Sunday, March 24, 2013

“Cyprus’ Deposit Scare, Chinese New Premier and US/Japan Easy Policies” --- The week saw equity markets pulled back slightly from the new cycle highs, as negative economic and political news have been hitting the wires since last weekend. In particular, fears that a bailout package for Cyprus that called for a one-off levy on existing depositors might prompt bank customers in Spain, Italy and Portugal to head for the exits gave investors and markets pause for thought in mid-March. However it seemed that the Cyprus event is just a scare to the investors, as according to EPFR Global-tracked Equity Funds, it was the 17th positive week running of which daily data suggested some DM investors saw drops in global equity markets as a buying opportunity.

That said, the rejection by the Cyprus parliament a week ago of the Troika bailout proposal brought EU event risk back to markets, pushing risk prices down and bond prices up early this week. Since then, most investors have concluded that the numbers at hand are small enough relative to the risks to both sides that some form of a compromise is likely by Monday. My guess is that Cyprus will decide it is better off (or less bad) staying in the EMU rather than going alone. But it will likely be forced to bail-in large deposits, putting a damper on its off-shore banking business. However, investors cannot discount Cyprus exit risk and it is likely higher than it ever was for Greece. If Cyprus decides it is better off outside, risk assets would suffer badly, but the impact would be tampered by EU messaging that the country was an offshore banking system that never belonged in EMU, and that this event has no implication for other periphery members.

But even if Cyprus does decide to stay in EMU, the saga will not be over and could have a nasty tail. It is quite possible Cyprus will have to instate capital control and/or deposit freezes after its banks open next week. And the sudden willingness of EU to bail in private depositors risks broader capital flight from other EU members, even those with more solid banks. It is estimated that large and uninsured deposits could make up ~50% of Euro bank deposits. As a result, I think investors need to monitor closely bank borrowings from the ECB in coming weeks to gauge any capital flight, in particular by smaller countries with large banking sectors, such as Luxemburg.

As the clock ticks down to Monday's ECB funding deadline, financial media (Financial Times, WSJ) suggest that the Cypriot government is tabling legislation, to be debated in parliament this morning, which will restructure Popular Bank and impose transaction restrictions across the country's banking system. The core part of the government's bank resolution proposal is a splitting of Popular Bank into a "good" and "bad" bank. Deposits under EUR100K will be transferred to the good bank and larger deposits will be folded into the latter. Other banks would be recapitalized. The draft legislation also seeks to restrict noncash transactions, curtail cheque cashing, limit withdrawals and convert checking accounts into fixed-term deposits when banks eventually reopen (WSJ).

Whether the latest proposals will pass parliament is still unknown at this stage. But the second hurdle is whether the measures go far enough in unlocking the EUR10bn of funds from EU/IMF. German FM Schäuble was quoted by Bild newspaper as saying that "cosmetic touches alone" would not be enough. The EU's statement was more positive, saying that EMU stands ready to discuss a new draft proposal with the Cypriot authorities. Interestingly, the EU's statement last night reaffirmed "the importance of fully guaranteeing deposits below EUR100K in the EU". So it seems after a week of turmoil that the politicians are now grasping some of the huge problems with the initial plan.

Macro wise, one differentiating factor in 2013 compared with last year is the diverging outlook for growth and economic policies across countries. This week alone, I have observed an upside surprise on US data and in China’s PMI and a downside one for the Euro area. The street economists raised US growth outlook, stayed comfortable about Chinese outlook, but were forced to cut 2013 growth for the Euro area, UK and EM Europe, bringing full European 2013 growth down from 0.4% to 0.1%.

Talking about Europe, the March Euro area flash composite PMI disappointed, falling 1.3pt to 46.5 (vs. cons= 48.2) .Germany (-2.3pt to 51.0) and France (-1.0pt to 42.1) both saw declines in PMIs. The PMIs suggest an easing of the recent improvement in the external outlook (new export orders -3.5pt). Given ECB’s reluctance this month to provide further monetary stimulus despite inflation projected to be well below target and a record high UNE rate, this week’s slump in the March PMI may not be enough to trigger a rate move in April. Given the renewed focus on Europe, Japanese headlines have largely taken a backseat this week. The pace of JPY depreciation has somewhat stalled with the currency now about 1.9% off the recent lows against USD. BoJ Governor Kuroda has been on the wires reminding us the central bank's determination to achieve a 2% inflation target. At the inaugural press conference, Kuroda said "we will do whatever we can" to achieve the 2% price target "at the earliest time possible".

