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    MARKET EDGES

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SUMMARY BULLETS:

China: 

  • All told, we anticipate the impact of recent and pending regulatory measures to continue weighing on both economic growth and investor sentiment across the Chinese economy (bird flu headlines don’t help either).
  • While continued CNY strength (~19-year high; trading band rumored to be widened soon) and incremental commodity deflation are supportive at the margins, the 1Q/MAR growth data (highlights below) is supportive of our view that economic rebalancing is not likely to be accelerated enough to offset the aforementioned headwinds.
  • As such, Chinese equities can no longer be considered a Best Idea at the current juncture.

 Japan:

  • As often cited in our work, a likely failure of int’l policymakers to censure and ultimately mitigate the impact of Japan’s monetary policy phase change is core to our bearish thesis on the JPY from here.
  • In that vein, Japanese Finance Minister Taro Aso confirmed that the G20 has accepted Japan's explanation that its aggressive monetary policy is aimed at beating deflation and not at a competitive devaluation of the yen.
  • Recall that in its semi-annual currency report released late last Friday, the US Treasury said that Japan should "refrain from competitive devaluation". It added that the US will continue to press Japan to adhere to the commitments agreed to with the G7 and G20.
  • In spite of these misunderstood developments, it is our view that investors would be remiss to allow the overt hypocrisy of the US government scare them out of the short yen/long Nikkei trade, which we still think has legs with respect to the intermediate term.

CHINESE CHICKEN INDEED

As we outlined in our recent work on China’s equity market, the Chinese economy has undergone a barrage of growth-negative regulatory reforms and macroprudential measures designed to quash speculative activity in the fixed assets investment (FAI) sector. As previously mentioned, this was not something we saw coming at the time of our 2/27 Best Ideas conference call and continues to weigh on the outlook for Chinese growth over the intermediate term.

  • CHINA’S IN NO MAN’S LAND (3/13): China’s fundamental outlook has become increasingly convoluted in recent weeks, posing material risk to its financial markets.
  • IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? (3/28): Systemic risks are present across China’s financial sector – as is the political will and fiscal firepower needed to avert a crisis.
  • BEST IDEAS UPDATE (LONG CHINA; SHORT YEN) (4/1): That the Shanghai Composite Index closed down -0.1% on today’s positive growth figures speaks volumes to the growing concerns surrounding Chinese banking risks as regulatory overhang continues to weigh on the Chinese equity market.
  • EARLY LOOK: Chinese Chicken (4/4): In spite of fairly recent gains, the fundamental backdrop for the Chinese stock market is as convoluted as it has been in quite some time. As such, we are sticking to our process and deferring to the quant on this one.

Nevertheless, we were definitely wrong in the context of the Shanghai Composite’s performance since that call (-3%) and, more importantly, it’s hard to justify China on the long side outside of the beneficial impact of incremental CNY strength and commodity deflation. Given the nature of the Chinese political structure (i.e. deeply entrenched interests compounded by decentralized control), it’s tough to see the Chinese Communist Party accelerating the economic rebalancing agenda fast enough to offset the impact of slower FAI growth over the intermediate term.

The latest development on the FAI front was the CBRC’s dramatic tightening of credit supply to the Local Gov’t Financing Vehicle (LGFV) sector. Specifically:

  • For LGFVs with lower than 100% cash coverage ratio (CAR) or asset-liability ratio of above 80%, their borrowings as a percentage of banks’ total issued loans must not exceed the level in the previous year;
  • Commercial banks should gradually reduce lending to such LGFVs while looking to recover loans (i.e. clamping down on refinancing/rollovers);
  • Commercial banks and regulatory bodies at all levels are to monitor LGFV loans in all forms – which include bank loans, corporate bonds, medium-term notes, short-term financing notes, trust products, and wealth management products;
  • Commercial banks should hand over the approval authority of LGFV bonds up to their head offices; and
  • Commercial banks will no longer be allowed to provide guarantees for LGFV bonds.

As an aside, “Local Projects” as defined by the National Bureau of Statistics account for 94% of Total Fixed Assets Investment in China (full-year 2012 figures). If enforced properly, these measures will bite. Chinese property developers are at risk – which should not come as a surprise to anyone. According to a 2012 survey conducted by the China Banking Association, nearly 70% of Chinese bankers expressed concerns over lending to the property sector (12.1 trillion yuan in total or 9% of Chinese banks’ assets).

Additionally, the Chinese property market remains hot from a pricing perspective (despite the recent curbs), which may mitigate any potential outlook for monetary easing over the intermediate term; average house price appreciation across the NBS’s 70-city sample was +3.6% YoY in MAR from +2.1% in FEB. Moreover, data from the Ministry of Land and Resources (MLR) shows that the average land transaction price in major Chinese cities was CNY 3,175 per square meter in 1Q13 – up +3.9% YoY (vs. +2.6% in 4Q12).

