My Diary 718 --- Thoughts on Hope vs. Inflation; The Debate over

My Diary 718 --- Thoughts on Hope vs. Inflation; The Debate over Burden Sharing; Renewed Worries on Hard Landing; Follow Oil and Check USD

Sunday, March 18, 2012

“It’s Show Time: GS’ Greg Smith; HK’s Tang and Leung; CQ’s Bo Xilai” --- Greg Smith, now the most famous former GS derivatives salesman on the planet, went off on his former employer in the opinion pages of the New York Times and earned him USD150 in this past week. Mr. Smith claimed that during his 12 years at Goldman, the ethics and morals of his co-workers deteriorated so dramatically that he just couldn’t take it anymore. This was much to the amazement of nearly everyone. The Washington Post columnist, William D. Cohan wrote on March 17…… [Quote]” Guess what, Greg? You didn’t do your homework about the firm where you worked for more than a decade and happily took home one bonus check after another. Goldman Sachs has been in and out of trouble throughout its 143 years — chiefly because it chose to put its own interests before those of its clients. What appeared to be a revelation to Smith was actually available to anyone who looked for it, buried deep within Securities and Exchange Commission and court records. Smith could have saved himself grief if he had only used his Stanford education to examine Goldman’s DNA before crossing its threshold”… Well, though it is not quite sure why Mr. Smith pressed the “Sent” button before his resignation, there is another piece of interesting comment worth for a reading (by someone with nick name of “diamond2”) …… [Quote] “If one just did the research on Goldman-Sachs breaking the back of Greece and then betting against time (which brought Greece down) one would know that G-S only looks out for G-S and the hell with the rest of the world.”

Across the Ocean, the politician’s shows have entered into the center stage of episodes. In what's being called the biggest Chinese political scandal in years, Bo Xilai, the Communist Party secretary in Chongqing, was axed after Premier Wen's criticism, according to the headline of Business Week Magazine. Mr. Bo's sudden departure has inspired the white-hot debate on the Sina weibo over whether his political demise is simply personal or also means the end of the "Chongqing model" of more equal growth that he championed. In HK, we had a Television debate among HK chief executive candidates. Mr. Leung Chun-ying maintained his lead in polls after pledging to narrow a wealth gap, as rival Henry Tang’s popularity dropped after he admitted knowing about a basement built without planning permission at a property owned by his wife. In October, he confirmed having an affair and said his wife had forgiven him. Public opinion is starting to weigh on the contest after Premier Wen said March 14 that the city “can elect a chief executive who is supported by the majority of the people.” That being said, I am not a fan of politics, but partially the history is made up by politics and politicians. The current political shows in this land can be well described by a paragraph in the book of “The Lost of Good Hell”, which was written by the famous “New Culture Campaign” leader and Chinese author in 1920s, Mr. Lu Xun --- [Quote] “the history of China is the history of a gang of reactionary guy to replace another gang. Their dictatorship to the people is a greater and deeper misery. At the beginning of each revolution, the goal is always to overthrow the old ruling class, and without exception, they use the good-looking logo and attractive sermon to confuse people and use the power of the people to win their right to rule. Once grabbed the emperor's throne underpinned by the flesh and blood of the people, immediately they turn the country into the home world, treating the people like slavery. Thus, Hell is still Hell!

Back to markets, equities and credits continued to rally this week with SP500 achieved a psychological milestone on Friday after having cracked the 1400 barrier for the first time since 5th June 2008. The SP500 is now 11.5% away from the record highs of 1565 seen back in Sep2007. But a number of other markets are reversing course, with gold and G10 government bond yields falling badly and USD gaining strength. The breakdown in correlations is heaven sent for macro HFs who were having problems making money in a global risk-on, risk-off world, but it raises the question whether asset reflation has ended and will take equities and credit down. I think the short answer is NO as the sell-off in gold and bonds simply reflects falling fears of downside risk on economic growth, confirmed this week by the FOMC. The FOMC statement contained my previous views on +VE US growth momentum and the likelihood that QE is done. But the market clearly suddenly realized that Fed was signaling no further need for QE, pushing up bond yields and steepening curves across the world. Gold fell badly as some investors have been holding it as a QE-motivated inflation risk hedge. Interestingly, some street economists instead lowered the US growth forecast in 1Q12 from 2% to 1.5% last week. But consensus forecasts for US growth have been very stable with 2% between now and the end of next year. So the real message in these forecasts is stability and reduced downside risk. That is what is driving risk markets up.

