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The Flight to Liquidity trade continues and capital markets are drying up globally as our call for compounding Interconnected Risk plays out in spades. Asia, which had been the last beacon of hope on the economic growth front YTD, is struggling mightily.


Asian equity markets got hammered this week, closing down -5.9% wk/wk on a median basis. Every country closed down on the week led by Indonesia (down -10.7%) – a country we were fortunate enough to book a gain in at the top of the intra-week rally just over a week ago. In addition to New Zealand, China outperformed, closing down “only” -2% wk/wk. China does, however, remain one of the few big mistakes we’ve made YTD (currently down -10.5% from our cost basis within our Virtual Portfolio). If there’s one lesson we’ve re-learned since authoring this thesis back in April, it’s that in these volatile times we must be increasingly cognizant of having our catalysts much closer in duration – on both the long and short side of a security. Being early is being wrong.

Asian FX markets also got rocked wk/wk, as the Flight to Liquidity trade (USD-bullish) continued. As a group, currencies closed down -2.9% on a median basis vs. the US Dollar. With the exception of the Japanese yen, we’ve been generally bearish on Asian currencies (vs. the USD) since we introduced our Deflating the Inflation back in 2Q and that thesis is playing out in spades. It’s not a trend we would recommend fighting, given the US Dollar’s quantitative setup – i.e. a Bullish Formation. The Aussie dollar, which we’ve been the bear on since earlier in the year, fell -5.4% wk/wk and broke parity with the USD for the first time since mid-March.

Asian sovereign credit markets were mixed, as we saw capital pour out of the more illiquid markets (Indonesia, Philippines, Thailand) and into the more liquid markets (Australia, Hong Kong, Singapore) – a phenomenon felt across the yield curve. As it relates to the slopes of Asian yield curves specifically, we are encouraged by what we saw out of China (widened +4bps wk/wk) – a move that would ultimately prove bullish for the Chinese economy if sustained over a longer duration. Conversely, the -29bps drop in Hong Kong’s 10-2 sovereign yield spread is an explicitly negative signal that growth is slowing within the territory, due to it being highly-levered to the global economic cycle (exports account for over 200% of GDP).

Asian 5yr sovereign CDS widened dramatically wk/wk, closing up +23.5% on a median basis! With the exception of Australia, New Zealand, Philippines, and Vietnam, Asian credit default swaps spreads have either doubled or are very near doubling for the YTD. Valuation remains no catalyst with this level of systemic risk spread throughout the global financial system.

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China: Given the country’s managed nature, official rhetoric remains a key factor to analyze in China and the big announcement we received this week was Premier Wen Jiabao’s statement that he remains “concerned about high prices”, as well as his assertion that “the government will continue to take measures to control prices”. We interpret this as the Chinese stimulus bazooka – which consensus continues to speculate on in the absence of positive news – is unlikely to be unleashed absent a major disinflationary shock. This is due to the likelihood that, while slowing, Chinese CPI will remain sticky and comfortably above the government’s 4% target well into 2012.

Elsewhere on the rhetoric front, Yi Gang, the PBOC’s deputy governor, confirmed that Chinese support for troubled European banks/economies will be limited in some regard and that China fully understands how weak many developed economies truly are:

“At the margin, we can do quite a bit to help. At the same time, the real solution of the European sovereign debt crisis has to be done by Europeans themselves… One hurdle is that most nations are constrained in implementing further fiscal and monetary policy measures as they have already used them to recover from the last slump. Fiscal capacity is limited and monetary policy is already used pretty much to the limit.”

China is well aware that Europeans can’t meaningfully increase debt and deficit spending and that the U.S. can’t cut interest rates from ZERO percent.

From a capital flow perspective, we’re seeing some things that certainly make us uncomfortable as holders of Chinese equities. Investors looking to get out of China via Hong Kong (more liquid market) have caused yuan spot rates to be nearly a full percent lower in Hong Kong than in the onshore Shanghai market. Additionally, 1-12 month non-deliverable forward contracts, which investors use to speculate on the currency, are all trading at a discount to the spot rate in Shanghai. The premium paid for yuan in the spot market has widened to the highest level since March ’09 (+0.2%).

