Readings

Is this the Right Time for the Fed to go Negative? - Wall Street Journal
Renminbi tensions - FT Lex
Some say bypassing a higher education is smarter than paying for a degree - WaPo
A Productivity Boom-in-Waiting? - Project Syndicate
How To Tell When There’s Structural Unemployment - Think Progress
The wholly fallible Ben Bernanke - Guardian

Greater China: Issues in Focus

- China: Moderation Continues "Against the backdrop of the authorities’ redoubled efforts to shut energy-inefficient production units, industrial production growth continued to moderate due to intensified supply-side adjustment. While fixed-asset investment growth saw a further slowdown, tailwinds (e.g. loosening of controls on new projects, aggressive implementation of the social housing program, easing in local government financing) have now appeared. We also expect the Chinese authorities to allow a faster appreciation of the RMB against the USD given the rising political pressure and the prospective large trade surplus in 2H10 compared to 1H10. Given the heightened uncertainties, we have launched the China Macro Risk Radar (CMRR) to provide a framework to systematically assess and monitor risk events of low probability but potentially high impact."
- Hong Kong: Robust Growth and Capital Inflow "The Hong Kong economy sustained robust growth in 2Q10 with real GDP expanded 6.5% YoY. We now expect GDP to grow 6% and 4% in 2010 and 2011 respectively. The Hong Kong banking system saw a significant increase in RMB deposits in July without hurting the growth of HK$ or other foreign currency deposits, signaling a genuine expansion in the banking sector balance sheet upon the further development in the offshore RMB business. We also observed capital inflow in July, and fundamentally the stock of excess liquidity in the banking system still remained sizable, offering little upward pressure on interest rates."
- Taiwan: 2Q GDP Beat Expectations by Wide Margin "Taiwan’s GDP expanded 12.5% YoY in 2Q10, driven mainly by an upside surprise in private consumption growth which should increase the overall economy’s resilience in the event that external demand faces any uncertainties. With the economy expanding faster-than-expected, we believe that interest rate normalization will continue for the rest of the year. We expect two more rate hikes in 2H10 (+12.5 bps each) to bring the policy re-discount rate to 1.625% by year-end."

Three themes for the rest of 2010: The US, carry and converging views on recovery (or recession)

- "With the financial market summer behind us, investors are looking ahead to an important few months. Macro returns have been poor, judging from most industry indices. Yet the landscape at present seems to offer an attractive mix for making up lost ground. Net speculative positioning across financial markets appears mixed at best; our CFTC positioning indices suggest speculative positioning has increased in the past month and is broadly positive risk – i.e. long commodities and short USD – but our separate hedge fund positioning analysis suggests this, often market-moving, group is very negative risk, holding shorts in stocks, longs in USD and longs in rates (Macro Chart Alert – Macro hedge fund pessimism, 01-Sep-2010). More important, we appear to be at a major inflexion point for the global economy. For much of this year, the main macro debate had centred on when G4 central banks would begin to normalise the super-easy stance of monetary policy. But over the past month, the tide has turned. Having effectively “eased” policy at its 10 August meeting by committing to sustain its balance sheet at current levels, our economics team now expects the Fed to announce outright balance sheet expansion this autumn (see Bernanke provides a call to action). The BOJ followed up quickly, announcing additional (admittedly modest) policy easing measures at its emergency meeting last week. Finally, the ECB confirmed it will maintain its “full allotment” policy of liquidity provisioning into 2011, even as it hinted at upside risks to its inflation forecast for the coming months."
- "To be fair, core G4 bond markets have moved rapidly to price in this new policy environment – so much so that our rates strategy teams are increasingly uncomfortable with the risk-reward of long duration position. That said, as we look across global financial markets, we still see plenty of opportunities to capture this shifting macro backdrop. In our latest Thinking Macro, we highlight three strategies for trading the shifting policy trends in the next few months."

