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    MARKET EDGES

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THEME

We’re starting to see some noteworthy bifurcations in the direction of monetary and fiscal policy across the region.

PRICES

Asian equity markets were largely mixed last week, headed by Vietnam (+5.7% wk/wk) and Indonesia (+4.1% wk/wk) and trailed by Japan (-2.4% wk/wk) and Korea (-2.9%). Asian FX markets declined broadly across the board, with the Kiwi dollar underperforming (-3.3% wk/wk) on the heels of dovish commentary out of the country’s Treasury department.

Speculation around interest rate cuts continues to broadly drag down yields throughout the maturity curve across Asia’s sovereign debt markets. China remains a key outlier with its 2yr yields increasing +4bps wk/wk. This expectation of future hawkishness was, however, not reciprocated in China’s interest rate swaps market (1yr tenor falling -9bps wk/wk).

From a yield curve perspective, it’s worth highlighting the +31bps expansion of the Filipino sovereign 10yr-2yr spread – a leading indicator for accelerating growth in our model. On the flip side, China’s 15bps-wide 10yr-2yr spread has compressed to a record low. Though we continue like the long-term mean reversion opportunity, the current setup is decidedly negative for the net interest margins of Chinese banks and their collective ability to generate internal capital ahead of what many expect to be a broad decline in credit quality throughout the Chinese banking system over the next 2-3 years.

Sovereign CDS widened broadly across the region with China’s +12bps wk/wk expansion leading the way. Interestingly, Fitch warned Thursday that it might downgrade the country’s credit rating (currently the lowest of the big three at A+) within two years should it become evident that China’s banks will indeed struggle with a broad-based decline in asset quality. Interconnectivity remains the dominant theme in global macro markets.

 

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KEY CALLOUTS

China: China had a busy week of economic data, which largely came in as we expected and continue to expect: growth slowed at a slower rate; inflation peaking/has peaked. Services PMI ticked down in Aug to 57.6 (vs. 59.6 prior); industrial production growth slowed in Aug to +13.5% YoY (vs. +14% prior); retail sales growth slowed in Aug to +17% YoY (vs. +17.2% prior); fixed asset investment growth slowed in Aug to +25% YoY (vs. +25.4% prior); CPI slowed in Aug to +6.2% YoY (vs. +6.5% prior); and PPI slowed in Aug to +7.3% YoY (vs. +7.5% prior). Net-net, we continue to believe slowing inflation will give the PBOC cover to remain neutral over the intermediate term, though outright dovishness is unlikely to be seen absent a further 100-200bps decline in China’s headline inflation rate. Still, China remains far and away the best positioned of all the major economies to stimulate on a large scale if deemed necessary. We demonstrate this quantitatively in our recent note titled, “Chinese Cowboys Intact”.

Hong Kong: There’s not much to flag beyond the territory’s manufacturing PMI plunging -3.6 points in Aug to 47.8. Much like Singapore, we view Hong Kong status as one of the most open, trade-heavy economies in the world (exports = 204.8% of GDP on a trailing 3yr average basis), and this nasty PMI reading is an explicitly negative signal for the near-term slope of global growth. We remain the bears on Hong Kong equities until our models suggest otherwise.

Japan: One of the more aggressive calls we made recently was that the slope of Japan’s YoY and MoM economic growth data was going to turn decidedly negative in the 2H – a call that is particularly contrary to consensus expectations for reconstruction-fueled accelerating “growth”. Though our call is only just over five weeks old, it the data continues to play out in spades: machine orders growth slowed in Jul to +4% YoY and -8.2% MoM (vs. +17.9% YoY and +7.7% MoM prior); both components of Japan’s Economy Watchers Survey ticked down in Aug: the current situation component fell to 47.3 (vs. 52.6 prior) while the outlook component fell to 47.5 (vs. 48.5 prior). We continue to expect more downside to Japanese economic data over the intermediate term.

An interesting callout we wanted to flag was the revision to Japan’s 2Q GDP, which was revised down nearly 62% to -2.1% QoQ SAAR. It appears the U.S. isn’t the only major economy that has significant trouble reporting key statistics – likely because it’s politically easier to report healthier figures while leaving nasty revisions like these to sneak in just beyond the consensus radar.

Regarding Japan’s currency, the yen, former Vice Finance Minster Rintaro Tamaki confirmed a belief that has allowed us to maintain a bullish bias on the yen over the last few months (with the exception of a one-off short position in our Virtual Portfolio ahead of the latest intervention). Specifically, he said that “members of the G7 have indicated that intervention should be done in agreement with the G7, as opposed to unilaterally.” As we anticipated, the G7 is coming across as less willing to tolerate currency devaluation strategies than they were when they assisted Japan in selling the yen after the March catastrophes – particularly as they each come to grips with slowing growth in their own economies.

India: We continue to stress that accurately predicting the slope of economic growth allows one to correctly predict outcomes across economies (both individual and global) and their financial markets. India has been a poster child for this YTD. Slowing domestic and global growth has been a major factor in various developments throughout the Indian economy.

