My Diary 716 --- Concerns Arise from Energy Prices; There Remain

My Diary 716 --- Concerns Arise from Energy Prices; There Remains Lots of Debt; PBoC Report vs. RRR Cut; Reaffirming Dollar Bear Position

Sunday, February 19, 2012

“LTRO = Lots of Trouble Rolling Over” --- Over the past two months, global central banks have moved into second gear, with BoE QE, ECB LTRO, Fed communication, and this week alone, another JPY10trn of BoJ Asset Purchases plus 50bps RRR cut from PBoC overnight. Given the YTD’s BTE macro economic data and the receding tail risks from European debt saga, it is very interesting, or somewhat confused, to observe that the recent pace of B/S expansion is the fastest since the collapse of Lehman. In particular, while for much of this period the pace has been set by aggressive Fed and BoE action, the more recent ramping up owes to ECB’s LTROs. My question now is whether this week’s action from BoJ is a sign of something more to come. Having said so, the January 24-25 FOMC meeting minutes did indicate that QE3 could be forthcoming if growth disappoints or if inflation undershoots Fed’s target, while they were relatively terse on the debate within the Committee regarding the prospects for more asset purchases.

Moreover, from the big picture’s viewpoints, given still huge excess capacity in the world and central banks’ easing tendency, this excess liquidity seems more likely to show up in the prices of risk assets than in goods and services inflation. But I think central banks are walking a tightrope here, as any rise in LT inflation expectations would Force them to abandon asset reflation. Macro wise, some key aggregate global economic indicators (PMIs, manufacturing output and auto sales) are pointing to a sharper acceleration in economic growth than market forecast. But that BTE pace may just reflect the disruptions from the Thai floods fades. Another question in my mind is, if everything looks so good, why then the major central banks have collectively accelerated the pace of B/S expansion in the past two months? Is there something we don’t know? So far, my best guesses for downside surprises include 1) the contagion risk from European periphery debt; 2) a sharp correction in China’s housing sector; and 3) a sharp move-up of crude oil price.

That said, the rally in risk assets reached a pause mode over the past week on higher oil prices and further delays in the 2^nd Greek bailout package. But I have not seen the correction expected as it does appear that Europe will bite the bullet next week and US data are again surprising on the upside. I still hold the NEUTRAL stance I had since two weeks ago on Equities because it seems the market has run ahead of fundamentals. The single fundamental reason for me to stand EW is market looks not expensive. The 12M FWPE for S&P500 and the MXWO, at 12.6 and 11.7, respectively, are low by historical standards. They are >2.5ppts below the PE ratios reached in Oct 2009. On the worrisome side, though current market technicals are very positive, I do expect them to worsen as more investors deploy cash (especially tomorrow after RRR cut), leaving the market more vulnerable to a consolidation in the next few weeks. In fact, local Fixed Income PMs thought that rate markets are “pricing in 4-5 times RRR cuts” in 1H12. Flow wise, YTD, investors have injected USD19bn into EM equity funds, reversing almost 60% of the total outflow seen in 2011.

Back to policy side, I can’t stop thinking that central bankers in DMs are desperately scared, because how else can you explain their willingness to provide financial institutions with massive quantities of virtually free money? Under the fiat money system, policymakers realize that it is the only way to prevent the debt-laden financial system from collapsing under its own weight. But never before have we seen such an overt transfer of wealth from savers to both borrowers and financial intermediaries. Savers were severely punished by high inflation and negative real interest rates in the 1970s, but that was a by-product of policy errors, not a deliberate strategy. In contrast, we are in the current mess because a tidal wave of reckless lending and borrowing led to the greatest credit bubble and bust in modern times. A reasonable person might think that a long period of conservative financial behavior is needed after such a traumatic cycle. Yet, here we are with central banks doing their best to create more risk-taking by making it as financially attractive as possible to borrow and lend again. Of course, it is not a black or white story. Current concerns about the economy and financial stability are valid, and easy monetary conditions are warranted. But, should investors be seduced into taking on more risk just because it is painful to earn nothing when hiding in the safety of cash?

