My Diary 724 --- The Macro Trend is still Good; What if Greece E

My Diary 724 --- The Macro Trend is still Good; What if Greece Exit; Climb the China Woes; Gold is More than Tired

“Greecexit: The Time is Running Out” --- It was a tough week and with earnings season coming closer to the end, it really isn’t getting any easier to ignore comments from ECB, politicians, or questions from investors because there was a very noticeable change in tone this week regarding a Greek exit, and the base case seems to be moving much closer to that. While Greece has been getting most of the headlines in the past few weeks, the more worrying aspect lately has been the failure to ring-fence Spain and Italy. Some of the quotes from Euro area policymakers and politicians this week sound eerily like those of last summer. The ECB has stood pat waiting for fiscal/political decisions even as Spanish (2YR =4.03%, +357bps mom) and Italian bond yields have surged anew (2YR =3.75%, +75bps wow). In the end, the authorities will respond since the key Euro area countries want to maintain the single currency. Greece, however, seems to be on the outside and its fate within Euro area awaits the results of the (second) election on June 17, unless a bank run forces the ECB’s hand earlier. So far, one thing different from last year is that contagion is not yet spreading as widely, nor as deeply. This resilience reflects the sounder position of the global financial system and improving trend in global LEIs. However, this performance is not of much comfort since a resolution is not yet in sight and the risk-off environment has persisted in select equity sectors and the commodity pits.

That being discussed, the odds of a Greek exit from Euro area are high and rising. Euro area authorities would probably prefer to wait until after the election to determine whether there is any hope for a continuation of the current program (even if modified) or whether the next Greek government will simply revoke the agreement and threaten to exit (as the Syriza party suggests). Thus, the markets will be jittery until the next Greek government’s policies take shape. There will be poker playing on both sides, with each threatening the other into compromise. The bigger issue is whether policymakers will soon act to protect Portugal, Spain and Italy, or allow contagion to spread. The latter seems probable without decisive policy action, both by national and regional leaders. Even formal discussions of a Greek exit could be calamitous unless policymakers begin to spell out how they will protect remaining members of Euro area.

However with regards to the Euro, a Greek departure would only be good for the currency if a firewall were put into place to protect other vulnerable members, especially Spain. Euro will weaken until there is clarity on how/when policymakers will act decisively to stabilize bond markets and the banking system. In the long run, it makes sense that Euro would strengthen if a weak member departed, but only after it is clear that the rest of the region is properly ring-fenced. In the near term, stay short the currency looks a profitable trade. The implications are that the markets will remain vulnerable until policymakers in the core countries (especially Germany) act to halt contagion. This remains my base-case scenario. However, the uncertainty remains how long that will take, or how much market pain is required, before policymakers react aggressively enough to stabilize sentiment. The spike in Spanish and Italian bond yields underscores that time is running out.

Macro wise, the flow of economic news remains consistent with the outlook that the global economy is expanding through 1H12 at a slightly below-trend pace. However, Euro area stress is once again intensifying. While it is far too early to gauge the magnitude of the event, two broad channels of transmission can be identified. The first operates directly through the trade of goods and services. With Euro area imports comprising roughly 5% of the rest of the world’s GDP, even a massive 10%-15% decline in regional imports would only be roughly a 0.5%-pt drag on rest-of-world growth. The second channel of transmission, related to financial spillovers, is multifaceted and has the potential to do the most damage in the event of a meltdown in the Euro area. A sharp pullback by Euro area banks, which have about EUR5 trn in foreign claims on the rest of the world (twice that of US banks), would impede credit creation around the world, with the most acute pain felt in EMs. In netting out these complicated moving parts, our analysis suggest that a 1% decline in Euro area GDP growth has on average been associated with a 0.7% decline in growth in the rest of the world, with the US seeing a somewhat smaller decline than in other parts of the world.

In short, the outcome of the June 17 Greek election will likely set in motion forces that have major consequences for both the regional and the global outlook. While the immediate risk relates to decisions in Athens, a key issue also relates to decisions in Frankfurt, where ECB will need to define its role more clearly in supporting regional financial and macroeconomic stability. The other big dominos in the global economy, US and China, are putting in a mixed performance. Worries about China have continued, even though the economy is more or less tracking a path that the government wanted. US is proving more resilient than many anticipated, although it will probably take better payroll gains to buoy sentiment.