In US, FOMC modestly upgraded their assessment of how the economy is performing but kept the central bank's easy-money policies intact in part because they don't see growth accelerating much. The improving outlook owes partly to the existing and expected policy mix. Moreover, Fed reaffirmed its intention to purchase USD85bn in assets each month and restated the economic conditions it deems consistent with exceptionally low rates – a 6.5% or higher UNE rate, 2.5% or lower one- to two-year ahead inflation projections, and well-anchored LT inflation expectations. In addition, Chairman Bernanke sounded pleased with recent labor market developments and expressed openness to eventually tapering off asset purchases. I think this won’t occur until late in the year, particularly since we see growth stepping back a bit in coming quarter.

To sum up, I think the March saw a subtle shift in the prospects for relative monetary policy, opening the door to greater divergences in LT bond yields over time. In particular, I expect a June rate cut from ECB, and more QE from BoE, in the wake of very disappointing Euro area PMI data, while Japan remains on the cusp of its newly-aggressive monetary easing. On the other hand, the next move from Fed is set to be a downward tapering in the pace of asset purchases, to be signaled around year end if the pace of labor market improvement pans out well.

X-asset Market Thoughts

On the weekly basis, global equities were down -1.1% with -1.1% in US, -1.4% in EU, -1.4% in Japan and –2.4% in EMs. In Asia, MXASJ and MSCI China closed -2.7% and -1.1%, respectively, while CSI300 rallied 3.1%. Due to the concerns of Cyprus, 2yr USTs yield was unchanged at 0.24% and 10yr’s narrowed 7bps to 1.92%. In Europe, the 10yr Italian BTP yield fell to 4.52%, a low back to late February. Elsewhere, The USD strengthened 1.24% @1.3194EUR, but relative stayed flat to JPY94.52. The weakness in commodities extended from concerns over weak Euro area PMIs and Cyprus event weighed on the CRB commodities index (-2.05%) with Brent (-2%) @ $107/bbl and copper (-2%) leading losses. Gold price were up +1% at $1613/oz.

Looking forward, with Dow broken above its previous cyclical high in 2007 and SP500 close to doing the same, investors are nervous that the rally is perhaps solely based on Fed policy. Having said so, equity risk premium has fallen from its peak, but this has been largely based on a moderation in perceived tail risk rather than stronger growth. Indeed, real GDP growth has struggled so far in this recovery to sustain even a trend pace of 2-2.5%. In turn, sub-par growth has kept FOMC under pressure to continually look for ways to provide additional stimulus. Perceptions among policymakers and investors regarding the sustainability of the recovery will change when real GDP growth finally shifts to an above-trend pace.

There are 3 key market indicators which can be used to monitor a shift in perception --- 1) gold prices should fall in absolute terms and relative to broad commodity indexes. Gold is a liquidity play and its relative performance is highly correlated with risk aversion; 2) bank stocks should outperform relative to the broad market and rise in absolute terms. This sector provides a read on financial systemic risk; 3) most importantly, rising real bond yields would highlight that the economic recovery is becoming self-reinforcing and can handle a gradual withdrawal of monetary stimulus.

With respect to equity market performance, EMs has now underperformed DMs by almost 900bps since Dec2012. But I think it is still too early to look for a reversal of EM and EU underperformance, as the ERR continues to improve in DMs from 0.82 to 0.90, while it dropped in EMs from 0.84 to 0.68. The Ratio also fell marginally in APxJ from 0.83 to 0.72. In particular, ERR improved the most in Japan (from 1.37 to 1.75) on the back of expectations a depreciating currency will flow through as a policies to earnings vs.US (from 0.76 to 0.84) and Europe (0.55 to 0.59). Within APxJ, ERR improved in Australia, Hong Kong, Philippines, Singapore and Taiwan, but fell in China, India, Korea and Philippines. As a result, I think contrarian investors waiting for a tactical opportunity to buy cheap EM & core European assets should either wait for more flow capitulation and/or ironically hope for a big risk-off event (like a Cypriot default) that first takes the market lower and forces cash to be raised.

March: A Turning Point

In the past 3 years, the month of March has always marked a turning point when improving economic conditions at the turn of the year gave way to renewed financial market stress and business caution. IT seems this time is a bit different partially due to policy actions that have curtailed downside risks and bolstered an improving foundation for economic growth. Still, the path to better growth has had some bumps, and recent developments between the surprising resilience of the US economy and the disappointingly limited improvement in the Euro area is especially striking.