A lot of research has been done to show that economic recoveries following financial crises tend to be labored and shallow. And this was a massive financial crisis, leaving behind huge structural impediments to growth. Consumer debt levels remain extremely high in the U.S. and many European countries, fiscal restraint is required throughout much of the developed world, and the downturn left deep scar tissue on business and consumer confidence. It would have been naïve in the extreme to have expected a normal recovery from such a catastrophic credit cycle. In short, easy money cannot solve the structural problems in the DMs. It can alleviate the symptoms, but there is always an asymmetry between the risks associated with being too easy for too long or not easy enough.

The same can somewhat be applied to equity markets today. Low interest rates alone are not enough reason to take on a lot of portfolio risk. Monetary policy is hyper-easy for a reason: the economic outlook is fraught with problems. One only has to look at the experience of Japan during the past two decades to see that. The BoJ lowered their discount rate to 1% in the 1H1995 and it has stayed between 0%-1% ever since. Yet the stock market is still more than 70% below its end-1989, all-time peak, and 40% below the level when BoJ first cut rates to 1%. But, the market’s PE ratio was absurdly high for much of the period, offsetting the benefits of low interest rates.

X-asset Market Thoughts

On the weekly basis, global equity was up 1.5%, with +1.4% in US, +1.6% in EU, +4.4% in Japan and +1.5% in EMs. In Asia, MXASJ added 2.2% and MSCI China +2.6%, while CSI300 +0.14%. Elsewhere, 2yr USTs yields and 10yr’s were flat @ 0.29% and 2.00%. Government bond yields across the Euro periphery area were widened with Greek, Portugal, Italy and Spain 2yr yields +1721bp, +36bp, -5bp and +3bp, respectively. The 3M Euribor-OIS stood around 70bp as of Friday. 1M Brent crude was up 3.3% to $121.35/bbl. The USD was flat @1.3140EUR and strengthened 2.5% to 79.55 JPY. CRY climbed 1.68% to 317.39, while Gold price was flat @$1721/oz.

Looking back into the past 4 weeks, the main driver behind LONG risk position has not been any upward momentum on growth expectations, but instead a gradual receding of the high uncertainty and resumed fund flows into equities. At this juncture, we are indeed not yet seeing any upward momentum in 2012 growth projections as the global economy growth remains far from the LT pace of 3% needed to make progress on public sector deleveraging. In addition, earnings estimate revisions are not supportive of the stock market surge. While equities have surprised many with an impressive start to 2012, the revision momentum for earnings have proven to be disappointing, with mixed forward profit guidance amidst uncertainty surrounding European economic activity, corporate margins and the impact of rising oil prices. Typically, there is a tighter relationship between earnings and S&P 500 and the divergence is worrying in ST.

Macro wise, risk concerns over US and Europe have receded, with Congress extending tax stimulus measures for the remainder of the year, and ECB willing to contribute to the eventual Greek bailout. The problem of execution risks has risen as we approach the March 20 Greek bond redemption and many important steps need to be taken before that. But the willingness to strike a deal is also increasing, as all sides must recognize the huge costs of a disorderly default. The news from China is more mixed as the real estate market continues to contract and last week’s surprise higher inflation reading (4.5%) for January casts doubt (does not seem to be now) over policy makers willingness to ease  funding conditions. One relatively new risk factor that is starting to worry investors is the heating up of the conflict with Iran and the 10% run-up on crude oil prices. Beyond the near-term risk factors around Greece, Iran, and economic data, an increasingly important and LT driver of risk markets is what called Asset Reflation. Asset price inflation works by central banks increasing the quantity of defensive, lower-risk assets (cash and safer government debt) and lowering their yield. Asset reflation dominated during the first two years of the rally in equities (from March 2009 on), but was overcome by fiscal concerns during much of last year.