X-asset Market Thoughts

On the weekly basis, global equity was down 5.34%, with -4.4% in US, -6.8% in EU, -4.26% in Japan and -6.07% in EMs. In Asia, MXASJ and MSCI China lost 6.04% and 5.16%, respectively, while CSI300 -2.4%. Elsewhere, 2yr USTs yield added 3bp to 29% and 10yr’s narrowed 11bps to 1.72%. Government bond yields of Portugal and Spain 2yr yields widened +742bp and +357bp, respectively. 1MBrent crude was down 3.63% to $107.98/bbl. The USD strengthened 1.1% @1.2780EUR and strengthened 1.2% to 79.02JPY. CRY was relatively calm (-0.47%) to 290.43, while Gold price went up to $1587.7/oz.

Looking forward, there are two important questions for investors watching at Greece/ECB/EMU now: 1) Do they have a sufficient firewall in place to prevent contagion if Greece leaves, and 2) Will Europe heading towards the brink once again be enough to provoke the aggressive policy response needed? The “Improvement” from the LTRO earlier this year only bought time.  Nothing structural has changed and the impact of a Greek exit would undoubtedly still be contagion to the rest of periphery through bank runs in Portugal, Spain, etc.  This has been a more growth or more policy market and we are now in desperate need of policy action. 

Having said so, asset allocators are having a struggling time as US, Europe, and China are all looking wobbly. Question is where should they park their cash? Arguably the answer is MMF, which are safer, but offer paltry yields. Personally, I strongly suggest equities, especially EM equities for the flowing two reasons --- 1) Amid bond yields plumbed into new depth across the world’s major DMs, there has been a significant increase in the yield gap between bonds and equities. In US, SP500’s DY/ UST10YR YLD is now 50% higher than that in October 2011. So do the cases in UK, Germany and Japan. This widened yield gap makes equities look more & more attractive; 2) EMs still offer better growth prospects and yields, though the assets tend to be more volatile, and in recent weeks have been hit hard. But if external conditions improve, then EM assets should bounce back and even if they don't improve measurably, investors still may be better off sticking with EM's better relative position in the world. In the near term, some sentiment gauges have swung to depressed readings, which are contrarily positive. However, given that the trigger for the correction has been in the financial area, it probably will take some stability, or even a bounce, in European/US bank stocks before the overall market advances. As with the outlook for all risk assets, such a turn awaits some good news from Europe.

The Macro Data Trend is still Good

Events of the past week have tended to heighten concerns about the potential threat to the US economy from fiscal and financial problems in Euro area. Consequently, the price of equities, the price of oil, and market interest rates have each declined. At the same time, incoming US data have printed in line with a moderate 2.5% real GDP growth this quarter. Initial jobless claims were steady in the week ending May 12 at 370K, which have largely reversed the 3WK rise during April and are nearly back to their lower March levels. This suggests that employment growth in May will be stronger than in March. This past week’s housing reports show that single-family starts (2.3%) and permits each posted good gains in April and that the May Homebuilder survey hit a new high for the expansion. Consumer spending reports have been on the encouraging side as well. Retail sales increased only 0.1% in April and core retail sales increased a lackluster 0.4%. But in a month when the CPI for goods declined 0.2%, the report looks consistent with real consumer spending growth slightly above the 2.8% saar forecast for 2Q12.

More or less the same trend, with commodity prices rolling over, global CPI inflation eased to 0.17% mom in April, the smallest one-month increase so far this year. The modest increase allowed yoy inflation rate to edge down 0.2 to 2.8%, a sixteen month-low. Softer commodity prices will continue to pass through to headline inflation rates in the months ahead and economists expect the sequential rate of global inflation to sink to 1% annualized in the three months to July, from 3% last month. This will allow further reductions in widely tracked year-ago rates to below 2.5% in 2H12. The drops in both measures are constructive: the decline in sequential inflation will boost purchasing power and real consumption while falling headline rates will give more maneuverability to central bankers. Others data are encouraging as well. G3 gross capital goods shipments rose a solid 1.0% mom in March, the second such increase in a row. G3 shipments track global capex well and as such, hint that global equipment spending may be accelerating following relatively subdued gains in 4Q11 and 1Q12. Despite essentially no growth in Euro area in 1Q, German capital goods shipments managed a 12.1% quarterly gain, a sharp pickup from the roughly 7% 4Q drop. In addition, global manufacturing grew at a 5.6% yoy in 1Q, the best increase since 1Q11 and materially stronger than what might be expected given the 2.4%ar expansion in overall GDP. 

