My Diary 714 --- Cool Down the Optimism; Dun Be Fooled by Headl

My Diary 714 --- Cool Down the Optimism; Dun Be Fooled by Headlines; Soft Landing on Course; Base Metal Run not Sustainable

Saturday, February 04, 2012

“A Month=A Year?  An IPO =A New Miracle?” --- World risk markets are on a tear, with global equities already up about 8%, EM indices up 12 -16% in January alone and SP500 seeing its best January in 15 years. Since most of the equity strategists forecasted last year that EM equities would see about 20-30% upside based on mean reversion (discussed later), it seems to me that we already have enjoyed most of returns in a single month so far. I think the rally in stock prices should carry a bit further both in distance and duration as there is still quite a lot of pessimism, shorts and cash. Many people are not convinced that the rally since early October will continue. As a result, it just needs to be less bad than what has been discounted by the market, especially when the market is recognizing that European officials are working towards solutions and that US economy continues to remain positive and the corporate picture remains pretty decent. However, as more and more strategists/ investors were dragged into the rally, I prefer to turning into NEUTRAL stance, compared with my positive stance in the Diary 459. Elsewhere, there has been no lack of coverage on Facebook's pending IPO. In what would be the biggest internet IPO in history, the company plans to raise USD5bn from the offering. This far exceeds Google's USD1.9bn IPO in 2004. The company is said to be considering a firm valuation of USD75-100bn. The top end of that range would value FB at around 27x trailing 12-month sales which is apparently more than double Google's valuation when it went public in 2004. An USD100bn market cap would also make Facebook the 27th largest company in the S&P500 (between McDonald's and Citigroup) and the 9th largest on the Nasdaq. I cannot help asking myself whether this is the start of a new internet based economy miracle, or this is simply the end of another Dotcom bubble. Time will tell anyway!

Back to fundamentals, January’s data releases suggest that there is a broader underlying shift in worldwide economy growth momentum with 1H12 risks to the upside. As discussed in the Diary 459, global PMI stands at an above-trend growth level with the global all-industry index is tracking 3% global growth in 1Q12. Looking at details, manufacturing PMI still points to much slower growth than hard activity readings. By contrast, the service PMI rose to 55.4 last month and has now fully reversed its 2011 decline. In addition, EM consumers and global auto sales stay firm. Following a strong 4Q11, January sales look to have posted a large gain across the globe. In DM, sales rose 4% mom, rising to their highest level since Mar2008. Importantly, EM retail sales accelerated into year-end, cushioning the blow from the Euro area recession. Another signs of life is the January US NFP report and nonmanufacturing ISM survey, both point to the direction of service sector revival --- a key for sustaining labor income and overall demand. The recovery in US has led the market to revise up and become more optimistic about 2012. Given that the B/S of large US corporate appear in good shape, any improvement in US business confidence should not be overlooked.

Across the ocean, the two-speed Euro area remained in place. Firm German data contrasted with weak periphery data. But it was the financial stress that grabbed the headlines, with more borrowing of ST funds from ECB and more banks parking money overnight at ECB. This was further evidence of the lack of confidence continental European banks appear to have in one another. With financial stress being mirrored by still-high sovereign borrowing costs, even if not rising, and ongoing economic concerns, European politicians did what they do best – announce some more summits. EUR drifted to its weakest level against USD since Sep2010. That is good news for the beleaguered Euro area and one should not be surprised if the authorities passively support further EUR depreciation. That said, the improvement in global manufacturing extends to Asia. A range of countries have reported output gains in December, led by Japan with a nearly 4% mom jump. These gains were accompanied by a widespread increase in PMIs in January. The rise in PMI orders appears related to a recent pickup in high-tech exports. Meanwhile, a move down in Asian PMI inventory indexes is now aligning. Signs of a growth pickup in EM Asia will encourage policymakers to stay on a path of gradual and selective easing.