Concerns from Energy Prices

US data released this past week remain consistent with that forecast. Even with an anticipated step down in 1Q12 activity, there were also encouraging indicators that suggest the deceleration should be short-lived and growth should firm into midyear. In particular, the ongoing decline in weekly jobless claims (348K vs. cons=365K) provides a comforting signal that the labor market continues to heal gradually. More generally, the supply side of the economy appears to be performing quite well, as January industrial production and the early February Empire manufacturing (19.53 vs. cons=15) together indicate ongoing healthy gains for the factory sector. More at issue is the demand side of the economy. Retail sales did rebound (+0.7%) in January, but only after a very deep decline in December (-0.5%). Looking forward, one negative that has been creeping into the outlook is the ongoing rise in energy prices. At the wholesale level, gasoline prices found a local bottom around USD2.52/gl in mid-December. The latest reading has gasoline prices up over 50 cents since then, reaching USD3.06 recently. In addition, housing data is unlikely to change the view that housing is showing only minimal signs of recovery. The settlement between the government and the banks on foreclosure abuses will bring more foreclosures this year and further downward pressure on prices.

Across the ocean, Euro-area 4Q11 growth was reported at -0.3%. In January the composite Euro-area PMI moved above 50 and Euro-area releases have generally beaten market expectations in recent weeks. This likely still leaves Europe in recession; though in Germany and France, at least, the downturn may prove less severe than feared. But it is no good telling this to the Greeks. The coming week brings PMI and the German IFO releases. In Asia, most data from EM Asia is distorted by Lunar New Year effects, with inflation artificially boosted and activity releases hard to interpret because of uncertainty over the seasonal adjustments. Markets will continue to watch for more signs of monetary easing in China.

More importantly, as discussed above, any discussion of upside risk of upcoming data needs to be tempered by recent concerns emanating from energy markets. The price of Brent crude oil has moved above $120/bbl for the first time since early May of last year, reflecting a 10% rise YTD. Although some of this increase reflects shifting expectations about economic growth, the latest move up also likely reflects concerns surrounding a possible oil embargo on Iran. In response to Iran’s nuclear ambitions, US and EU have agreed to impose a set of aggressive sanctions on Iran. In addition to the European plans to curb imports starting in May, US will impose sanctions, due to take effect at the end of March, that would deny access to the US payments system to anyone that does not show an effort to reduce trading activities with Iran. The threat of sanctions is combining with a cold snap across Asia and Europe to push up prices. Companies have begun curtailing trading activities with Iran and there is precautionary stock building in advance of a more adverse scenario. With roughly 16mbd shipped through the Strait of Hormuz, military action that temporarily disrupts flows would produce a material oil price shock. JPM analysis suggests that each 1mbd removal of oil supply (sustained for a full year) would raise oil prices by 26% and reduce global GDP by 0.5%pt.

There Remains Lots of Debt

Bloomberg top news reported that Euro-area governments closed in on a deal to unlock a EUR130bn aid package for Greece, seeking to avert the region’s first sovereign default on 20 March. With Greece, Euro area faces a classic time inconsistency problem --- How to ensure that a policymaker sticks to its commitments, when incentives wane as time passes. This problem arises from two features of the Greek drama – 1) most of the money in the second package is frontloaded and related to the PSI; and 2) the looming elections in April raise concern that a new government will not feel obligated to follow through on commitments made now. Indeed, once Greece reaches a balanced primary position, which could occur next year, the region loses considerable leverage. The new Greek government could refuse to follow through on its commitment to generate a sizable primary surplus and to continue with structural reforms.

As a result, EMU’s strategy to deal with this problem is to push for passage of measures in parliament before the package is finalized – 1) to ensure that as many measures as possible are implemented in the coming weeks; 2) to require written commitments from party leaders that they will abide by the program after the election; and 3) to ring-fence coupon payments in an escrow account. That said further technical work is still needed for Greece to identify the additional EU325mn worth of fiscal measures and to establish an implementation timeline. But even if everything does fall into place, the events of the last month have added to doubts both about Greece’s ability to stand the pain and Germany’s patience. The drawn-out nature of this saga has helped create what is an escalating mistrust between Greece and the wider EU community. Greece’s President was quoted by Bloomberg news as having said “I don’t accept insults to my country by Mr. Schaeuble”, “I don’t accept it as a Greek. Who is Mr. Schaeuble to ridicule Greece? Who are the Dutch? Who are the Finns?”. Tensions are clearly mounting.