However, I think the selloff in bonds does raise the question of how much further it can go and when & how it becomes a threat to risk assets. The week’s selloff means that 2014 FFFF implied rates are now somewhat higher than before Fed provided its low through 2014 guidance in January. Question is what would make the market raise bond yield forecast for this year? I think we need to see significantly stronger growth, inflation, and/or inflation expectations, i.e. if monthly US NFP were to rise to 300K or surveys to reveal that economic agents become worried about inflation, then the market will start expecting Fed to begin normalizing rates next year already. Then UST yields would be headed to 3%. Given the political event risk around the massive fiscal tightening currently on the books for 2013, Fed is not likely to signal an early exit from monetary easing. Moreover, the MTD rise in USD and its de-linking from the risky assets raises the issue whether there is again a flight to quality into the safe currency of the world. Again, it is a “NO” as the higher USD reflects a view that there is clearer differentiation of where central banks are in their monetary easing cycle. In a nutshell, the market has come to see Fed is done with QE, Europe still halfway in its LTROs, and Japan only now seriously considering starting the fight against its deflation.

Policy wise, FOMC statement showed little change from the previous month – the main message for investors is that monetary policy is loose and will remain so for another 18-24 months at least. Still, the committee acknowledged an easing in global financial market strains (Europe) and a slight improvement in business capex. It also recognized the drop in the UNE rate. Together, these developments were enough to warrant an incremental upgrade in Fed’s description of the prospects for economic growth, from “modest” to “moderate”. In addition, the successful conclusion of Fed’s stress tests has shored up confidence in bank B/S and provides a rather robust validation of the strength of US banking system. The Fed’s analysis determined that the average Tier-1 CAR would be 6.2% (well above 5% target) even under the most severe scenario, and even after allowing for currently proposed plans to return capital to shareholders. The outcome was that 15 of the 19 banks will have their capital plans approved and JP Morgan stock price climbed 8.7% in a week.

X-asset Market Thoughts

On the weekly basis, global equity was up 2%, with +2.4% in US, +3.0% in EU, +2.43% in Japan and +2.39% in EMs. In Asia, MXASJ and MSCI China was flat, while CSI300 -1.53%. Elsewhere, 2yr USTs yield and 10yr’s add 9bps and 31bp, to 0.38% and 2.29% respectively. Government bond yields across the Euro periphery area were widened with Portugal, Italy and Spain 2yr yields +19.6bp, +13.8bp and +5.5bp, respectively. 1M Brent crude was up 0.5% to $126.4/bbl. The USD was weak a bit @1.3175EUR and strengthened 1.2% to 83.44 JPY. CRY stay flat to 317.93, while Gold price down 3.3% to $1656/oz.

Looking forward, combined central bank action has provided sufficient liquidity support to reduce ST risks within the banking sector, but structural macroeconomic challenges remain. In the absence of ST wealth destruction risks, I think we are shifting back to a structural reallocation of portfolios towards EMs. As discussed in my last diaries, what might end the bull run? --- If oil prices surge above $140/barrel within a short period, or if bond yields spike to over 3.5%. Neither is going to happen any time soon. Oil prices have barely budged in the face of Israeli Prime Minister Benjamin Netanyahu’s near-bellicose statements. As for bonds, Fed’s commitment to ZIRP until 2014 will serve as a key anchor suppressing the long end of the curve. Therefore, the mini “melt-up” in stocks may continue for a while. Such a mild +Ve outlook was supported several macro backdrop, including --- 1) an improving US economy, which is evidenced by strengthening private-sector payroll growth (233K vs. 225 expt.), increasing retail sales (0.9% vs. 0.7% expt.) and an upward revision in income gains (1.8%). By historical experience, the current private-sector payroll growth is consistent with 4% GDP growth instead of the consensus call of 2-2.5%; 2) the monetary easing in Europe, with ECB B/S shooting up by nearly 60% in nine months. The impact of the ECB’s QE on financial markets will likely be akin to what occurred after Fed conducted its QE2 that ended last summer. Obviously, European economy is still moribund and stuck in a debt-deflation trap. However, with “systemic risk” being taken out, ECB has “liberalized” the global financial system; 3) currency intervention BoJ to weaken JPY, which is a de facto QE program. For the first time, BoJ has set an inflation target at 1%, which means the authorities there will continue to push down JPY by expanding domestic liquidity.

