My Diary 737 --- Fiscal constraints vs. Lower Inflation; Term pr

My Diary 737 --- Fiscal constraints vs. Lower Inflation; Term premium vs. Expected Rate Path; A 360° Analysis of Chinese Equities; Some Discussion on USD and Commodity

Sunday, December 23, 2012

“The Mayan apocalypse & Merry Xmas, The US fiscal cliffs & Market outlook” --- I would like to take this opportunity to say “Happy Holidays” to everyone and many thanks for reading in 2012 and for the support and interaction.  That said, as markets around the world count down to the end of an eventful year, I saw the downside risks to global growth stemming from Europe and China are diminishing, while political uncertainty persists in US. More importantly, investors now have better visibility on most of the global political event risks (China, Japan, Korea). Meanwhile, QE money flows continue to flood HK and currency markets (Liquidity is abundant with the HKMA having injected another HKD5.04bn to the currency market with aggregate balance now reaching HKD245.8bn since QE3)

One thing, which made the year of 2012 different, is the political power transition in many countries.  Earlier, President Obama captured a second White House term. While Romney and Obama both spoke of the need for unity and healing the nation's partisan schism, the election did nothing to end America's divided government, with many domestic and foreign issues to be solved, including  fiscal cliff battle,  Syria's civil war and Iran's nuclear program, etc. But, Obama's victory comes as a relief to China since Romney had pledged to declare it a currency manipulator, potentially leading to sanctions and escalating trade tensions. In China, 2012 marks the end of the Hu-Wen era. The power transition this year was accompanied by a sharp economic slowdown and various high-profile political scandals, making it all the more dramatic and confusing. The dust began to settle toward year-end, and the power transition is expected to finish early next year.

In the rest of Asia, Park Geun-hye becomes South Korea's first female head of state, and she is also the daughter of late dictator Park Chung-hee. Park, who is unmarried, faces economic as well as political challenges in her new job. South Korea faces a large wealth gap and high youth unemployment, and North Korea remains a constant diplomatic challenge as well as a looming security threat. In Japan, the LDP leader, Shinzo Abe, becomes the nation’s next Prime Minister. Looking at his policy statements, Abe promises a return to the days of frivolous government spending and easy money — policies that have already proved unable to extricate Japan from 20 years of economic malaise. And this time around, the damage could be severe as such promises could seriously weaken Japan’s already fragile financial position. More importantly, there was a strong current of nationalism running through Shinzo Abe's campaign. He took a hawkish position on territorial issues with China over disputed islands in the East China Sea., which created nervousness.

In the coming month, US politics play the key as cliff clock continues to tick and a deal before the Christmas break is now looking increasingly unlikely. Cliff concerns have lifted market volatility into year end with the VIX up 14.25% in the past 3 days. No matter who gets the upper hand in the fiscal cliff battle, the outcome is almost certain to do little to address the longer-term fiscal sustainability issues the country aces.  I think the cornerstone of any possible deal is an extension of the lower- and middle-income Bush tax cuts, coupled with increased upper-income revenue.

Macro wise, contrary to concerns that fiscal cliff uncertainties would depress business spending into year-end, US employment and capital spending appear to be lifting. Indeed, the important shift toward caution on the part of corporate took hold earlier this year. Firms across the globe watched profit growth slow and became concerned of a more intense margin squeeze because of risks emanating from China and the Europe. In response, global spending and hiring growth slowed around midyear with both US and global equipment spending contracting in 3Q12. Manufacturing production also fell sharply. In the event, global final demand growth lifted modestly in 2H12 as solid performances from non-Japan Asia, the US, and Brazil have offset contractions from Europe and Japan. As a result, firms have seen profits grow and inventory positions gradually get leaner. Combined with the fading of concerns about China and the Euro area, these developments are generating a sigh of relief from firms. The bounce in US capital goods orders and the lift under way in our global PMI survey is the manifestation of this sigh.

In the background of these swings in business activity has been the relatively stable and solid profile of consumer goods spending. Although there has been significant MoM volatility, the 6-month yoy gain in global retail sales volumes has remained close to 3% throughout this year. The outlook for the consumer over the coming months has however turned more uncertain as two powerful forces are expected to pull global consumers in different directions --- 1) inflation slide delivers a purchasing power lift. Global inflation is now moving sharply lower due to falling energy prices and weak pricing power for finished goods producers. 2) fiscal policy depresses income. DM fiscal policy is set to tighten more aggressively in 2013, with much of this drag falling on households.

