My Diary 723 --- Growth 1H, Inflation 2H; The Spanish De”B”tiny;

My Diary 723 --- Growth 1H, Inflation 2H; The Spanish De”B”tiny; MXCN PB at 2008–09 low; USD Remains Crucial

Sunday, April 15, 2012

“The Glass is Half-empty or Half-full” --- Risk assets have enjoyed a strong start to the year, with equity markets performing particularly well in 1Q12. EM equities added +13.6%, while US and Asian equities returned 12% for the quarter. EM local-currency bonds had returns in >8% in Q1, while EM hard-currency debt returned around 5%. While credit spreads in EM and Asia are still wider than in 1H11, they came in by around 75bps and 60bps, respectively, over the first 3M12. Equity and currency volatility has also declined significantly in 1Q12 and is close to the lowest levels since early 2007. In my view, the rally in risk assets in early 2012 had three primary drivers --- 1) ample excess liquidity in the system, 2) extremely light positioning among investors, and 3) an improvement in the overall macro story.

Stepping into 2Q12, the overall market environment has become more complicated and tougher than it was before. With the explosive surge of stock price and a 5yr low VIX, it is not surprised to see a corrective action. Investors are highly skeptical about the sustainability of the recent stock market advance. This is understandable. After all, the world economy is still fraught with many risks and potential shocks. The Euro debt crisis remains unresolved and there is still uncertainty surrounding the longer term outlook for the U.S. economy. The sustainability of the stock market rally depends on whether the underlying economy can validate market expectations, in particular the three major economic blocs – US, China and Euro zone. These observations have led to my further thinking of the LT fundamental driver of equity market return --- the growth rate of an economy.

Economics 101 tells us that the potential growth rate of an economy is measured by the product of the growth in labor force and productivity. The growth of the labor force is largely baked in the cake because it reflects demographics. The bigger challenge is to figure out what will happen to productivity. In addition, the history proves that the gap between successful and unsuccessful countries is all about productivity. Of course, there are basic prerequisites to sustained economic success such as the rule of law, open and transparent markets, minimal corruption, and some correlation between risk and reward for businesses and investors. But, even where these conditions exist, there can be marked differences in productivity performance, prosperity and wealth creation. For a country, wealth comes from investing in productive assets – both physical and intangible. And it does not really matter if the investment is financed by debt – as long as the investments provide a suitable return relative to the cost of borrowing. (A quick note here is that housing investment does not really count, beyond ensuring that the population has a safe and reliable place to live. A homeless population would not be a very productive population.

With the above mentioned economic theories in mind, then I could see US is still in a current difficult position as the country’s net saving/ NDP currently is zero. In other words, domestic saving is just enough to cover depreciation and nothing more. In the past several decades, not only have we seen the persistent failure of policymakers to address structural imbalances growing in the US economy, but also they have always been more expedient to force-feed the system with reflationary polices rather than accept the cost of washing out financial excesses, when faced with any economic or financial problems. While now may not appear to be the best time to rebuild the national saving rate, a serious financial crisis is inevitable within the next several years if the authorities do not take action to bring government finances under control. The alarming trend in public deficits and debt is undoubtedly one of the factors encouraging companies to keep a lid on capital spending. Of course, a high level of capital spending alone does not guarantee rising wealth and prosperity. For example, Japan’s high investment rate has not translated into a strong economic performance in the past couple of decades. The investment has to be in areas that will promote faster productivity growth as opposed to spending on misguided infrastructure projects or in sectors already facing excess capacity. US housing bubble in the 2000s was a classic case of misallocated capital.

What about other countries? Europe’s fiscal crisis has already arrived with many countries being forced to pursue aggressive austerity. As necessary as it is to bring fiscal finances under control, securing sustained gains in wealth and prosperity will depend on boosting the supply side performance of the affected economies. While US needs an increased saving and investment, the solution for Europe’s troubled economies lies more in the direction of reducing bureaucratic and regulatory obstacles to growth. For Japan, rapid population aging is a huge and growing problem, as is the massive overhang of public debt. Living standards, as measured by per capita GDP, have held up well, reflecting the large pool of domestic savings. Moreover, in the decade prior to the recent recession, Japan’s productivity performance had broadly matched that of US and the overall OECD. Not surprisingly, the best long-run prospects for growth and prosperity are in the Emerging countries. These economies are still in the catch-up phase of development when there is tremendous potential for increased productivity and wealth creation. Of course, issues such as governance, corruption, inequality and political incompetence can represent major obstacles to growth and this explains the large differences in country performance. Considering the huge deficit of public pensions and fiscal expenditure with US and Europe, I continue to think EM equities are a better mid-to-long term asset classes, assuming other things held the same.