All told, we anticipate the impact of recent and pending regulatory measures to continue weighing on both economic growth and investor sentiment across the Chinese economy (bird flu headlines don’t help either). While continued CNY strength (~19-year high; trading band rumored to be widened soon) and incremental commodity deflation are supportive at the margins, the 1Q/MAR growth data (highlights below) is supportive of our view that economic rebalancing is not likely to be accelerated enough to offset the aforementioned headwinds. As such, Chinese equities can no longer be considered a Best Idea at the current juncture.

  • 1Q Real GDP: +7.7% YoY from +7.9% vs. Bloomberg consensus estimate of +8%
    • +1.6% QoQ from +2% prior
  • MAR Industrial Production: +8.9% YoY from +10.3% YoY in DEC (no JAN-FEB figures) vs. Bloomberg consensus estimate of +10.1%
    • +9.5% YoY in 1Q from +10% in 4Q
  • MAR Retail Sales: +12.6% YoY from +15.2% YoY in DEC (no JAN-FEB figures) vs. Bloomberg consensus estimate of +12.6%
    • +12.4% YoY in 1Q from +14.5% in 4Q
  • MAR Fixed Assets Investment: +20.9% YoY from YoY +21.2% in FEB vs. Bloomberg consensus estimate of +21.3%

BEST IDEAS UPDATE: LONG CHINA (NOT); SHORT YEN - 4

TARO ASO’S POKER FACE

As often cited in our work, a likely failure of int’l policymakers to censure and ultimately mitigate the impact of Japan’s monetary policy phase change is core to our bearish thesis on the JPY from here. In that vein, Japanese Finance Minister Taro Aso confirmed that the G20 has accepted Japan's explanation that its aggressive monetary policy is aimed at beating deflation and not at a competitive devaluation of the yen.

Additionally, BOJ Governor Haruhiko Kuroda said that the G20 is understanding of the case for Japan's unprecedented, world-beating monetary easing. Moreover, he reiterated that the BOJ is not trying to weaken the yen, rather it is designed to achieve the Abenomics-mandated +2% inflation target as soon as possible.

Recall that in its semi-annual currency report released late last Friday, the US Treasury said that Japan should "refrain from competitive devaluation". It added that the US will continue to press Japan to adhere to the commitments agreed to with the G7 and G20. In spite of these misunderstood developments, it is our view that investors would be remiss to allow the overt hypocrisy of the US government scare them out of the short yen/long Nikkei trade, which we still think has legs with respect to the intermediate term.

In short, we think the USD/JPY cross has upside to 110 as we progress through calendar 2013 and then to 125 as we progress through calendar 2014-15. NOTE: these aren’t big, round sell-side-style forecasts; rather, they represent the long-term levels of resistance on the USD/JPY cross. 100 is the first psychological barrier to overcome; from there, the aforementioned targets come into play, in that order.

BEST IDEAS UPDATE: LONG CHINA (NOT); SHORT YEN - 5

The pace of the US recovery and investor expectations of the FOMC’s next move will also determine the pace of yen depreciation from here (thus far, it’s been mostly a Japan-driven phenomenon). Is this the mid-to-late 90s all over again, however? The USD/JPY cross ripped from 80 to ~147 over a span of four years as the respective policy paths for the Fed and BOJ diverged substantially – as we believe they are poised to do once more with respect to the long-term TAIL duration.

BEST IDEAS UPDATE: LONG CHINA (NOT); SHORT YEN - 6

That’s why US housing and labor market improvement remains so critical to the US side of our thesis. The Fed has already signaled what would get them to turn off the QE spigot and FOMC leaks. A 6-handle on the US unemployment rate would really start to make yen bulls quite nervous. As we’ve penned in recent work, neither the buy-side (via CFTC net length), the sell-side (via out-year USD/JPY targets), nor Japanese corporations (via Tankan Survey USD/JPY forecasts) is Bearish Enough on the Japanese yen – all of whom having been numbed to secular yen strength over the past ~6 years.

The aforementioned secular policy divergence, the lack of consensus over the yen’s outlook from here and the following cyclical reminders that Japan has barely emerged from recession all combine to point to a higher dollar-yen cross and higher Nikkei/TOPIX from here – the latter of which is being underpinned by record int’l inflows.

  • MAR Machine Tool Orders: -21.6% YoY from -21.5%
  • MAR Goods PPI: -0.5% YoY from -0.1%
  • MAR Consumer Confidence: 44.8 from 44.2
  • MAR Exports: +5.5% YoY from +11.9%
  • MAR Imports: +1.1% YoY from -2.9%
  • MAR Trade Balance SA: -¥922B from -¥1.09T
  • MAR Economy Watchers Survey – Outlook: 57.5 from 57.7
  • Week Ended 4/12 Net Foreign Purchases of Japanese Stocks: ¥1.57 trillion from ¥868.6 billion; highest weekly total on record

To the extent you may have missed them come through, we encourage you to check out our recent work on this topic if you’re looking to fully comprehend the gravity of the BOJ’s monetary policy phase change:

Have a great weekend,

Darius Dale

Senior Analyst