My Diary 676 --- Econ Data Play Key Role Ahead; The ECB Learned a Lesson; Tension between Policymakers and Markets; Copper Trapped by Bull and Bear

Sunday, May 22, 2011

“Sina Weibo: a New Lifestyle or a New Toy” --- I did two interesting things over the past few weeks – 1) Opened my first ever Weibo site (http://weibo.com/huashenyu), and 2) Paid a visit to several cities along Yangtze River. Let me elaborate them one by one. Honestly, the experience of playing around Weibo helped me understand better why the street analysts assign USD2-6bn market value to the Weibo business of Sina. Meanwhile, I have no surprise to observe the 109% rise of LinkedIn's share price on its first trading day, of which the firm is the largest professional-networking website. At USD100/share, LinkedIn is worth USD9.45bn or 25X Price/Sales.  By the same valuation multiple, Facebook is worth USD100bn already. In short, the past few days’ experience with this new toy tells me that these SNS websites are redefining the way that people communicate, social and network with others. That being said, my recent trip to Yangtze River area is less optimistic. Local media reported that all coal-fired power plants of China’s 5 largest IPPs were running on loss (>RMB10.6bn) in 4M2011, mainly due to higher coal prices. In addition, the Yangtze River area has been struggling with mild draught with the loss of base-load capacities (most are hydro). As a result, power shortage/ restriction can be seen in many capital cities without air conditioning in Airports and hotels, and some factories in the area are forced to shut down operations in the past 2 months. There is no doubt that we will see the economy slowdown in 2Q11 and CPI  will not peak by mid-year at all and could climb beyond 6% as these area are the main production base of  grain in China. In 2010, the 6 provinces (CQ, SC, HB, HN, JX, AH, totaled 118.6mn ton) in the Yangtze River area accounted for nearly 22% of grain production in China.

Having talked about new economy, the week found evidence that the global IP cycle has reached an inflection point. Latest data showed that global IP growth is slowing from 9% QoQ in Feb to around 2% in 2Q11 due to an inventory swing and the supply chain impact of the Japanese Tsunami. But it should then rebound to over 7% in 2H11. In particular, US May regional business surveys suggest that the industrial sector downshift will extend through midyear. After softening in 1Q11 vs. 4Q10, US economy remains in a soft patch in 2Q11. In Euro area, 1Q growth boom looks likely to shift down a gear in Q2. This week, German May IFO survey should show some　moderation. Such DMs data also mean that growth expectations in the export-led EMs are being pared back. In China, the recent drop in industrial commodity imports likely signals that its correction is well under way. The electricity shortages may also accelerate this adjustment. Overall, the softening in global LEIs implies more muted growth expectations around markets in Asia. However, Asian economies are still likely to beat DM peers according to IMF’s forecast in April, which expects EM Asia will expand 8.4% this year vs. 2.4% in DMs. Looking ahead, the disruptions to the supply chain globally are likely accelerating and intensifying the global inventory correction. As this disruption fades and Japan begins to rebuild, global growth will get a significant lift in 2H11. On inflation front, with commodity prices have come off (5-10%) of late, the strong trajectory into Q2 along with the lags in the transmission to CPI will keep upside inflation pressures through the summer months. Assuming commodities stabilize from here, I expect global inflation to peak sometime around August on yoy basis. In the meantime, the potential pass-through to underlying inflation continues to trouble policymakers, particularly as core inflation have trended up of late in the US, EU, and UK.