X-asset Market Thoughts

For March, SP500 (+3.3%) was a clear winner, but Hangseng (-4.9%), IBEX (-5.4%) and FTSE (-1.3%) were all lower. The weakness in the EM indices was also a notable theme, led by equity market falls in China (-6.8%) and Russia (-5.0%) while India and Brazil were also down 1.6% and 2.0% respectively. As equities rebounded from their 2011 lows, government bonds were modestly negative in Q1. Treasuries and Gilts were down 1.3% and 1.8% while Bunds were around flat on a total return basis. Interestingly, Spanish bonds were down 1.9% in March on some renewed focus around its structural and budgetary challenges. The Bank of Spain last week said that the Spanish economy is expected to see a negative print in Q1 which if confirmed will ensure a fresh recession. The budget statistics released by the Spanish government last week also showed further deterioration in its fiscal position. EM bonds were up 8.3% in 1Q12 but the asset class did give up 1.4% in March.

Credit complex saw solid total and excess returns in 1Q12 despite a softer performance in March. On a relative basis, EU HY and EU Fin Sub added +12.5% and +15% respectively since the LTRO announcement in Dec2011. March was a weaker month for US credits with US HY (-0.3%) marginally lower after having rallied 2.7% and 2.6% in January and February. Commodities are still higher since the end of last year despite the weakness in March. Silver, Gold, and Copper were down 1.7%, 6.9% and 1.2% in March but still 6.7%, 15.9% and 11.3% higher in YTD terms. Brent is up 15.6% this year. Finally, in currencies GBP and EUR have appreciated around 3% against USD since the end of 2011. USD is down 1.5% against a basket of major currencies.

Looking forward, while liquidity remains strong, the other drivers of the rally are, arguably, in clear decline. Economic data out of Europe has become decidedly weaker. The LTRO reduced the risk of such a sudden stop, but the growth outlook remains weak. Continued austerity and additional reform measures in the context of economic weakness are likely to be very challenging for Europe. PMIs in Europe continue to suggest a worsening trend in the euro-area periphery, with numbers for Spain and Italy showing a sharp deceleration. The key near-term trigger for risk assets is the potential for rating downgrades by Moody’s of a number of European banks. The bad news to market sentiment lately is that the European situation is still incredibly political. ECB last week indicated that they felt the recent widening in Sovereign spreads was more due to sluggishness in the pace of reforms. They are therefore unlikely to intervene in a hurry. Moving to the US, macro data has been stronger of late, I remain skeptical about the sustainability of the numbers. With tax cuts expiring, USD1trn in mandatory federal budget cuts due to kick in, and rising gasoline prices eating into consumer spending, risks to US economic growth are clearly to the downside. Asian export data weakened in the first 3M 2012, reflecting the recession in Europe and the weakness in the US. The real worry is the potential for a hard landing in China and India, where further monetary easing is expected in the coming months.

That being said, commodity and equity markets already appear to be in the midst of a correction. Commodity markets have been consolidating since late February, with precious and base metals showing the clearest corrections. Gold has fallen by 8%, while LME base metals are down about 5-10%. Brent has also fallen c.3%, despite being supported by sustained tensions in the Middle East. In the near-term, headwinds for equity prices are --- 1) global equities have risen anywhere between 10% and 30% since early October and most markets have reached overbought conditions. A pause is needed as if SP500 maintains its current pace, it would reach 1860 by the end of the year, which is possible but highly unlikely; 2) another potential headwind for stocks is corporate earnings growth. For SP500, the consensus estimate is 9% profit growth this year. During 1Q09-1Q12, US corporate profit growth exceeded revenue growth, which is unprecedented among postwar economic recoveries. The key reason is laid in the subsidization from interest costs and wages. Now these are behind us because for the first time since 2009, the net change in workers’ compensation has turned positive, while top-line growth has also begun to exceed bottom-line growth; 3) As discussed in the previous diary, I think investors should watch the French elections carefully. Socialist candidate Francois Hollande has identified international finance, not incumbent Nicolas Sarkozy, as his main enemy. He has also stated that he would renegotiate the German-designed “fiscal union” Treaty, potentially delaying its ratification process. The French elections matter because of their potential to impact future euro area management; a fundamental break between France and Germany would alter the outlook for the euro area. Also, France is the second largest guarantor of the EFSF and the second largest contributor to the ESM, so any market pressure on France reduces these programs’ credibility as effective firewalls. Finally, there is an expectation that France will follow the path of Italy and Spain and pursue austerity and structural reforms. A failure to do so would invite market uncertainty and raise debt servicing costs.

