Conclusion: Hong Kong looks ripe for a bullish trade.
Position: Long Hong Kong equities (EWH).
Down -17% from when turned outwardly bearish on the Hang Seng, we are well aware of the bear case for Hong Kong. That puts us a unique position to have an educated view on the catalysts that could get this thing turned around – specifically on the growth/inflation front.
The immediate-term catalyst calendar looks favorable (views based on our models and global macro outlook):
- JAN 10: DEC Chinese exports should continue to slow and lower expectations for the following week’s growth data;
- JAN 11: DEC Chinese CPI and PPI should show continued disinflation and create incremental room for China to ease monetary policy;
- JAN 16: DEC Chinese industrial production, retail sales, fixed assets investment data and 4Q11 real GDP should all slow at a slower rate and may even surprise depressed consensus estimates to the upside;
- JAN 19: Hong Kong unemployment rate should continue to back up, though only marginally;
- JAN 20: Hong Kong CPI should continue to slow on the strength of King Dollar’s increase in purchasing power, which the Hong Kong dollar is pegged to; and
- JAN 26: Hong Kong exports should continue to slow at a slower rate and on a lag to a pickup in manufacturing.
From an intermediate-term perspective, buying the EWH with the Hang Seng less than -0.3% shy of our TREND line of resistance does indeed suggest we believe in the index’s ability to break out above the TREND line on the strength of the aforementioned macro calendar. As Chinese and U.S. economic growth bottoms in 1Q12 (China = 52.7% of Hong Kong’s export demand; the U.S. = 11%), we look for Hong Kong manufacturing and shipping orders to accelerate ahead of reaccelerating end demand in the coming months. To that tune, manufacturing slowed at a slower rate in DEC, with the PMI reading ticking up to 49.7 vs. 48.7.
Growth slowing at a slower rate is a leading indicator for a reacceleration in growth.
Conclusion: India screens flat-out awful on all of our fundamental and quantitative factors. As such, we remain bearish on Indian equities and the Indian rupee over the intermediate-term TREND.
Virtual Portfolio Position: Short Indian equities (INP).
From a quantitative perspective, Indian equities look awful. From a fundamental perspective, India’s economy looks just as dire. While neither point is new news to Hedgeye clients, we have taken advantage of the latest price action in Asia to hedge our long Chinese equities position with one of our least favorite international stories (equities, debt, and FX) for the better part of the past 14 months.
As a refresher, our updated views on India are as follows:
Growth: Indian real GDP growth continues to slow and looks to sink to bombed-out levels in 1Q12, where we’re modeling in a range of +6-6.5% YoY based on all the data and quantitative signals we currently have at our fingertips. Those estimates are subject to further downward revisions pending more 4Q high-frequency data.
Inflation: Inflation remains the largest headwind for the Indian economy and corrosive to the real returns of holders of Indian assets. Just like in late 2010, the Reserve Bank of India is again guiding consensus expectations to an intermediate-term inflation target that we don’t think they’ll achieve (+7% YoY by MAR from +9.1% in NOV). To that tune, while slowing, our models can’t get below +7.8% on YoY WPI over the intermediate term, as Indian inflation continues to be fueled by sticky energy costs, rather than slowing food and primary articles inflation. Further, Brent crude oil remains in a Bullish Formation amid heightened geopolitical risk. Net-net, the RBI will be forced to continue largely sitting on its hands as elevated inflation continues to narrow the scope of using monetary policy to support economic growth.
Policy: Speaking of policy, economic and political leadership in India remains among the worst (w/ Argentina and Russia), if not the worst, of any of the G20 economies. We’ve been all over their ineptitude over the past year (FEB ’11: India – Missing Where It Matters Most and MAY ’11: India’s Nasty Trifecta) and continue to see little in the way of positive momentum.
Subir Gokarn, deputy governor of the Reserve Bank of India, said last week that “the monetary cycle has peaked.” While not at all a surprise, we do think his additional commentary confirms our view that the RBI is in a box as it relates to monetary policy. More specifically, India’s growth/inflation dynamics prevent them from raising or lowering interest rates – a condition that is usually a leading indicator for “creative” central banking and misguided capital account policy changes in emerging markets:
“The RBI is very concerned about the impact of rupee depreciation on inflation… The central bank remains more comfortable using open-market operations to inject liquidity for now, because cutting the cash reserve ratio would send a premature signal that the monetary policy stance has changed.”
-Subir Gokarn, 1/5/12
To that tune, Indian banks are taking advantage of RBI liquidity at an accelerating rate in the face of ever-tighter interbank lending conditions, borrowing an average of $22 billion a day from the central bank in DEC (up from $17.5 billion in NOV). We remain the bears on the Indian rupee, which has fallen nearly -16% vs. the USD from its cycle peak in early AUG. We look for King Dollar’s breakout vs. the INR to keep an elevated floor under the dollar-denominated debt servicing costs of Indian corporations and their ability to refinance – dramatically eroding what little earnings growth is left on the table. Per the latest data, India’s corporate bond issuance dropped to 14-quarter low of 257 billion rupees in 4Q12 (through mid-DEC).
On the fiscal front, India’s widening federal budget deficit and resultant increase in sovereign debt supply continues to provide an overhang on Indian growth and the nation’s currency, as well as a floor under interest rates absent RBI intervention in the secondary market (the RBI has purchased just under 500 billion in sovereign debt since NOV). As Indian banks are forced to underwrite incremental sovereign debt supply amid a -97% miss in the FY11 state asset sales target of 400 billion rupees and a big miss in tax revenue stemming from a pollyannaish +9.25% FY11 growth target, interbank liquidity is eroded (see previous chart).
