My Diary 624 --- The Good, Bad and Ugly; The Open Mouth Operations; The 2010 Policy Layouts; The Special Note to Commodities

December 13, 2009 (The last diary in 2009)

“The Christmas Happy Gift vs. The Copenhagen Unhappy Talk” --- The world is in its critical transition point. In the financial markets, after the shock in 2008, equity has come back with a rocking 2009 to record as the 3rd largest yoy rises since 1930s. If the momentum keeps moving ahead, it seems the MXCI AxJ index will achieve the second highest year-end point in the history (only lower to 2007). That is a great early Christmas gift, isn’t it? Put it aside, the 2009 UN Climate Change Conference in Copenhagen is turning into a blame game. Developed countries led by US are asking developing countries to do more in reduction emissions and boosting fuel economy standards, and so on. Otherwise, they will not channel USD10bn a year for the next 3 years to help developing nations cope with the immediate effects of climate change and early steps to bring down their emissions…Well, I am not in any positions to criticize any side. However, my simple question is, are we really in a position to point fingers when losses from weather and flood catastrophes have skyrocketed? According to a latest British government report, climate change could cost 5-20% of the annual global GDP. Ironically, the US is more willing to spend an average of USD130bn a year on the wars in Afghanistan and Iraq from 2003 to 2009. The Obama administration has requested USD138.6bn for 2010, plus ~USD30bn more for the additional troop surge. In contrast, the US Congressional Budget Office estimated the cost of a climate bill several months ago with a much lower sum -- USD22bn per year.

Though US is not yet committing to its international responsibility, the country makes some progress in its domestic tasks --- 1) with a 223-202 vote, the US House tightened rules for derivatives and created powers to break apart large, healthy financial firms that could threaten the economy. The measure is central to lawmakers’ effort to end government rescues of firms deemed too big to fail; and 2) the federal bailout plan will be extended until Oct2010. However, it will be scaled back and refocus on newer programs designed to stop foreclosures and make loans to SMEs. That said, on the central bank front, there has been plenty of rhetoric to underscore the growing divergences in the macroeconomic backdrop. Nevertheless, rate decisions came without any surprises. In US, speeches by both Bernanke and NY Fed Governor Dudley stressed that inflation pressures would be low for long, implying so too would the Fed. BOE held rates at 0.50%, keeping the asset purchase target at £200bn as expected. Similarly, the RBNZ, SNB, BoK and COPOM (Brazil) all stay on hold.

Macro wise, data from US on Friday brings good news with Nov retail sales jumped 1.9% yoy, the first +VE yoy reading since Aug2008. Meanwhile, core sales also increased a solid 0.5% yoy. However, I have to say that this figure is contradicting to the micro guidance delivered by the corporate America. Over the week, I see 3M gives cautious FY10 guidance as it continues to face the affects of high UNE as well as weakness in construction and manufacturing; 2) the supermarket manager, Kroger lowers its full year EPS guidance to USD1.60-1.70, much below consensus of USD1.96, citing continued deflation and the competitive environment; 3) McDonald’s SSS in US fell for the second consecutive month, down 0.6% in November, below forecast. These messages are in line with Meredith Whitney. In an interview last week, she said there are still troubles for the banking system and consumers since, for the first time in modern economic history, bank loan growth is still plummeting and the securitization market remains shut - a double whammy for consumers that she said "are being thrown out" of the banking system at a wholesale rate. Moreover, I would add one more point that, indeed, initial claims have dropped substantially in recent weeks, but it usually requires a drop in claims to below 400K before signaling the end of the job-shedding phase.

One thing for sure is that nothing could stop the money from flowing into emerging markets. According to Citi, YTD inflows to total EM funds now reached USD61.4bn, blowing away the previous record high of USD40bn in 2007. AxJ funds seeing sizable inflows (USD851mn) in the week ending 09 December, led by China (USD396mn) and India (USD128mn) as money rushed into the robust economies. As for HK, recent volatility in the stock market could not dent demand in HK's asset market. The HKD stayed on the stronger side against USD, with the 1yr FWD rate at HKD7.725 on 09 December, way outside the peg range of HKD7.75–7.85…So it seems there are further rally to come in HK?

