competitive devaluation is the only alternative to creating and sustaining nominal growth. The SNB has targeted the Franc, leading to an explosion of its monetary base. At some point, BoJ may do the same; 4) Bank deleveraging; the banks delver-cycle has followed a rotational pattern, first developing in US and now moving to Europe. This could mean a rotational credit crunch and is intensifying in Europe. Overall, global credit demand will stay chronically weak. Meanwhile, it suggests to me that I would need to keep the tables of Euro area bond issuance and the calendar of economic releases for China, Europe and US handy as well as watch every development on Greece's next bailout payment.

US Econ is the Bright Spot

Looking into 2012, a key element supporting a positive view on US economy lies with the corporate sector. It has continued to generate solid profits despite a tough business environment. In addition, companies have accumulated a high level of liquid assets and have maintained very healthy balance sheets. In the meantime, consumers have defied conventional wisdom and have continued to show strength. Many have argued that HH sector is heavily indebted and will go through a prolonged period of retrenchment by spending less and saving more. In reality, consumers spurred a one-off increase in the saving rate in 2008 and since then have kept their spending more or less in line with GDP growth of around 2% in real terms and about 4% nominally.

Another positive development is US labor market. The December employment reports were generally pretty solid all around, and consistent with a view that GDP growth popped to around a 3.5% rate last quarter. Initial jobless claims retreated to 372K last week, reducing 4WK MAVG to 373K, the lowest level since Jun2008. The ADP report found that 325K private-sector jobs were added in December. This is nearly double the consensus estimate of 175K. NFP growth quickened last month to 200K, albeit with some temporary supports that is likely to fade in January and the average workweek ticked up. More striking is the continued and now steady decline in UNE rate, which fell another tenth to 8.5%. With corporate layoffs has fallen off sharply, there is no compelling reason for consumers to suddenly stop spending. It is important to note that the HH sector has been deleveraging quickly, with the Debt-to-DI ratio having declined by 16% since 3Q2007. In fact, ISM manufacturing index rose to 53.9 (cons=53.5) in Dec from 52.7 in Nov. This was the best result since June and compares with an average reading of 51.0 from Jul through Oct.

The third positive indicator is money and credit, both of which are reaccelerating. Although the risk of a credit crunch remains, US banks are becoming more willing to lend. This will help businesses, especially small firms. The NFIB survey suggests that it has become easier for small businesses to borrow. It seems that American banks are taking market share from European banks, which are under enormous pressure to shrink their B/S outside their home countries. To sum up, domestic spending is the primary driver of US economy, which has allowed it to weather the European financial storm reasonably well. These basic attributes will not change much in the next year. The US. economy should advance along its underlying trendline growth rate of 2-2.5%, unless Euro zone crisis gets out of control leading to a full-blown shutdown of the global banking system. The Fed will stand by and hold off on QE3 unless growth slackens and/or USD soars on Euro debt crisis.

ECB Will Ultimately Act More

Entering 2012, the Euro zone debt crisis will continue to cast a long shadow over the global economy and the stability of banking system. Although European authorities have made several attempts to stem the crisis, financial markets have been disappointed by politicians’ inability to move things forward, and by dogmatism of the ECB. Having said so, debt crises are a historically recurring economic phenomenon. As such, it is always useful to look at some of the more classic cases to gain insight into how the current episode will likely evolve and eventually get resolved. The root cause of the Great Recession is very similar to that of the Great Depression of the 1930s, with both episodes spurred by an excessive buildup in debt, oversupply and enormous leverage in the banking system.

There are many lessons that can be learned from the Great Depression, but the most important one is that monetary reflation is the only viable way to fend off a debt crisis. In essence, a debt crisis occurs when creditors have collectively lose their confidence in the liabilities they hold. As a result, they liquidate their holdings of debt for cash, creating a severe shortage of money, which is the most liquid form of an asset that carries a zero default risk. A central bank must increase MS in order to meet the escalating demand for money, or the banking system finds itself under siege. Without a lender of last resort guaranteeing the solvency of its lending institutions, a panic run and spreading failures among banks become inevitable. In the 1930s, the UK was the first nation to abandon the gold standard and begin to reflate. It was also the first country to stabilize its banking system and recover from the depression. Germany was, in practice, the last one to leave the gold standard and it suffered the longest economic decline.