As a result of India’s Finance Ministry being way off on its economic growth assumptions, the country is all but assured of missing its 4.5% budget deficit target, contributing to a crowding out of private sector credit growth. That may ultimately spark a wave of defaults across the lower end of the country’s credit spectrum.
To that tune, the RBI released a report on 12/22 that forecasted India’s aggregate NPL ratio could climb +300bps to 5.8% by March 2013 in a “stressed macroeconomic scenario”. We’re not sure what they define as “stressed” but their history of underestimating the downside in growth and the upside in inflation suggests to me that their worst-case scenario may ultimately be closer to baseline when it is all said and done. With elevated mortgage rates (16.5%), slowing property sales (-20% YoY in Mumbai in NOV), and eroding earnings growth (-23% YoY in 3Q11), Indian property developers may pose a serious risk to the balance sheets of Indian financial institutions with 1.8 trillion rupees in debt coming due over the next 3yrs.
This dire scenario is being reflected in the 5yr CDS of the State Bank of India, which at 405bps wide, is challenging post-Lehman levels of stress.
Jumping ship to regulatory policy, India has recently hit rock-bottom in this regard. India’s lawmaking body passed just 22 laws in 2011 (the second-lowest since 1952) amid several notable corruption scandals that fueled political gridlock, a well-publicized renege on pro-growth retail market reform, and a monumental failure to pass Prime Minister Singh’s anti-corruption Lokpal bill at year’s-end.
Turning to what’s coming down the pike, India will have five regional elections next year, and reading through from the macroeconomic malaise, Singh’s Congress party stands to lose incremental support in parliament over the intermediate term, which may perpetuate gridlock. India’s inability to get it done on the regulatory front forces us to remain skeptical that they’ll be able successfully reform the country’s convoluted tax code – a key “win” needed to reign in the federal budget deficit. For example, India’s government revenue as a % of GDP is only 18%, which compares to 21%, 36%, and 37% in China, Brazil, and Russia, respectively. Moreover, India’s lawmaking ineptitude and de facto green light for corruption suggests to us that they’ll are likely to fail to capitalize on a planned $1 trillion in infrastructure spending over the next 5yrs. Time will ultimately tell here, but if their past behavior is any indication, India will have limited success in this regard.
All told, India screens flat-out awful on all of our fundamental and quantitative factors. As such, we remain bearish on Indian equities and the Indian rupee over the intermediate-term TREND.
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Positions in Europe: Covered France (EWQ) today in the Hedgeye Virtual Portfolio
Below are key European banking risk monitors, which are included as part of Josh Steiner and the Financial team's "Monday Morning Risk Monitor".
Euribor-OIS spread – The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States. Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal. By contrast, the Euribor rate is the rate offered for unsecured interbank lending. Thus, the spread between the two isolates counterparty risk. The Euribor-OIS spread tightened by 4 bps to 94 bps w/w.
ECB Liquidity Recourse to the Deposit Facility – The ECB Liquidity Recourse to the Deposit Facility measures banks’ overnight deposits with the ECB. The ECB pays lower rates than the market, so an increase in this metric demonstrates increased perceived counterparty risk and liquidity hoarding. Over the course of the last few months, this metric has been making higher highs and higher lows, a pattern that continued last week.
European Financials CDS Monitor – Bank swaps were wider in Europe last week for 29 of the 40 reference entities. The average widening was 2.5% and the median widening was 7.2%.
Security Market Program – The ECB's secondary sovereign bond purchasing program bought €1.104 Billion in the week ended 1/6 versus no reported buying in the week ended 12/30 and €3.361 Billion in the week ended 12/23 to take the total program to €213.0 Billion.
Keith covered France via the etf EWQ in the Hedgeye Virtual Portfolio, managing immediate term TRADE risk (range) of the position. The CAC40 is now holding its TRADE support at 3,076. Intermediate term TREND resistance in the CAC40 is 3,271 (see chart below).
Despite the updated TRADE signals, we remain bearish on France over the intermediate term due to the continuing factors of:
- Pending downgrade of France’s AAA Sovereign Credit rating
- Public debt rising through the 90% (as a % of GDP)
- Slowing growth (below the government’s 1% 2012 projection) and sticky inflation alongside Austerity’s Bite = Stagflation
- Banking risk, including any difficulties for its major banks (BNP, Credit Agricole, SocGen) to raise capital to the 9% Core Tier 1 ratio (see Unicredit for a preview!), and sovereign risk as France is the largest holder of Italian public debt and private debt, according to BIS
- EFSF and IMF are undercapitalized to materially aid any potential sovereign and banking bailout needs of France
- High unemployment rate of 9.8% (versus 7% in Germany); 22.8% among the French youth
- Smaller export profile (versus Germany), so there’s less benefit to grow via exports
Today Sarkozy met with Merkel in Berlin to discuss among other issues, a financial transaction tax. Sarkozy got a light nod from Merkel in her comment, “Personally, I’m in favor of thinking about such a tax in the Eurozone”, yet there’s no indication the either the Eurozone (17) or the EU (27) will vote to follow suit. Sarkozy’s willingness to go-at-it-alone approach, particularly given the very public push-back from with the British under Cameron, is a false step in our opinion. Sarkozy’s positioning is surely connected to his re-election desires, however a financial transaction tax, especially in a go-at-it-alone-approach, is an anti-competitive move that would not only cost the French banking sector dearly, but the economy at large.