Economic Insights

Strategies For This Week

I have been calling for “sell the EUR crosses especially against the commodity currencies” since late last month, and I am looking at taking profit because all these pairs have reached another historical low.

This model could be my continuous strategy in the near term. However I am looking at certain setups after some rebounds unless the fundamentals in the currency bloc deteriorate further.

The US Advance Gross Domestic Product (GDP) and Federal Reserve’s (Fed) reaction on that will be a key benchmark to know whether the commodity currencies will continue to outperform the rest. A rebound of the EUR/commodity currencies might happen if another “sell in May and run away” appears.

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Key Events Last Week

US Retail Sales contracted 0.5%
No quantitative easing (QE) hint in Fed Chairman Ben Bernanke’s Congress testimony
US initial claims rose and Philly Fed Manufacturing at -12.9
Spanish bond auction showed lesser demand
European Union (EU) finance ministers approved up to EUR 100 bail out for Spain, detail to be released after audit

Key Events to Focus On This Week

HSBC China flash manufacturing Purchasing Managers’ Index (PMI)
Australia Consumer Price Index (CPI)
UK preliminary Gross Domestic Product (GDP)
US GDP

Global Macro Brief

Black clouds deteriorate investors’ mood once again

Valencia and a few other regions in Spain are seeking for financial assistance from the national government to offset the expected EUR 100 billion bailout approved earlier. Spain’s IBEX-35 index dipped 5.8% last Friday amid the country will stay in a prolonged recession, and Spain 10-year bond yield hit as high as 7.28%, calling for more international intervention since there isn’t much the Spanish government could do at this time.

In China, an adviser from the People’s Bank of China’s (PBOC) predicted the country’s Q3 GDP growth would shrink to 7.4%, adding the fresh concern that China’s economy has not yet reach the bottom yet. The government has done almost everything they could to bolster the growth above the bottom line targeted at 7.5% set by the government earlier this year. In my Market Brief of the Week report last week, I highlighted a few direct and indirect threats such as the lower consumer expenditure/GDP ratio, negative factors on the rising housing price although it has a long industry chain, weaker export due to the turmoil in Europe. Thus, we could only expect the government to increase investment and ultra-loosen the monetary policy to provide a short term relief for the economy. Meanwhile, Shanghai Composite Index is trading 1.15% lower.

Commodities retraced lower as well since last Friday, paring the earlier week’s strong gain due to the escalating conflict in the Middle East and Saudi oil production has shown a decline. Also the extreme drought in the US has pushed the agriculture prices to another high; the US corn crop condition index has reached the 1988′s low purely due to the dry and hot weather conditions.

Source: Bloomberg

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All these factors that are pushing up the commodity prices are certainly not relevant to the fundamental demand growth. With that said, the rally is hard to sustain.

The troika will arrive in Greece tomorrow to inspect whether the country is going to keep its earlier commitment. If there is any condition that diverges from the expectation, it will be very tough for Greece to be granted further bailout. At this time, the country is expected to live in a tough situation by fulfilling its obligation on the past EUR 240 billion bailout.

The US Q2 GDP to be released later this week may trim some gains for the US dollar amid a “risk off” environment. I expect a weaker than expectation figure to be released due to the soft domestic consumption and global recovery continuing to lose the momentum.

Fixed Income

Return of investment instead of return on investment; high-yield bonds in sweet spot

Given the continuous negative events happening in the currency bloc, I would continue to Overweight (OW) on:

EM (Emerging Markets) over Developed Markets (DM)
real high-yield bonds such as the Aussie bonds
safe nature such as in Germany, United States, etc.

JP Morgan Emerging Market Bond Index (EMBI) and Emerging Markets (EM) Corp have rallied more than 10% year-to-date (YTD). The theme is likely to continue because more EM countries ease their monetary policies such as China, South Korea, Brazil, etc. which help bolster the bond market further. The US High-Yield (HY) and High-Grade (HG) bonds have more than 5% return YTD due to the benefit from the high uncertainties in the Euro Zone and soft economy to trigger further stimulus from Fed. Overall, it is an environment for bond market.

