My Diary 641 --- The East is Safer; The Confidence is Key; The A-shares are Cheaper; The EUR- Oil Season is coming

Sunday, June 20, 2010

“While France needs a miracle in World Cup, equities see a squeeze-up” --- The under-fire France coach Domenech says his team need a World Cup miracle after their shock 2-0 defeat by Mexico. In contrast, equity markets have gradually drifted higher over the past week along with thin T/Os and technical rebound. Indeed, most traders’ morning notes have been repeatedly saying that aggregate AxJ USD T/O recently was around X-mas holiday levels. According to Goldman, the regional turnover velocity (5DMVG) is now ~ 50%, close to the level seen in Sep08 and Jan09. CLSA strategist, Laurence Balanco, argues that it is not the World Cup, but the Presidential Cycle the most important sentiment contributor at this stage. Every four years, since 1900 in the Dow, this cycle has marked either a bear market low or a steep correction low during a bull market. Meanwhile, since SP500 hit a bottom at end-May, the index has rebounded and appears to be tracing the 50-61.8% Fibonacci retracement of the May decline at 1130-1151 for the wave 2 rebound, which could be completed sometime next week, after which the index should go on the next down-leg.

That being said, June FMS shows investors' growth expectations in danger of “double-dipping”. Overall market sentiment is defensive, but pessimism is not yet extreme enough for a big buy signal on risk assets. Cash levels fell marginally to 4.1% (from 4.3%), failing to provide a clear buy signal, too. Investors’ conviction on O/W remains at near-record lows, with the most-popular-sector (Industrials) indicating +22% o/w, about half the normal level. In addition, Eurozone growth outlook collapses to near-zero levels, witnessed by a net 7% of European investors now see a stronger economy in the next 12mos, a huge drop from 62% in 2 months ago. Obviously, European policymakers have noticed the market’s perceptions and announced plans for a widespread stress test of major European banks, similar to what occurred in US in early 2009.

Another signature event worth for a note here is that China just announced to allow RMB to de-peg from USD and to switch to the reference of a currency basket. The trading band for USDCNY will be the same as the exiting (or pre-crisis) one. PBoC emphasizes that there is still lack of a solid foundation for large-scale RMB appreciation in the near term. Interestingly, the latest statistics show that FDI into China continued to recover in May, rising nearly 30% yoy. It seems some investors have placed a high conviction bet on RMB appreciation before the G20. However, the implication to offshore Chinese equities could be a one-time impact, while a multi-year appreciation would force investors to focus on the –VEs, such as weaker exports, rising unemployment and a capital spill-over into China. So far, the gradual appreciation is still the ideal policy choice for China as we are facing the tough combination now with the needs to raise the value of RMB, to raise interest rates and to raise wages. If all are done quickly, the country may get a collapse in consumption as a consequence of a surge in unemployment.

X-asset Market Thoughts

On a weekly basis, global equity rose 3.18%, led by US +2.38%, EU +2.36%, JP +1.97% and EM +3.9%. Elsewhere, 2yr & 10yr UST yields both slipped 2bp to 0.71 and 3.2%, respectively. The 2yr Greek rose 92bp to 8.75% and on 10s by 108bp to 9.42%. 10yr Spanish saw their spread to bunds come in 25bp to 186bp after IMF expressed confidence. 1MWTI oil price added $3.4 (or +4.5%) to $77.18/bbl on the weekly basis. EUR ticked up 2.3% against to 1.2388USD, while USD lost 1% against Yen to 90.71JPY. Credit side, TED spread came in 4.3bp to 44.4bp. The measure of credit risk hit a 12mos high of 48.6 on Monday……Looking across asset markets, the world equities markets were caught in a tug of war between +VE news out of Europe, namely a decent Spanish bond auction, and the mixed macro data out of US and German. That being discussed, gold, the safe-haven metal, approached its record high (USD1260.3/lb) as demand escalated for an alternative investment to currencies amid a slump by USD (DXY -2% wow) and Europe’s mounting sovereign-debt crisis. Copper fell the most in almost two weeks after WTE US data.

Looking forward, the recent rise in risky markets bears watching. DM stock prices are up +5% since last Monday, with an even bigger gain in Europe. However, I think it is too early to say that the spillover from peripheral Europe will be limited. One thing important to remember is that markets had been expecting a robust earnings recovery. Consensus earnings forecasts look for a near 60% increase in EPS between 2009-11 for DM equities. That means equities are vulnerable even to a growth slowdown, not just to fears of a double-dip. In Asia, the key leading indicators for equity markets remain SHCOMP and HK-listed Chinese property stocks, as both are good indicators of Chinese tightening or loosening. In the near term, in the absence of a significant +VE catalyst, it will be up to valuations to put a durable floor under equity prices. Since valuation metrics are not an ideal timing tool, investors should expect an equity bottom to be a process rather than a sudden event-driven shift in market direction. The good news is that value has improved considerably --- 1) the 12M FWD PE is closing in on the 2008 low, and 2) the yield gap is relatively wide from historical context. Corporate buyback is another key indicator to watch for. Looking back, the end of the mid-cycle correction in 2004 coincided with an increase in corporate buyback announcements and a decisive shift from net equity issuance to net repurchases.