Once the package is complete, the nature of the Greek problem will change. With coupon payments in escrow, and most of Greece’s sovereign liabilities maturing far in the future, the focus will shift toward understanding the implications of Greece’s macroeconomic tragedy. The economy has already contracted + 17% from its peak and looks set to experience a cumulative fall of 25% or more. Against this backdrop, the region’s leverage for failure to meet fiscal goals --- limiting EU structural funds or access of Greek banks to ECB --- seems punitive. At the same time, the risk that poor performance without a clear light at the end of the tunnel pushes Greece to leave EMU, which would magnify weakness in the short term, is also elevated. There remains a lot of debt that could be defaulted on with an EMU exit --- around EUR250bn of official loans; around EUR100bn of market debt; and EUR100bn of liabilities in Target 2. This amounts to almost twice Greek GDP.

To sum up, even though the near-term default of Greece gets rolling over, it is another tough year for Europe's periphery. Imbalances within Europe have developed gradually since the creation of the Euro zone, resulting in a cumulative CA surplus in the core countries and a CA deficit in the non-core areas. Fiscal austerity is limiting growth, which contributes to a rebalancing across countries by dampening import demand. The extensive fiscal austerity measures implemented in Spain, Italy and other non-core markets have offset the automatic stabilizers that otherwise would smooth out GDP growth in times of crisis, so the recession could be quite severe within these countries. S&P’s real GDP forecast for the Euro zone is +0.2% in 2012, so a less rosy growth outcome could trigger more downgrades. Others project EU GDP of about -1% this year..

PBoC Report vs. RRR Cut

MSCI China has rallied 37% since its low in Oct 2011 with returns heavily skewed toward the oversold stocks with depressed valuations, particularly in cyclical sectors, including shipping, real estate, banks, machinery, materials and autos. In addition, low-valuation sectors have outperformed high-valuation sectors in general. Over the week, the mean reversion trades continued with the most hated names performed best in HK, such as NWD and Henderson. Technical strategists are calling Hangseng index in the process of “filling the gap” and is approaching its triple bottom resistant level of 21617. CSI300, however, remained lackluster as investors remained concerned about ST liquidity and related issues (FX flow, lack of meaningful monetary adjustments, FDI decline, etc) and eroding fundamentals.

Policy wise, despite the better risk appetite around the global,  A share market was weighed on by --- 1) Jianping Fan, the head of Economic Forecasting Department said that the Government may lower its growth forecast to 7-7.5% during the NPC meetings; 2) the usual lack of the well expected RRR cut; c) Qing Hong of MOHURD said that the property curb will continue; d) the 95bps increase in 7-DAY repo rate due to the CCC IPO lock-up.  However, the performance of HK listed China ppty names continued (COLI +3%, KWG +6.68%, R&F +4.65% and Hopson +7.31%). This came despite the sector in general suffered its worst month in the past 12m with none of the 70 cities experienced mom gains in prices, according to NBS. There are some selective easing on the local level, as SH raised the threshold for “normal” housing from RMB2.45mn to RMB3.3mn which means more people will enjoy preferential tax treatment.