Foreign exchange market once again in hands of Federal Reserve

- "U.S. real GDP data revisions by the Bureau of Economic Analysis this past July 30 put a dent in our growth and monetary policy scenarios."
- "The data revisions, which showed the U.S. economy running at an even lower capacity utilization rate than initially reported, converged with a soft job market to leave the financial markets feeling disenchanted about the possibility of an imminent interest rate hike in the United States."
- "The euro should not trend up in any sustainable fashion over the medium term. However, if macroeconomic policy in the United States takes a more stimulative turn, the greenback is likely to depreciate to some extent. This is why we believe the European currency will in the short term climb a little above its present level without, however, gaining any undue momentum."
- "Moreover, if the Fed sticks with its extremely accommodative monetary policy, a quick flurry of interest rate hikes this side of the border could launch the loonie into orbit. The Bank of Canada will therefore likely adopt a “stop and go” strategy."
- "Against this backdrop, we still see the loonie attaining parity with the greenback, only now at a slightly later date and at a somewhat slower pace."

Overwriting: adding alpha across Asia

- Overwriting has boosted returns on every Asia index since 2008 "A systematic strategy of selling monthly 1-mo 105% index calls has boosted returns across equity indices in Asia over the past two years. When coupled with a simple momentum filter determining whether or not to overwrite, returns have improved even further. The outperformance has been particularly significant on HSI, where systematic overwriters have outperformed long-only by 960bp annually since Jan 1, 2008."
- Slower-paced upside environment conducive to overwriting "While we remain positive on markets, we do not anticipate the explosive valuation upside that was experienced in 2005-07 and 2009. Instead, we believe markets will rise as earnings appreciate, which we expect to be a lower volatility, more gradual move higher and conducive to buy-writes."
- We screen for buy-writes: China Telecom, KB Financial, Canon "The additional returns from overwriting have turned many negative performing stocks into positive performers. On AEJ telcos, consumer, and utilities, for example, overwriters have outperformed by over 30pp since 2008. We screen for opportunities and find China Telecom, Canon, and KB Financial attractive buy-writes."

Enterprise 2.0: How companies are tapping the benefits of Web 2.0

- "Web 2.0 is currently the subject of much debate in (expert) public circles – with one of the driving factors being the increasing private use of social media. The growing popularity of the phenomenon – not only among young people – confronts decision-makers with the question of whether they want to deploy Web 2.0 tools actively in their own company. Companies can no longer ignore Web 2.0: the fact that the young generation is making a habit of Web 2.0 indicates that its importance will increase in future."
- "Today, 20% of the companies in the US and Europe use blogs, forums or wikis for internal or external purposes. Web 2.0 applications offer the opportunity to develop networked exchanges and consolidate knowledge. Web 2.0 builds on the input of the participants. In this way, Web 2.0 tools offer recognisable advantages over Web 1.0 communication and traditional knowledge management."
- "Web 2.0 use is predicated on a corporate culture that is big on openness and transparency. Companies must ask themselves the basic question of whether they are ready for this. Clear targets and supportive management are key to the success of Web 2.0 projects."
- "Sequencing: first in-house, then externally – first light-touch, then process-oriented. Companies often start to experiment in-house with Web 2.0 tools before they actively involve their customers or suppliers. Communication and marketing are still the primary objectives linked with Web 2.0 today – but there is also potential to be tapped in the areas of innovation and collaboration."
- "External use: experiments with social networks and microblogging. Frequently, companies recycle information produced for traditional corporate communication on these platforms. But this has little impact on corporate processes and their communication culture. This contrasts, for example, with a corporate blog that opens the door to the critics and their issues, demanding an open exchange of views."

Two Risks, Two Views

- Long double-dip risk — "in August, markets responded negatively to the slide in the US data. Yet our economists continue to believe that double dip concerns are overstated. And, even if they do come to fruition, we believe corporates in core Europe are relatively well equipped to handle the downside. So we retain a moderate long overall."
- Short periphery credit risk — "although sovereign spreads were under pressure in August, we did not see the same divergence in core vs. periphery corporate spreads as earlier this year. Our work on past sovereign crises suggests this could be temporary. We’d be short periphery credits, especially the banks."
- Don’t chase the real junk — "rock bottom spreads analysis suggests credit is least well protected against another economic downturn at the bottom end of the credit quality curve. We favour being slightly more conservative, and holding double- and triple-Bs rather than triple-Cs."

