We continue to flag accelerating exchange rate risk as a key risk to monitor over the intermediate term and continued declines in Asian currencies vs. the USD puts downward pressure on the un-hedged returns of U.S.-based investors, as well as upward pressure on the foreign currency-denominated debt service burdens of Asian corporations and governments.
Asian equity markets were fairly weak across the board this week, with India, Japan, and Korea the only markets to close up wk/wk. As we alluded to earlier, we saw general weakness across Asian the FX markets, with exchange rates falling nearly a full percent on average vs. the USD wk/wk. The Korean won (KRW) and Indonesian rupiah (IDR) led the way to the downside at -3.1% and -2.4%, respectively. The Philippine peso (PHP) also underperformed (down -1.9% wk/wk), as the government introduced capital controls designed to aggressively limit bullish speculation in the currency.
This was one of the first weeks in quite some time where sovereign bond yields backed up broadly across the curve throughout the region. Backups were lead by Indonesia and, to a lesser extent, Philippines, as both countries struggled with investor liquidations amid declines in the local currency. One-year on-shore interest rate swaps for both countries also widened +10bps and +20bps, respectively, though, economic fundamentals and recent central bank commentary do not suggest a rate hike is imminent in either location. It could be, however, if exchange rate declines continue and stoke incremental inflation – an outcome we don’t expect, judging by us going long of the USD in our Virtual Portfolio, which makes us generally bearish on commodity-based inflation. India’s fundamentals do, however, support the +31bps widening of its interest rate swap market.
Five-year CDS widened broadly throughout the region, bookended by Australia (76bps) and Vietnam (400bps).
China: Chinese economic data came in fairly mixed: export growth accelerated in Aug to +24.5% YoY vs. +20.4% prior; trade balance growth slowed in Aug to -$2.3 billion YoY vs. +$2.8 billion prior; loan growth accelerated in Aug to +548.5 billion yuan MoM vs. +492.6 billion prior; M2 money supply growth slowed in Aug to +13.5% YoY (slowest pace since Oct ’04) vs. +14.7% prior; and China’s Manpower Employment Outlook Survey (a gauge of employer hiring expectations) edged up in 4Q to 25% vs. 19% prior.
The PBOC’s quarterly inflations survey pointed to a more hawkish picture of Chinese CPI, though our model’s Chinese CPI outlook tell us to fade these results: the % of respondents expecting higher prices in the next quarter increased +410bps to 49.6%; the % of respondents who stated that overall prices are “too high to accept” increased +380bps to 72%; and the % of respondents who said property pries are too high rose to a record high of 75.6%. Rhyming with our stance, a PBOC survey of 3,000 financial institutions showed that only 56.4% of Chinese financiers expected interest rates to continue rising in 4Q, down -1,180bps QoQ.
Dim-sum bonds, which are yuan-denominated notes issued in Hong Kong and available to foreign investors, are now outperforming the local-currency bonds of China’s BRIC counterparts since the start of the quarter, mostly due to exchange rate depreciation of the other currencies from the perspective of dollar-funded investors: China +0.8%; Russia -7.1%; India -4.8%; and Brazil -7.4%. Since the start of the quarter, the Chinese yuan is up +1.3% vs. the USD; Russia’s ruble has declined -8.9%; India’s rupee has fallen -5.6%; and Brazil’s real has dropped -8.6%. We continue to flag foreign currency exchange rate depreciation as a major risk for U.S.-based investors seeking higher returns abroad and our long-USD position suggests we expect this trend to continue.
When asked about the possibility of LGFV debt driving up defaults and charge-offs across the Chinese banking system, Ma Weihua, president of China Merchants Bank Co. (the country’s sixth largest bank), said that “it’s impossible to have a repeat of the large-scale non-performing assets [crisis of the early 00’s]”. Outright denial of risk by corporate executives remains one of the key signs we look for in trying to gauge risk, and we typically fade their bold claims (see: BAC and Brian Moynihan). We remain long of Chinese equities as our Chinese Cowboys thesis continues to play out in spades on the growth/inflation front, but we would be remiss to ignore this systemic risk as Chinese bank CDS blows out to new wides:
Hong Kong: The “Ack-Attack”, as we have dubbed famed investor Bill Ackman’s activist strategies, has recently migrated from underachieving U.S. retailers to the land of Global Macro. Speaking at CNBC’s latest “pitch us your book” intuitional investor conference, Ackman unveiled that he was purchasing Hong Kong dollar call options in anticipation that the city-state revalues the currency’s HK$7.80 peg to the USD by +30% at some point and then link it the Chinese yuan over the next “three-to-six years”.