Policy side, the decisions make by FOMC (continue to buy USD85bn securities/month in 2013) and BoJ (additional JPY10trn asset purchase)  are simply to push the size of B/S higher as both central banks constrained by the ZIRP bound. However, the important policy signal is shifting away from B/S expansion toward communication policy --- the signal policymakers send about their objectives (Fed: .5% UNE rate and inflation tied to committee projections and its assessment of LT inflation expectations), and how they react to changing economic circumstances. The healing the ECB has set in motion by finally committing itself to a backstop role (with some conditionality) is seen in the narrowing of spreads and stability of European financial market conditions since the launch of the OMT program. As the markets saw important new initiatives delivered from Fed and ECB in the recent months, BoJ and BoE are set to come under significant pressure for change next year alongside leadership changes.

Having said so, one thing to watch is that demands on Asian central banks are heating up in the face of the global economic downturn and amid political leadership changes, raising questions about their ability to remain independent in setting policy. Many monetary authorities in the region have been aggressive in cutting interest rates and then keeping them low. But lawmakers have stepped up calls for more easing --- and that is likely to pick up as more countries head into election cycles in 2013 and 2014. The issue has come to the fore with Japan's incoming Prime Minister Shinzo Abe pressing for, and securing, pledges of looser policy.

X-asset Market Thoughts

On the YTD basis, global equities were up +13.45% with +13.82% in US, +13.91% in EU, +14.97% in Japan and +13.91% in EMs. In Asia, MXASJ and MSCI China closed +17.89% and +17.17%, respectively, while CSI300 +1.12% only. Elsewhere, 2yr USTs yield widened 3bp to 0.27% and 10yr’s narrowed 11bps to 1.76%. In Europe, Greece 10yr sovereign yield narrowed 1699bps to 11.39% and Italy 10yr also went down 249bp to 4.46%, while Spanish 10yr  added 20.9bp to 5.20%. 1MBrent crude went up +2.09% at $109.83/bbl. The USD weakened 1.75% @1.3188EUR and strengthened +9.53% to JPY84.24. CRY index was down 3.66% to 294.13, while Gold price were UP 5.21% at $1658.5/oz.

Looking back, in 2012, liquidity played a vital role in propping up asset prices, even though growth disappointed. The divergence between German share prices (DAX +29.5% ytd) and its IFO index (-4.5%) is a vivid example. This demonstrates how liquidity and improving investor sentiment boosted German equities at a time when the country’s growth and manufacturing sector has suffocated. Meanwhile, despite having declined, equity cross-correlations have remained above average in 2012. High equity market correlation implies that large abnormal returns, or alphas, should be scarcer, making it more difficult for asset managers to add value. In fact, the importance or size of alpha has been depressed over the past three years by elevated market volatility. This suggests that the outlook for volatility is a key factor for investors seeking alpha. Volatility is likely to remain elevated as long as real growth remains subpar. In the near term, this means that the equity market is likely to remain at least partially in a “risk on/risk off” mode due to the impact of the fiscal cliff negotiations, and the potential for a renewed flare up in Europe.

Looking forward, the major theme in 2013 will be the tug of war between global central banks’ continuous monetary stimulus and global economic growth. Global growth has decelerated markedly, as evidenced by the stalling growth of world trade volume (+1.36% yoy). Consistently, global cyclical stocks and the EM equity benchmark have been in a trading range in absolute terms and since late 2010 have substantially underperformed defensive stocks. That being said, in 2013, global growth will be a more important variable than liquidity in defining trends in equities, especially EM stocks. Equities have been cheap relative to IG corporate bonds and HY bonds for some time, in part reflecting an elevated equity risk premium. The beginning stages of the mean reversion in the ERP as growth shifts to an above-trend pace should therefore be accompanied by a sustained outperformance of stocks.

In addition, many non-cyclical equity sectors both in the DM and EM markets have already benefited significantly from liquidity, and are richly valued. Historically, multiples expansion in equities occurs only at times of expanding earnings. When profits are shrinking, equities cannot be re-rated on a sustainable basis, regardless of liquidity conditions and interest rates. This is why cyclical equity sectors that have reasonably low multiples can enter a genuine bull market only if their profits improve. Therefore, if global growth picks up going forward, corporate profits in global cyclical sectors as well as in EM will improve, and the latest rally in EM share prices will be extended. However, if global trade begins to contract – even marginally, earnings for EM will further disappoint, and share prices will relapse anew. A benign liquidity backdrop may not be sufficient to prevent their slide.