Fundamentally, according to Morgan Stanley, with 68% and 66% of companies have reported in MSCI APxJ and EM, results have missed 4Q11 consensus estimates by 5% and 7%, respectively.  I think the miss of earnings is more due to the margin erosion as revenues for EM and APxJ have beaten consensus by 3% and 2%, respectively, with 61% of the EM companies (59% for APxJ) have reported in-line revenues. To sum up, I remain HOLD and positive over the current investment environment, which is best characterized as a “sweet spot”, supported by the modest economic growth, low inflation, hyper-simulative policy and genuinely under-invested retail and institutional investors.

Thoughts on Hope vs. Inflation

The past week continued to see global economy is gaining momentum. As 1Q12 comes to a close, a number of the key elements for the outlook are adding to investors’ conviction --- 1) manufacturing bounces back to life. As discussed in My Diary 462, global industrial output advanced a strong 0.5% MoM in January following an outsized 1.2% MoM jump the month before. In whole, global factory output is on pace to post a robust 5.5% yoy gain this quarter, much BTE. In US, Friday’s reported solid gain in US factory output in Feb puts production on pace to surge 10% annualized this quarter, while the March business surveys (Empire & Philadelphia) underscore that a downshift is in the offing; 2) Ex-China Asia on the move. Given the region’s gearing to the manufacturing sector, it is no surprise that Asia is benefiting the most from the cyclical upswing in global industry. This was underscored by the jump in machinery orders (3.4% vs 2.3% expt.) in January. Elsewhere in the region, the recent signs of a pickup in exports from Korea and Taiwan were echoed in Friday’s report from Singapore.

3) US consumer not so fragile. Concerns regarding the recent soft patch in consumer spending growth were allayed somewhat this week by a strong gain in retail sales in February (1.1% mom) along with notable upward revisions to the previous two months. Combined with strong auto sales, US consumer expenditures looks set to expand 2.2% yoy this quarter. But confidence unexpectedly dropped in March as this year’s 17 percent jump in gasoline prices threatens to squeeze household budgets; 4) Euro area stalls but no collapse. ECB’s LTROs along with constructive steps to build a bigger liquidity facility have short circuited the credit crunch that was building last quarter. Although considerable damage has already been done, the activity data in hand along with the latest reports on bank lending suggest that any contraction in output will be modest. Key for the outlook will be next week’s flash PMI report for March and the M3 report for February.

With the momentum in economic activity building, the focus will undoubtedly begin to shift back to inflation. The decisive actions taken by monetary authorities in recent months will bolster the perception that easy money will eventually find its way into higher prices.  Commodity prices have been on the rise, with crude oil jumping 16% on the year and US retail gasoline prices seeing a similar rise that drove this week’s US headline CPI reading (+2.9% yoy). However, we are too early to worry about inflation in the DMs. This week’s soft reading on US core inflation in February along with the latest reading on average hourly earnings is a reminder that underlying price pressures are well-contained. In contrast, inflation pressures in EMs are more complicated. The leveling out in commodity prices after last year’s surge is passing through to softer core inflation. However, with resource utilization elevated, the shift toward building momentum in global growth could reverse any recent inflation relief. That side, policymakers in most EM countries are moving to the sidelines as global risks diminish and domestic growth prospects improve. Nonetheless, a handful of the majors are still active, including in China and India. Each country was in the news this week. Chinese policymakers have moved cautiously despite a sharp slowing in the growth rate (below 8% in 1H12). The RBI stayed on hold, leaving the repo rate at 8.50% and the CRR at 4.75% (RRR was cut 75bp last Friday) and saying "upside risks to inflation have increased from the recent surge in crude oil prices, fiscal slippage and rupee depreciation.”