Besides the segment between DM and EM, I also prefer the Indonesian bonds among the EM and Australian bonds in DM given the high-yield offered. A cheaper Indonesian Rupiah (IDR) has attracted more regional investors to shift more portfolios into the Indo bond market, while steady economy in Australia and relatively high-yield offering have attracted more traders as well.

Source: Bloomberg

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Source: Bloomberg

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The hole in Spain’s economy is getting deeper even though there is an up to EUR 100 billion final approval by the EU finance ministers in exchange of a EUR 65 billion austerity programme. Thousands of anti-austerity citizens in Spain gathered in Madrid last Friday to protest the austerity package; on top of that, the people are extremely against tax hike and unemployment benefit cut.

Spain is also going to use EUR 18 billion from its lottery and leave EUR 12 billion for the Treasury to finance, which tries not to affect the nation borrowing programme by not tapping on the bond market. However, economists promptly doubted that the resort of the fund and where it comes from without tapping the bond market, and probably it will be provided by the Treasury’s cash, which the portfolio holds around EUR 45 billion in total.

Without going further, plenty of uncertainties will keep bond investors to stay away from Spain’s sovereign debts; and according to the data from Bloomberg, foreign investors who invested in the Euro Zone bonds have decreased to another historical low. The figure slipped to EUR 1.6 billion only, compared with EUR 26.9 billion in June 2011 and EUR 49.5 billion in 2007, according to the European Central Bank (ECB) and Bloomberg.

Source: ECB, Bloomberg

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Foreign investors’ fixed income portfolio carries a better benchmark to judge the economic condition in the currency bloc. Below is the chart on comparing the equities and fixed income investment from Non-Euro area investors. It shows that the equities cover only EUR 9.5 billion while fixed income covers EUR 21.6 billion.

Source: FXPRIMUS Research

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Thus, I expect the Germany/Spain spread to widen further because it is the time of “return of investment”, instead of “return on investment” until there are more measures in details and the central supervision body is announced which is likely to be the ECB.

Source: Bloomberg

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Global Equities

Corporate earnings and global manufacturing indices continue to suggest Overweight (OW) non-cyclical and defensive stocks; US Markit Purchasing Managers’ Index (PMI) in focus

Source: FXPRIMUS Research

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The US Equities gained moderately last week, mainly due to:

continuous short covering
further Fed stimulus that continuously to be priced in
less disappointed Q2 earnings although the Surprise Index has dropped

Dow Jones Industrial Average (DJIA) and S&P 500 Index (SPX) have recovered sharply since middle of June. However the lack of EU implementation and the concern for the US fiscal cliff have stopped me from joining this rally at this time because there is enough evidence that shows the short covering positions which has played an important role for that. Below is the S&P 500 companies’ earnings growth for Q2 despite the sample is less than half at this time. Materials and Financial sectors which are the typical cyclical counters, underperformed those non-cyclical sectors such as telecom and utilities sectors; together with those soft global manufacturing indices, it suggested that equities have not entered the “bull run” stage although it has climbed sharply recently.

Source: Bloomberg

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Source: Bloomberg

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Source: Bloomberg

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Markit PMI and advanced Q2 GDP will offer some clues for investors that they will need to shuffle their portfolios. A positive US PMI figures may signal a resilient recovery since a less catastrophic event appeared from the Europe in a very short term. Stocks still trade a low Price to Earnings Ratios (P/E) at 12.81X, while 12.62X in 2011, 13.41X in 2010. Thus, I am going to shuffle the equities portfolio from OW defensive to Underweight (UW) non-cyclical if manufacturing picked up, otherwise I remain my UW cyclical counters.

In Asia, I prefer the Hang Seng China Enterprises Index (HSCEI) property sectors due to:

the changing of policy from the Chinese government
further interest rate and reserve requirement ratio (RRR) cuts to boost the lending
low valuation given the high discount/ Net Asset Value (NAV) ratio.

In China, housing market contributed a substantial portion in the pie of the GDP growth, thus encouraging the property growth could be the tactics used by the local officials again in order not to fail the key threshold of 8% growth.