X-Asset Market Thoughts

Globally, equity prices closed 0.3% wow lower with flat in US and Japan, -1.56% in EU and -1.07% in EMs. Elsewhere, 2yr UST yields closed down 3bp at 0.80% and 10yr gaining 8bp to 3.55%. MTD, 2yr and 10yr have risen 14bp and 35bp, respectively, from multi-month lows. 1MWTI oil declined for the seventh consecutive day, slipping to $69.87/bbl. Oil has dropped $5.6 MTD and fallen below $70 for the first time since early  October. USD strengthened for the week with EUR @1.462 (+ 1.7% from 1.485) and weakened 1.6% against JPY @ 89.1 (90.6)…Looking back into the asset classes, it seems that the liquidity panic for December due to Dubai events has failed to materialize and I am seeing a re-pricing in risk along the curve. Surely, US labor data was a big surprise to the market, but the real test is how the Fed interprets the data and what it means for policy? The answer so far is that policy markers continue to err on the dovish side. As a result, USD advanced to a two months high against EUR due to BTE retail sales and consumer sentiment. In turn, crude oil fell for a fifth day as it is still tied to the Dollar. Importantly, oil have fallen roughly $10/bbl from its October peak and is moving toward the $68 threshold. In general, it seems the risk appetite and equities are once again exerting the greater influence in FX market, with Dubai back in the headlines, instead of rates movements (not much anyway).

At this moment before the year-end, the more important question is what will look like in 2010?  Looking forward, the consensus is that global economy remains in recovery mode. Asia is now downshifting to a more sustainable pace, while the laggard DMs such as US is just gaining steam. Meanwhile, much of the extreme policy stimulus remains in place. Thus, we should maintain LONG on risky assets as the combination of economic recovery and unusually low policy rates should continue to support to asset prices. However, I think investors should always bear in mind that all good things will end, and this unusually friendly environment for financial assets will too, probably in 1H10. Ironically, the signal could be the above-trend economic growth in US (i.e. 4-5% GDP growth) and/or the peak of UNE rate in 1Q-2Q10. Such a development would likely generate concerns that Fed will soon begin to remove its extraordinarily accommodative stance. History suggests that this would interrupt the steady rise in asset prices and produce a broad-based correction with MM rates (up), Dollar (up), and Gold (down). The equity and credit markets will not be immune. Sentiment wise, the recent market reaction to the shock from Dubai World reveals an underlying edginess among investors.

For the equity markets, as discussed above, low risk-free rates in the near term remain a major source of support. The average yield on govt bonds is <2%, a record low and well below the global equity EYs. Meanwhile, even though the 12MFWD PE ratio has rebounded sharply during the ytd rally, valuations are only back to the LT average. Earnings are expected to rebound strongly next year, aided by a sharp recovery in banking sector profits and at least some recovery in top-line growth for non-financials. For the rates markets, though the upside surprise on NFP has driven a powerful bearish steepening of the UST yield curve, the debt market over the coming month is unlikely to price in more rapid Fed tightening. For the FX markets, I remain a mid-term USD bear given the outlook for gradual, non-inflationary recovery in the global economy. However, as repeatedly discussed in the last few diaries, I see increasing risks of a short-term USD bounce in 1H10 as risk appetite fades and investors anticipate some slowdown in 2H10. For commodities, prices look to lose upward momentum as the markets head into 2010. In particular, the upside for oil is capped by the potential output expansion. Gold looks to consolidate recent gains, but may resume its advance further out on healthy central bank demand and broader investor interest.

The Good, The Bad and The Ugly

The G3 macro data have provided a picture of the good, the bad, and the ugly over the week. The good were US payrolls (Initial claims 474K), retails sales (+1.3% mom) and BTE consumer confidence (73.4). Combined with stronger inventory (+0.3% mom), it is suggesting US GDP growth of 4.5% in the 4Q09 is not out of the question. In comparison, the bad came from EU, with weak Oct German machinery orders (-8.5% yoy) and IP (-12.4%). This situation was only exacerbated by the sovereign debt troubles in Greece and Spain. The ugly came from Japan’s terrible 3Q09 GDP, revised down sizably from 4.8% to 1.3% yoy, mainly due to downward revisions of private business capex (from +1.6% to -2.8% QoQ). In short, the private final demand (consumption + housing investment + business capex), which accounts for 75% of Japan GDP, continued to decline.