Regarding the policy side, the 27 April FOMC minutes come as no surprise with details on how　best to normalize monetary policy. However, the minutes made clear that the talks over the exit strategy don’t mean that tightening “would necessarily begin soon”. Policy makers agreed that the Fed’s securities portfolio, set to reach USD2.6trn next month, would be shrunk “over the intermediate term” and return to “essentially only Treasury securities,” the minutes said. The more important point to me is that the Minutes solidified the notion that tightening will commence as follows: stop QE2, stop reinvesting proceeds (including USTs), raise rates by draining and paying higher rates on excess reserves, and then sell assets. Note that the new paradigm for Fed rates will thus be "corridor" style - interest on excess reserve rate the floor, the discount rate the ceiling, and the FFTR the middle of the corridor. In Japan, BOJ voted not to expand its monetary policy despite a significant GDP miss. Data over the past few weeks clearly show that global commodity prices are pushing Japanese prices out of deflationary territory, but the earthquake’s hit to confidence and the economy is severe. As emphasized in the minutes of the April 6/7 BoJ meeting, power availability and supply-chain disruptions are key uncertainties. In other news, China's PBOC governor said that inflation remains high and China needs to strike a balance between growth and inflation. To sum up, EM and commodity-based economies are at the vanguard of policy rate normalization.

X-asset Market Thoughts

On the weekly basis, global stocks declined 0.47% with US -0.33%, EU -0.29%, Japan -1.49% and EM -0.9%. Elsewhere, UST yields dropped with 2yr -2bp to 0.51% and 10yr -1bp to 3.15%. 10yr Greek-German spread hit 1351bp (+115bp wow), the all time high after ECB rejected the debt restructuring proposal and Fitch cut the country’s credit rating three levels to B+. 1M BRT dropped 0.9% to USD112.78/bbl. CRB index went up 0.9% to 341.6. EUR picked up 0.76% to 1.4161USD. JPY weakened 1.11% to 81.7. The Dollar Index was largely flat at 75.44 and gold stay above 1500.

Looking forward, the “Sell-in-May” correction appears to have paused for breath. Based on the latest Merrill FMS, the asset markets movements were primarily position-driven rather than a fundamental repricing. The current pause does not, however, signal that market positioning has fully cleared. Indeed, a raft of indicators suggest that the scale of unwinds has been very modest, i.e. CFTC positioning data for USD vs. G10 currencies little changed. Looking at the key events that will probably shape markets in the week ahead, US economic data (durable goods, Income and HH Spending) should continue to be the main focus. There are also more than a handful of Fed speakers this week featuring Bernanke, Bullard, Dudley, Fisher and Evans. Overall, with US growth expectations declining and a continued deterioration in economic surprises, I am looking for the turning point as the driver of a USD bounce. Moving on to Europe the immediate focus will be the ECOFIN Finance Minister's meeting. Greece and Portugal are likely key agenda items but we would be surprised if a final (second) deal for Greece is sealed this week. Investors will also watch for German PMI, IFO, CPI and 9 June ECB meeting. 

In the near term, there are 6 key issues worth for attention -- a) the possibility of a Greece debt restructuring; b) US budget discussions and the debt ceiling circus (August 2); c) US labor market (May NFPs on June 3); d) Chinese trade activity (June 10); e) accelerating inflation (an issue everywhere outside of the US and Japan); and f) the pace of central bank hikes (watch BoC). That being said, the earnings season in US has doing OK with EPS and revenue beat to miss ratios for the quarter stabilized at 72%:26% (in line) and 68%:32%, respectively. Around 300 European firms have reported so far and the beat/miss ratio is 63%:36% for EPS and 62%:38% for revenues - broadly in line. Growth wise, it is expected that the EM-DM growth gap at 4% should stay wider than average this year. Meanwhile, global monetary policy, in both EM and DM, is very easy and needs eventual significant normalization. The timing is subject to great uncertainties as it is affected by inflation and the coming fiscal tightening in many DM countries. In two years from now, global short rates might still be quite low, or might already have moved up in a 1994 size tightening cycle. Putting all together, I expect equity markets in a range trade over the next 1-2 months due to soft economic data, concerns over the end of QE2, uncertainty regarding a Greek debt restructuring and fears of monetary tightening and a hard landing in China, offsetting the positive forces of valuation (12.6XPE MXWD AC) and strong earnings growth. I would suggest to slightly OW EM, given better growth and fair valuation, but UW Cyclical sectors as an inventory driven correction in global manufacturing is still underway, hurting sectors with high manufacturing exposure such as industrials and commodity sectors.