In theory once a nation is trapped in a debt crisis, there seems to be only three ways out: grow, default or inflate. In reality, however, economic growth has rarely proven to be a feasible way to lift a country out of a debt trap. The only period when US economy was heavily indebted but was able to reduce its debt burden by growth was in the 1950s. However, during that time US was not in a debt crisis and the economy was able to grow rapidly because of the post-war reconstruction boom. In most other post-war debt crises, there are no additional examples where debt-laden and crisis-stricken economies were able to grow out of their troubles. This is because an economy, once caught in a debt crisis, is often stuck in a vicious downward spiral, with rising interest rates and shrinking output becoming self-sustaining. In practical terms, either default or reflation are the only viable options. Default is equivalent to confiscation of creditors’ wealth and therefore can be regarded as a form of reflation – it reduces the liabilities and boosts the net worth of borrowers. In the end, authorities must manage to create enough money to generate rising prices and/or a falling currency in order to allow nominal output to rise and the debt-to-GDP ratio to decline.

In sum, Euro zone needs a large infusion of money to alleviate debtor burdens. It also needs nominal growth to reduce indebtedness. This can be done either through default, a huge transfer of wealth from outside Euro zone or ECB money printing. The financial markets have already fully discounted a Greek default. The market is also expecting a more than 70% chance of a debt restructuring in Portugal. Nevertheless, Italy and Spain are huge economies that must not be allowed to fail. Italy and Spain need to borrow EUR550bn next year. Their economies are contracting. If they borrow at market rates of over 7%, these countries will look a lot more like Greece over time. Germany has ruled out the Eurobond proposal and IMF is running out of money. There is no country that can marshal sufficient resources to bail out Italy or Spain. The need to reflate by the ECB is obvious. Needless to say, the consequences of a breakup in EUR are so devastating that ECB ultimately will be forced to act. The only question is whether we are on the cusp of decisive action by ECB or we are going to have a period of even more dramatic financial instability before the ECB moves. So far, the turmoil has produced some important changes, but not enough.

Listen to the Top Leaders

Entering into New Year, the China’s top leaders are increasingly worried about growth. Premier Wen has stated that he has noted an accelerated slow-down in the pace of growth over the last three months. Wen has also warned about the lagged impact of monetary policy and has already acted with RRR cut, slowing RMB appreciation, increasing QFII, and deferring higher CAR requirement for banks. Zhou Xiaochuan, PBoC Governor, has stated that he would support a reasonable increase in social financing index which fell about 14% in 2011. Based on the latest observations, I think it has become a consensus at BeiJing that in 2008 the real impact on China from the GFC was seriously over estimated and stimulus package was massively over done --- 1) the RMB4trn original plan ended up with RMB40trn of total social financing in the past three years, which drove up China's ratio of total credit over GDP from 120% to 175%. This has caused many problems; 2) the last two years’ growth was driven by monetary policies, with M1, M2 and loan growth all shoot up to 30% in 2009; 3) most of the 40trn money went to all the projects that are capital intensive and energy/material consumptive, with immediate effect on economic growth, but made the economy more investment dependent than before, worsening the imbalance.

As a result, looking ahead, what will the government do in a growth scare? There will be no 2009 type stimulus, but credit could go where growth has stalled such as infrastructure (railways, local govt project, south to north waterway and social housing). 2012 will be mainly driven by fiscal spending, and the money will be spent to lower the overall tax burden, shore up pension and medical coverage, develop local infrastructure, and support SMEs. The government will also slow RMB appreciation to help SMEs and exports. Needless to say, the Chinese government did not anticipate the Euro debt crisis to snowball and infect Chinese exports so quickly. Therefore, it is fair to say that WTE fall in growth has been somewhat of a surprise. The problem is the time lag between credit easing and economic response is about six months. Therefore, the economy will likely continue to soften well into 1Q12 before reacceleration begins to take place.

Nevertheless, weak economic growth is already fully-anticipated by the stock market. With property prices in the major cities either still falling or flattening out, construction spending will decelerate. Bad debt in the banking system will rise. However, the performance of other segments of Chinese economy is consistent with a soft landing: export growth, though having slowed, is still growing at a 13.8% yoy. Import growth has been rather steady and sustained at 22.1% yoy, suggesting that overall domestic demand remains healthy. Real retail sales growth is 12% and even FAI has been growing at a 21.2% annual rate. Regarding the policy response, the first RRR revision will never move the market, either cut or hike, because it is the liquidity that dictates market performance which will need time to change after the first move. With M1 growth further slipping to 7.8% in Nov, it is not surprising to see A shares continue to lose momentum. We need to be patient as it normally takes 3-4 months to see the real improvement from the first RRR cut. But once the policy is turned, the direction is set. We might need 2-3 months to digest, consolidate and find the bottom, but it will rally when M1 growth climbs back up to double digit growth. Under the assumptions of RMB8.5trn, and 3-3-2-2 quarterly distribution, RMB2.5trn in 1Q is the watermark to check upon.