Domestic Switch Over?

- Volatile — "Equity markets have appeared almost schizophrenic of late. Mid-year optimism gave way to a new sell-off in August before another rally this month. The six-month trading range is intact; we continue to expect an upside breakout in Q4."
- Multiple contraction — "Emerging markets are largely flat in 2010 (+2%). Earnings have risen strongly – even if momentum is now slowing. The consequent severe multiple contraction this year (trailing P/E from 20x to 14.7x) represents a buying opportunity, assuming the global economy and earnings stay on track."
- Rotation Over? — "The well-documented switch from global cyclicals into domestic growth stocks (which generated outperformance of 10% over the summer) seems to be ending, based on long-term optimism over the global economy, combined with rich valuations in domestics (notably consumer staples)."
- Valuations v. Earnings — "Across sectors on valuations and EPS momentum, the cyclicals look far better placed than most domestic sectors, notably Cons. Staples. Also, Industrials look rich, while Health Care, IT, Telecoms and Utilities are attractively valued. We are Overweight Materials and Underweight Cons. Staples."
- Stock Screens — "We screen for Global Cyclicals with 2011 P/Es of 9x EPS growth; the list includes Vale, S-Oil, Severstal, Mechel, Adaro and BBMG. We screen for Consumer Staples stocks with P/Es >20x and weak EPS growth; the list includes Modelo, Hindustan Unilever, Tsingtao, CP ALL and BIM."

Asia: Markets revive, backed by positive regional indicators

- Markets revive, backed by positive regional indicators "Asian markets were on the upside over the last week, encouraged by strong regional indicators and improved global sentiment."
- China’s PMI and 2Q GDP for Australia underscore Asia’s economic vitality "China posted a better-than-expected August PMI (see Highlights). Moreover, 2Q GDP growth in Australia also beat expectations (3.3% y/y, consensus: 2.8%), as domestic and external demand improved. That said, Korean exports fell in August (see Highlights), as regional export growth continues to show signs of slowing. On the inflationary front, prices remained under control in Korea (2.6% y/y) and Thailand (3.3% y/y), and picked up in Indonesia (6.4% y/y)."
- The uncertain global environment is keeping monetary authorities on a cautious footing "As expected, Bank Negara Malaysia and Bank Indonesia left their policy rates unchanged last week. However, Bank Indonesia raised its reserve ratio to 8% from 5%, in order to drain liquidity in the midst of rising inflation. Moreover, the Bank of Japan and the government unveiled a new stimulus plan (see Highlights)."
- In the coming week…. "Trade figures in China (see What to watch), Philippines and Taiwan, inflation in Philippines and Taiwan, industrial production in India and Malaysia, and machinery orders in Japan. On the monetary policy front, we expect Australia, Korea and Japan to all leave rates unchanged."

Asian Markets – Different Actors, Same Script

- The view amongst investors is that these markets are unusual/different — "The good news is, they are not. If we take the performance of the market since the turn in earnings, the region is up the same percentage as on average in all the cycles since 1975. In all other cycles, Year 2 of the recovery was a year of multiple contraction, and unless markets rise by 36% between now and year end, so will this year. We may perceive it to be different but perception does not make for reality."
- In Year 2, markets historically reward earnings, they are doing so again — "The highest return factors in Year 2 have historically been upward revisions to earnings, rising margin forecasts, and low P/E stocks. Over the last 6 and 12 months the second best investment factor has been EPS revisions. Multiples expand out of the market trough as investors anticipate a recovery, then they look for proof of a recovery. They find proof in the year post the lows, i.e. Year 2-now."
- LEI continues to fall but liquidity indicator showing tentative turn around signs — "Our LEI fell from -56 to -65.5 over the month, signaling that the growth outlook remains weak and has weakened further. The correlation between LEI and equity markets remains high at 0.6. Now the good news, our excess liquidity indicator, which turned negative in March, has turned up (smaller decline) vs. the prior month. This is signaling that, at least in Asia ex, liquidity for the market is less tight than before."
- August was a poor return month as per the last 30 years — "That clearly was no different, and next comes September which historically is only slightly better. August and September are the only two months of consecutive negative returns in Asia ex over 30 years. The surprise is that on average October is actually quite good."