Beside the above-mentioned, export data from US are indeed getting better. Oct trade deficit narrowed fast from USD35.7bn to USD32.9bn, along with exports surged 40% yoy above its 3Q level. The US flow of funds shows household net wealth surged USD2.7trn in 3Q09 after jumping USD2.2trn in 2Q09. Nevertheless, the level was revised down USD2.4trn as of 2Q09 owing to larger losses in housing wealth. The revision brings the total peak-trough loss to a staggering USD17.5trn, implying consumer deleveraging is still a long process. Across the Pacific Ocean, China’s Nov macro data suggested the economy is in a inflection point. CPI inflation turned +VE to 0.3% yoy. Industrial production growth surprised on the upside at 19.2% vs. 16.1% in Oct. Retail sales and FAI unexpectedly declined in Nov to 15.8% and 32.1%, respectively, but remained solid. Money data indicated ample liquidity with loan growth declined a bit to 33.8% yoy and M2 growth was up slightly to 29.7%. I think the strong growth recovery has allowed the Chinese government to begin phasing out the extraordinary stimulus programs adopted last year. Such a policy tightening will mainly be conducted through administrative measures on direct control over capital spending and bank lending. The impact of policy tightening measures will unlikely cause a major relapse in economic growth, but will likely cause heightened volatility in the financial markets, particularly for A-shares.

To sum up, I expect strong global growth in the next two Qs, due to the base effect and the catching-up of US and EU economy. The inflation risks remain muted globally, as excess capacity remains pervasive. In Asia, China and India’s inflation should rebound early in 2010 and this would be a trigger for monetary tightening earlier than in US and Europe. Moreover, the end of QE in major economies will bring long-term rates gradually higher. But these exit strategies may not cause a dramatic market correction because tighter policies should mostly be the result of strong economic activity and be managed very carefully by global authorities. 

The Open Mouth Operations

Sovereign risk was in the headlines again as Greece was downgraded by Fitch to BBB- and the credit outlook of Spain was revised by S&P into negative. Meanwhile, Moody's claimed that public finances in UK and US may "test the Aaa boundaries." Such news has not put upward pressure on UK or US govt debt, as ongoing QE in both countries continues to support those markets. However, the Greek downgrade and the Spanish credit revision cast further doubt on the ability of some sovereign issuers to meet their debt obligation- -- an issue already quite vivid in the markets after the standstill on the debt of DW fully owned by the sovereign. Relatively, Greece and Spain are a lot more important than Dubai as many banks in Europe have exposure to Greece and Spain.

In the rates spectrum, following the June inflation scare and premature yield backup, the G7 central banks have all used “open mouth operations” to influence market expectations. Their efforts have proven very successful in convincing investors that inflation will not get away from policymakers and that economic conditions justify maintaining an ultra accommodative policy setting well into the future. The impact has been a collapse in policy rate expectations and implied bond market volatility, as well as a significant drop in yields across the government curve. For example, Fed rate hike expectations for 2010 have virtually disappeared. The 2yr UST yield has fallen back to the panic-driven lows of last December and the 10yr yield has dropped to the bottom end of its trading range. Increased investor confidence and reduced anxiety regarding the actions of policymakers has also translated into an easing in the term premium and sharp reduction in implied volatility. In turn, these developments have provided a powerful enticement for investors to dump cash holdings, boost risk tolerance and undertake carry trades.

That being said, I would continue to keep a closer eye on policy maker’s intention. Over the week, Fed is testing its reverse repo. Some street analysts interpret it as a move to drain excess reserves or a form of tightening monetary conditions, while others think it is simply a change of the source of funding for long-term asset purchases. As discussed in Chairman Bernanke's original speech, excess reserves are an alternative to issuing CB bills (which Fed cannot do), or using Treasury borrowing (which would violate the debt ceiling) to fund asset purchases. The excess reserves are likely a negative carry asset for banks (-100 to -200bp in opportunity cost). Thus, it is likely for the banking system to add capital to increase repo desk capacity (so the Fed can fund itself in the market) rather than to use bank balance sheets.

The 2010 Policy Layouts

An interesting research piece caught my attention yesterday reveals that there is a strong relationship between changes in actual interest rates (instead of the changes in interest rate expectations) and that of Asian equities. Put differently, you don't need to worry about where market thinking on policy rates is going, only where policy rates themselves are going. Interestingly, the recent A-share market seemed following the call as it has been stuck within 20 points range trade after 2% decline on Tuesday. The market felt lost and investors are just wondering whether they have already known too much or too less, after the government has laid out major play rules for 2010.