Though Ackman correctly cites that the peg has contributed to a -7% decline in the HKD/CNY exchange rate, which is fanning inflation driven by a property bubble which itself is being driven by mainland Chinese buyers, he fails to realize that Hong Kong is among the most export-driven economies in the world (exports account for roughly ~205% of GDP), which means policymakers don’t want to see the HKD appreciate vs. the currencies of its top two export markets (China at 52.7% and the U.S. at 11%).
The Hong Kong Monetary Authority agrees with our view, saying, “[We] have no plan or intention to change the system as it continues to serve Hong Kong well”. Moreover, Hong Kong policymakers have shown that their preferred response to rising inflation has been to extend handouts, increase wages, and selectively combat real estate speculation with targeted regulation, rather than a tightening of monetary conditions – an option that is admittedly limited by the currency peg. Still, you typically see aggressive bets like these at/near the top of an inflation cycle – an outlook we authored and is currently supported by our fundamental modeling of Hong Kong CPI, as well as our current Virtual Portfolio (long USD) and Dynamic Asset Allocation (only 3% commodities) positioning.
Japan: While light, Japanese economic data came in better on the margin: business sentiment ticked up +6.6 points QoQ in 3Q vs. a decline of -22 pints in the prior quarter and PPI slowed in August to +2.6% YoY vs. +2.9% prior. Our models do, however, continue to point to slower rates of Japanese economic growth over the intermediate term, and we are not shocked to see several Japanese central bank officials come out with more fear-mongering hints of further stimulus. BoJ board members Ryuzo Miyao and Sayuri Shirai both said the central bank stands ready to take “appropriate” and “bold” action to “support the economy”. As such, neither is ruling out further monetary stimulus efforts over the intermediate term.
Interestingly, Shirai did say that, “Too much intervention in financial markets has the possibility of leading to distortions in the price-setting mechanisms in the long run.” A worthwhile warning indeed. Unfortunately for believers in free-markets, how much is “too much” continues to be largely determined by the bubbly community of Keynesian economists.
On the fiscal policy front, Japan’s newly redesigned leadership continues to echo hawkish comments as relates to future debts and deficits. Prime Minister Yoshihiko Noda reaffirmed his commitment to fiscal reform, specifically with regard to eventually raising taxes to help tackle the “multitude of problems” the country faces. To that tune, Finance Minister Jan Azumi said that “a combination of income and corporate taxes will be the pillar [supporting earthquake/tsunami reconstruction]”. The government may also sell off state-owned assets, such as shares of Japan Tobacco and Tokyo Metro Co., per Azumi’s comments. While it does appear that Japanese officials are growing increasingly cognizant that they are inching closer to the tipping point of a fiscal crisis, we don’t believe there’s much they’ll be able to do in the way of deficit-cutting that won’t have a profound negative effect on the economy anyway (i.e. higher taxes; lower social security spending, etc.).
India: The key news out of India this week was the RBI’s bold resolve to hike interest rates +25bps in order to continue combating inflation, which had accelerated to +9.8% YoY in Aug (WPI). The latest increase marks their 12th rate hike since the start of the current cycle, which began in Mar ’10. As we have been saying in recent notes, our model’s outlook for Indian WPI would suggest that this is indeed the RBI’s last rate hike within this current cycle – an outlook supported by the central bank itself, saying, “As monetary policy operates with a lag, the cumulative impact of policy actions should now be increasingly felt in further moderation in demand and reversal of the inflation trajectory towards the latter part of 2011-12”.