However, equity market fundamentals seemed passing the bottom already. In March, the Global ERR improved from 0.58 to 0.72 and this is a positive signal. In the past, when ERR was rising and at this level (0.70 - 0.80), the MSCI ACWI index returned 12% in the subsequent 12-month period, on average. At the regional level, the ratio increased in Europe from 0.59 to 0.76, in US from 0.71 to 0.86, and in Japan from 0.74 to 1.12. The Ratio also improved in APxJ, from 0.45 to 0.55, and in EMs, from 0.48 to 0.56. Valuation wise, in particular the Ems’ forward PE is still around 7% below its historical (post-2000) average. Also, the discount to DMs is at the high end of recent historical experience. One explanation for this is that market expectations about future earnings increase more quickly than analysts’ earnings expectations. To sum up, unless economic data (from US, Europe and China) or macro and geopolitical developments (in Europe and/or the Middle East) turn significantly negative, I do not expect the consolidation to be deep or long-lasting.

Growth 1H, Inflation 2H

Though this week’s China 1Q GDP release threw in some soft flavor, strong key global indicators (PMIs, manufacturing output, and auto sales) have resulted in the significant recent revisions to growth estimates across the rest of the globe. With Japan (2.8%), US (2.5%), and EM Asia ex. China (9.4%) now all projected to deliver above-trend outcomes, global GDP growth is tracking close to a trend pace last quarter, even in the face of continued Euro area contraction. But some broad data are still mixed, i.e. global manufacturing PMI edged down 0.1pt in March, the same as in February, to a level of 51.1. The details were mixed, with production gaining slightly vs. a small decline in new orders. I still look for IP growth stabilized at 3% or higher in 2Q12 unless there is a drag from business inventories.

By regions, US economy is expanding at a "modest to moderate pace" was the key tone from the February 17th - April 2nd Beige Book released last week. The Fed mentioned all districts had experienced economic growth. Increased petroleum prices were noted as a concern by manufacturers as well as consumers, potentially causing a decrease in spending and increase in transportation costs. Hiring was steady or showed modest gains in most areas of the country. As a result, I saw sell side economists revised up their forecast for 1Q US GDP growth to 2.5% from 1.5%. However, the latest LTE NFP numbers (120K vs. cons=205K), UofM confidence (75.7 vs. cons=76.2) and the higher initial jobless claims (380K vs. cons=355K) seemed the US economy likely running out of steam. In China, the two PMIs diverged in March and in 1Q more generally, with the NBS measure posting a good gain vs. the slide in the HSBC/Markit version. The conventional wisdom is that the NBS PMI is biased toward large firm activity. However, the latest data seems to suggest the worst is over and 1Q12 could be the trough of this cycle. Within 1Q12, March data improved from Jan-Feb, though GDP growth slowed to 8.1% yoy in 1Q12 from 8.9% 4Q11. Checked the details, FAI growth moderated to 20.9% yoy in 1Q (March =20.4%) from 21.5% yoy in Jan-Feb. Robust FAI growth sustains growth of China’s import demand of some major commodities like oil, iron ore and copper (11.3%, 5.6%, 50.5% yoy in 1Q, versus 12.5%, 10.6%, 38.7% in 4Q). Growth of retail sales (proxy for consumption) ticked up to 15.2% in March from 14.7% yoy in Jan-Feb. Chinese exports jumped a BTE 7.6% mom in March, more than reversing the 4% February drop. More importantly, bank loan growth increased at a 1.5% mom clip in March, in a hint that policy easing is working. Total social financing increased RMB1.86trn, compared to RMB1.04trn in February, along with a BTE +13.4% M2 growth.

Back to Asia, the positive news is that Inflation is still falling around the region. South Korea March inflation came in LTE at 2.6% yoy (3.1% in Feb). Indonesia March inflation picked up to 3.97% yoy from 3.56% in Feb, but core inflation is still drifting lower on y/y basis. I expect this downward trend to continue in 2Q- 3Q12 due to a favorable base effect and stable food prices. However, consumer price inflation could pick up again 2H12. Taiwan is lifting retail fuel prices by around 10% starting in May2012. In Thailand, the increase in minimum wage in Bangkok and six other provinces (effective on 1 April) could add 0.2% to inflation. In Indonesia, the 33.3% fuel price hike is likely to take place in July, instead of April, will lift headline inflation to 6.5% by end 2012. China and Vietnam have already raised their retail fuel prices, although the short-term inflationary impact is likely to be offset by stable food prices. This implies that room for Asian central banks to cut rates is becoming limited. However, conditions for hikes are not in position either.

