My Diary 734 --- Policy in the Central Roles; The Likely Scenari

My Diary 734 --- Policy in the Central Roles; The Likely Scenario of Fiscal Cliff; The Green Shoots of China; The Trends of USD and RMB

Sunday, October 14, 2012

 “IMF warnings, Q3 earnings and Political fighting” --- The IMF this week revised downward growth expectations for 2013 in most markets. The global economy watchdog expects global growth to be 3.3% and 3.6% in 2012 and 2013, respectively. This marks a downward revision from 3.5% and 3.9% back in July. The fund also warned of an "alarmingly high" risk of a serious global slowdown given fiscal issues on both sides of the pond and sees a 1/6th chance of global growth falling below 2%. In its October WEO, the IMF found that fiscal multipliers have probably been larger than 1, implying that severe austerity creates a negative feedback loop. On financial system stability it warned that delays in resolving the Euro zone crisis could see European banks B/S contract severely by USD2.8trn, or +7% of their B/S by the end of next year. This is up from a USD2.6trn baseline scenario projected back in April. Under a more pessimistic scenario, total deleveraging could reach up to USD4.5trn. With regards to the risk factors of the global outlook, the IMF said “the answer depends on whether European and US policy makers deal proactively with their major ST economic challenges.” Other risks include a renewed increase in oil prices and an inability to raise the US debt ceiling. The major wildcards regarding the near-term global growth outlook include the US fiscal cliff and the timing and magnitude of the Chinese policy response.

Having said so, I observed that equity markets are trading heavy lately, and giving back most of their gains of the past 1-2 weeks, despite no clear change in fundamentals. Other risk markets, such as credit, commodities, and the Euro periphery, are not following equities this time, indicating we are largely seeing profit taking after the hefty rally in stocks over the last four months. One of the big events of the week stateside is likely to be the start of Q3 earnings in the US as Alcoa again kicks-off proceedings on Tuesday. Consensus expects SP500 Q3 EPS to fall 2.3% QoQ, which would mark the first quarterly decline in 11 quarters. However analysts expect Q4 to be positive, and therefore the guidance will probably be as important as Q3 numbers for which weakness has already been priced in. According to Bloomberg, earnings pessimism among US CEOs is climbing to levels last seen when SP500 Index was mired in bear markets. Warnings that estimates are too high by companies from Intel to Caterpillar came even after analysts lowered predictions for Q3 income growth by 11%  this year. Meanwhile, SPX has gone up 14% this year, poised for the biggest annual gain since 2009. The rally pushed the gauge’s PE ratio to 14.5X, up from 13.7X at the end of 2011.

That said, global equities are up 10.2% on the YTD basis and investors remain cautious. In my views, equities and other risk markets can rally despite lackluster growth as they offer high risk premium against events that will not all come through. As a result of less volatility (VIX=16.14, -31% YTD) and tail risks, investors will over time gradually switch some of their defensive holdings into better-return, but riskier asset classes. This risk-premium-focused strategy into equities assumes volatility will remain subdued and markets will be buffeted by only modest adverse shocks. Indeed, I have not seen huge volatility from data or earnings surprises, with macro volatility having collapsed over the past 2 years. This leaves us with the political surprise factor, including another EU Summit, US elections, and Chinese leadership change, each of which with potentially momentous impact.

Political wise, the top priority of Chinese leaders will likely be stability and continuity, and the markets do not foresee a major change in direction nor worsening of the territorial conflict with Japan. The recent rebound in Chinese equities shows the market is hoping for positive news coming out of the Communist  Party Congress on Nov 8. The EU Summit on Oct 18-19 has an ambitious agenda on both long- and short-term issues. But the lack of an imminent crisis, thanks to the ECB's OMT promise, suggests we are unlikely to see much progress. Unfortunately, given the need to merge sovereignty, EMU members seem to be unable to make major decisions without being subject to undue pressure.

That leaves the US elections and nearing fiscal cliff.  According to the FT, the VP debate overnight was generally judged to be a more even affair than the Obama-Romney event last week with Biden aggressively defending the administration’s tax and foreign policy against Ryan’s criticisms. Post-debate polls on who won the debate are mixed, with a CNN and CNBC polls giving a slight advantage to Ryan, while a CBS poll gave the victory to Biden. Irrespective of who wins the elections, both parties will soon have to seek compromise on avoiding a recession caused by fiscal tightening, as it appears extremely unlikely one party will have a blocking majority. But into the elections, and the year-end decisions on taxes, inevitable political posturing, as neither side wants to show their cards yet, can easily have a depressing effect on economic activity, if not on risk prices.