Can the world grow without fiscal and monetary stimulus?

- "Our concern is based on the observation of recent trends: after the tightening of monetary conditions and the slowdown in credit and after the beginning of the reduction in fiscal deficits, there has been a slowdown in global growth."
- "This could show that highly stimulatory monetary and fiscal policies are needed to maintain robust global growth, which would be worrying. Why would that be the case? We can imagine that:
• global private savings have become excessive, which explains the slump in consumption;
• risk aversion has increased due to the crises, which explains the depression in investment;
• the private sector debt ratio has become excessive, and this must be offset by an abnormally expansionary monetary policy."

How can excess indebtedness be avoided?

- "Excess indebtedness always leads to a serious economic and financial crisis (as we saw in the early 1990s, the early 2000s and since 2007). What accounts for excess indebtedness? The fact that borrowers link their borrowing capacity to the present value of their income, their wealth and interest rates, and not to the future values of these variables, which can be unfavourable."
- "So to avoid excess indebtedness, the risk premium in the calculation of borrower solvency (and hence of the maximum acceptable indebtedness) must be increased. If banks and financial markets do not do so spontaneously, the government can do so by taxing credit, only during expansion periods and of course not in periods of sluggish growth or low credit growth, either through banks (which will then include the tax in the cost of the loan) or through borrowers."
- "The counter-cyclical bank capital ratios proposed currently by the Basel committee may play this role."

eIDS in Europe: Not (yet) yielding profits for the cross-border financial services sector

- "E-government and online shopping are on the increase, but the use of cross-border financial services still lags some way behind."
- "At the European level a number of electronic identity cards (eIDs) and the qualified electronic signature (QES) do already exist. Together they possess the potential to form another of the foundations of the internal market for financial services – especially for opening accounts."
- "The future of e-services hinges on two mutually reinforcing developments: harmonising the diverse regulatory regimes across Europe and boosting acceptance among the general public."

Funding update: ECB’s bank liquidity stays on max, periphery needs it most

- Full allotment extension is a positive "The ECB has opted to keep the full allotment stance on bank liquidity supply. This is important as a switch to a competitive auction would be unwelcome news for liquidity ‘have nots’, as we believe it would introduce scope for triggering a sharp increase in funding costs and hence bank COE for the European bank sector as a whole."
- Sharp fall in ECB use for the core’… "Not all European banks are in need of the ECB facilities. In fact, its aggregate use has fallen sharply, driven by a remarkable decrease in use by banks based in the European ‘core’. For these banks, we believe this trend will continue since:
1. Market rates allow for cheaper funding when compared to the cost of ECB facilities, both for euro and US dollar funding.
2. Funding markets have partly re-opened, with the amount of unsecured issuance picking up
significantly;
3. The deposit gap continues to shrink, structurally reducing the reliance on wholesale funding."
- … but the ‘periphery’ has no other funding options "In contrast, the reliance of the Greek banks on ECB funding continues to grow and now stands at the equivalent of 20% of sector assets (European ‘core’ at 1.1%). These banks continue to have limited access to the wholesale funding markets, with the ECB facility a critical funding avenue, the importance of which continues to grow. A switch from full allotment to a competitive auction would result in a spike in the cost of funding, adding further pressure on these institutions, in our view."
- Our preferred sector positioning "We recommend being positioned within the (few) banks that we expect to exhibit positive volume growth trends (eg Unicredit, Erste Bank), to benefit from structural change (eg Lloyds), while we recommend avoiding banks on the ‘periphery’, most notably domestic Spanish, Italian and Greek banks."