YTD the upside surprises have been concentrated in two nations: US and Japan. In the US, business sector is willing to look through any softening in consumer spending growth in response to the 2% hike in the payroll tax that took effect in January. This challenge increased with a surprising jump in gasoline prices in February and further reductions in government spending that took effect on March 1. While this week’s passage of funding for the remainder of FY2013 is welcome news, it leaves in place a total fiscal drag of about 1.7% on GDP growth this year. And yet, despite these headwinds, March has delivered mostly upside surprises, starting with a strong payroll (Initial claims =336K) followed by a string of upbeat housing data (Single +2.7%, Multiple +8.1%), a strong PMI report (54.9), and an expansion low on the 4WMA disappointing export data, along with a still-depressed Reuters Tankan (-11) reading pose just a bit of downside risk to sell side’s strong GDP call (+2.3%) this quarter in Japan. Next week’s IP report and business surveys should show that the underlying story of a robust expansion is on track.

In contrast to US and Japan, the Euro area has largely disappointed this year, reflected by both softer data and the increased uncertainty surrounding recent events in Italy and Cyprus. The OMT has brought less relief than expected to private-sector borrowers in the periphery, which has limited the support provided to the real economy. Meanwhile, in France, it looks like the increased fiscal austerity this year is weighing heavily on the economy. The bigger worry is its PMI dropped 1pt to a new cycle low of just 42.1. A concern is how the weaker Euro area spills over into the rest of the world. It has been encouraging that despite an unsettling election outcome in Italy, turmoil in Cyprus, and the US government’s inability to find an alternative to the sequester, financial markets have been largely unfazed. In particular, the containment mechanisms put in place by the ECB (LTROs, OMT) appear to be working.

Back to Asia, this week RBI cut policy rates by 25bp as expected but refrained from cutting the RRR to alleviate tight interbank liquidity. While the central bank vowed to manage liquidity actively through more OMO, conditions are tight enough to impede transmission of policy rates. The RBI noted limited space for more cuts, suggesting that government action and a moderation in inflation and the trade deficit would be prerequisites for a cut at the May review. Elsewhere in Asia, the data this week delivered mixed messages on the momentum in economic activity, with Taiwan’s February export orders disappointing (-15.8%) and a more positive read from China’s March flash PMI. It is hard to know whether these divergences reflect the impact of the Lunar New Year or differences in the relative strength of demand growth.

The Script of Cyprus Scare

Overall, I think Cyprus scare has some symbolism impact on Europe, but it’s not a really major economic issue. Cyprus is the fifth Euro-zone country to seek a bailout since 2010 to avoid a collapse of its financial system. Its initial plan announced on March 16 called for a tax of 6.75% of all deposits in Cyprus up to EUR100K and 9.9% above that. The bank deposit levy sparked outrage in the island nation. It also ignited concern among investors about breaking the taboo over the safety of bank deposits and potentially triggering bank runs in other European countries. As of now, it is really a debate upon whether you are going to have the EU becoming more controlling, if there’s going to be funding in Cyprus, how that funding will be, who will bear some of the responsibilities.

At the time of this writing, the fate of the Cypriot bailout package remains unclear, but the matter should be resolved by the time banks reopen on Monday night. Under the terms of last weekend’s agreement, Cyprus is required to contribute EUR5.8bn from a levy on bank deposits to unlock EUR10bn of rescue loans. Having voted down a particular proposal on this levy this week, the Cypriots remain locked in negotiations with the Troika that center on a package that would involve the winding-down of Laiki Bank and some form of amended levy on deposits above EUR100K. Regardless of the outcome, the parliament is expected to pass capital controls (permissible in extremis under Article 65 of the European Treaty) to constrain deposit flight once banks reopen (likely Tuesday). Assuming an agreement is reached and that the crisis simmers down, the largest risk, though still manageable, is for Russia. A large deposit tax on the estimated EUR10-20bn of Russian deposits in Cyprus is bearable, but capital controls could impact corporate transactions using funds that have been parked in Cyprus for tax purposes.

Having discussed so, the initial Cyprus deal raised concerns about the fate of deposits in weaker banks from weaker countries, and systemic risk measures in money markets have repriced wider. Given that ECB is likely to quickly provide liquidity in an extreme scenario and the more general trend towards bail-in-able debt, it is instead senior financial debt that should incorporate a bigger risk premium. Meanwhile, it is the first time that ECB has publicly said it would consider removing a member state's banks from the Euro-system's ELS program, putting the ball squarely back in the hands of the island's politicians. The island's banks have remained closed and are scheduled to reopen on Tuesday.　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　"You cannot keep the banks closed forever. This ECB announcement is increasing the pressure," said Carsten Brzeski, an economist with ING Bank.