X-asset Market Thoughts

On the weekly basis, global equities were down 2.03 % with -2.19% in US, -2.39% in EU, -2.37% in Japan and -2.09% in EMs. In Asia, MXASJ and MSCI China closed -1.54% and +1.83%, respectively, while CSI300 +0.50%. Elsewhere, 2yr USTs yield stayed flat 0.258% and 10yr’s narrowed 9bps to 1.66%. In Europe, Spanish 10yr sovereign bond narrowed 6bp to 5.584%, despite S&P downgraded the sovereign 2 notches to BBB- (outlook Negative). S&P had a higher rating to start relative to Moody's and Fitch so the magnitude of the cut was not a huge surprise. 1MBrent crude went up +1.74% at $114.21/bbl. The USD weakened 0.72% @1.2951EUR and stayed relatively stable to 78.44JPY. CRY index was down 1.26% to 306.55, while Gold price were down 1.2% at $1759.95/oz.

Looking forward, I agree with IMF that economic reform is the key to sustaining strong economic growth in EMs and restoring it in DMs. According to Standard Charter Bank, the pace of reform has slowed in many countries, apparently due to a mixture of complacency, resignation, disillusionment with market-oriented reforms, and political resistance. This follows a “golden era” of reforms in the 1990s which brought accelerated growth and improved living standards in many EM countries. The SCB economists estimate that failure to pursue vigorous reform is costing emerging countries 1-3% pts of GDP growth. Successful reforms could boost GDP per capita in 2030 by an extra 20% in Korea, Sri Lanka and Taiwan, 40% in Brazil, China, Indonesia, Nigeria and Thailand, and 50% in India.  For markets, economic reform is usually a major positive, boosting returns and smoothing volatility by encouraging economic growth, lowering interest rates and attracting new investors. Markets often move early, responding to expectations for reform ahead of implementation.

That being said, equity markets have risen strongly over the past few months in the face of weak economic and earnings momentum. The reason is that the Fed and ECB are providing open-ended "put options” via QE. During the past three years, stock markets have risen by 3% a month during periods of QE and fallen by 2% outside these periods. Now, with short covering largely behind us, the equity market appears to be lacking strong drivers. The US reporting season is generating a small positive surprise, but this is not enough of an impetus. A subpar 2% pace in global GDP growth for Q3 is not enough to change the pattern of stagnation seen in SP500 EPS since 3Q11. The street looks for a Q3 EPS of around USD26, similar to Q2’s USD25.8 and little changed from Q3 2011. I think the US reporting season provides two interesting themes --- 1) domestically oriented US companies are the ones whose earnings are outperforming, suggesting a focus on US-centric stocks; 2) financials will likely be one of the bright spots in Q3 driven by improving credit and loan demand and a solid recovery in US housing. In addition, in the EM equities, value stocks are likely to be the biggest beneficiaries from the easing of global financial conditions. I think investors should avoid taking a position on the strength of the global economy, where there is heightened uncertainty about growth, both on the upside and downside.

Policy in the Central Roles

Most of the sell side economists are forecasting a modest accelerating of global economy toward year-end as the recent combination of faster consumption growth and still-sluggish manufacturing sector sets the stage for a fading inventory drag and firming business sentiment. However, the key challenge remains the recent poor performance of capital goods. August data show that G3 capital goods shipments, which are a close proxy for global business spending, are on track for a decline of around 4% yoy in 3Q12. The growth of global capex already was very soft in 1H12, averaging near 1.5%. With G3 shipments recently falling, the forecast assumes that global capex declined in 3Q12.

Regional wise, US economy continues to expand but at a lackluster pace.  With additional data on August foreign trade (-44.2bn) and wholesale inventories (+0.5%) out this past week, real GDP growth last quarter is tracking just a bit lighter than expected and the quarterly real GDP forecast is revised slightly lower to 1.4% saar (from 1.5%). The first October business surveys, regional manufacturing surveys from the NY Fed (Monday) and Philly Fed (Thursday) and the Homebuilders survey (Tuesday), will condition views on activity early in the quarter. Across ocean, Euro area business surveys have been sending a clear message of ongoing recession in 3Q12. However, the incoming IP data have not been playing to this script, even in the periphery. With back-to-back gains in July and August, Euro area IP is tracking up 4% so far in 3Q12, after almost one year of contraction. Seasonal adjustment problems are likely contributing to this. In China, next week’s release of 3Q GDP and September activity data are expected to bolster confidence that economic growth is lifting very gradually toward trend. The GDP report is anticipated to show that growth rose modestly to 7.4%, up from 6.7% in 2Q. IP is likely to fall to 8.7% yoy, FAI growth to remain flat at 20.2% yoy, while retail sales growth to remain flat at 13.2% yoy. September’s CPI inflation will likely fall to 1.7% yoy (August: 2.0% yoy).