Until Friday, the market feels that policy easing has been slow and stingy. PBoC’s 4Q11 Monetary Policy Report was notable for its still-cautious tone on inflation. Not only did the central bank make note of the HTE January CPI inflation print, but it suggested that inflation expectations in China remained unstable. In particular, the PBoC cited local factors like China’s tight labor market and needed adjustments in domestic resource product prices, as well as external factors such as ample global liquidity, and possible increases in commodity prices. This cautious attitude toward inflation is having an impact on the timing of China’s policy easing, as shown by the failure to deliver a second RRR cut and the LTE loan growth in January. However, the broad turn away from tightening is still under way with PBoC emphasizing that monetary policy will be fine-tuned as and when appropriate. The central bank announced a 14% M2 growth target, up slightly from last year’s 13.6%. This target is consistent with 3-4 times 50bp RRR cuts in 2012. Inflation was certainly not the only focus of PBoC report, with the risks of weak economic growth also emphasized. In reality, on Saturday evening, PBoC announced a 50bp RRR cut across all banks, effective from 24 February, taking RRR to 20.5% for all big banks and 18.5% for smaller banks. This is the second reserve ratio cut in the current easing cycle which officially started in late November, when the PBoC surprised markets with its first reserve ratio cut. This move will inject approximately RMB400bn of liquidity into China's banking system.

Looking forward, liquidity remains an important concern for investors. I think that although current market technicals are very positive, the RRR cut induced rally is likely to absorb a significant portion of the available cash, worsening market technicals over time. This is likely to leave the market more vulnerable to a consolidation and most investors expect a pullback towards the end of February. I would suggest taking the opportunity to rotate out of weaker, more illiquid names into fundamentally stronger names..….Lastly valuation wise, MSCI China is now traded at 9.8XPE12 and 12.9% EG12, CSI 300 at 10.1XPE12 and 20.6% EG12, and Hang Seng at 10.9XPE12 and 4.2% EG12, while MXASJ region is traded at 11.8XPE12 and 10.5% EG12.

Reaffirming Dollar Bear Position

The USD reversed lower in late January on Fed policy and better data. But I stick to my outlook of a broad USD weakness on the back of global economic recovery, enormous liquidity from the major central banks, diminishing credit risk in Europe but obvious event risks in all regions throughout 2112. Fundamentally, as a zero-yield currency for a country running the largest financing requirement in the world, USD has little value outside of a global recession or financial crisis. Its fall this year vs. over 90% of currencies, including EUR, confirms that the principles which have driven FX for the past decade --- more growth and less stress deliver USD weakness --- still hold.

Policy wise, Chairman Bernanke believes that the devaluation of USD vs. gold in 1933 was pivotal in getting the economy out of the Great Depression. Because US were operating under the gold standard at the time, the Dollar’s devaluation allowed the Fed to expand the money supply. This was the 1930s equivalent of today’s QE policies. In addition, I believe that Fed will not repeat the mistake of preemptively exiting from the expansionary policies. Bernanke has said that the premature tightening of monetary policy in 1936/37 triggered the second leg of the Great Depression. This is the reason behind the Fed’s commitment to hold ZIRP until the end of 2014. Moreover, lower Euro rates would be Euro-negative all else equal, but all else is not equal. The ECB’s LTRO relieves credit stress (+VE) more than it boosts inflation expectations (-VE). Europe is running a near record trade surplus compared to the US’s deficit; and investors are still quite short EUR or heavily hedged compared to near-record USD longs when the Fed launched QE in 2009.

Commodities rallied almost 3% this week led higher by oil markets. Brent is now up 14% YTD and is now hovering around $120/bbl, raising risks to global economic growth. This reflects two forces. Demand has been much stronger due in part to a pickup in global IP but also due to unusually cold weather across much of Europe and North Asia. The second factor is supply risk. There has been a suggestion from Iran that it may preemptively ban exports to Europe in retaliation for the sanctions that are due to be imposed later this year. The sell-side’s base case remains that this risk does not materialize and that OPEC is able to offset lost Iranian exports when sanctions are imposed in May. However, the uncertainty caused by the geopolitical situation combined with lower than normal stocks of oil mean consumers are hedging their bets by building inventories. An alternative lower probability scenario is that lost Iranian exports are not offset by OPEC. In this instance, we would expect a strategic reserve release but in the interim oil prices would likely spike much higher.

Good night, my dear friends!