The East is Safer

The week saw weak US macro data, including initial jobless claims (472K vs. cons=450K) and Philly Fed Index (8 vs. cons=20). I think the stall in first-time jobless claims may be signaling that 2Q10 US economy growth will fall short of 4% market forecast. Judged by the latest job market trends, we are at least a year away from meaningful payrolls recovery. As a result, the JPM econ team is pushing back expectations for the first Fed rate hike from 2Q11 to 4Q11. In addition, US homebuilders survey (NAHB) skidded in June (17 vs cons=21), confirming that the expiration of the tax credit has been followed by a drop in sales and construction. For now, one silver lining is that the NAHB index remains well above the lows set last fall. In Europe, the plunge in German ZEW surveys (econ. sentiment=28.7 vs. cons=42; current conditions= -7.9 vs. cons=-15) reflect the heightened concerns about the outlook. In general, as I discusses in the previous diaries, June surveys of business activity and consumer sentiment will be more important as they shed light on what damage the European debt turmoil might be doing to the global economy.

On the inflation front, it is impressive for the slide in core inflation in US and EU paused in May. US core rose 0.1% in May or 0.9% yoy. Over the past six months, US core inflation was just 0.4% Saar. In the EU area, the core CPI rose 0.9% yoy (vs. 0.8% in April). Looking ahead, there could see additional declines in core inflation in both regions in the coming months, based on lags between movements in the output gap and core inflation. Outside of G3, major central banks continue to drift toward policy normalization, including Brazil, New Zealand and India. The India’s WPI headline inflation came at 10.16% yoy and RBI signaled a likely intermeeting move.

All that said, “policy works+ recovery happens” has probably been the key message over the past year. Despite what we have seen, it remains a tale of two worlds: a fragile West, and a far more buoyant East. As a result, I observe a subtle shift in investor “safe haven” perceptions. In the past, while DMs displayed less volatility than EM at times of crisis, the opposite seems to be occurring this time. EM economies are now seen as safer. In this context, the performance of the EMBI index vs. SP500 shows the EM credit index has become less volatile over time. Thus, I believe that emerging markets, especially Asia, will continue to attract investor interest, once market feel convinced that contagion from the Western world will be contained.

The Confidence is Key

ECB Board Member Paramo said the central bank will absolutely NOT provide banks with capital should stress tests show they need, as that is not part of the ECB’s functions. He also mentioned that Spain faces a “singular challenge” because of the diverse nature of its financial industry. However, the announced plans for European banks’ stress test seems receiving good response from the market, witnessed by 10yr and 30yr Spanish bond auction (EUR3bn@4%2020; bid/cover=1.89x and [email protected]%; 2.45x) and a strong Hungarian auction (bid/cover > 2x). That said, after the big Greece downgrade last week, the country’s sovereign CDS drifted 75bp wider in front-end, despite ECB buying in clips of 20-30mm provided some stability. Clearly, the credit and bond markets are doing their job. Unless you reform, you’ll be stuck on government support for the foreseeable future.

In addition, the mission for ECB is to prevent the sovereign crisis from turning into banking crisis. In the Europe, banks are still struggling to borrow even from one another and loans with a maturity > 1 Month are “rare and expensive,” making them depend more on ECB funding, according to Deutsche Bank on June 9. As a result, European lenders tapped ECB for EUR122bn of 7-day cash on June 8. The 96 bidders paid 1% on those loans, almost 3X the one-week Eubor of 0.37%. The ECB didn’t identify the banks involved. In addition, Europe’s lenders deposited a record EUR369bn in the ECB’s overnight deposit facility on June 9, more than in the aftermath of Lehman’s collapse. Deposits have surpassed EUR360bn for the past week.

Clearly, this is why EU policymakers decided to run a wide-range stress test over European banks, similar to what occurred in US in early 2009. Looking back, the US stress tests were performed in conjunction with the announcement of the CAP program. These two developments ultimately corresponded with the bottom in US financial stock prices, as they helped restore investor confidence. In Europe, the announcement that stress tests will be published by 2H July is a hopeful development. But in any case, the lesson from the US is that ending a financial crisis is all about confidence. The recent announcement from Europe is a step in the right direction.