Econ Data Play Key Role Ahead

The week saw a handful of weak economic data, including Philly Fed (3.9 vs. cons =20.0), which added to a steadily growing list of evidence that seems to indicate that the data momentum could be slowing. Indeed in just a little over a month, I saw WTE 1Q11 GDP, two disappointing ISM Non-Manuf reports (for March and April) and the weak April IP (flat vs. +0.4%) and the May Empire State Manufacturing (11.88 vs. 19.55) earlier this week. Not to also mention the ongoing challenges in US housing with the unexpected fall in Existing home sales (-0.3% vs. +2.0%) being the latest evidence. Having said all that, the good news is the most recent ISM Manufacturing is still running at its cyclical highs and the labor market recovery (jobless claims 409K vs. 420K) seems to be still intact. Economic data over the next couple of weeks will continue play a central role as markets try to assess whether this is just a minor blip or the start of a worrying trend. In contrast, EM Asia continued to look strong with Taiwan’s 1Q GDP (6.6% yoy) report shows strong, broad-based expansion in the real economy. Singapore in fact raised its growth forecast for 2011 to 5-7%, from an earlier forecast of 4-6%. In contrast, Japanese GDP fell 3.7% QoQ in 1Q. The outcome was much WTE based on available expenditure data. Though activity looks to have bottomed in March, the low 2Q starting point will likely lead to another GDP contraction (-2.5%) in 2Q11.

Back to the Fed, during the press conference, Chairman Bernanke took several questions about inflation, saying that “ultimately, if inflation persists or if inflation expectations begin to move, then there’s no substitute for action.” He indicated that he wasn’t concerned yet because “medium-term inflation expectations” had “not really moved very much.” Since that briefing, crude oil has dropped to $99.65/bbl from $112.76, while 10yr BE rate has fallen to 2.357% from a high of 2.656% just slightly over a month ago. However, US gasoline prices haven’t had a similar drop yet, with the average retail cost at $3.93, compared with $3.89 on April 27. Across the ocean Eurostat released the April final inflation number for the Euro area, and headline inflation was confirmed at 2.8% yoy (cons=2.8%). In Asia, inflation is not quite at the turning point. Data from HK and Singapore will be in focus this week, with markets looking for 4.5% and 4.7% in the respective island. India’s WPI inflation rate edged down from 9.0% to 8.7% in April. The RBI recently stepped up the pace of tightening with a 50bp move on May 3. The Bank expects inflation to remain very high at near 9% in 1H11, followed by a gradual moderation to 6% in early 2012.

The ECB Learned a Lesson

Moving on to Europe, the sovereign’s rating continued to be hammered by US rating agencies.   Italy had its credit-rating outlook lowered to negative from stable by S&P’s, which cited the nation’s slowing economic growth and “diminished” prospects for a reduction of government debt. Fitch Ratings today cut Greece’s LT debt rating to B+, four notches below IG grade, and placed it on rating watch negative. That said, Euro zone Finance Ministers meeting is held in Brussels this week. Whilst EU officials have been at pains to ensure the market doesn't get its hopes up that any kind of decision on Greece will be made, so much more is up in the air besides a second Greek bailout, the market does expect some of the uncertainty to be resolved. For one, Trichet is expected to step down and be replaced by Mario Draghi - after German Chancellor Merkel gave her approval last week, the succession was all but ensured. Secondly, a EUR78bn bailout package for Portugal is expected to be finalized. The average interest rate for the first three years of the loan will be around 5% and the rate for the remainder of the 7.5-year package will be around 5.2%.