To the Chinese equities, it is fairly to say that we have a low start-up for 2012. MXCN index lost 20% in 2011 and 38% in the past four years. After two years of negative gains, SHCOMP share index dropped 58% since the end of 2007. In the past 16 years, A-share index had never suffered losses in three consecutive years. I thus maintain my positive bias over the Chinese equity markets at the current index level. Earning wise, a few sell side strategists are forecasting A shares net profit (14% in 2011) to grow 11.6% (14.4% for fins and 8% for non-fin). These are way below IBES consensus 22.6% for 2012. Meanwhile, the aggregate ROE of A shares will further slip from 12% in 2011 to 11% in 2012, which is below the historical average of 13%, but way above the 9.5% in 2008. The PB of Large Cap is already lower than that of 4Q08, but the small caps are still 30% above. Thus, A shares should have limited downside risks unless we see the harsh tightening continues to hit in driven by the depressed property sector, EU sinks into recession and the headline macro numbers look awful and corporate earnings growth fall over the cliff..….Lastly valuation wise, MSCI China is now traded at 8.4XPE12 and 13% EG12, CSI 300 at 9 XPE12 and 22.6% EG12, and Hang Seng at 9.3XPE12 and 3.8% EG12, while MXASJ region is traded at 10.3XPE12 and 11.2% EG12.

Weaker EUR and Stronger Gold

For the year of 2012, Euro weakness is more likely to persist. EUR weakness would come from two fronts – 1) if ECB refuses to reflate, then the debt crisis could worsen, putting downward pressure on EUR. This means that global equities and EUR could continue to be positively correlated, which is a bad outcome; 2) if ECB eventually turns around and monetizes distressed debt rather aggressively, it should also drive down EUR. This is a good outcome and should bode well for global equities. In other words, the correlation between the euro and risky assets would change. As discussed the abovementioned section, my guess is that ECB will have to start a full-fledged QE2 in order to weaken the common currency and allow nominal output to expand. In addition, EUR is expensive against all major trading partners, not to mention the banking-sector is deleveraging, which is always bearish for the currency market.

In contrast, RMB has limited upside and it will stop appreciating against USD at least in 1H12 for the following reasons --- 1) Chinese manufacturing is suffering from the shock of the fallout in Euro zone demand. Further appreciation of RMB will hurt exporters even more; 2) PBoC will ease more, reducing the yield appeal of the currency; 3) on PPP basis, RMB is no longer undervalued. In reality, RMB has appreciated by roughly 60% in real terms against USD since 1997, and is reaching a point of indigestion. Although US will keep pressing China for more revaluation, the Chinese government, especially the new leadership, will fight off American pressure aggressively. In the end, the Chinese will dictate their own foreign exchange policy and they will have to put their own national interests ahead of everything else.

For gold, the latest sharp fall of spit price has prompted some analysts calling for the death of the gold bull market. The bear is focused primarily on the strong USD. They argue that the gold bull market has mirrored a weakening USD. With Euro zone crisis running amok, USD may have bottomed. However, I think the behavior of USD only tells part of the story. There are several other forces behind the gold’s price movement --- 1) the low and falling real rate mirrors rising gold prices. This may not change very much next year; and 2) the central banks are doing monetization. Most of G7 is implementing QE and competing for a cheap currency. In the end, the world economy will create overflows of fiat money and gold price inflation.

Lastly is Crude oil. Recent events in the Persian Gulf have once again highlighted the importance of the Strait of Hormuz to the global oil markets. Any disruption to this key transit point would have a major impact on global oil markets, pushing prices sharply higher. While pipeline alternatives exist, they (1) are not of sufficient capacity to compensate for the loss of 16-17mbd of crude oil that travels through the Strait, (2) would add to transport costs and (3) could only be brought online with a lag. While crude oil prices have ticked higher following the escalation of rhetoric over the New Year weekend, the USD 5/bbl rise in ICE Brent is small compared to the potential fall-out should disruption actually occur.

Good night, my dear friends!