Put all together, latest data has continued to picture the 2012 outlook -- Fragile DM vs. Resilient EM, though I did not believe EMs were immune to events in Europe. In particular, many EMs are slowing -- in response to tightening in 2011 as they tried to curb rising inflation -- and also as exports are hit by the slowdown in Europe. Latest US data will mitigate this slightly. The key message is the gradual fading of the three most important risk concerns --- US, EU, and China --- is taking place more rapidly than expected, but still has further to go in coming months. Having said so, equally important are signs that central banks are putting themselves even more into a stimulus stance, given that inflation slide gathers momentum. Global inflation is in the midst of a sustained slide that is bringing purchasing power relief to consumers and creating policy flexibility for central banks. The latest round of CPI reports showed that inflation stood at 3.3% yoy, down from a peak of 3.9% in Sep2011. The process has considerably more room to run. In part this slide is coming from a “base effect” as the surge in global oil and agricultural prices in early 2011 will soon run off the year-ago comparisons. In all, street economists expect global inflation to fall to a 2.5% yoy by midyear.

Policy markers wise, FOMC stated that it does not expect to raise rates for another three years, almost a year later than the market had expected. And Chairman Bernanke made it clear that it would not take much to start another round of QE. In Europe, BoE has undertaken a very aggressive expansion of its B/S, and MPC is expected to approve a GBP75bn extension of QE at the February 9 policy meeting, bringing the total to GBP350bn. ECB has shied away from QE, and has focused instead on providing adequate liquidity to the banking system. The nature of this provisioning changed dramatically in December with the unprecedented, 3-year LTRO worth EUR489bn (net EUR210bn). With a second such operation scheduled for February 28, this will produce a major expansion of its B/S. The market expects banks to take up EUR350-400bn at the next LTRO on Feb 29, of which EUR250-300bn would be new money. In EM, RBI gave us a surprise 0.5% drop in reserve requirements. This may not signal a big change, but investors do expect rate cuts from Q2 on as inflation is falling. Overall, both DM and EM central banks have become more growth supportive over the past month.

X-asset Market Thoughts

January was clearly a good month for risky assets with equities, credits and commodities all enjoying solid positive returns. Mean reversion was a key theme, given the O/P in assets that underperformed the most in 2011. Staring with equities, the reversion of DM vs. EM strength was a main theme with key benchmarks in China , Brazil, India, Russia up +14% (‘HSCEI), +11%, +13% and +8% respectively after having declined -22%  -18%, -24% and -15% last year. EM currency strength also played a role here. In the DM world, the Stoxx600 and SP500 were +4.2% and +4.5% respectively on a total return basis with notable strength in Financials. The Stoxx600 Bank index added nearly 10% in January after having lost 30% in 2011. The S&P 500 Financials index is up 8% after a 17% decline last year.

Turning to fixed income markets, Credit was helped by the better sovereign sentiment and dataflow in January with indices producing positive excess returns across the board. Italian bonds added +5.6% after having lost 5.7% last year. In Europe the best performances came from HY (+6.5%) and Fin Sub (+8.6%) while the performance in US HY (+2.7%) was relatively subdued. Not surprisingly it was a less impressive month for core government bonds given the risk-on trade. Bunds, Gilts, and USTs were +0.1%, +0.5%, and +0.4%for the month after having gained +9.7%, +16.6% and +9.9% last year. In commodities and currencies, Copper is up 10% in January which helps reverse some of last year's decline (-22.7%). Silver is the outperformer after having gained 19.2% last month vs. a 2011 decline of 10%. USD was weaker against major currencies (DXY -1.11%), which partly reflects a renewed pledge from the Fed to keep rates lower for longer.

Looking forward, it is likely that the global beta factor continues to dominate relative returns. Defensive positioning and a reduction in tail risk remain as drivers of the risk rally, and they are joined by upgrades to growth projections, a move by central banks to be growth supportive, and the self-reinforcing nature of any broad gain in asset prices. The strong and widening rally in risk assets may give the impression that the investment community is turning bullish about the world. However, weak trading volumes, surveys, implied betas and market conversations reveal instead that this is a very reluctant rally. Those going Long in late January are frequently saying this is only for tactical and not fundamental reasons. And others are merely temporarily reducing or flattening their risk shorts. It is interesting that macro hedge funds seem to be going against the grain of the market by going even shorter equities.