The Spanish De”B”tiny

Spanish bond yields (10yr=5.94%) have spiked, dragging Italy along (10yr=5.49%). Concerns have intensified around growth, the budget and potential liabilities related to the regions, the banks, Portugal and real estate. This is despite positive policy actions taken in the last few months. The recent Spanish bond auction failure highlighted the market nervousness --- the European crisis is not over yet. The Spanish MoEF expects Spain’s debt/GDP ratio to increase to 80% by year end, from 69% at the end of 2011 even without bailing out the banks or the regional governments. Investors worried that deficit targets have not been met, and the debt load could deteriorate further if rates stay elevated, if Spain’s banking and regional debt problems worsen, or if global growth does not pick up materially to help offset Spain’s weak domestic demand. Spain needs to strike a particularly difficult balance between austerity and growth in an economy where employment has been decimated, consumers have been cutting back and real estate assets continue to lose value. Spanish PM Mariano Rajoy will likely pass the Budgetary Stability Act, but Spain’s confrontational attitude towards European partners is a risk for Spanish yields .

Given the underlying risks in Spain combined with budget slippage, market sentiment has turned pessimistic. Negative sentiment is pressuring Spanish and according to Moody’s, bond-implied ratings on Spanish regional bonds are 4 to 9 notches (depending on which issuer) lower than their Moody’s ratings, which range from Aa1 to Baa1. Spanish 10-year spreads vs. bunds are 100bp wider than their recent tight level of 300bp that was reached on Feb2012. Investors are increasingly skeptical that policymakers or the rescue funds will solve Spain’s problem quickly, and concern is mounting about contagion to Italy. Surely, I continue to believe that, if needed, support will eventually be forthcoming to avoid a restructuring or default in these large markets. Support could come from ECB through SMP bond purchases or additional LTRO liquidity, but ECB is reluctant to add to either program. The potential effectiveness of official bond purchases on the relatively large Spanish bond market is questionable. More LTRO funding would only be forthcoming if bank liquidity is clearly compromised, but Spanish banks loaded up on liquidity in December and February and have even been able to issue public debt recently, albeit at high rates.

Several comments during the press release clearly reveal ECB’s bias to now remain on the sidelines. Mario Draghi feels that ECB has done its part to improve the liquidity environment and that it is now up to governments, banks and the ESM/IMF firewall to improve the outlook for Europe. He underscored that the needed fiscal consolidation and strengthening of bank capital are out of ECB’s hands. Although the LTRO has worked to ease financial/banking tensions and unfreeze markets, the impact on the real economy is still uncertain. All of this suggests that ECB is in a ‘wait and see’ mode. Draghi was remarkably upbeat about the prospects for an increase in the size of the ESM rescue fund, and therefore about the availability of more help from the IMF, which further underscores that ECB is unlikely to provide more liquidity.

MXCN PB at 2008–09 low 

There has been an interesting divergence between industrial commodities and key equity market indices in recent months. For instance, copper and CRB index have been flat since the end of January, while the SP500 has soared. A similar phenomenon also exists between Chinese stocks and US equities. These market divergences are rare in recent history and reflect the fact that whiles US economy might have passed its “soft patch” and is re-accelerating, Chinese economy has been softening. In other words, the behavior of copper and raw materials suggests that the Chinese economy has not yet entered into acceleration mode.

Given the LTE 8.1% GDP in 1Q, the critical question going forward is how much the Chinese authorities will ease policy and how the Chinese economy will respond to new policy initiatives. We all know that there have been two major reflation or policy stimulation cycles in China (1999-2000 and 2008). In both periods, the Chinese government responded with force, implementing massive fiscal stimulus packages. The economy bounced back quickly and stock prices soared. In contrast, economic conditions in China today are very different from those of the late 1990s - early 2000s, or that of 2008. The economy does not face any imminent danger of a major slump as a result of a collapsing global economy. Instead, the economic slowdown in China is largely a result of the government’s monetary tightening campaign, which was launched three years ago to contain property speculation. Policymakers may have gotten too aggressive in cracking down on real estate speculation, creating undue damage to business activity as a result of an insidious credit crunch. Nevertheless, the authorities have also been quick in reversing some of the policy tightening measures to ease the pain, including the credit quota easing, the RRR cut and liquidity injection. Of course, the easing cycle is early and more reflation is obviously needed because growth may still be softening.