The main European headlines will continue to surround EMU/ECB's opinion about a Greek debt restructuring. In a nutshell it looks like the central bank is firmly against the idea of a soft restructuring option that was floated by key EU politicians in the last few days. ECB's Executive Board member Juergen Stark said that any restructuring would undermine the collateral Greek banks used to gain loans from ECB and "this holds true for all kinds of restructuring". He added that "a restructuring would wipe out part or all of the capital of the Greek banks". ECB's Wellink said that a "Greek re-profiling is not the solution". Angela Merkel strongly rejected any Greek restructuring as it would raise incredible doubts about the credibility of the Euro zone and she also added that "creditors should only become involved in combating debt problems before 2013 on a voluntary basis". Reading through the lines this may indicate that an imminent restructuring is not on the cards and Germany seems to be happy to give Greece a "second chance" to improve its fiscal finances before hitting the restructuring button. Greece's 5yr CDS closed 50bp wider at 1275bp.

Looking at details, it is not too much unexpected to hear the opposition from ECB. The current EU/IMF program for Greece assumes that the sovereign will be able to reaccess capital markets when the official support starts to decline next year. However, it has been evident for a while that renewed market access is very unlikely to happen, so that Greece would need another official program. However, ECB has learned a lesson from its bailout plan provided to Ireland. In fact, the original bailout plan was that the loan portfolios of Irish banks would be sold off to repay these borrowings. However, foreign banks know that many of these loans, mortgages especially, will eventually default, and were not interested. As a result, ECB finds itself with the Irish banks wedged uncomfortably far up its fundament, and no way of dislodging them. This allows Ireland to walk away from the banking system by returning the Nama assets to the banks, and withdrawing its promissory notes in the banks. The ECB can then learn the basic economic truth that if you lend EUR160bn to insolvent banks backed by an insolvent state, you are no longer a creditor ---you are the owner. At some stage ECB can take out an eraser and, where “Emergency Loan” is written in the accounts of Irish banks, write “Capital” instead.

Tension between Policymakers and Markets

Much street talks over China are focusing on growth momentum slowing down due to 1) a downshifting IP led by a falling auto sales(-4.7% mom in April and -5.2% in March); 2) an inventory adjustment witnessed by total commodity imports (in volume terms) fell 13.7% QoQ in March, after peaking at 60.7% QoQ sin January. Also, the manufacturing PMI orders to inventory ratio has fallen steadily since November last year, hinting at more modest growth in IP for the coming months; 3) concern has arisen over the potential for more widespread electricity shortages in the coming months, reflected in a notable rise in coal prices, while authorities have kept electricity prices largely steady given inflation worries. Combining these factors, sell-side economists expect China’s IP slowing from 14.1% in April to 10.2% by July. In terms of the GDP trajectory, they expect 2Q GDP growth to ease modestly to 8.3% QoQ, compared to 8.8% in 1Q. That said, a research paper done by Barry Bosworth and Susan Collins in 2007 has highlighted strong TFP (total factor productivity) growth in China’s reform era. They estimate that TFP has run at 3.8% a year (2/5 of growth). This is spectacular, since it suggests that China is not following the low-TFP, wasteful growth path that many believe the rest of Asia took until the 1990s. The implication is that with strong TFP growth, China’s economy can keep growing strongly for a long time, even as the infrastructure build-out is completed and labor-market growth slows.

Policy wise, in its 2010 annual report, PBoC said it will continue using monetary policies to manage inflation. It reaffirmed its target of controlling M2 at 16% in 2011, and said it will increase the role of interest rates in managing inflation expectations. However, based on NBS, home prices still climbed in the majority of big cities in March. And pork prices are moving higher. According to MoC, the latest wholesale price of pork was RMB20.61/kg, up 41.3% yoy. Clearly, inflation pressure, along with the draught I saw in Yangtze River area, will not wane soon. As a result, policies are still unlikely to be eased. Moreover, it seems that China will enhance RMB flexibility and keep exchange rate basically stable at a balanced level. Using the 2006-08 period as a benchmark, the RMB/USD appreciation could accelerate from the current pace of below 5% yoy to near 8% yoy. Importantly, since China is the anchor in Asia, the rest of the region would likely follow RMB’s faster appreciation. To sum up,  the Morgan Stanley Economist, Wang Qin, has a excellent summary over the relationship between policymaker and financial markets ---[Quote] “Chinese policymaking is based on consensus (among key ministries), which is by default backward-looking and behind the curve (at least by financial market standard), instead of by an independent central bank. But financial markets are inherently forward-looking. This tension between policymaking and financial market is particularly serious in China and a constant source of frustration, confusion, and uncertainty among markets participants, contributing to high market volatility and even de-rating of the equity market.