We use the word “bold” in describing this latest rate hike because much of India’s “fundamentals” (financial market price trends and economic data) had been eroding on the margin: industrial production growth slowed in Aug to a 21-month low of +3.3% YoY; Indian banks increased their holdings of the country’s sovereign rupee-denominated debt by the fastest pace since 2009 (up +1.1 trillion rupees 3Q-to-date to 17 rupees trillion total); the rupee itself had fallen to an intraday price of 48 per dollar – a level not seen since mid-2009 – prompting the central bank to intervene in the FX market by selling dollars, as well as a +50% increase of the unregulated foreign borrowings cap out of the central government (more external debt issuance typically equals more upward pressure of the currency as proceeds get repatriated); and 50% of SENSEX-listed companies missed earnings estimates last quarter as rising interest rates caused debt service to increase to the highest proportion of sales (1.8%) in seven quarters.
All told, India’s fundamental story appears to be going from “pretty bad” to “less bad” on the margin, and we would expect that transition to prove bullish for Indian equities at some point over the intermediate term – particularly if we’re correct in calling for headroom for the RBI to shift to a more dovish monetary policy stance.
Australia: Yet another capital markets sign that links the current Global Macro environment to the 2008-09 mayhem are Aussie sovereign bond yields, which have plunged across the curve to levels that are all below the RBA’s target policy rate of 4.75%. The nominal yield on Australia’s 15yr note, it’s longest sovereign issue, is -37bps below the central bank’s cash rate. Aussie 2yr sovereign debt yields are a full -112bps below the cash rate. Per Bank of America government bond indexes, Australian sovereign debt has returned investors +5.3% quarter-to-date – the largest gain since a +9.2% return in 4Q08.
As mentioned before, the spread between the market’s expectation of Australian economic growth and inflation and the central bank’s official stance hasn’t been this wide since late ’08/early ’09. The RBA board led by Governor Glenn Stevens, continues to point to declining productivity growth and rising consumer inflation expectations (which accelerated +10bps sequentially to +2.8% YoY in Sep) as reasons for maintaining the central bank’s hawkish bias. We’ve been all over this topic YTD and were far and away the first to forecast the move in Aussie interest rates and we continue to expect the data to support our bearish intermediate-term TREND and long-term TAIL view of the Australian economy.
From a very near term perspective, however, the fall in Australian interest rates is supportive of rising consumer confidence due to the heavy floating-rate nature of consumer finance down under. In fact, Wespac’s consumer confidence index ticked up in Sept to 96.9 vs. 89.6 as a fall in Australian mortgage rates buoyed sentiment around household finances. We could see a rally in Australian consumer stocks if Stevens and crew allow these gains in consumer confidence to continue by cutting interest rates. Elsewhere, business confidence lags far behind, with the NAB’s business confidence falling in Sept to the lowest reading since April ’09 (-8 vs. 2 prior). The NAB business condition index also declined, falling to -3 vs. -1 prior.
In other ‘08/’09 corollaries, Australian banks’ reliance on external wholesale funding has fallen to its lowest level since Aug ’09 (A$314.1 billion), as term deposits grew to a record (A$469.5 billion), driven by the Australian consumer’s increased propensity to save amid falling asset prices and rising joblessness. Indeed, falling asset prices, particularly in the Aussie stock market (down -12.7% YTD), are especially painful to Australian consumers, whose 47% pension fund allocation to equities rivals only the U.S. and Finland globally. The country’s insistence on the “stocks over bonds” mantra (only 11% exposure to fixed income – lowest in the OECD) has caused Australian savers to suffer an annual average net loss of -2.8% since 2008. While low interest rates (vs. historic averages) have been supportive of the institutional marketing message behind the country’s misallocated pension savings, some Aussie fund managers are actually keen to call out the phenomenon for what it is:
“In Australia, we have this cult of equity even though bonds have provided much better returns over the past five years.” – Vimal Gor, head of fixed income at BT Investment Management Ltd. with A$13 billion AUM
“Rather than saying interest rates are too low, investors should be more concerned about what low rates are telling them about economic growth and the expected return on risky assets.” – Robert Mead, portfolio manager at PIMCO’s Sydney office
A worthy callout indeed.