The Debate over Burden Sharing

As is often the case in a financial crisis triggered by excessive leverage, Euro area is struggling with the issue of burden sharing. The on-going debate is who should bear the consequences of prior mistakes? Another way of expressing this is that Euro area is struggling to find the right balance between collective solidarity and individual responsibility. One response is that the very limited burden sharing that is part of the current agenda is unfair: essentially, that Germany should recognize the enormous benefits that have accrued to it due to EMU membership and should be willing to accept more burden sharing as a consequence. The other response is that, regardless of fairness, the region will not be able to reach the low-debt equilibrium envisaged in the fiscal compact

In a recent report, McKinsey calculated that the creation of the Euro area lifted the level of area-wide GDP by EUR330bn over the first decade (3.6% of GDP in 2010).The report argued that Germany received >50% of the total benefit, significantly more than its share of area-wide GDP. A key reason why Germany is considered to have benefited disproportionately is that it didn’t experience any currency appreciation to offset the improved competitiveness delivered by labor market reforms. That said, we all know when the Euro area crisis began, there was both solidarity and responsibility, but the solidarity was in the form of loans and the burden of adjustment was put squarely on the shoulders of the debtors. The situation has become much murkier over the past 2 years with loans becoming increasingly concessional and various channels for opaque fiscal transfers opening up. For Greece it is particularly confusing: should we view the Greek debt exchange as a punishment for failing to live up to the conditionality of the EC/IMF program or as a reward in recognition of the need for debt relief? Normally sovereigns avoid default and debt restructuring because it affects future market access and it adversely impacts their domestic financial system, which holds a lot of sovereign debt. Neither of these costs seem to apply to Greece. The debate about burden sharing will continue until this crisis is resolved one way or another. As we understand it, the region has no plans to change the current stance of rather limited burden sharing. According to the fiscal compact, the burden of this adjustment will be borne by the highly indebted sovereigns, and the intention is that deleveraging will be largely achieved by sovereigns moving to sizable primary surpluses.

Despite the discussion above, bond and credit markets have breathed a sigh of relief in response to the successful Greek debt restructuring that followed in the footsteps of ECB’s LTROs. 10yr Italian bond yields have fallen 240bp since their highs on 25Nov2011, back to levels last seen early last year. 2yr Italian yields have fallen even further since they peaked. However, there are still plenty of risks still hang over markets, which are summarized here --- 1) European bank B/S risks and recapitalization plans; 2) Contagion stemming from Portugal to Spain, whose banks have EUR90bn exposure to Portugal, and from Spain and Italy to France given the banks’ heavy exposures to these countries; 3) Spanish banks are facing strict regulatory enforcement of more loan write-downs. The Spanish government might be on the hook to rescue some banks, and to shore up local govt finances; 4) Political risks such as French and Greek elections, Italian labor market reforms, Spanish austerity slippage and potential German Euro-skepticism; 5) EU enforcement of the fiscal compact. This week, the EU illustrated its fortitude by pushing Spain to reconsider the slippage in its 2012 budget. The outcome tries to balance austerity with growth considerations, but the EU’s resolve might be more severely tested by France, especially in the event of a Hollande election victory; 6) Inadequate size of the rescue fund; 7) Enlarging or at least combining the firewalls (ESM/EFSF) would probably trigger IMF support for Europe. The question is still whether Germany will go along with such a precautionary action, especially without a market riot providing an incentive, because it might risk weakening the resolve of the weaker countries to implement reforms and austerity measures.

Renewed Worries on Hard Landing

This year’s NPC is of particular interest, as the Chinese government has unveiled a conservative growth target (cut from 8% to 7.5%, compared with 9.2% achieved in 2011 or 8.9% in 4Q11), and fiscal policy is less simulative than expected. Policymakers appear to be confident that the economy is on course towards a soft-landing, and are not ready to pump prime just yet. Even if the government does not officially announce an end to the housing tightening cycle, some policy easing on the housing sector has already begun. In addition, despite a lower growth target, Premier Wen listed “promoting stable and relatively fast economic growth” as the government’s first major task for 2012, unlike last year when “maintaining price stability” was top priority. The subtle shift in wording does not necessarily signal a dramatic change in policy direction, but it clearly highlights that the authorities’ top concern has shifted away from inflation. Even though Premier Wen has maintained a 4% inflation forecast for 2012, unchanged from 2011, headline inflation has been rapidly declining in recent months, and there is little risk of another round of major inflation flare-up, unless global growth rebounds significantly. All of this means that without major negative growth surprises, the Chinese authorities’ policy easing will likely remain cautious and tentative.