In Asia, Japan’s V-shaped rebound is about to end. Japanese real GDP expanded a much BTE 4.1% in 1Q12. With the V-shaped recovery in GDP following the Tohoku earthquake essentially complete, a downshift in growth now seems likely. Chinese policymakers responded to the weak April activity data by easing RRR 50bp. It is unclear how much net liquidity this will add since it has to compensate for a reduction in reserve accumulation stemming from smaller foreign trade and portfolio inflows. It looks to me that it may be too late for policy action to deliver a meaningful lift in 2H12 growth and the risks appear still to the downside. In India, the modest inflation relief in India that gave the RBI a chance to deliver a 50bp rate reduction in April likely as data showing that WPI rose 7.2% yoy. The RBI had predicted that inflation would remain in the 6-7% range over the coming year.

What if Greece Exit?

Under the current position stated by Greece’s radical left party Syriza, EU would likely delay necessary funding and place the country on a collision course with the region. If Greece declares a moratorium on its debt payments, it could begin a process that ultimately leads to its loss of access to the TARGET2 payment system and thereby force a Greek exit from the EMU. There is of course an opportunity for compromise and a reasonable chance that a more Eurofriendly government emerges from the election. A Greek exit from EMU would produce significant contagion to other peripheral countries, where both sovereigns and banks would come under pressure. Limiting the damage of contagion would depend crucially on the speed and magnitude of the policy responses in several folds --- 1) the banking system would need to be shored up with shared resources provided for area-wide deposit guarantees to limit capital flight and bank recapitalizations; 2) as Spain’s and Italy’s access to capital markets becomes impaired, the ECB would likely need to restart its SMP program and the EFSF/ESM; 3) A further injection of liquidity and new monetary stimulus would be needed to bolster confidence and offset the tightening of regional credit market conditions. In each of these areas, ECB holds the key to success. It is the only institution in position to act quickly and with the capacity to provide immediate resources to support both banks and sovereigns.

Thus, with Greece exiting EMU a real possibility, questions are being asked about the ability of  EMU, i.e., the ECB and NCBs to absorb any losses. In fact, the key liability of Eurosystem is Greece’s TARGET2 imbalance, not regular repo operations or the ELA Unless Greece chooses to leave Euro area, which I doubt will happen, a Greek exit will require the rest of the region to push the country out. The EMU’s financial buffer consists of its paid-up capital, reserves and risk provisions that have been set aside, any profit made during the year, and the revaluation account. The sum of these buffers is just above EUR500bn based on the M3 report, with the March-end position at EUR509bn. Meanwhile, the available data suggest a direct exposure to Greece of around EUR155bn. This includes EUR104bn via TARGET2, EUR18bn related to the allocation of Euro banknotes, and perhaps EUR30bn or so of Greek government bonds held in the SMP. Certainly, the TARGET2 exposure will have increased further as deposits flow out of Greece. Overall, the EMU’s exposure to a Greek exit still appears quite manageable.

Until recently, the sell side credit strategist accessed the likelihood of a Greek exit from the monetary union range from 20 -50%. This partly reflected a judgment that Greece would be better placed to make its fiscal and structural adjustments within the monetary union rather than outside it. However, it has also been clear that an exit would require two conditions: for a Greek government to reject the terms of the EU/IMF program and for the rest of the region to take a hard line in any renegotiation process. Although it is now possible to imagine this path, there are two additional considerations --- 1) deposit flight out of Greece could greatly accelerate the pressure in the system, forcing policymakers to make decisions more quickly than they might ideally like; 2) there is likely to be considerable negotiation between a new Greek government and the rest of the region. Syriza doesn’t want to leave EMU, and the rest of the region would like Greece to remain. The key issue is whether there are terms of continued EMU membership that are acceptable to both sides. There will be an attempt to reach a compromise, which is possible if both sides are willing to concede some ground.

To sum up, although policymakers in the Euro area are saying that it is up to the Greeks to decide whether they want to stay in EMU or not, the scenario described above indicates that the deciding issue will be central bank financing for Greek banks and the Greek sovereign. Shutting Greece out of TARGET2 is not a decision that ECB would make alone: ultimately it would be a political decision made by the heads of state of the Euro area. 

Climb the China Woes

The week saw China’s RRR cut was insufficient to offset disappointment over April macro weakness and soft lending data, hurting sentiment early on. Continuous newsflow of hiccups in EU and soft US data further weighed on performance, more than offsetting positive news of China’s decision to subsidize energy-efficient white goods/autos to stimulate consumption. In particular, data releases from China over the past week have pointed to a further deceleration in macro activity. Equity and commodity markets appear to be interpreting this as mounting evidence of a “hard landing”, an interpretation partially reinforced by PBoC decision last weekend to reduce RRR for the third time since the current easing cycle began in November. Although the economic evidence remains ambiguous, I remain confident that a soft landing is underway.