Going forward, I think several developments are worth noting ---1) investors should realize that it is unrealistic to expect a major reflation cycle similar to 1999 or 2008. That being said, it is also true that broad money growth is now below nominal GDP growth, indicating that the downward momentum pressuring growth has not been reversed;2) Chinese government has cut its growth target to 7.5% from 8%. This does not mean much as far as China’s economic performance is concerned, merely signaling that Beijing is no longer striving for fast growth with a one-track mind. Given that there are at least 6mn new workers entering the job market and 10mn laborers migrating from the countryside annually, the economy needs to grow by at least 8.5-9% a year to keep UNE rate steady; 3) inflation has always been a big hurdle for fast growth, and the Chinese government is particularly mindful of rising prices. The good news is that food price inflation is lower now compared with a year ago and oil prices have stayed virtually unchanged for the same period. This, together with softer economic growth, means Chinese inflation will likely fall further, creating more room for the authorities to promote growth; 4) China’s economic growth will continue to be led by investment rather than consumption. In fact, the Chinese household sector saving rate is similar to India’s. The reason China has maintained a very high gross national savings rate, is due to the high saving rate by the corporate sector.

Fundamentally, MXCN 2011 earnings were +15% yoy, which is 2% below consensus. Earnings decelerated meaningfully in 2H11 to single digits (7%), compared to 23% yoy in 1H11. Cyclicals were the main disappointment, with transport/IT/steel, aluminum/ metals/cement missing FY11 consensus by 6%-30%. Insurance and retail were also weak at 12%/7% below consensus. Meanwhile, ss of last Friday, approximately 80% of A shares have reported 4Q11 results. The summary is: in 4Q11, revenue growth 12%, net profit -8%, gross margin 33.4%, net profit margin 7.5%. On full year basis, total net profit grew 12%, but all driven by 24% earnings growth from financials. For FY2012, consensus earnings are now +12% yoy vs. sell side top-down +8%. Earnings revisions may not turn positive until mid-year, however, according to CS, MXCN price-to-book is at 2008–09 lows, with Real Estate, Industrials, Materials, Utilities, Banks, Insurance and Telcos at or below 2008–09 lows...….Lastly valuation wise, MSCI China is now traded at 9.6XPE12 and 12.5% EG12, CSI300 at 10.7XPE12 and 18.6% EG12, and Hang Seng at 10.3XPE12 and 4.5% EG12, while MXASJ region is traded at 11.7XPE12 and 13.6% EG12.

USD Remains Crucial

As Fed highlighted in Beige book, oil price is a major threat to growth now. With Chinese data somewhat patchy, US employment growth slowing, Europe still in the midst of a protracted recession and oil prices close to bearing down from their narrow USD121/bbl -126/bbl range, it is tempting to focus on the short-term downside risks. The reality is that any short-term weakness in energy prices is likely to prove limited, providing an opportunity to add to strategic storage, and potentially strengthening the case for higher oil prices in the second half of the year. Crude stocks should build in the coming months—they nearly always do in Q2. Putting this into perspective, by the end of 2012, global crude stocks are projected to return to broadly the same level they were at the start of this year—a level that left the market vulnerable to shocks in demand or supply. Subtract from that balance a further 350 kbd for Chinese stock building and inventories start to look tight again—hence prices likely move to $125/bbl in 4Q12.

The DXY index started 1Q12 at 80.27 and ended it at 79.00, with a quarterly high of 81.78 and a low of 78.10, confirming the choppy-two-way volatility. For 2Q12, I expect more volatility and a firmer tone to the USD, supported by economic divergence, narrowing interest-rate spreads, continuing event-risk in Europe and the end of Operation Twist in June. The USD call remains crucial for all major FX pairs, yet challenging as USD has been alternating between both peaks of the Dollar Smile. To recap, the Dollar Smile theory suggests USD typically weakens in “moderate” economic events (i.e. mild expansion or deceleration) and strengthens in more “extreme” economic events (i.e. recession or inflationary boom). Thus, USD has tended to be inversely correlated with global risk appetite, weakening when risk appetite is strong and vice versa. In Q1, I saw strong risk appetite and pockets of USD strength, causing speculation that USD had become more pro-risk. However, I think this USD performance was more a function of economic divergence rather than risk per se. More recently, US data surprises have turned down again, triggering initial USD weakness. However, I expect this US data deterioration to be more of a negative for risk than USD. Moreover, seasonal are typically less favorable for G10 and EM currencies against USD in Q2. Furthermore, Euro area-related event risk increases substantially in Q2 with the upcoming elections in France and Greece. Given the weak economic backdrop, i expect the ECB to cut rates again by 25bps in Q2. These three factors should weigh on EUR against USD.

Good night, my dear friends!