Loosen monetary policy excised by the PBOC may speed up the entire fund flow. Developers’ funding concern eased compared with last year, and housing buyers’ high chance of loan approval and quicker loan disbursement benefit those developers’ sales figure.

The chart below shows that Hang Seng Property Index has gained more than 12% YTD, and I will continue to OW this sector given the 51% discount/NAV ratio.

Source: Bloomberg

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Among the different players, I prefer those large scale companies focusing on the medium market instead of high-end market given the lower liquidity risk, as economy still faces the downward pressure.

Euro Zone

Post-European Union (EU) Summit: Champion of EURO Cup 2012 in focus again

Around one third of the 17 countries in the Euro Zone are still suffering from the deep recession, and Spain, which is the 4th largest economy, becomes the market focus again on its difficult financial environment because of the lack of measure details agreed in the EU Summit and the gradual appearance of implementing risk; the key issues are the weak fundamentals and tough austerity measures moving ahead. Also Valencia has sought assistance last Friday, which after that, six more Spanish regions sought for bail out from the central government which made the situation worse.

Source: Bloomberg

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Source: Bloomberg

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The investors remain worried on Spain’s sovereign and it is possible that Spain is going to ask for sovereign bailout as it is just a matter of time. The borrowing cost shoots up instead of a retracement despite the austerity package approved by the Spanish government last Friday. The package of up to EUR 100 billion is more or less buying more time for Spain no matter how the stress test result will be, until further new measures to be released and implemented.

The new measures would be the EU policymakers and ECB co-ordination as there is nothing Spain itself can really do. Spain government has little capacity to recapitalise its banking sector. Its banking system could do little to buy the government securities to lower the yield, so the cycle is almost dead. The only solution next is the European Stability Mechanism (ESM) bailout. However nothing is out from the German’s court yet.

The bottom line is I am looking at it as the “Fresh Capital” for Spain to reach the bottom, and then a temporary recovery kicks off. The fresh capital should be able to provide enough liquidity from the big financial institutions to the smaller institutions.

Spain is also going to release its Q2 GDP estimates and it should not be an optimistic figure. The future growth could be worse as high debts/GDP % and tough budget deficit target triggers a more vigorous austerity and government expenditure as well. According to the data from the Spanish Finance Ministry, the government’s debt is expected to rise in the coming few years while the government’s expenditure is going to shrink sharply.

Source: Spanish Finance Ministry

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Source: Spanish Finance Ministry

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The little support from the ECB rate cut encourages the lending since majority of the Euro Zone’s mortgages are floating based on the Euro Interbank Offered Rate (Euribor). However, zero per cent deposit rate aiming at the bloc currency to become another funding currency to encourage the depositors to withdraw partial cash as well which has the same effect of “bank run”.

United States

Eyes on US Gross Domestic Product (GDP) this week; Federal Reserve’s main theme unlikely to change in coming Federal Open Market Committee (FOMC)

The US advanced GDP and Markit flash manufacturing PMI are the two key events to watch while investors might pay little attention to new home sales, durable goods order and initial claims.

Based on my model, my forecast for advanced USD Q2 GDP growth is 1.5%, slightly higher than the market forecast around 1.3-1.4%.

Households in the US cut their spending in Q2 because of:

dark job market
fiscal cliff, which dampened the consumers’ confidence substantially, and dropping energy prices seems offered little support to spend further

As long as the job market grows without a resilient tone and fiscal cliff is a concern, the uncertainties will keep the spending growth in a subdued pace.

Lower inflation below the Fed’s target of 2% eased the concern from the central bank and investors expect Bernanke to act further aggressively given the domestic economic growth has faded. In my point of view, I only agreed with that inflation is not in the Fed’s primary watch list at this time. With that said, Fed will not benchmark the inflation figure to decide its coming monetary policy.