Putting everything together, I expect some short-term impact over the different sectors --- 1) Coal: +VE given the high demand. I think that China’s coal import will continue to increase, especially in 2H; 2) Clean energy: Neutral as the sector will benefit although it will be more on the headlines. This sector still relies heavily on government subsidies/policies and public projects; 3) Steel: -VE profit margin is likely to be compressed though ASP may o increase; 4) Cement: Neutral as margin compression is likely in the near-term. But the recent events will continue to force out obsolete capacity and give the established names higher market share and eventually more pricing power......Lastly, regional wise, MSCI China is now traded at 11.5XPE11 and 19.7% EG11, CSI300 at 13.7XPE11 and 26.2% EG11, and Hang Seng at 11.8XPE11 and 20.7% EG11, while MXASJ region is traded at 12.5XPE11 and 14.5% EG11.

Copper Trapped by Bull and Bear

The above-discussed Greek debt restructuring issue is broader than peripheral Europe, so the currency consequences are worth considering. While asset sales in Spain, Ireland and Portugal would reduce their debt stocks by a trivial amount (2%-5% of outstanding), these flows in combination with Greece’s well exceed EMU’s CA deficit. The US’s remaining TARP disposals make even less of a dent in America’s indebtedness (1% of outstanding USTs) but provide decent financing for the current account (24%) if nonresidents are considerable buyers. The UK’s bank sales could be quite sterling-positive for their sheer size (over 170% of the current account), but the timing and terms are too uncertain to influence the currency this year. As a result, USD is expected to be up & down in 3% range with upside bias on volatility.

Meanwhile, crude oil prices have corrected further over the last week, despite ongoing supply risks, and remain choppy as macro concerns, USD weakness and specific concerns over US oil demand have continued to dominate price direction. Overall investor positioning in oil is still relatively high. I think this is justified by underlying fundamentals, but this does leave the market vulnerable, should data disappoint, to the downside risks. It is expected that energy prices to remain choppy over the next few weeks, but for the market to emerge on a more solid footing as demand picks up seasonally in June. In particular, I expect strong diesel demand from China to compensate for power-sector constraints.

Same as Oil, metal prices remained under downward pressure in the past week, as investors cut their exposure to commodities across the board for the 3^rd consecutive week and weaker economic data from China heighted concerns about a softer patch for the global economy. Silver once again led the way down, while other precious metals held up relatively well. Gold has held up well in the face of USD strength, but HF selling of physical ETFs is dampening bullish sentiment. In the base metals complex, copper is currently trapped between bullish and bearish influences. China’s April IP growth slowed to 13.4% yoy and inflation remains above target, with CPI reaching 5.3% for the month. As a result, monetary tightening continues. However, commodity fundamentals suggest a continued bullish medium-term view. China’s State Grid intends to boost investment by 10% this year – lifting copper and aluminum wire and cable demand. Also, many consumers are operating with very low inventories, due to tight credit conditions, suggesting restocking is likely once the economic cycle starts to turn. Finally, metals consultancy CRU estimates that global copper supply growth will be just 0.5% in the first six months of this year, which would help underpin prices. However, investors have also started to become less bullish on commodities and equities, according to some reports. A recent BBG survey of global investors found one-third plan to hold more cash, while 30% plan to reduce investments in commodities. US net speculative positions in copper fell by 44% wow and 62% mom.

Good night, my dear friends!