Fiscal constraints vs. Lower Inflation

The Nov-Dec global data flow is bolstering confidence that the global economy is lifting modestly as we move to the end of 2012, with temporary drags are fading fast, including Hurricane Sandy, the China-Japan dispute, and auto industry volatility. Data wise, US dataflow was encouraging  with final Q3 GDP was revised up to 3.1% due to a combination of stronger personal consumption (1.6% vs. 1.4% previous), net exports (-$395B vs. -$403B) and government (3.9% vs. 3.5%). Inventories ($60.3bn vs. $61.3bn) were only revised slightly lower. The Philly Fed's manufacturing index recovered in December (8.1 vs -3.0 expected and -10.7 previous) driven by new orders and shipments. Existing home sales topped expectations in November (5.04mn vs. 4.90mn expected. Finally, jobless claims increased to 361K vs. 344K the previous week, settling broadly at the average that was recorded prior to Hurricane Sandy. However, the concerns remain as this kind of growth is hard to support robust job gains that will bring the UNE rate down faster, thereby keeping in place the highly accommodative stance of the Fed for quite some time. Moreover, Chairman Bernanke said a tightening in fiscal policy is a “major risk factor” that is already harming investment and hiring decisions by causing “uncertainty” or “pessimism.” The central bank “doesn’t have the tools” to offset that event, he said during a Dec. 12 press conference.

That said, December manufacturing flash PMIs rose this week (US, China, and Euro area), suggesting that global output and orders readings will continue the upward trajectory that began last quarter. This week’s BTE Nov IP reports from US and China support the view that global manufacturing is lifting. The risk to sell side China economists forecast is that Chinese growth could have the potential to be lifted above 8% this quarter. The risk is, however, the current lift in global retail sales gains will fade quickly in response to fiscal drags, limiting the pickup in GDP growth. Aside from US fiscal cliff, a key outlook issue is whether the improvement in wholesale financial markets generated by ECB actions will support Euro area growth next year. The decline in average effective lending rates for households and corporate seen since midyear is consistent with a financial lift to growth, but rate declines appeared to have stalled in September and October. The M3 report for November (January 3^rd) and the MFI interest rate report (January 8) will provide an important update on how financial conditions are evolving.

Another power force for the growth in 2013 is inflation. While not as volatile as in 2010-11, commodity prices have whipsawed over 2012 as the ebbs and flows of geopolitical risks in the Mideast have been amplified by midyear droughts. The result has been an extremely volatile year for inflation, with swings in purchasing power translating quickly into spending behavior. This roller-coaster ride is set to end the year on a positive note. PP is getting a sizable boost as sequential inflation rates tumble on the back of declining energy prices and stabilizing agriculture prices. After peaking at a robust 4.2% yoy in the 3-month through October, global inflation now looks set to tumble to a very soft 1.5% rate in the 3-month through December, an outcome supported by this week’s soft inflation readings from US (-0.3% MoM) and across most of Europe (-0.21% MoM). The result is likely to produce acceleration in consumer spending into year-end that will aid in the manufacturing inventory correction now under way. As global inflation is pushed around by the volatile food and energy components, underlying inflation is drifting lower. Two years of below-trend growth has increased economic slack and relieved overheating pressures building in parts of the EM. Core inflation has slid to 1.9%oya as of October, and this downward pressure will likely continue.

Term premium vs. Expected Rate Path

During a slow growth environment, the expected path for interest rate differentials is a key determinant of government bonds performance. But in the aftermath of the 2008 credit crisis, monitoring the size of central banks B/S has also become critical due to ZIRPs. In 2013, the Fed’s B/S should expand faster than the ECB) The ECB’s B/S will stagnate until a member country requests financial assistance and is eligible for ECB purchases under the OMT program. For now, there is no urgency for Spain (or any other country) to accept a new financial rescue as the country can still borrow at affordable short-term rates in the market. Even if the ECB begins buying bonds under the OMT program, it will very likely lag the 35% expansion expected in the Fed’s B/S in 2013. The Fed will be buying over USD1trn of USTs and MBS next year. It is difficult to see the ECB buying an equivalent amount of distressed Spanish or Italian debt. Meanwhile, poor euro area economic activity means that the ECB has the scope to resume cutting its benchmark interest rate, but this is already reflected in the OIS curve. Real interest rate spreads are expected to gradually move further in favor of a stronger EUR. 