I do think NEUTRAL stance is the right strategy in the near term, after the strong rally in January. The mid-to-long term economy trends still have many question marks. The buoyancy in US data since the end-2011 arose from special factors. Investment was boosted by companies bringing forward spending to exploit the 100% depreciation allowance temporarily available. Consumers spent more out of incomes, with the savings rate falling from 5% in mid-2011 to 3.5% in 4Q11. As US data turn down again, markets will face a world economy which looks weak everywhere. However, Fed could respond with QE3 before long. Meanwhile, Europe continues to tackle its crisis in a way that worsens the current recession and makes a full solution harder to achieve. The new measures agreed at the December summit were mostly aimed at preventing a future crisis and did not solve the immediate problem of how to convince the markets that Italy and Spain can avoid recession and insolvency. Both countries are taking encouraging steps towards reducing deficits and reforming their economies but doubts remain about the effectiveness of these policies, especially in the face of a steep recession. Asian economies are feeling the consequences of the European slowdown and their own monetary tightening in 2011. The countries that have slowed most are those sensitive to the world cycle (Singapore and HK) and those that tightened policy aggressively (India). China‘s slowdown is unfolding gradually, but I expect more weakness in 1Q12 as the housing sector squeeze hurts construction spending.

Earnings wise, as of last night, 246 of SP500 companies (65% of SPX mkt cap) have reported 4Q11 earnings. While actual earnings are tracking +4.2% ahead of consensus (+1.9% excluding AAPL) and revenues have come in +1% above consensus (+0.5% ex AAPL), consensus estimates and guidance have been trending weaker.  In Europe, it's still early days as we've only heard from 86 companies so far (14% of MSCI Europe mkt value), but the underlying trends do not look good either. 24% more companies have missed earnings expectations than have beaten.  These numbers would put the current quarter on track to be the worst since 2008.  Despite this somewhat mixed start, the improving macro and notion that "tail risk is off the table" has caused a notable decrease in stock level correlation. This has led many analysts to call for a return to stock picking. More importantly, technical SELL signals are flagging --- according to the ML, redemptions from Europe and Japan continue, while US equities record first outflows (-USD2.7bn) in 4 weeks. The anomaly is EM equities recorded another week of robust USD3.5bn inflows to total USD11.3bn YTD. Based on the EM Flow Trading Rule, A 4-week inflows = 1.6% of AUM (above 1.5% threshold) would spur a contrarian sell signal. Historically, 11 sell-signals since we the Indicator introduced in 2007, average 4% correction in following 4-5 weeks with hit ratio = 8/11 for absolute  declines.

Cool Down the Optimism 

The US saw an early round of comprehensive data for January that is much BTE. Most important, Friday’s NFP report showed a 243K increase in employment with a 60K net upward revision to the two prior months. Job gains by this measure have averaged 200K per month over the past three months, up from an average of only 106K per month over the prior six months. Strength in the payroll survey is mirrored in the more volatile household survey that shows a giant 631K increase in employment (after adjusting for a break in the population estimate) and a further drop in the UNE rate to 8.3%. Moreover, other January reports are also strong --- 1) The ISM manufacturing survey improved for the third consecutive month and the key new orders component rose 2.8pt to 57.6, its highest reading since last April. The ISM nonmanufacturing survey rose 3.8pts to 56.8, and new orders rose 4.8pts to 59.4, its highest level since last March. In addition, the rise in January auto sales also suggests the recent slowing in consumer spending should prove temporary. New car and light truck sales increased to an annual rate of 14.1mn in January from 13.5mn for both December and the 4Q11 average.

