My Diary 736 --- What about Global Economy? What about Euro Zone Crisis? What about China’s Transition? What about USD and Gold?

Tuesday, November 27, 2012

“What to Look Forward in 2013” --- With only one month left, 2012 is earmarked as a year of troubles, namely shocks in every continent (China/Brazil/India slowdowns, Greek elections, US fiscal cliff), policy surprises from major central banks(Fed QE3, ECB Outright Monetary Transactions, BoJ’s 1% inflation goal), but little trend in the USD and below-average returns for currency. In general, the 2012 environment has been difficult for most fund managers to monetize. YTD returns have been about -1.9% for global macro funds, 1% for currency funds and 5.3% for emerging markets funds, all below their LT average performance of 6%, 2.5% and 10.6%, respectively .The good news is that two of 2012's fault lines (China’s slowdown, Europe’s funding crisis) look much less strained given China’s recent data upturn and the ECB’s funding backstop via the OMT. The remaining issue is US fiscal policy, and while the multi-month, multi-stage drama will influence markets throughout 2013, it is much less complex than the EMU crisis and less opaque than China’s rebalancing.

Before moving into the outlook of 2013, let us take a review over X-asset markets performance on the year-to-date basis. Global equities were up 9.95% with +11.9% in US, +10.24% in EU, +7.48% in Japan and +8.72% in EMs. In Asia, MXASJ and MSCI China closed +13.78% and +12.32%, respectively, while CSI300 lost -8.32%. Elsewhere, 2yr USTs yield moved 2.7bp @0.266% and 10yr’s narrowed 22bps to 1.66%. In Europe, Italy 10yr sovereign bond yield has traded down 220bp to current level at 4.75%. 1MBrent crude went up 4.04% at $111.93/bbl. The EUR was almost flat against USD at 1.2936 and weakened 6.34% to 82.12JPY. CRY index was down 2.5% to 297.74, while Gold price were up 10.98% at $1749.4/oz.

With respect to global economy growth outlook, the year of 2012 was WTE in China, Brazil, India (forecast fell ~1%), BTE growth in SE Asia (up 1%), expected recession in Europe; and modest expansion in the US. These aggregated into a global growth clip which was below-trend but also the least volatile in decades. In contrast, 2013 looks like a year in which medico growth rotates. With a global GDP at 2.5% (unchanged from 2012), the improving economies should be China (8% in 2013 vs. 7.5% in 2012) and Brazil (4.1% vs. 1.4%) in response to previous stimulus, and Euro area (-0.4% vs. +0.1%) on loosening financial conditions plus less fiscal drag. The softening economies should be US (1.7% vs. 2.2%) and Australia (2.5% vs. 3.5%), both on fiscal drag. These forecasts are not far from street consensus – most surveys expect another year of sub-par global growth with some shift in momentum across regions – and so the question for currencies is whether any baseline view deserves a strong risk bias.

For the next few months, the US outlook seems the most variable globally. The US will undertake fiscal tightening next year of at least 1% of GDP since the payroll tax holiday, which has no core Congressional sponsor, will expire, and because some portion of automatic spending cuts mandated by the Budget Control Act will take effect. Beyond that almost-guaranteed tightening, which alone would take US growth down to 1% in 1Q13, the full fiscal drag depends on what President Obama and House leadership can agree in coming weeks. The optimistic scenario assumes they strike a grand bargain during the lame duck session which extends all Bush tax cuts to at least mid-2013 in exchange for comprehensive fiscal reform encompassing tax and expenditure policy plus entitlement programs during the new Congress which begins January 3. If no grand bargain is reached pre-Christmas, full implementation of the cliff implies another 2.5% of GDP fiscal tightening.

The year of 2013 will also differ from this year in terms of global imbalances, which have shifted notably over the past few quarters. Entering 2013, the following trends are emerging: current accounts are deteriorating the most rapidly in UK (from -2% to -3.6%), Indonesia (from 0.2% to -1.4%), Japan (from 2.5% to 1.2%) and India (from -3.7% to -4.7%); and they are improving the most quickly for peripheral Europe (average of -4.5% to -2%). The US's position has remained stable around -3% of GDP, which may surprise those who forecast that record US oil and gas production would bring energy independence and USD strength through a narrower trade deficit. It hasn't: the US current account balance has been stuck at 3% of GDP for three years. The Euro area’s aggregate position improved modestly from 0.3% to 0.7%. Judged by the more comprehensive basic balance, which sums the current account and LT capital flows, shifting vulnerabilities amongst the G4 currencies is more dramatic. The Euro area’s basic balance has improved from about -2.4% of GDP in 2009 to balance in 2012. Over the same period the US basic balance has worsened from -3.1% to -4.8% due to an increase in FDI and equity outflows. Japan's reversal has been even sharper, from a peak surplus of 4% of GDP in mid-2010 to a deficit of -1% this year due to the narrowing of Japan's CA surplus and the increase in FDI and equity portfolio outflows.