In my views, I could see limited contagion risk for several reasons --- 1) the OMT is in place , i.e. the ECB being willing to be lender of last resort provided the country concerned has signed up to the appropriate fiscal consolidation and other reforms. The more political turbulence in Italy or Cyprus, then the greater the chance of the Spanish PM Rajoy signing an MoU and activating the OMT as crises elsewhere provide the political cover to do so. The barometers of the situation in the Euro area are Spanish 3 year bond yields (2.75%, close to a post-2010 low) and deposit/capital outflows from Italy (on the Target 2 which did partly reverse last month); 2) The Cypriot bail out is about EUR10bn (the deposit haircut is part of a program to reduce the bail-out from EUR17bn), less than one tenth of the second bail out in Greece. This suggests that pragmatism can be allowed to rule if this does end up as a more systemic crisis; 3) part of the rationale behind the deposit haircut is because the OMT is now in place and the problem of the solvency of much of the periphery has been partially resolved, leading to a general feeling that Cyprus can be ring fenced.

One complicating issue in Cyprus is the role of Russia and the extent to which deposits in the banking system were made to try and evade Russian taxes. Investors appear to be focused on Russia. Here are some thoughts prevailed in the markets --- 1) Russia loses money under any outcome anyway. Russia is effectively being asked to throw more good money after bad and double up on the commitments it has already made, so the risk-reward trade off doesn’t appear to make sense. The Government may well determine that cutting losses at this point is a reasonable strategy. In the Iceland case, depositors’ governments (like UK) were prepared to recompense their own depositors, but not to bail out the sovereign. It is unclear why Russia would be any different; 2) Cyprus probably can’t offer them anything substantive. It is not clear what Russia could get in return for support that would make a deal worthwhile. Strategic assets have been one suggestion, but NATO is unlikely to allow Russia to secure a naval base in Cyprus. Russia may also have trouble taking at face value any Cypriot commitments over natural gas, given the regional challenges. Any offer to effectively hand over the financial system is also unlikely to be attractive given the likely state of that financial system in a few weeks time; 3) they can get a great deal later. If Cyprus ultimately defaults and needs to leave the Euro area, its dependency on Russia is likely to increase dramatically.

The New Premier’s Road Map

With the closure of the NPC & CPPCC, China's newly appointed Premier Li Keqiang delivered several very strong messages on the government's determination to push forward market-oriented reforms. I summarize the important conclusions and investment themes as below --- 1) macroeconomic targets for 2013: pro-growth with real GDP at 7.5% yoy and a high FAI growth target of 18% yoy (vs. 16% in 2012). It seems to me that 7.5% GDP growth is the bottom line accepted by the new generation of government leaders. Meanwhile, the government is to keep CPI at below 4% to maintain social stability. I think 4% inflation is the level that could trigger monetary tightening. In addition, 2013 will see a bigger fiscal deficit of Rmb1.2trn, up from Rmb800bn in 2012. The budget deficits (2% of GDP) will be made up by debt issuance; 2) monetary policy wise, Beijing aims to stabilize growth, adjust structure, manage inflation expectation and control financial risks this year. However, the room for monetary policy maneuver is much limited, as inflation should be manageable in 1H but uncertain in 2H depending on local govt investment impulse and strength of price reforms. M2 growth at 13% reflects the stance and does not indicate tighter policy with lower growth potential & expansion of financing outside of the banking system. Over the past few years, I believe most investors have realized that the relation between M2 and GDP growth has changed where bank loans no longer have strong correlation with growth. Moreover, PBOC holds a neutral attitude toward "shadow banking" and think the risk mainly lies with liquidity, but not default risk.

The LT macro theme for China is clearly based on the urbanization. Over the past 2 decades, over-capacity and over-investment is mainly concentrated in low-end manufacturing businesses and sectors. In contrast, public infrastructure is largely inadequate to accommodate further urbanization. Even after to massive FAI boom, China is, at best, half-way through its urbanization process, because about 50% of the Chinese population still lives in rural areas with little prospect to improving their living standard. If using South Korea as the benchmark, China would need to move another 500mn population into urban areas, which will certainly add huge demand to the existing public infrastructure capacity including highway, rail and airports which are already strained. The continued urbanization will require capital investment, and China is far from a saturation point. Even per-capita FAI is way below the world average. Hence, capital investment, especially in public infrastructure, will continue to drive the economy.