With all the encouraging signs of growth momentum discussed and probably discounted in the latest market rally, there are concerns to keep in mind --- 1) global credit conditions remain tight. The Fed’s January SLOS found that domestic banks made little change to business loan standards over the past three months. Meanwhile, the tighter credit conditions stays in Europe and EMs. The evidence from both regions suggests this tightening is taking hold. The Euro area M3 report for December (+1.6% vs. cons=2.1%) showed the largest monthly fall in private sector bank credit on record. While this drop almost certainly exaggerates the trend, the latest ECB survey of bank loan officers registered a sharp increase in the net tightening of lending standards and a net decline in loan demand, in line with the view that the regional recession is likely to continue through much of this year. In the EM, loan growth appears to have slowed below a 5% pace last quarter, sharply off the 30% pace in early 2011. The latest IIF EM bank lending conditions survey shows EM banks suffering a substantial worsening in international funding conditions and tightening credit standards. BIS data show that both Euro area and US banks reduced their exposure to the EM in 3Q11. 2) The fiscal drags in DMs remain the case. In terms of global outlook, The IMF on January 24 released its latest updates, claiming that “… Global output is projected to expand by 3.25% in 2012 --- a downward revision of about 0.75% relative to the Sep2011 WEO.” Over the course of this year, the street expects a fiscal drag of about 1.3% in Euro area and 0.6% in US. The advance 4Q US GDP reports highlighted the multiple channels by which policy is weighing on growth as defense spending is now being cut back and HH purchasing power is limited by a reduction in government transfer payments.

In contrast, EM Asian countries have considerable resilience. They lack the fiscal problems of DMs, have strong banking systems and high FX reserves. Importantly, high inflation, a major worry just a year ago, is now fading, opening the way to monetary easing as required. I expect that disinflation and growth disappointment is turning most central banks toward easing. Next week, Bank of Indonesia is forecasted to ease another 25bp. BoK, however, is likely to stand pat, with inflation expectations still high and fiscal easing in the pipeline. I expect China to gradually ease monetary policy, according to the pace and depth of the slowdown. The authorities are anxious not to abort the slowdown or the squeeze on the property sector too early, but equally they want to avoid a hard landing. India too will start to ease policy soon, with inflation falling. Elsewhere, with official rates close to neutral currently, easing will mostly be modest.

Dun Be Fooled by Headlines

The FOMC signaled a later start date to the next tightening cycle, but there are things to be carefully analyzed. The weighted average of the newly released FFTR projection across 17 policymakers was roughly in line with market expectations, in both real and nominal terms. Interestingly, however, data on the appropriate timing of policy firming shows that 11 policymakers would begin raising rates before the end of 2014 (3 favor hiking in 2012). The divergence with the forward guidance language in the Statement shows that Chairman Bernanke and other high-profile FOMC members are heavily skewing the tone of the Statement in a dovish direction. If it were a simple majority vote, the Fed would be inclined to tighten much earlier. In theory, one benefit of the new communication strategy will be to reduce volatility in UST market, especially during periods when growth is surprising on the upside. Policymakers could use the rate projections to temper UST selloffs that risk prematurely tightening financial conditions and truncating the fragile recovery. However, it is not clear how the market will react to seeming inconsistencies between the FOMC statement and the rate projections.

That said, Italian and Spanish bond markets have calmed further in the past week despite limited progress on the European crisis to justify the market optimism. EU leaders announced encouraging agreement on the fiscal compact and committed to enacting the permanent ESM bailout fund starting in July this year. However, the decisions about increasing the size of ESM or combining it with the EFSF are unlikely to be made until March. Support for either outcome by the Germans is questionable. Whilst Greece PSI negotiations have been hogging he headlines, developments in Portugal show that the "who's next" mindset remains very much in play as bond vigilantes search for other high debt/low growth lookalikes. The tortuous process of finding a way to strike a deal that is acceptable to all parties with respect to Greece is a reminder that there are no magic solutions. With a messy default still a strong possibility, additional pressure will fall on G20 to find a way to increase the size of the firewall at next month's meeting on. Without an effective safety net, markets are likely to remain nervous and we can expect further calls for Germany to lend a helping hand.