The A-shares are Cheaper

China's State Council issued a directive on LGFVs over the week, recognizing LGFVs' contributions to economic development and to further classify LGFV loans into three types --- 1) Type I: loans to public projects without stable cash flow and purely dependent on fiscal transfer; Type II: loans to public projects with their own stable cash flow; and Type III: loans to non-public projects. For Type I loans, banks will cut off additional lending and new funding can only be obtained via fiscal budget. In addition, the central government compels local govts to take responsibility for their LGFVs by avoiding intentional default. Even such measures are taken by CSC, the first round of municipal bond auctions were poorly received. The 3yr bonds were auctioned at 2.77% (exp. =2.46%) while the 5yr bonds were auctioned at 2.90%, 24bps above market expectations. This implies that the bond investors demanded 35bp and 28bp premium over the respective sovereign BM yield and reflects concerns over local governments' finances.

In terms of confidence to the economy, due to concern of rising production costs and shrinking demand, Q2 entrepreneur’s confidence index dropped 0.5ppt QoQ to 83.9%, ended the rising trend since 1Q09. Q2 bankers confidence index fell to 64% (-5.8ppt). The govt has reiterated that it would continue its proactive fiscal policy and moderately loose monetary policy, but also make proper adjustments according to changes in economic conditions. One of the repeated policy is that China now aims to create 3-5 major steel companies that could compete in the international market and to produce 60% of the nation's steel by 2015 (up from 44% in 2009) by top 10 steelmakers. However, China’s steelmakers will continue to face cost pressure. Baosteel just agrees to 23% iron ore price increase.

Market wise, SH A-share dropped 2.2% in two days after the 3-days holiday. I saw a major profit-taking from healthcare sector due to a rumor of price curb on medicine. Part of the reason could be the high PE in healthcare stocks (30-40XPE10 vs. ~15X PE for the CSI 300 and ~10x PE10 for A-share Chinese banks. Meanwhile, according to a survey conducted in 50 cities by t PBoC, 70% of respondents think property prices will come down, and current home prices were "too high to be acceptable." Liquidity wise, PBOC net injected RMB500bn in one month, which almost reversed a RRR hike…Sounds contradicted, but the upcoming ABC IPO could be the key reason… In Hong Kong, IPOs’ launches are not doing well. After Goldwind scraps its USD1.2bn IPO offering, WWTT also withdraws IPO. While Liansu successfully raises USD250mn and a Chinese battery maker, Chaowei Power, aims to raise up to USD93mn. More importantly, for the first time in 3 years, A-shares were trading at a discount to H shares. Historically, A shares were sold at a wide premium to their H-share counterparts - average 40% during the past three years. Large-cap A-share valuations are close to their Oct2008 trough, for instance, with SHA50 trading at 14x trailing PE and 2.3x trailing PB, or 10% higher than its 2008 trough, but 70% lower than its 2007 peak. Similarly, CSI300 is just 15% higher than its trough in trailing PB terms and 28% higher in trailing PE terms…Lastly, regional wise, MSCI China is now traded at 13.2XPE10 and 24.9%EG10, CSI 300 at 14.8XPE10 and 32%EG10, and Hang Seng at 13.4XPE10 and 25.3%EG10, while MXASJ region is traded at 12.5XPE10 and +36.9%EG10.

The EUR- Oil Season is Coming

EUR bounced sharply since last Thursday, in line with a broad retracement in USD. The up-move was further facilitated by the successful auction of EUR3.5bn of Spanish government bonds. Technically, the breach of 1.2360 has opened the door for a retest of 1.2670. However, fundamentally I still believe the move higher in EUR/USD is largely due to positioning adjustment. The economic outlook is clouded by the ongoing focus on fiscal consolidation. Indeed, I have seen street economists lowered EU 2011GDP forecast to 1.8% from 2% to reflect the asymmetric impact of fiscal tightening on different member countries. In line with this, markets now expect the ECB to hike in mid-2011. As such, the policy combination of monetary easing and fiscal tightening is likely to be bearish for EUR.

Regarding to the crude oil, the price has benefited from EUR strength in a very illiquid market this week, rising above USD 77/bbl (WTI), despite bearish US inventory data released. YTD, The correlation between crude oil and USD has been relatively weak, but rose to 87% over the last week. Renewed (but far from resounding) confidence in financial markets and the global economic recovery have contributed to the oil price rally, but it is no coincidence that the bounce from the mid-$60s started almost to the day that Asian refinery maintenance passed its peak. Looking forward, I expect further EUR weakness, which, when combined with volatile risk appetite, is likely to keep crude within the USD70-85 trading range. The market is likely to see an uptrend over June and July as demand seasonally increases.

Good night, my dear friends!