As investor capital flows out of the country, we’re seeing corporate capital flood in, though most likely from ailing property developers. We believe mainland Chinese developers, who are largely struggling to secure refinancing domestically (bank credit down -75.1% QoQ in 2Q), are contributing heavily to the recent surge in U.S. and Hong Kong dollar-denominated borrowing (the former up +122.2% YoY; the latter amount of HK$10.2 billion is highest quarterly volume since 3Q10) due to the ~72% discount Chinese corporations are receiving on such external financing.

As this money gets repatriated back into China, accelerated PBOC purchases of foreign exchange have sent Chinese financial institutions’ net yuan positions up +72% in Aug from July – the largest gain in five months. While consensus was quick to speculate on portfolio investment inflows attempting to take advantage of Chinese economic growth, we believe that deteriorating metrics in the real estate space is incrementally driving up the domestic cost of capital for Chinese property developers, forcing them to look abroad for refinancing. Such metrics include: land transactions -14% MoM in Aug; land auction failures up +242% YoY in the year-to-date; and the number of cities posting flat-to-down MoM property price increased to 47 in Aug – the most ever, according to Samsung Securities.

Japan: The new Japanese leadership, headlined by recently-elected Prime Minister Yoshihiko Noda, appears slightly more willing to put up with persistent yen strength than the previous administration. Though details are not yet finalized, Economy Minister Motohisa Furukawa did introduce a new program designed to help companies cope by increasing subsidies for building factories in Japan. This latest round of deficit spending is designed to discourage large exporters like Panasonic (the world’s largest maker of rechargeable batteries) and Elpida Memory Inc. (the world’s third-largest maker of memory chips) from proceeding with recently-announced plans to ship manufacturing capacity abroad to escape FX-based profit erosion.

As with any new fiscal strategy Japan outlines (see: energy reregulation), we have serious questions as to how it will be financed, given the government’s weak fiscal positioning (deficit/GDP = 8.1%; debt/GDP = 225.8%). Higher taxes and slower growth continue to loom on the horizon that is Japan’s long-term TAIL. It’s not at all ironic that Japan’s 5yr sovereign CDS blew out to new wides this week, closing at 140bps. For reference, when we introduced our bearish long-term thesis on Japan in 4Q10 titled Japan’s Jugular, Japan’s 5yr sovereign CDS was trading around ~50bps.

From an intermediate-term TREND perspective, we expect the Japanese economy to continue to get weaker as the capacity restoration we’ve seen in the wake of the March/April disasters comes to a halt. Japanese export growth, which consensus celebrated as the first positive YoY gain since Feb (+2.8% in Aug), did little to actually add to Japanese economic growth, given that a pop in import growth (+19.9% YoY) contributed to the removal of -¥823.8 billion from the Japanese economy when analyzing the trade balance on a YoY basis.

As it relates to the burgeoning Eurozone banking crisis, Japan took even a more hard-line stance than China and stated that Japan won’t be offering the PIIGS a “blank check”, per Finance Minister Jun Azumi:

“While additional aid is a possibility if Europe succeeds in creating a system for dealing with crises, it’s not like we’re going to provide a blank check. This is a Euro-area problem and the Euro-area nations should be the ones to solve the problem.”

Japan is right. It’s got its hands full with trying to prevent a similar crisis from emerging at home over the next 3-5 years.

India: As we forecasted back in March it’s all but set in stone that India misses its budget deficit target in the current fiscal year. Specifically, the rout in the SENSEX (down -21.2% YTD) is preventing the government from unloading state-run companies alongside a boost in subsidies stemming from elevated inflation. Having raised a minuscule 3% of the 400 billion rupee target at nearly the halfway point of the fiscal year, India risks missing its divesting goal for at least the second year in a row (only 57% of the total was raised in the last fiscal year). This is likely to force the Indian government to have to borrow above and beyond their target of 4.17 trillion rupees in FY12 – at a time when foreign demand for Indian assets is dropping like a rock (INR/USD down -4.4% wk/wk).