For investors in 2012, the dominant trades have been to buy US shares and HY corporate bonds, while selling Euro zone, Japan and EMs. Commodities have been sagging since April 2011, pulling down resource-heavy markets. But I think it is time to buy a market when it is out of investment favor, when prices have fallen sharply and when multiples are relatively low because of cyclically depressed earnings. When thinking about markets in these terms, Europe, Japan and China come to mind. My bet is that euro zone stocks, Japanese equities and the Chinese H share index will likely outshine the SP500 next year. Weights in these depressed markets should be lifted in a global portfolio at the expense of US equities. In terms of relative performance, the US equity market may face several headwinds --- 1) its outperformance has been long in the tooth and most fund managers are overweight US stocks – i.e., there could be a period of mild exhaustion in buying power for US equities; 2) the broad trend for USD is neutral to bullish. At a minimum, I do not see another major down-leg in USD. This will remove a source of stimulus and could dampen the performance of US shares; 3) after a period of hyper growth, US corporate profits will settle on a new path that is closer to nominal GDP. However, earnings recoveries in other parts of the world, especially in those countries that have been going through double dip or triple-dip recessions, will likely be sharp.

What about Global Economy?

With November flash PMIs moving higher in US, China, and Euro area, the global PMI index is on track to post its third consecutive gain. The global survey remains at a low level --- the global output and orders reading will not materially breach 50 this month --- but survey details suggest that the finished inventory reading fell to its lowest level since the current long phase of subpar global growth began in early 2011. With surveys pointing to a meager pace of inventory accumulation and temporary drags set to fade, global industrial activity looks poised for a pickup as we turn toward the New Year.

The worrisome is that any pickup in industry will prove transitory if it is not accompanied by solid growth in final demand. On this key issue, current trends are harder to tie down. Following Q3’s rebound in global retail sales, there could be further solid growth into year-end. Consumers’ purchasing power will be buoyed by a sharp slide in the run rate on global consumer price inflation into year-end. In the three months through December, global consumer prices are expected to rise at less than a 2% pace, about half the rate of the previous three months. However, a new round of fiscal tightening in DMs is expected at the start of the year --- in the US the payroll tax holiday is anticipated to end --- that will squeeze purchasing power and may already be weighing on confidence and spending.

Global capital spending indicators have been consistently downbeat since midyear and should continue to be held back by recessions (Japan and the Euro area) and a compression of EM corporate profit margins. However, we believe that the sharpness in the high tech spending slide last quarter overstates the slowdown under way. The early signs of a rebound in tech activity may be contributing to the pickup in Asian exports and industry.  In Asia, production dynamics have been varied for most of this year. Chinese output expanded continuously during the year. This appeared to give rise to a pickup in inventory growth that since has subsided as final demand has gained speed, including exports. Elsewhere in EM Asia, output fell during 2Q and 3Q, an even worse performance than at the global level. However, this pattern was broken in September, when output turned up across most of the region. Signs of a broad-based pickup in EM Asia output and exports normally indicate global manufacturing is shifting gears.

For China, I expect urbanization to be a long term economic driver and property investment to be a mid-term stabilizer for the Chinese economy. One thinking tank believes rural land worth RMB 15-30trn will be unlocked over the next decade, a figure 5-10x higher than the amount of urban land unlocked over the last decade. Rural land aggregation and increased tractor use can increase domestic agricultural productivity by at least 40%. Unlocked rural workers can move into rural secondary and tertiary industries. UN research indicates that a dual state/market model is often more effective in solving housing problems in low and middle-income countries. Based on the experience in South Korea, investment in affordable housing can stabilize the economy in the short term. China may have to double its affordable housing plan in order to cover 5% of its population. Meanwhile, property market tightening measures will gradually ease. These are positive to the equity markets in the long term.

What about Euro Zone Crisis?

It is encouraging that Euro zone distressed sovereign spreads have barely widened during the recent stock market shakeout. Before this week’s bounce, the SP500 was down about 8% from its recovery highs, and the Euro STOXX index had corrected 6% over the same period. Italian and Spanish spreads have not widened. The sharp decline in sovereign credit spreads YTD has acted to ease monetary conditions quickly for the Euro zone economy. With tail risk removed by the ECB, the Euro zone corporate bond market has rallied hard. Of course, no one expects the Euro zone economy to roar back at any time soon, but some growth stabilization should be seen in 2013, followed by a recovery. All of which suggests that investors are no longer willing to sell down European assets on the same old horror story.

Another positive sign is that the recent downgrade of French paper by Moody’s has not caused any meaningful change in the marketplace. Despite sovereign ratings downgrades, the bond market has rewarded France since President François Hollande was elected last June. Yields have dropped, and French CDS and spreads versus bunds have tightened 50-100 bps. However, the optimism about France could be misguided and one of the biggest concerns is that economic fundamentals show no signs of improvement.  France has a dismal track record when it comes to budget restraint and structural reform. It is doubtful that President Hollande will manage to follow through on his intentions to reform labor markets and to tackle the 25% youth UNE rate while meeting the balanced structural budget target for 2016. The government’s GDP growth assumptions of 0.8% and 2.0% for the next two years appear overly optimistic, so the budget targets could easily be missed. Meanwhile, the French banking system remains heavily exposed to the periphery economies.