But, this does not mean that Euro area risks have clearly not gone away, though some constructive progress on Banking Union coupled with a more vague set of commitments on longer-term integration came out of the latest Summit. The reduced risks related to the European sovereign debt crisis and the potential for a hard landing in China is positive to European bond markets. But it is hard to argue that the Euro area comes out of this Summit with its firewall complete as it remains unclear --- 1) when the ESM will be able to act as a backstop to regional banks, and 2) whether it will be capable of being applied to existing problems (legacy assets). It remains unclear how ‘legacy assets’ will be defined. Beyond this, the questions are largely second order. The path towards further integration, including the possibility of a ‘solidarity’ fund or an embryonic Euro zone budget, will take a long time. I don’t think that investors should expect significant progress before next year’s German election.

Back to US, the nation’s political dysfunction determines whether the federal fiscal drag next year might drive the economy back into recession. Absent such headwinds, the US economy may be on the verge of returning to or outpacing a trend growth rate. The deleveraging cycle is well advanced, the housing market has responded vigorously to Fed stimulus, consumer confidence is firming and the fiscal drag from state and local governments is nearly complete. As a result, I expect a strong correlation between the term premium component in UST curve and the expected time to Fed rate liftoff has been reinforced by the shift toward outcome-based guidance. If UNE growth unfolds according to the Fed’s base case, the term premium will rise from -70 bps to its equilibrium level of about 50bps over the next two years. The next several months could be rather volatile for both rate expectations and the term premium until a more robust pattern of employment growth is established. Nevertheless, the trend in the term premium will be steadily higher on a one to two year horizon.

A 360° Analysis of Chinese Equities

The latest CEWC is the most important annual event in the past 3 year for China, as the newly elected policymakers were gathering to build consensus and map out major policy directions for the coming year. The results are not unexpected. The stance on both fiscal and monetary policies remains unchanged in 2013 vs. 2012, and GDP growth would likely be kept at 7.5%. Urbanization is highlighted as the most important structural driving force of the economy. The work conference was frank about the domestic and international problems confronting China in the year ahead. "We face a number of risks and challenges," the statement said. "The problems of unbalanced and unsustainable development remain. Growth faces downward pressure. There is excess production capacity. Enterprises face rising operation costs and capacity to innovate is inadequate. There are latent risks in the financial sector."

That said, the most recent macro data (PMI 50.9, Power consumption +7.6% yoy, IP +10.1%, Retail sales +14.9%, FAI+20.7%, Real Estate +28%) confirm that the Chinese economy has turned the corner from a cyclical perspective – something that is also being reflected in equity markets. It is now almost certain that fourth quarter GDP growth will trend higher. The critical issue is whether the budding growth recovery is just a temporary blip or has staying power. My view is that the current business cycle expansion is still at an early stage, and the recovery phase will last for at least three to four quarters. If so, Chinese equities will remain well bid in the coming months. Historically, China’s business cycle expansion has predominantly been driven by credit expansion and capital spending accompanied by fiscal and monetary easing. In turn, the peak of the business cycle is typically associated with bottleneck constraints in the economy, heightened inflationary pressures and concerns of asset market bubbles, which eventually leads to policy tightening and administrative controls. So far China’s developing business cycle expansion is driven by several factors --- 1) the resumed expansion of credit; 2) the ramping up of public sector capital spending, and 3) the stabilizing export sector performance after a period of a sharp slowdown. The global outlook is turning better, showing signs of bottoming for the first time since global demand peaked in mid-2010.

The question is whether business cycle expansions could help corporate profits. The most recent data suggest that the industrial sector registered a sharp profit rebound in October, rising by 20% from a year ago, from 8% and -6% respectively in September and August. The monthly profit numbers have historically been volatile, and the latest numbers have most likely exaggerated the profit trend. However, it is safe to conclude that the sharp slowdown in China’s profit cycle is late, if not already over. Looking forward, the ongoing business cycle expansion will likely lead to increased volume and improved margins, leading to quicker profit growth. From a macro perspective, interest rates, the exchange rate and the cyclical trajectory of the economy, have been the three key drivers behind China’s profit cycles, all of which are showing signs of improvement at the moment.