Policy will play a central role in the 2013 outlook. Policy uncertainty or expectations about next year’s stance may already be influencing activity including the recent softness of business demand. After assuming that an agreement is reached that avoids the worst of the US fiscal cliff outcomes, the markets anticipate a DM world fiscal drag of >1% of GDP next year. The fiscal stance for EM countries is expected to be broadly neutral. The offset to global fiscal drag --- and what is now approaching two full years of subpar global growth --- by monetary authorities looks small. Notwithstanding the broadening in the set of countries that have eased --- with Brazil, Korea, and Australia delivering the most recent cuts --- global policy rates have fallen only 43bp over the past year.

The Likely Scenario of Fiscal Cliff

Bonds edged higher on the week, but essentially remain in the very narrow range. That overall stability masks some striking crosscurrents, however. One is the Fed-fuelled compression of US MBS spreads, given an extremely tight supply demand balance. Another is the better tone in Euro area sovereign debt markets. I agree with the broad view that the promise of the OMT backstop marks a major step forward in the Euro area’s crisis management, and are encouraged by some tentative signs of capital returning to the periphery. These include a fall in Spain's Target 2 balance and bond managers' shift to OW peripheral bonds, for the first time since 2010, as reported by ECB.

Having said so, there is a battle underway between two forces for control over the performance of IG corporate bond market --- aggressive Fed policy vs. the looming fiscal cliff. Since mid-Dec2008, when the Fed first broadcast that it intended to do whatever it takes to prevent a meltdown in financial asset prices and a slide into debt deflation, the IG bond market has outperformed. Since then, each time the market sneezed, the Fed stepped in with a new dose of stimulus, which drove spreads steadily tighter (5Y NA IG CDS spread -59% YTD vs. HY -26% ). The Fed’s latest announcement of a new round of asset purchases was no exception and the option-adjusted spread of the IG index (55.6) has narrowed 16bps since the FOMC meeting on Sep 12-13.

While an aggressive Fed provides a firm tailwind for risk assets, additional monetary stimulus cannot possibly offset any meaningful fiscal contraction next year. Some argue that the fiscal cliff will not happen because politicians in Washington know that the economic fallout will be too great. The full fiscal contraction implied by current law (about 4% of GDP) will be avoided, but some fiscal drag remains likely, in the order of 1-2%, no matter what the outcome of the election. The fiscal cliff issue has received considerable coverage, yet risk assets have not made much allowance for the potential disruption that the coming debate among policymakers may incur. The most likely scenario is that Congress agrees at the last minute to temporarily extend the Bush-era tax cuts and delay the sequestering to provide more time for debate. The final showdown among policymakers is likely sometime in Feb-April 2013, when the debt ceiling again becomes binding and a compromise can no longer be delayed. At some point in the process, investors suffer a replay of the 2011 debt ceiling debacle. Recall that the corporate bond market registered a severe selloff in Aug2011 as spreads jumped by 64 bps in a couple of weeks.

The Green Shoots of China

The latest grass-root researches over the micro & macro economy of China indicate that the Q3 growth remains downbeat. In September, some of the upstream industry improved slightly, i.e. restocking drove steel prices rising, cement sales show signs of recovery in the East and South China, but overall trend is still weak. On the micro level, I am yet to observe obvious improvement to the infrastructure projects and to the actual needs of the raw materials. Friday’s trade data reveal that iron ore imports slumped 29.3% yoy after contracting 20.9% yoy in Aug. Real estate sales in September is slightly LTE, with the housing prices have begun to impact the sales in some cities. Golden week sales were up only 15% yoy, the lowest growth since 2007.  Department stores and supermarket sales were all WTE, as suggested by Luk Fook, Intime, Belle and Daphne’s results. Shipping in September was not busy as well with overall shipments fell 20%. As a result, all routes saw different degrees of lower freight rates.

However, financial markets believe that the growth of the world’s second largest economy may be quickening. Chinese stocks have begun to advance of late, coinciding with a notable rebound in global commodity prices, both of which are sensitive leading indicators of the Chinese business cycle. Surely, the rebound in China-related assets may be attributable in part to the implementation of the Fed’s QE3 and easing pressure in the Euro crisis. With investors becoming increasingly pessimistic about China’s outlook and major brokers slashing growth forecasts, there are some tentative signs of growth recovery. September saw a jump in export growth to 9.9% yoy in Sep (vs. cons=5.5%) from 2.7% in Aug and a nice rebound of import growth to 2.4% yoy after contracting 2.6% in Aug. While China’s M2 money supply rose at BTE at 14.8% yoy in Sept (cons=13.7%), compared to 13.5% yoy in August. Bank loans rose 16.3% yoy in September, picking up modestly from 16.1% yoy in August. New loan creation came in LTE at RMB623.2bn in September (cons=700bn), following 703.9bn in August.