Specifically, the -17.3% YTD decline in India’s benchmark equity market (SENSEX) has been very unkind to Indian capital markets. For example, share sales in India have declined -53% YoY on a YTD basis and the 338 billion rupees of equity capital raised happens to be the lowest amount since 2006! This is complicating the government’s efforts to monetize 400 billion rupees worth of state-owned assets through share sales, with only 11% of the target amount completed over five months into the fiscal year. As we pointed out very early in the year, this was one of many factors which would ultimately cause India to miss its aggressive and celebrated deficit reduction target.

Furthermore, the inability for Indian companies to finance growth through equity capital has driven up Indian corporate foreign currency borrowing +8% YoY on a YTD basis, which, in turn, has widened spreads on Indian dollar-denominated bond yields +164bps YTD to 489bps more than U.S. Treasuries. Elsewhere, increased provisions for defaults to the tune of +30-80% (depending on the bank) has driven Indian bank CDS to noteworthy levels, closing the week at 276bps, 303bps, and 343bps for State Bank of India, IDB of India, and ICICI Bank, respectively. Though still well below the highs of the Lehman aftermath, we will continue to monitor these swaps closely for evidence of further alarm.

Amid the realization of slowing economic growth, Indian policymakers dropped three separate hints regarding the potential for near-term stimulus. First, RBI Governor Duvvuri Subbarao explicitly stated that the central bank intends reduce India’s “high” reserve requirements “gradually” to “enable banks to boost lending”. Currently, Indian lenders are required to set aside 6% of their deposits to meet the mandatory cash reserve ratio and another 24% must be invested in approved securities to comply with the country’s statutory liquidity ratio. Elsewhere, RBI Deputy Governor Subir Gokarn said that currency intervention is not completely off the table should the central bank deem it necessary to weaken the currency to aid exports. Lastly, India’s commerce ministry is came out today with an official statement claiming that they are preparing proactive and preemptive measures to stimulate exports – which is indeed aggressive, given that export growth is currently at +44.2% YoY.

Australia: Glenn Stevens and his RBA board members continue to fight the market, holding Australia’s benchmark interest rate flat at 4.75%. For reference they’ve been on hold since November – their longest such pause since ‘05/’06. Meanwhile, Aussie economic data continues to come in soft: the unemployment rate backed up another +20bps to 5.3% in Aug; payrolls growth slowed in Aug to -9.7k MoM (vs. -4.1k prior); and while accelerating +10bps to +1.1% YoY in 2Q, the 1.05% YTD run-rate of real GDP remains substantially below the RBA’s already-reduced target of +2% GDP in 2011 (down from a May ’11 estimate of +3.25%).

Though we maintain our respect for his central banking prowess, Steven’s models have been flat-out wrong YTD – much like Bernanke’s and the sell-side’s. We continue to side with the Aussie sovereign bond market, its interest rate swaps market, and the country’s dried up corporate credit market and foresee a continuation of the recent trend of slow economic growth Down Under. Whether or not Stevens finally cracks will ultimately have a large effect on Australia’s currency market (AUD/USD down -1.9% wk/wk).

Korea: South Korea took a step backwards this week from a policy perspective. First, policymakers imposed a 14% tax on interest income from kim-chi bonds (foreign currency-denominated Korean sovereign debt) to slow currency-pressuring capital inflows. We remain negative on governments that aggressively pursue interventionist strategy – such as Korea’s. Secondly, President Lee Myung Bak failed to sell a tax cut plan that would have pumped 2.8 trillion won ($2.6 billion) of fiscal stimulus into the $1 trillion economy. The plan, which was scrapped due to populist claims that it would’ve only benefitted “a few rich people”, underscores President Lee’s drive to spur economic growth and balance the budget by 2013 through a variety of tax cuts, tax deductions for facilities investment, and tax break incentives to hire new employees. If he is ultimately successful in these initiatives, we could see the Korean economy take a huge step forward in the longer term.

Indonesia: The key callout from Indonesia this week was the central bank’s noteworthy decision to favor supporting economic growth over combating inflation. Though CPI accelerated on a both a headline and core basis in Aug (to +4.8% YoY and +5.2% YoY, respectively, vs. +4.6% and +4.6% prior) the central bank decided to keep its benchmark interest rate flat at 6.75% (on hold since Feb). Their choice came amid sour economic data, which highlighted declining consumer confidence (88.2 in Aug vs. 89.6 prior), slowing export growth (+39.5% YoY in Aug vs. +49.1% prior), and slowing trade balance growth (+$1.5 billion YoY in Aug vs. +$2.7 billion prior). Sticky Stagflation continues to keep central banks from Asia to Latin America in a box from a policy perspective.

Philippines: In a shameless pump of our own book, CPI slowed on both a headline and core basis in Aug to +4.7% YoY and +3.4% YoY, respectively. Our models point to further downside over the intermediate term, which should allow the Filipino central bank to start to ease monetary policy if deemed necessary. Their most recent decision (maintaining the hold on their benchmark interest rate at 4.5%) came earlier this week.

Darius Dale

Analyst