My Diary 376 --- Inflation on Radar Screen; Has Recession Priced-in; China has Two Targets; Reversed Currency Models

February 21, 2008

Overnight, the news focused on the Fed downgrading its forecast of future US economic activity (from1.8% to 1.3% GDP), citing damage from the double blows of a housing slump and credit crunch. Fed also expects higher unemployment rate (5.2%) and inflation (2.2% core). It looks like that the growth-inflation mix has deteriorated and US remains on the razor’s edge of recession … Hopefully the economy will not go too far into the worst scenario of “Staginflation” under which both equity and bond will be dead. Moreover, volatility remains high witnessed by the flip-flop in the US Dollar, equities, bonds and commodities and VIX index was range-traded at 25-30.

Intra-day today, Most stock benchmarks in Asia advanced 1.7% (except China/HK), led by electronics exporters and metals producers, measured by MSCI AP, on the hope of better earnings prospects from tech sector. Nikkei 225 rose 2.8% as YEN strengthened, while Chinese indices are flat, including CSI 300 (4876), ‘HSI (23623) and HSCEI (13561). The 1M WTI contract stayed high @ $100.02/bbl. The price of oil has risen +$13 over the past two weeks. As a group, base metals were flat on the day. The 2y UST yield (2.18%) moved up 9bp while 10yr ticked down to 3.88%. The US Dollar strengthened a touch against ten @108.11, but not EURO @1.4727…

Weather side, Hong Kong now is much warmer than it was during the Chinese New Year……But has inflation any correlation with the temperature?...

Inflation is on radar screen

Globally, inflation is making news everywhere, ranging from the commodity prices to national CPIs. Market wise, with 1M WTI contract price rallied to close just above $100/bbl, rising 7% YTD, compared with gains of 17% in agricultural and 16% in metals. The ongoing rise in global commodity prices will continue to reallocate income from net commodity-importing countries to exporters, many of whom are in the emerging world, including China. Having said that, the sustained high raw materials and commodities prices are not good news for consumers in the developed economies, where growth is already slowing down. According to BBG, in 4Q07, the squeeze on household purchasing power from higher food and energy prices ranged from +1% yoy in Japan, to 2.5% yoy in US and to almost 3% yoy in EU.

Looking forward in 1Q08, this drag is forecasted to be less due to the advance in energy prices not matching the magnitude of last quarter, but there may be less relief than we expected. In addition, EU’s unit labor cost growth has been subdued relative to the movements in the unemployment rate and headline inflation. Thus, a period of catch-up may be in store, similar to what happened in the early 2000s…Keep an eye on it… In the US, a simultaneous rise in unemployment and inflation (Deflation vs. Inflation Fight) will pose a dilemma for Chairman Bernanke.

Looking back to the history, during 1970-80s when inflation rose to almost 15% and unemployment reached 9%, US economy went through three recessions after Fed dramatically boosted interest rates. Yet there are similarities. As in the 1970s, surging commodity prices are leading the way as suggested by that crude oil rose to a new nominal high (near 1980 inflation-adjusted peak) and wheat prices have hit a record. Moreover, as in the 1970s, the rate at which the US economy can grow without generating inflation has fallen, mainly due to lower growth in labor force and productivity. Today's circumstances are far from that. Inflation is lower while unemployment has risen, but only to 4.9%. The biggest difference is that in the 1970s, the Fed was unwilling to bring inflation down, while the Fed today sees achieving low inflation as its primary mandate.

Has recession priced in?

Overnight, even though home sales and housing starts/permits continue to plummet, the sentiment index (NAHB Housing Market Index 20 vs 19 consensus) was near expectations. Personally, I remain skeptical to this confidence level and am more willing to pay attention to the upcoming data on existing home sales (25Feb), Case-Shiller (26 Feb), OFHEO (26Feb) and new home sales (27 Feb). My bet is on a continuing down trend. Market talk is beyond than that as Minneapolis Fed President Gary Stern said --- there's a risk of a broader credit crunch that would hurt economic growth and drive up unemployment in a pattern reminiscent of the early 1990s.