How about Greece? Isn’t it teetering on the edge of full-blown sovereign default? There is no question that Greece is still insolvent, and according to our European experts another quarter of Greek debt must be written off before its fiscal arithmetic can stabilize. Nevertheless, Greece is small and the cost of making Greece solvent and thereby unifying the euro area is much less than the cost of its exit – a potentially catastrophic demonstration that euro membership is reversible. The Troika will find ways to keep the Greek government afloat. Odds are that the ESM will lend funds to Greece, allowing it to buy back its old debt from private holders at a significant discount. Again, private creditors will lose out, but the integrity of Euro will be maintained.

What about China’s Transition?

The 18th Party Congress has ended without much surprise, and the key word for the Chinese leadership transition is “continuity”. Although many have wished that the new leadership would begin reforming the Chinese political system, Mr. Xi, the new party boss, is under no pressure whatsoever from within the party to do that. Mr. Xi’s mandate from the party is to maintain stability and to keep the status quo. Hence, talk or expectations of Chinese political reforms have simply been wishful thinking.

From an investor’s point of view, I think sweeping political reforms may not be bullish for the equity market. The reason is simple: political change is a high-stakes game that often provokes social upheavals or even chaos. The political elites in China are extremely mindful of any social instability. They often remind themselves of the social breakdown brought about by the perestroika in the former Soviet Union. From Mr Xi’s inaugural speech, he has made clear that the Party must deliver more economic benefits to ordinary Chinese. Hence, it should come as no surprise that the new leadership continues to place an overarching emphasis on the economy and growth. In recent years, ordinary Chinese have openly ridiculed President Hu’s and Premier Wen’s leadership as a “lost decade”. Going forward, Mr. Xi knows that his maneuvering room has been narrowed by his predecessor’s populist policies. He will have no choice but to focus on promoting growth and efficiency. Given the dismal performance of the Hu-Wen government, it will not be too difficult for Mr. Xi to overachieve and over deliver.

From a cyclical viewpoint, a turn in the Chinese economy in 4Q12 is highly likely. The HSBC PMI (50.4 in Nov.) has risen, suggesting that manufacturing business is expanding again. Chinese export growth (11.6%) has also rebounded sharply. Real estate transactions are climbing and money growth (14.2%) continues to signal a broad-based recovery. As result, I think investors should continue to OW Chinese stocks, although A-shares have made fresh three-year lows. Personally, I do not trust A-share, which often makes mindless moves. The market is driven by retail investors who tend to speculate more than invest. In 2006 A-share market rose 500% for no apparent reason. Similarly, the market has fallen more than 40% from its 2009 peak, even though economic growth has only slowed to 7.4%. H-shares or MXCN are much more relevant benchmarks in terms of gauging the economy, and both of these indexes seem to be on the verge of making major moves. From sector strategy point of views, I think investors should OW energy, capital goods, property, healthcare, and consumer staples, while UW telecom, auto, and transportation...….Lastly valuation wise, MSCI China is now traded at 9.6XPE13 and 9.7% EG13, CSI300 at 9.1XPE12 and 16.7% EG12, and Hang Seng at 10.7XPE13 and 8.8% EG13, while MXASJ region is traded at 11XPE13 and 14% EG13.

What about USD and Gold?

Gold tends to do well when USD is in a bear market and fare poorly when it is in a bull market. The relationship does not imply causation, and even if I remain bullish on gold, yet far from confident that USD will continue to erode in the next few years. Why could USD stabilize after a decade long bear market? The answers are --- 1) the shale oil and natural gas boom increases the US terms of trade and lowers energy costs, which in turn boosts the equilibrium value ofthe dollar against other major currencies. 2) Economic distress in the rest of the world makes it painful for many countries to handle a depreciating USD. For example, Europe needs a cheap currency more than the US, even though the latter country has plenty of difficulty growing. 3) The US housing bust is over. This reduces consumer pessimism and banking stress, which in turn lessens the pressure for    a “beggar-thy-neighbor” dollar devaluation.

The above-mentioned three factors suggest that a falling dollar is no longer a “sure thing”. Can gold fare well if the dollar stops declining? I think so. First of all, real interest rates remain low and market-based inflation expectations remain stubbornly-high across the world. The decline has been steady in some countries, such as US, and more recent in others, such as Australia. However, in all cases, it is highly unlikely that real yields will rise sustainably for quite some time.

Second, the Fed wants strong growth because the starting point for activity and employment is too low, despite the housing recovery. The “fiscal cliff” poses a short-term risk, as reflected in NFIB small business confidence and durable goods orders. However, even if much of the fiscal cliff is avoided, and the global economy manages to grow modestly (as we expect), the US will still suffer from a large amount of economic slack. Conventional economic estimates suggest that the US can grow 4% annually for another three years before inflation rises.

At some point in 2013, growth-sensitive commodities like base metals and bulks will overtake liquidity-sensitive ones like gold and silver. However, that will require a “turn” in China and recovery in global leading economic indicators. Until then, there will be intense pressure around the world for policy to be generous and “creatively reflationary”.

Good night, my dear friends!