In particular, the CEWC concluded the tone and objectives for next year’s economic policies. The official message is to maintain an appropriately relaxed monetary policy and a proactive fiscal policy while increase flexibility in policy implementation. This is consistent with market expectation. Looking into details, NDRC expects 2010 growth to be 8% yoy but the target is changed from “to ensure growth” to “stabilize growth speed”. There is a small chance for “apparent inflation” in 2010 as a majority of industrial and agricultural products still see over supply. Edible oil overall sees over supply despite recent price fluctuation but crude oil remains a question. In addition, more focuses are put on the structure reform with 2010 Consumption Stimulus finalized. In short, I saw three major themes — 1) Auto industry disappoints (7.5% tax on <1.6L cars vs. 5% in 2009; 2) Property tax to lower secondary supply (preferential tax on 2-5yrs holding period for residential property cancelled); 3) Rural subsidy program extended (auto and motorcycle to Dec10 and Jan13, and old-for-new home appliances to May2010). In my own view, the government has turned into more hawkish toward asset bubble issues, from property market to stock market and from bank loan supervisory to loan guarantees by local government. Moreover, I would expect such kinds of attitude to become more obvious if more detailed measures to be rolled out. So, stay cautious!

Lastly, I agree that Chinese consumer  will be one of the best sectors to be OW in the coming years, as incomes continue to rise and savings rate falls. However, the key is that raw material costs do not increase too quickly to erode margins. This is important as stocks are not cheap and are therefore pricing in sustained earnings growth…Valuation wise, MSCI China is now traded at 14.1XPE10 and 21.6%EG10, CSI 300 at 20.4XPE10 and 27%EG10, and Hang Seng at 14.1XPE10 and 21.3%EG10, while AxJ region is traded at 13.9XPE10 and +26.8%EG10.

The Special Note to Commodities

As markets march into year-end, FX has become increasingly choppy in the past few weeks due to a combination of factors, including declining year-end liquidity, events in Dubai and the BTE US November employment report. Historically, DXY has fallen for seven of the last nine years in December, by an average of around 2.72%. On the two occasions that it rallied (2001 and 2006), it gained only 0.74% and 0.10%. Although I am not sure when USD will bottom out, 2010 should see the greenback doing better due to 1) the elevated USD risk premium diminishes; 2) Japan's latest policy response to the appreciating JPY will help reduce the perception that USDJPY is a one-way trade; 3) EUR is under increasing pressure after Fitch downgraded Greece to BBB+ from A-.

In physical commodity markets, China obviously saved the commodity world with YTD refined copper imports up 160%, aluminum +180%, coal +170% and iron ore +24%. This is by largely offsetting the double-digit demand declines seen in OECD economies. On the other side, investors appetite for commodities has seemed almost insatiable, with metals now behaving like financial instruments rather than responding to the physical S&D. That said, several recent development in the markets are worth for a special note – 1) EIA lowered its forecast for global oil demand next year, indicating a weaker recovery from leading consumers, such as US, while the agency also sees bigger petroleum supplies available in the market; 2) both the World Steel Association and EUROFER separately commented on the proposed BHP-RIO Pilbara iron ore JV. WSA argued that the “industry believes competition must be preserved in the iron ore market” and called “for competition authorities to thoroughly examine the impact of the proposed joint venture.” EUROFER also warned about the “pricing power of the new company”; 3) currency and inflation hedge buying have propelled gold to record highs. Increased mine output, surging scrap supply and weak jewellery demand have failed to deter the rally. However, the phase of the strong trending market will come to an end, if USD turns into north due to the change of Fed tighten expectation.

[Appendix]: 1973/74 vs. 2007/08

From a macroeconomic perspective, the US contracted on a QoQ SAAR basis in five out of seven quarters from 3Q-1973 to Q3-1975. By comparison, from Q1-2008 to Q3-2009, the US also contracted for five out of seven quarters. This is no accident, but rather the result of the same type of macroeconomic forces as those at work in the 1970s. The recent US November employment report greatly surprised the market on the upside of expectations, but the US labor market has virtually replayed the collapse of the mid-1970s – and the ensuing bounce. Were history to rhyme, this labor-market bounce would extend significantly.

Similarly, the relative performance of the DJIA benchmark stock index in 1973-77 versus 2007-present. If the DJIA were to repeat the bounce of the 1970s, it would test 13,000. This is not to suggest that it necessarily will. However, it is to say that very similar ‘governing dynamics’ – to borrow from John Forbes Nash Jr. – to those that created the boom/bust of the 1970s appear to be at work now. The 1970s were typified by a weak growth recovery, deleveraging, high taxes, and social unrest. Heading into 2010, many of the developed markets face the same prospects.

the performance of the DXY (USD) index and spot gold in 1973-77 versus 2007-present. Interestingly, the USD and gold show weaker correlations between these two periods than gold. That said, both periods depict a multi-year USD decline/commodity boom followed by a sharp correction. We continue to expect a sharp, if temporary, corrective bounce in the USD in H1-2010.