In the near term, many Chinese economists expect 1Q13 GDP to grow at 1.9% QoQ or 8% yoy. On the back of stronger new orders (53.3) and export growth (51.1), the BTE manufacturing PMI (51.7) suggest that both domestic and external demand have picked up in March. I think Chinese economy will again follow the old political cycle, bottom in the year 2 and peaks in the year 7 (i.e. 1992-1997, 2002-2007) as the reshuffling of political leadership still plays a significant role in the China economy cycle. Meanwhile, inflation is still well behaved, leaving room for Beijing to keep policy relatively accommodative. Liquidity in the banking system has remained abundant, suggested by O/N SHIBOR rate at 1.94% on 21 March, despite an RMB47bn liquidity withdrawal by the PBOC this week. This liquidity and interest-rate backdrop should support a further economic recovery in the next two quarters.

The downside risks to China economy mainly comes from domestic factors. Other than possibly weaker global economy, the potential risk factors are liquidity tightening and growth volatility as a result of more strict controls on shadow banking and local government platforms. In terms of structural reforms, the central govt plans to move forward with energy & utility price reforms this year, to control pollution and fight against corruption. I do not expect a wide-spread property tax, an obvious change in the one-child policy, or any significant progress in Hukou reform, land reform, or public finance reform just yet. The concept of gradual reform since Mr. Deng Xiaping is well accepted by these political elites.

Lastly, I want to highlight an interesting piece MS strategist Jonathan Garner, looking at a long term bull scenario in which the ‘HSI could achieve 50000 by the end of 2015 (121% upside). Jonathan thinks that easy money and accelerating global growth provides a powerful combination for strong equity performance. Importantly, while 121% upside sounds punchy, these sort of returns have been achieved nearly 1/3 of the time in the HSI's existence. Peaks have occurred every 6-8 years, and based on this cycle, a new peak could form some time between end 2013 and end 2015 .. Lastly valuation wise, MSCI China is now traded at 9.5XPE13 and 11.5% EG13, CSI300 at 11.0XPE13 and 17.3% EG13, and Hang Seng at 10.7XPE13 and 12.2% EG13, while MXASJ region is traded at 11.4XPE13 and 15.7% EG13.

The Infection point of USD and JPY

USD has risen about 4% since the end of January and is higher against all other G10 currencies. While many would probably dismiss this move as reflecting no more than the effect of the negative stories that have afflicted EUR, JPY and GBP, there is a growing risk that its rally could be extended. A significant surprise in Friday’s payrolls, either positive or negative, could both see USD rise. Macro wise, US activity data have been generating +VE surprises recently, and a standout positive payroll release could lead the market to reassess the potential timing of a change in Fed policy. This would likely have a strong +VE USD impact. While strong US growth will take a long time to feed through to the rest of the world, liquidity reduction is immediate. Alternatively, a very weak number would see a lurch back to “risk off” and probably also result in a higher USD.

Tactically I can see this type of market reaction, but any further ST rally in USD is unlikely to be the beginning of a sustained move higher. The Fed has set a high bar for changes in policy. It will take many months of strong payroll growth to get the UNE rate down to the Fed’s 6.5% target. However, given the strong run of data it is worth asking how the market may respond to a genuine one-off surprise.

That said, the performance of USD/JPY over the last few months has been stunning. Verbal intervention to this point has turned out to be very effective in weakening JPY. But arguably this is probably the first and easiest phase of a three-phase process for JPY. I think the next two phases will see either a retracement of JPY or at the very least a much slower fall --- 1) Verbal promises: pledge to a future radical easing of policy, float ideas of foreign bond buying programs, negative interest rates, unlimited QEs, and the promise to end deflation – the JPY duly depreciates. I believe this phase is now at its end; 2) Authority Action: this is a far more testing phase as any slippage will reverse gains. The markets will want to see a radical BoJ governor, and will want him to enact radical policies. Promises of further action at this stage are priced in. I believe this is the phase when the USD/JPY rally will start to trip up; 3) Final Results: now for extended JPY weakness to be justified, the reflation strategy must be successful and be seen to be working. This means not just higher inflation, but also higher wages growth, real economic gains alongside supply-side reforms.

I think have reached an inflexion point in the JPY depreciation process, when words are priced in and action is needed. With a speculative market still positioned short in JPY, and much drama arguably already in JPY after its 20% slide since August 2012, the risk for disappointment is growing.

Good night, my dear friends!