This explains well why Italy’s 5 and 10yr auction results this week did not sound any alarms, but LT bond yields remain relatively elevated (5.66%)  and subject to sentiment driven volatility. In fact, the LTROs provide a possible solution to banks’ funding problems for the next three years and large bank participation in the LTROs will anchor ST spreads, but other lingering risks could push Italian and Spanish sovereign spreads wider for longer maturities. Moreover, banks now face a dilemma as they plan for the February 29 LTRO tender. They can pre-fund their liquidity needs for the next three years at an enticing 1% cost, but they would need collateral to post and then they would have to do something with the funds, such as 1) deposit with ECB; or 2) buy sovereign bonds (core or peripheral) and/or 3) provide new loans. The banks have likely used existing holdings of peripheral debt as collateral, which reduces selling pressure and thereby supports sovereign bond yields. Re-depositing at ECB at 0.25% is a money-losing proposition, but adding risky sovereign debt through the “carry trade” without a credible backstop for the sovereigns could threaten their already-weak capital base.

In other words, the LTROs can solve the banks’ refinancing needs for the next few years if they choose to take advantage. Yet the LTROs’ effect on peripheral sovereign debt is only indirect and is subject to the banks’ fickle appetite for risk. According to BBG, the Italian, Spanish, and French banks soaked up the bulk of the roughly EUR200 net LTRO and MRO funding, while German banks stayed mostly on the sidelines. Net new (i.e. net of MROs) participation in the February 29 LTRO tender is anticipated to be EUR500bn to EUR1trn. This level would be a good sign that banks are reducing their funding and liquidity risks, and optimism has already driven yields tighter. Sentiment could deteriorate once market focuses shifts back to the underlying problems with bank B/S and capital needs. LTROs tackle liquidity, but they do not solve bad debt problems or eliminate large cross-border exposures. In the long-term, economy growth is the only credible solution to the crisis in the Euro area. IMF has warned on too much austerity, and cut growth forecast. The latest IMF forecasts put Euro zone growth at -0.5% , cut global growth to 3.3% (from 4.0% in Sep) and warned large countries against austerity measures that are too aggressive. High financing costs and weakness of the banking sector were cited as the main risk for the economies in EU, which the fund said requires a greater 'firewall'...In short, the situation &  economic prospects in the euro area did not change much over the holidays.

Soft Landing on Course

The week saw China market strength as a result of both reductions of tail risk in DMs as well as improving cyclical factors in China. In the coming week, some macro data release for Jan will be incomplete (Jan+Feb together), but focus will be on evidence of continued monetary normalization - possible disappointment on loan data (BOCI: Big 4 banks lost RMB439.7bn deposit, while total loan growth =317.5bn) could trigger profit taking. But a pullback beyond 10% not likely, unless the global picture collapses or confidence in policy responsiveness erodes.

Data wise, the latest China's official manufacturing PMI came in at 50.5 in January, up slightly from 50.3 in December. This reading is better than market expectations of 49.5-50. The HSBC PMI, at 48.8 in Jan vs. 48.7 in Dec, shows a similar steadiness but a lower level. PMIs for January suggest that the Chinese economy has remained resilient. It worth a note on the negative side, the trend of further deceleration of exports and construction activities remain intact. The new export orders index fell 4ppts to 46.9 in January, which remains broadly consistent with export growth of 8% in 1Q12. The import order index also fell by 1.8ppts to 46.9 in Jan, suggesting in part the weaker demand for raw materials. The sub-50 reading of the HSBC PMI also raises the question of how representative the official PMI is. Thus, it is too soon to claim the worst is over, but the economy’s remarkable resilience is encouraging. The near-term outlook remains uncertain given many conflicting data points. Economic data coming out of China needs to be closely monitored in the coming months for confirmation of the macro trends.

Looking forward, in line with Premier Wen’s warning over the year-end about a difficult Q1, I expect business activity likely to moderate and growth in China to slow down in Q1, possibly to around 8%, before policy easing. That said, it is important to note that the economy’s various trouble spots were able to withstand severe policy headwinds in 2H11, when the tightening campaign was at its maximum strength. The odds of an economic crash will likely decrease because the policy pendulum is clearly swinging back to easing. This should increase the availability of credit, reduce the cost of borrowing and help the economy to stabilize. This time around, baring an extreme external shock, a soft landing remains the most likely scenario. In addition, Governor Zhou Xiaochuan’s interview in the first edition of Caixin magazine in 2012 was an interesting read. Zhou argues that China is not far away from an open capital account. In other words, RMB needs to appreciate further. The PBoC’s first USDRMB fix of 2012 on 4 January was set at 6.3001, meaning a 4.87% yoy appreciation since 2011.