However, interestingly, A-shares got sold off (-3%) following comments made by Premier Wen. I think there are a few concerns in the domestic investors’ mind --- 1) NPC meeting failed to identify alternative growth engines; 2) Premier Wen said that ‘current property prices are still far from reasonable levels’, which further dashed expectations of property loosening; 3) Comments on political reform urgency and subsequent senior leadership changes also surprised. These surprises were partly echoed by the renewed worries that China is in hard landing in the face of weakening macro data, and as investors feared inadequate policy response. I remain confident on the soft-landing forecast and see a bottom in China’s growth pace at 7.5% QoQ in the current quarter. I expect the economy to bottom up gradually in Q2 as the weakness has much to do with the impact of previous monetary tightening. A change is already underway. The PBoC has cut RRR twice and this week it dropped interest rates on repo agreements, leading to a decline in interest rates on MMFs. More easing will be delivered, should the economy weaken further. Most importantly, inflation has come down fast, which is a major positive development as lower inflation frees up the hands of the central bank to ease policy.

Fundamentally, according to Goldman, 25% of MXCN and 9% of CSI300 market cap have reported FY11 results thus far. MXCN is tracking +3% vs. consensus and for sectors with 25%+ of market cap already reported, insurance, healthcare and semiconductors missed so far while staples beat. Telecom & property (excl revaluation gains) are in line. CSI sectors are still very early in the results calendar but thus far white goods are beating estimates...….Lastly valuation wise, MSCI China is now traded at 9.7XPE12 and 11.4% EG12, CSI 300 at 10.5XPE12 and 20.9% EG12, and Hang Seng at 10.9XPE12 and 3.8% EG12, while MXASJ region is traded at 11.9XPE12 and 9.1% EG12.

Follow Oil and Check USD

Reading through the research papers, one can easily find that current conventional global S&D balances appear to show a market awash with crude oil. Yet inventory data from Europe, US, Japan and China show few signs of these surpluses being realized. Most oil market balances tend to be a bit of mismatch due to the complexities of modeling crude oil and product supply and demand. Accounting for strategic stock building, working storage needs, increased volumes of oil in transit and refinery expansions helps to explain the disconnect between the ‘apparent’ surplus shown by conventional balances and the amount of ‘free’ inventories in the market. As a result, the oil market today could be regarded as being as tight as it was at any point last year, and potentially as tight as early 2008. Supplies look as if they will improve modestly over March-to-May, but not significantly if China looks to fill its SPR. Several developments over the past week reinforce the idea that the East of Suez crude market is tight in spite of the region heading into peak spring refinery maintenance.

In addition, the impact of the Euro zone economic fragility on oil was muted by a cold start to the year, particularly in Asia, and a series of supply disruptions that left Brent futures prices holding on to February’s gains in 1H March. Looking forward, crude supply is seen to be improving—April North Sea loadings of 2.4mbd are at their highest level in a year, and Nigerian and Angolan loading programs are also increasing month-on-month. The May-June Brent spread has weakened recently from intraday peaks of over $1/bbl to $0.42/bbl, suggesting that the strength in the market is dissipating. I think oil prices are likely to stay high, but are unlikely to reach demand-destructive levels of above USD 135/bbl. While today’s oil prices have not led to demand destruction on a global basis – which would put downward pressure on benchmark prices – oil demand is declining in some regions as high prices exacerbate secular trends. Europe is vulnerable to high oil prices given its weak recovery and US consumer confidence has felt the misery of high gasoline price, according to BBG.

A short ink on USD here as sovereign crisis has sidelined for a while, and traditional forces like monetary policy are causing substantial swings in currencies. At first blush it looks as if BoJ is starting a major easing cycle (more asset purchases), ECB has just eased massively (EUR1trn of LTROs) while Fed may scale back its 2014 rate guidance (perhaps at April FOMC). This pecking order drove many to buy USD/sell EUR and JPY this month, though both trends are reversing sharply lately. I think it is true that any consistent rise in US yields would drive USD higher vs. other lower-yielders (EUR, JPY) and even some high-yielders initially (AUD, NZD), The central issue for the 4Q12 and 1Q113 FX forecasts is US fiscal policy. Under current legislation, US will undergo roughly USD500bn (3% of GDP) in fiscal tightening next  Year due to expiry of the Bush tax cuts, a rise in payroll taxes and automatic spending cuts (sequestration) due to the budget super committee’s failure to agree program-specific cuts last fall. Fiscal retrenchment of this magnitude would probably guarantee a US recession and USD strength vs. most currencies through deleveraging.

Good night, my dear friends!