This RRR cut was likely triggered by the disappointing April economic data released last Thursday and Friday, including trade (Exp=4.9%, Imp=0.3%) , IP (9.3%), retail sales(14.1%), and FAI (20.2%). Bank loans in April were also WTE (681.8bn). Meanwhile, CPI inflation came down to 3.4% yoy in April, opening room for the RRR cut. In addition, financial institutions’ positionfor foreign exchange purchases declined by RMB60.57bn in April, despite a trade surplus ofUSD18.4bn in April, suggesting hot money outflows and slowdown in the growth of reserve money. Macro policy is behind the curve. The surprisingly weak economic activity in April underscored the external and internal challenges faced by the Chinese economy. On the external side, the weakness in the global economy, especially in Euro area, has been a drag on China’s external sector. On the domestic front, the government has continued its efforts to address imbalances in the economy and maintained tightening measures in the housing market and sectors with overcapacity. While these efforts are helpful to achieve the transition to more sustainable sources of growth in the long run, in the short term they have caused significant slowdowns in certain key industries (e.g., housing, auto, steel, and cement) and weakness in domestic demand. Thus I expect the economy’s growth rate might not have bottomed after a sluggish 1Q outcome.

That being said, local media reported NDRC, MoF, MoC and MIIT are busy with research and field trip in May to study new stimulus measures. Markets suspect government to announce new stimulus soon to boost domestic demand. Infrastructure and agriculture investment would be remaining the key focus, together with tax reform and energy saving consumption subsidy. Total size could be as high as Rmb1tn. As discs cussed in the looking-forward section,  I continue to recommend an OW position in Chinese equities within an EM equity portfolio. Valuations are attractive and reflation – albeit a mild easing cycle – should unlock the valuation opportunity...….Lastly valuation wise, MSCI China is now traded at 8.7XPE12 and 11.6% EG12, CSI300 at 10.9XPE12 and 17.9% EG12, and Hang Seng at 13.7XPE12 and 2.8% EG12, while MXASJ region is traded at 10.5XPE12 and 11.6% EG12.

Gold is More than Tired

The correction in industrial commodity and energy prices has turned ugly in recent weeks, as trendlines and moving averages have been shattered, and fears of a repeat of 2008 are spreading. The decline is disproportionate for commodity prices and the relative performance of related equity sectors given the more limited global financial market contagion from the euro area. Some of the recent decline reeks of a dumping of stale long positions built up during the mini-boom in 2011, as well as forced liquidation (as credit lines dry up). Technically, prices are hitting oversold levels, on a par with the 2001 recession, but not as severe as in 2008. Commodity prices lag trends in the GLEIs, and the latter has rebounded in recent months. Thus, it seems likely that commodity prices will trough over the summer, although it is always difficult to gauge how far sentiment will swing. Looking forward, prices are undershooting, which is pro-growth and will set the stage for a market trough – but only once the pessimism towards the Chinese economy diminishes.

The latest gold’s sluggish behavior in the face of falling real interest rates and increasing revulsion towards the major currencies indicated overvaluation and a mature bull market. However, the slide in prices to oversold readings as EMU debt tensions have worsened suggests that there may be more at work than just these factors. Gold tends to act as a “canary in the coal mine” in terms of signaling excesses/shortfalls in global liquidity conditions. The more recent message from gold is that there is a shortfall in liquidity because euro area policy has stood pat in the face of intensifying deflationary pressures.

While monetary policies have been very accommodative in recent years, gold prices still corrected slightly in 2010 and 2011, indicating liquidity conditions are clearly not accommodative enough for the weak economic and financial links in Euro area, i.e. real interest rates have soared in the sick economies. The Fed is unlikely to ease further given the domestic economic recovery and signs that the monetary transmission mechanism is starting to function again in US. However, the same is not true in Europe. While the ECB did (eventually) step up aggressively late last year, despite criticism from the Bundesbank, the recent pause by the ECB has allowed the financial markets to riot anew. Thus, it is inevitable that ECB (and possibly the BoE) will ease further. Thus , I would expect a decent rebound in prices once Euro area authorities leave the sidelines and act to drive down Spanish and Italian bond yields.

Good night, my dear friends!