The downside risk is now acknowledged by Fed, but to how large extent that the risk of US recession is priced into markets. Market check, the recent rise in commodity prices, higher bond yields and out-performing cyclicals looked more like a cyclical turn. Moreover, while the flow of economic news has worsened, not every leading indicator is in recession territory. This is an important question as if market has not fully priced in the recession scenario (which may already on the road), then equities are not cheap (MSCI US 14XPE08 &15.3% EPSG), despite relative value vs. bond. A simpler test of this --- how does the market react to incoming news? If the recession is in the price, then we should expect equities would be able to shake off poor macro news.

A second watch point is on Financials as the sector has not convinced us that banks are finally on top of their books and where they are marked. In the past few days, credit markets were struggling with a string of negative headlines (iTraxx S8 IG closed 8bp and HY 19bp wider yesterday), including weaker earnings at Barclays, further write-downs confirmed at Credit Suisse and flagged by the WSJ to take place at Lehman, continued monocline uncertainty, plus Moodys' 16 CPDO downgrades. Looking ahead, while Fed rate cuts will lower reset payment shocks for US ARM borrowers for the rest of 2008. But as resets will continue in 2009, payment shocks may be delayed and lower fed funds rates may over-stimulate the economy and/or raise inflation expectations…… see the inflation arguments comes back….

China has two targets

China government has set two main policy targets for 2008 --- preventing 1) an economy-wide overheating; 2) a broad-based inflation. With the US recession risk still looming large and January’s disastrous snowstorm in southern China, investors are most interested in how a soft landing at the macro level (GDP lowering to 10%) would translate to corporate profits and profitability at the micro level. But data are not fully supportive to a soft landing as January trade and loan growth numbers, and CPI/PPI on the upside. Hong Kong also saw significantly higher growth as a re-export center for China. YTD, due to strong Euro, exports to EU continued to grow (33.3% yoy) in January, up from 27.8% yoy in December.

Earning wise, market is now looking for more visibility after March congress meeting as about 50% of MSCI China companies will report 2007 earnings in March /April. Meanwhile, the implied equity risk premium, at 7.9%, has gone up over 200bps over the past four months according to HSBC’s quant model. Valuation wise, MSCI China has de-rated almost 40% to 14.5X from 25X peak last October on a 12Mforward PE basis. In comparison, MSCI AxJ has only de-rated 25% to 13X from 17X over the same period. Lastly, the A/H share premium for tops 100%. This probably means a fair amount of negative news flow, particularly China’s deteriorating growth-inflation outlook, has already been priced in for MSCI China…no surprise, China is still a higher risk emerging market … Liquidity side, money flows to Hong Kong should remain ample with further US rate cuts expectation, but A-share markets are under pressure as there are 23 listed companies announced refinancing plan within one month, total worth RMB204.3bn(U$28.6bn) .

In the near term, given the economic situation in both China and the US, market should keep its range trading patter until April, it is still somewhat too early to bottom fish sectors like financials, property and commodities as these are highly macro sensitive. Overweighting sectors recommended include --- 1) Energy (-27% since Oct, 13.5X 12MFPE, 24% EPG08, 3% DY); 2) Banks (-35% since October; 15X 12MFPE, <3X FPB, 25% EPG08 and +20% ROE). To the Banking sector, the challenges will come from domestic credit risks due to credit control and a weaker dilution effect as a result of the slowing loan growth.

Currency reversed classical models

Currency markets have reversed the classical economic models, such as Purchasing Power Parity (PPP) and the International Fisher Effect, saying that higher inflation will require exchange rate depreciation. However, according to BBG, recent currency performance has been the opposite. Currencies with higher inflation rates in the DM and EM have outperformed, as higher inflation has boosted expectations for further monetary tightening, including AUD and NZD.

In Asian, currencies have been supported by expectations that monetary policy will remain tight to offset inflation. Some might come from monetary policy, but it is also due to greater tolerance for currency appreciation by local central banks in order to limit imported price pressures. Expectations of high inflation should boost money market prospects and lead to short-term capital flows, supporting liquidity. But, in the long run, higher inflation rates will cause a loss of trade competitiveness, which will result in trade and CA balance deterioration, as well as exchange rate depreciation. The conclusion is straightforward: it is capital not trade flow that dominates exchange rates over the short term and the main focus in Asia is still RMB.

Good night, my dear friends!