In addition, there are signs that domestic demand is already beginning to strengthen, aided by both infrastructure spending and housing investment. After a two-year sharp deceleration, capital spending in infrastructure has increased strongly in recent months compared with a year ago, alongside projects financed by fiscal budget. Last month, the government approved a list of major infrastructure projects, which suggests that another policy-driven infrastructure spending cycle is beginning to unfold. It is unrealistic to expect another massive construction boom like what took place after the global financial crisis. The important point, however, is that spending on public projects, a major drag on economic growth over the past two years, is once again becoming a driving force. Meanwhile, the housing sector continues to improve, and the recovery is spreading from housing demand to supply. Rising sales are improving the financial situation and confidence of real estate developers, which should in turn encourage them to expand in due course. Indeed, land sales have picked up sharply in recent months after a deep contraction, and new housing starts are also beginning to reaccelerate. While policymakers are not ready to ease their tight grip on the housing sector anytime soon – especially if home prices begin to move up substantially, a further broad crackdown on housing activity is highly unlikely. Looking forward, barring a major relapse in external demand, the case is strengthening that China’s growth may have approached a bottom. This suggests that Chinese growth could be near an inflection point.

Same as US, we are approaching the Q3 earning season. Many A-share strategist expect Q3 non-bank earnings decline to be worse than Q2, down further to -17% to -18% vs. -17% in Q2.  This means continue to disappoint the market expectations of bottoming out.  Q4 likely flat yoy, but that's due to low base last year.  A share market has been dragged by poor earnings this year.  Earnings disappointment started last Q4 and getting worse each quarter.  For 2012 full year, it is estimated that we will see earning -13% to -14% vs. consensus -10%. Bright spot is for 2013F, market expects 10% growth. I think this fits well with current macro environment, where the problem is most sectors have poor pricing power due to weak demand. Without a pickup in economic activity, rising input/labor costs will cause margin contraction..….Lastly valuation wise, MSCI China is now traded at 10XPE12 and 3.3% EG12, CSI300 at 10.8XPE12 and 7.9% EG12, and Hang Seng at 11.1XPE12 and 4.2% EG12, while MXASJ region is traded at 12.3XPE12 and 6% EG12.

The Trends of USD and RMB

The market has been looking for USD weakness on the back of increasing signs of stabilization in the global economy. However, in practice, it has been driven by policy actions from the ECB and Federal Reserve, which have reduced market tail risks and injected liquidity. From here, I expect the USD to remain generally weak into year-end before a more mixed performance in 1H13.

In the big picture, the fundamentals of all of the G4 remain very poor, with anemic or even negative growth, substantial debt burdens, deteriorating credit quality and low carry. With G4 fundamentals similarly weak, the USD is better able to hold its own. Moreover, economic and political divergence from the US in the wake of the European debt crisis means that relative US economic outperformance should support a more favorable move in interest rate spreads, and thus the USD, against Europe.  More broadly, I believe fundamentally that the USD multi-year downtrend from 2002-10 is over. It has not yet been replaced by a sustained USD uptrend – which would require materially lower current account deficits – but the downtrend is over. Accepting this requires some adjustment to the premise of the “Dollar Smile”, which says that the USD weakens during moderate economic trends, but strengthens in more extreme economic trends. The “dollar smile” works well in a synchronized world with simultaneous economic experiences, and less well in a situation of divergence.

For RMB, the market now expects RMB gains to average 2.5% p.a. over the years from 2012-16, down from 3.2% in the previous profile. The vast majority of these gains are expected beyond 2013 – the anticipated RMB gain of just 1.0% for 2013 would be the weakest full-year CNY appreciation since the 2005 de-peg.

The case for a substantial change in the RMB TW value in either direction is weak at this point. There is much to support the mainland authorities assertion that the RMB is not far from equilibrium, with the slump in the current account surplus to 1.9% of GDP this year from 10.1% in 2007 undermining a key argument for new RMB gains. Robust domestic demand relative to the G10 economies has played a powerful role in trimming external imbalances. Notably, there are also signs that China’s export gains may be slowing, even adjusting for the weakness of export markets. The CA surplus will likely still prompt new PBoC FX intervention, but this reflects an absence of private-sector surplus recycling rather than the size of the surplus itself.

Good night, my dear friends!