That said, 2012 witnessed a material deterioration of investor sentiment on China’s growth fundamentals and stock prices. The economic slowdown, structural imbalances, political uncertainty associated with the leadership transition and some accounting scandals of Chinese companies created a perfect storm for Chinese stocks, pushing their valuations to record low levels. To be sure, all those concerns are legitimate and deserve close scrutiny. However, the sharp multiples compression also means that the market has assigned a large risk premium toward Chinese equities. Sentiment wise, according to Morgan Stanley’s global survey in US (+60 accounts overall), the majority of the US LOs are still UW in HK/China with very little exposure in the Chinese banks (arguments would be "why buy Chinese banks with potential asset deterioration issues and trading at 1x book, when the US banks have improved their books and are trading at 0.5x"). Learning from the history, once the Chinese company earnings recovery is visible, I would expect global portfolio allocation to rotate to China/HK equity.

Finally, there are various debates over the disastrous performance of domestic A shares compared with HSCEI and MXCN. I think this may be attributable to several factors. The valuation starting point of A shares was more demanding than their H-share and red-chip counterparts two years ago, and the lagging performance is to some extent a valuation adjustment process. Furthermore, the Chinese domestic A-share market is much more driven by retail investors, compared with red-chips and H shares which are much more institutionalized. This also means that the A-share market has historically been much more emotional and volatile than its investable counterparts as well as other major global bourses. Indeed, the Chinese economy is neither bulletproof nor a house of cards. However, investor sentiment swings between these two extreme views, leading to wild oscillations in Chinese equity valuations over the years. It is hardly a prudent strategy for investors to pay hefty premiums to buy the growth story without proper assessment of risks, as the case in 2007. But it is equally wrong to shun Chinese shares when they are completely de-rated and are trading at deep discounts to their EM and global peers. The record-low valuation levels currently in place means the trade-off is decisively in favor of risk-taking in Chinese equities…… Lastly valuation wise, MSCI China is now traded at 10XPE13 and 10% EG13, CSI300 at 10XPE13 and 17.6% EG13, and Hang Seng at 15.2XPE13 and 9.8% EG13, while MXASJ region is traded at 11.5XPE13 and 14.9% EG13.

Some Discussion on USD and Commodity

Judging US politics in tandem with other global developments over the past month, the mid-term USD path in early 2013 seems much clearer than the ST direction over the next few weeks. Mid-term, the Dollar will likely be undermined by --- 1) Fed policies which are keeping real rates at an extremely low level (-80bp, based on 10yr TIPS), 2) China's growth upturn, which has renewed demand for EM Asian and commodity currencies, and 3) Europe’s ability to manage sovereign stress through the ECB's OMT program, which drives a modest reallocation into cheap European assets. However, over the next few weeks, USD will probably gain 1%-2% vs. commodity currencies but lose about 1% to JPY. This pattern is typical during market deleveraging driven by US growth concerns, and anxiety around the US’s growth momentum will likely persist until Congress negotiates smoother fiscal cliff. It seems a given that the US will undertake at least 1% of GDP fiscal tightening next year.

As a whole, commodities have been in a choppy range for over a year now so what will it take for them to get back onto a more bullish track? The key long run determinant of this is physical demand, which is heavily linked to global industrial activity and thus the strength of the global economy. China is especially important given its very large share of global demand across commodities. China’s slowing economy has been a significant drag on commodities over the last few years and this likely need to stop before we can get any material bull market in commodities. This brings us to an interesting observation. Chinese policymakers can only provide stimulus to boost their economy while inflation is contained. However, as China accounts for such a high share of demand for so many different commodities, a sharp rise in demand pushes up commodity prices, and thus Chinese inflation. This is especially true for agricultural commodities and thus Chinese food prices, which are one of the most volatile components of inflation and particularly important in maintaining social stability. It thus seems unlikely that China can grow at its pre-crisis double digit pace and maintain a low level of inflation going forward. This creates a conundrum for policymakers in China and may well be one reason why Chinese stimulus efforts have been so much more subdued this time around. This means that for us to go overweight commodities, we really need a sustained pick-up in global growth.

Good night, my dear friends!