CLSA Greed & Fear - Exit neurosis and getting tough in China

         CLSA Greed & Fear- Exit neurosis and getting tough in China

The past week has seen an escalation of the normalisation scare with the surge in the 10-year US Treasury bond yield. GREED & fear’s guess is that the US yield curve has seen most of its steepening for now.

·         GREED & fear would personally be surprised if Ben Bernanke is not himself surprised, if not alarmed, by the extent of the sell-off prompted by his rather anodyne comments. GREED & fear takes the Fed chairman at his word that policy will remain data dependent.

·         The degree of the market turmoil must be viewed as hard evidence of the scale of the leverage in carry trades taken on as a consequence of the remarkably seductive incentive to put on such a carry trade provided by Bernanke’s “forward guidance”. It is not only US Treasury bond yields that have risen sharply but government bond yields almost everywhere as the “from-risk-on-to-risk-off” trade has once again proved to be highly correlated.

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·         While there is a plausible argument for rising bond yields in America for those who believe that the US housing recovery will lead to a revival of the credit multiplier, it is harder to see why that dynamic should apply to, say, the Australian bond market. GREED & fear’s view remains that Australian bonds are probably the most interesting long-only fixed income opportunity globally, though there is clearly an issue of currency risk for US dollar based investors.

·         If the housing recovery remains investor-led, as GREED & fear still suspects, then the back up in bond yields will not have as negative an impact as many fear. But there is surely a limit to how long a housing recovery led by investors can run if there is not a genuine pick up in end user demand.

·         While capital outflows have doubtless played a role in the recent liquidity squeeze in China, there are clearly elements within the PRC leadership who understand China’s structural problem and want to make the necessary reforms. But it is less clear to GREED & fear whether they will really be able to do so given the constraints posed by the current political system and the related need to forge consensus.

·         If China’s leadership is really serious about structural change, it has implications not only for China geared stocks but also China geared economies. Australia is perhaps the most obvious example. The Australian central bank has begun to capitulate to the view that the economy is fundamentally weak courtesy of an overvalued currency, continuing high real mortgage rates and the peaking out of the China-related mining boom.

·         In GREED & fear’s view a further pronounced decline in interest rates and indeed bond yields in Australia is only likely to occur when signs of asset-quality problems emerge in the Australian banking sector. The continuing risk of an asset-quality cycle remains a key issue for the local stock market.

·         Australian banks are some of the most expensive banks in the world, as measured by market capitalisation. Yet these valuations look questionable in the extreme to GREED & fear given the likelihood of continuing weak credit growth and slowing bank earnings growth going forward, even if there is no bad debt cycle. The overall Australian stock market also looks expensive.

·         Indonesia is another Asian economy with a certain China gearing via its coal and palm oil exports. It is a positive that Bank Indonesia raised its policy rate by 25bps to 6% on 13 June. The move should be interpreted in part as a defence of the exchange rate which has been under pressure of late. But the central bank also cited as a reason for the rate hike the need to curb inflation expectations ahead of a long-anticipated fuel price rise which finally occurred on 21 June.

·         The fuel price rise in Indonesia will cause a temporary spike in inflation to the 7.5-8% level. But, more importantly, it should lead to a decline in fuel subsidies and a fall in the rapidly expanding oil and gas trade deficit. Indonesia’s macro story is looking on somewhat more solid ground; though it would have been far better if both the rate hike and action on energy subsidies had happened far earlier.

·         The prospects for the Taiwan stock market remain driven primarily by the outlook for the county’s tech component sector. The good news is that growing commoditisation of the handset business means that the price of everything is in the process of collapsing as the utility of devices converge. And if the price of everything drops then the volumes will rise, which is a positive for the components makers.

·         GREED & fear will introduce a stock from Taiwan’s tech component sector into the long-only Asia ex-Japan portfolio. A 4ppt investment will be initiated in MediaTek, with the money raised by removing the existing investment in Baidu.

·         Italy's judiciary has reportedly opened an inquiry into the Italian Treasury's use of derivatives to hedge public debt after the leaking this week of an Italian Treasury document concerning Italy’s potential losses of billions of euros on contracts restructured during the Eurozone debt crisis last year.

·         There has been more pain for gold enthusiasts this week as the yellow metal looks on the brink of testing the US$1200/oz level. This market action is the natural consequence of the growing market focus on the potential normalisation of American monetary policy. If American policy does not normalise and the exit strategy proves much more tricky than the stock market bulls expect, then gold is a massive buy here.

·         GREED & fear’s base case remains that there will be a continuing liquidity trap leading to more and more extreme monetary policy initiatives with the end game being either deflation, hyperinflation or a nasty mixture of both, when markets finally lose confidence in the manipulations of central bankers. Such an end game is more bullish for gold than just about any other asset. The trend in the Western world remains far more deflationary than markets want to admit with their current hopes for ‘normalisation’