Based on the Taylor’s model which is focusing on Inflation and Unemployment gap, the estimate interest rate should be 0.5%, which generated from a net replacement ratio (NRR) 2%, Core Personal Consumption Expenditures (PCE) 1.8%, Alpha 0.5, Inflation 1.8%, Beta 0.5%, and unemployment at 8.2%. Thus it comes to the conclusion that current interest rate has been ultra-loosen based on the Taylor’s model, and the spread between Fed rate/Taylor’s estimate turned negative since Dec last year, mainly due to the Euro Zone’s contagion. With that said, I do not expect there will be any major decision to change in the coming FOMC meeting.

Source: FXPRIMUS Research

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Beige Book: Tone turned softer

The Beige Book will be used for discussion in the coming FOMC at end of the month. In the statement released on 18 July last week, it indicated that the overall economic activity continued to expand at a “modest to moderate pace” in June and early July. The report honoured the improved housing market and a modest growth in the mortgage market, but manufacturing has been slowing down compared with the earlier months this year.

By referring to the earlier Beige Book statement on 6 July, “modest” was skipped in the entire summary. Thus I can see a little downgrade from Fed for the growth forecast, and if I count the word “uncertainties”, the numbers were doubled on the 18th compared with the numbers appeared on the 6th.

Besides that, Fed reassured that “tepid employment market” and “fiscal cliff” would be the main benchmark for the coming monetary policy adjustment. There are obscure evidences that Fed is unlikely to ease the monetary policy further in the coming one or two FOMC meetings.

Bernanke’s neutral testimony in front of the Congress

There was really nothing new from Bernanke’s testimony because not only the tone was neutral, but also lacking of any meaningful clues. In the psychological point of view, he just wanted to avoid the hot topic in the market which is the “QE3″. Thus in other words, he does not wish to act further at this stage.

It is really not necessary to study every single word from his mouth which some analysts have exercised this practice since Q2 this year. In his testimony, he recognised the growth is on-going in the US, and job growth has been slowing down, but it has not reached Fed’s threshold to consider additional steps, which most likely will be increasing the balance sheet, but most importantly, no consensus has been made to use which choice at this point.

The bond and currency markets have priced in some QE possibilities, especially on the US Treasury bills.

United Kingdom

Further dovish tone expected from Bank of England (BOE)

Last week, the Monetary Policy Committee (MPC) minutes showed a 7-2 votes for additional QE, and a rate cut if necessary, which would be a tough decision.

While the ECB is expected to cut the benchmark refinancing rate to negative, it will be difficult for the BOE to act at the same pace to prevent a sharp rebound on its currency. With the recent implementation of the Funding for Lending Scheme (FLS) to reduce the banks funding cost, given the 5% cap of their existing lending, which eases the BOE’s concern that banks are unwilling to lend if a rate cut squeezes out their margins. Thus, a rate cut will be feasible as long as FLS exists.

However bear in mind that a possible rate cut proposal is for coping with the ECB’s rate cut, which later could start as early as end of the year. Thus the BOE is unlikely to do so in the coming few meetings though the theory’s possibility has increased.

An improved labour market and lower inflation released last week could boost the consumers’ spending. Plus the Olympics effect, which could only stay in a very short period. The UK seems impossible to walk out of the “technical recession” cycle after a second consecutive quarter GDP contracted, the Q2 GDP is going to be released in 2 days. I forecast the growth could be contracted further from -0.4% to -0.5% range.

Source: Reuters

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Source: Bloomberg

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Ideas For Currency Trading This Week

AUDCAD: Bearish theme to appear if it fails to break 1.0520

As I mentioned in the Daily Market Report article last Friday, the AUDCAD is likely to retrace lower because the level of 1.05 is set for a strong resistance for the pair.

Markit could release another weak China flash manufacturing figure tomorrow and an adviser of PBOC has hinted a weaker Q3 GDP. So it seems that there are some doubts that the Aussie dollar could slip a bit as China may not reach the bottom yet.

The next support for the pair will be at 1.0420 and the second support at 1.0365.

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Disclaimer The analysis we provide is based on the average estimate of price movements in one day. Does not guarantee what we deliver is actually a proper and correct. Everything that happens in the decisions you make on your trading transaction is to be Your responsibilities. Visit Us www.deryworldscorp.web.id

Monday, July 23, 2012