The rupee’s decline coupled with the recent gasoline price hike out of Indian Oil Cop. (the country’s largest refiner) may serve to push up reported inflation by as much as +7bps in the short term per P.K. Goyal, India’s Oil Finance Director. Still our fundamental models and quantitative signals across the commodities market(s) continue to signal that WPI in India has peaked and that the Reserve Bank of India is done tightening in the current interest rate cycle. This dovish outlook is shared by the RBI itself, with Deputy Governor Subir Gokarn saying:

“You could say that the cycle is nearing its end, given the projection that inflation will start coming down and will continue to move down from December onwards. Oil Prices do not appear to be going higher and we are seeing some deceleration in domestic growth because demand is being moderated.”

Even though the RBI is shifting to a more neutral-to-dovish monetary policy stance, we like that they aren’t using fear mongering to support doing so. This is in stark contrast to the U.S. and Japan whose central bankers tend to depress investor, business, and consumer confidence via the gloomy commentary provided alongside dovish policy actions.

Korea: When an economy reports that its unemployment rate has fallen to a three-year low and its benchmark equity index plummets -7.8% wk/wk, it’s an explicitly bearish sentiment signal insomuch that people believe there is little-to-no good news left on the economic growth front as it relates to South Korea.  This is yet another bearish emerging market story we’ve been ahead of YTD and the KOSPI’s breakdown through any meaningful level of quantitative support this week is an explicitly bearish read-through for where we are within the cycle of global manufacturing, pharmaceutical, and tech demand.

Digging deeper into Korea’s domestic situation, the government aims to pass carbon trading legislation by December, which, per the Korean Chamber of Commerce (120,000 members) will stand to increase costs for Korean corporations by an additional 5.6 trillion won ($5 billion) and force abroad manufacturing capacity to competitor nations without such “punitive” schemes. Korean policymakers, who initially agreed to eventually implement such policies back in 2009, appear pretty set on delivering on their promise, given the country’s unfavorable status as the world’s ninth-largest greenhouse gas emitter (only the world’s 13th-largest economy). All told, such legislation is more than likely to be taken in an unfavorable manner by Korean financial markets, given its negative impact on corporate profits and positive impact on rates of Korean CPI and PPI over the long-term.

Elsewhere in the Korean economy, Finance Minister Bahk Jae Wan vowed to support the Korean won from “herd behavior in financial markets” via further intervention. Ironically, previous intervention designed to artificially limit won appreciation is largely the reason the won (down -4.6% wk/wk vs. the USD) is being especially punished in the global FX markets – not unlike the Brazil’s current predicament with the real (BRL). Recent maneuvers included: forced tightening of currency forward positions, imposing a level on non-deposit foreign currency liabilities held by domestic and foreign banks, and prohibiting financial companies from investing in foreign currency-denominated bonds issued to finance domestic initiatives.

Singapore: The key callout as it relates to Singapore this week is that CPI accelerated to a 34-month high of +5.7% and our models are pointing to higher-highs through October. And given that the Monetary Authority of Singapore doesn’t meet until October for its second of two monetary policy-setting meetings, we could see the MAS revalue the Singapore dollar higher in that meeting (they don’t use interest rates to set monetary policy). That makes Singapore one of the few moderately hawkish stories left in Asia and the +23bps wk/wk widening of Singapore’s 1yr on-shore interest rate swap is supportive of this view. Still, the MAS will have to counterbalance the inflationary situation at home with a slowing global growth outlook (exports > 200% of GDP).

Australia: The key callout from Down Under this week is the near closure of Australia’s kangaroo bond market. Back in early May, we correctly called out the general frothe of this market as a leading capital markets indicator for the topping of the global economic cycle. Sales of kangaroo bonds, which are debt securities issued in Australia by foreign borrowers, have plummeted -72% YoY in September! This general illiquidity rhymes with what we’re seeing domestically (foreign bond issuance in the U.S. is running at less than half the YTD run-rate in Sept.) and up north (Canada’s maple bond market has been “closed” since June).

As capital markets continue to dry up on the uncertainty stemming from the Eurozone and the realization that U.S. growth is likely to come in a lot lower than consensus expects over the long-term TAIL, we would tend to expect the reflexive nature of the global economy to feed upon itself in a negative way – especially given what the Chinese have astutely laid out above:

“One hurdle is that most nations are constrained in implementing further fiscal and monetary policy measures as they have already used them to recover from the last slump. Fiscal capacity is limited and monetary policy is already used pretty much to the limit.”

“Hope” is not an investment process.

Darius Dale