In terms of the stock market, investors have been pessimistic enough on both China’s cyclical outlook and structural fundamentals in the 4Q11. This means that the market has priced in enough bad news and is more likely to respond to positive growth surprises and policy reflation going forward. In China, policy easing has been selective but not insignificant. Reverse repo and fiscal deposits in commercial banks are, though temporary, equivalent to three RRR cuts. Outright easing including RRR cuts is inevitable if exports, property investment, UNE and fiscal status of local governments deteriorate in the coming months. In the near term, China is unlikely to do more, given the resilience of economy activities.  Thus, stock markets likely stay range-bound in ST. I would prefer those sectors with relatively low valuations and stable earnings, and that can benefit from policy easing and promotion of infrastructure investment, including banks, insurance, energy, internet, capital goods, metals & mining, railway, utilities and airports...….Lastly valuation wise, MSCI China is now traded at 9.5XPE12 and 13.5% EG12, CSI 300 at 9.8XPE12 and 21.5% EG12, and Hang Seng at 14.9XPE12 and 2.8% EG12, while MXASJ region is traded at 11.4XPE12 and 8.3% EG12.

Base Metal Run not Sustainable

Industrial metals are up 10%-15% YTD. All six base metals ended the past week higher, with copper decisively breaking out of its previous range of USD7-8000/ton to an 11-week high of USD8089/ton on 16 January. Copper was the best performer, rising 7.9% wow, followed by Tin + 5.3%, Zinc +4.4%, while Lead and Aluminum advanced 3.3% and 2.6%, respectively. Looking forward, I think these metals’ run are not sustainable, especially from a near-term consumption stand-point. First of all, the global economy lacks the demand sparks needed to generate significant upside to base metals prices in the near-to-mid term. According to JPM, the forecast of Global GDP is well below trend at 2.2% in 2012, with DM at 1.2% and EM at 4.8% (down from 5.8% in 2011). In particular, Euro area GDP is on track to be -0.5% to -0.8% in calendar 2012. Recent PMIs indicate that the European economy is likely immersed in recession, although the global industrial economy is slowly cobbling together a modest industrial recovery.

China will continue to remain the anchor tenant in the demand side of the metals’ B/S and, save for copper, should post real consumption growth of 8%-10%+ in 2012. Copper is going to be a lower number however, for the dominant reason that there isn’t enough copper for China to post a real consumption number of 10%. Demand rationing, substitution and thirsting will act to ensure that China’s real consumption of copper travels sub-IP for at least 2012 and 2013. This keeps prices higher until the collectively recalcitrant mining sector delivers much-needed volume to the market, starting late 2012 and working into 2013-2015. However, investors should keep an eye on the negative readings from China’s property sector, a large consumer of base metals and steel. Property development investments continued to weaken in 4Q111 amid a tough market environment. Residential housing investment growth slowed to a 30-month low of 10.8% yoy in December (average growth of 19.6% yoy in Q4) vs. 35.7% average growth in the first 3Qs 2011. Floor space sold for residential housing fell 8.4% yoy in December (from 12.9% average growth in 3Q11), the third consecutive month of negative yoy growth. I do expect China's residential property market to remain depressed in 2012 as property developers will face rising unsold housing stock, falling demand and softer prices in the coming months, weighing on construction investment and thus economic growth.

To sum up, the global economy lacks the demand ‘spark’ needed to generate significant upside to industrial metals prices in the near to medium term. DM demand will be constrained by high debt levels, a near term economic weakness due to austerity measures. The upside surprise of real demand relies on China’ willingness to take simulative policy action. However, the market may be overly enthusiastic in expecting material monetary and fiscal support from Beijing.

Good night, my dear friends!