US Congressional supercommittee fails to agree on plan to reduce deficit

At a time when contagion risk from the European debt crisis is still brewing, global economic momentum waning and confidence plunging, these Congressional leaders responsible for restoring confidence in the US state of fiscal health have decided to put politics ahead of the economy.

The failure does not mean that the US will not cut its deficits because there is an automatic spending cut or “sequester” rule that will start in January 2013 for ten years. It just means that both the Republicans and the Democrats have squandered a golden opportunity to strike a compromise to restore the country’s finances and also to demonstrate leadership to the world.

Under the sequester rules, roughly half of the spending cuts would come from defence and homeland security, and the other half from domestic programmes such as roads, education, energy and housing. An automatic cut from every federal agency is far from an ideal way to manage a budget, because it does not set priorities and largely exempts the major entitlements like Medicare and Medicaid. In other words, as President Obama has said, the deficit would be trimmed with a “hatchet instead of a scalpel.”   

So far rating agencies S&P and Moody’s have said they won’t lower ratings on the US despite the supercommittee’s failure and bond yields haven’t reacted much even though stocks continued to plummet. Perhaps from the go it was considered a long shot and optimism was never high that the panel would succeed given the proximity to the Presidential election next year. 

Still the outcome depressed market sentiment further at a time when confidence in political leaders to find solutions to the world’s problems is waning. In fact, in some countries, politicians are seen to be the problem. These feelings have given impetus to movements like the Arab Spring, Occupy Wall Street etc. to agitate change from the bottom up. In more democratic countries like Greece and Italy, incumbent administrations have made way for more technocratic governments.  

The world is in dire need of leaders who are operators with an understanding of economic issues and market solutions, and not mere career politicians. With economies slowing, unemployment high, workers taking to the streets, it is not far-fetched to imagine technocratic governments even in France and Germany in the near future. 

Or perhaps the fault lies with the system rather than the people. Democratic capitalism seems to be ill-placed to deal with the economic crises in both the US and Europe where politicians cannot see beyond their partisan stance for the greater good. Perhaps if either Europe or the US had an autocratic system, their leaders could have accomplished much more. This is only hypothetical and I do not want to start a debate about whether democracy or autocracy is the better model. Ultimately, it is about governance and it is about both the structure and the people in it.

To conclude, we believe that political risks and policy risks will remain elevated and continue to drive the markets into 2012. It is tough to be bullish in such an environment.

Greek Referendum Throws a Spanner in the Works

Greek Prime Minister George Papandreou's call for a referendum on the freshly minted bailout package rattled global financial markets as officials and investors panic over the possibility of a collapse of the euro-zone.

After what seemed like a Sisyphean task to hatch a comprehensive plan to deal with the sovereign debt crisis by European leaders, Greece’s shock decision late Monday to hold a referendum threatens to unravel all the goodwill mustered over the past few days.

Essentially, Mr. Papandreou is asking his countrymen to decide if they wish to accept the debt deal that will require Greece to implement all the austerity programmes forced upon it by the “troika” (EU, ECB and IMF) for at least a few years in return for continued funding. But effectively, the referendum amounts to a vote on Greece remaining a member of the euro-zone and could potentially lead to a disorderly default of its debt.

The referendum is not expected to be held before December and current opinion poll suggests 60% of Greeks oppose the deal. Many things can still happen between now and then. Mr. Papandreou is already facing revolt within his own Pasok Party and a confidence vote against him may be in the works. Or perhaps, he can persuade Greeks that their best option remains within the euro-zone.

This brings home the point that when push comes to shove, Greece can still reject the deal, exit the euro and reclaim their sovereignty. While this may not be such a bad option for Greece, coming at such a tense time could fuel concerns about the viability of the entire euro-zone.

In one broad stroke, Greece has lost the goodwill from European leaders and the bailout package is held hostage by Greek voters. The sixth tranche of the aid disbursement to Greece is now in jeopardy while countries such as China and Japan would surely have second thoughts about risking their taxpayers’ money to invest in any bailout fund.

Our recent upgrade of equities was premised on Europe avoiding a messy, disorderly default of Greece. We had that for a few days last week when leaders agreed to a 50% haircut on Greek debt, enlarging the EFSF to EUR1 trillion and forcing banks to recapitalise their core capital ratio to 9%.

With the Greek referendum on the cards, we are back to square one with the tail risk of a disorderly default on the radar again. Worse, this looks like a binary outcome and it is not in the hands of the politicians. Strange, for once, I’d rather it is in the hands of politicians. Now, it is down to a flip of the coin.

There may be some reprieve from the G-20 summit this weekend. But as long as the tail risk remains elevated, we will lighten up at every opportunity.

Is there a silver lining? Yes, but that’s a topic for another time.

Finally, a deal! Tail risk of a disorderly Greek default dissipates.

European leaders have finally delivered what looks like a comprehensive plan to manage its sovereign debt problems from spreading to bigger economies such as Italy and Spain and to avert a possibly ruinous banking crisis.

After what seemed like days and hours of deadlock and brinkmanship at the EU ministerial summit, significant progress has been made on three key areas, even if key details are lacking.

On the Greek situation, officials have managed to persuade bondholders, especially banks, to take 50% losses on their holdings of Greek government bonds.

This paves the way for European banks to recapitalise their dented balance sheets to an agreed target of 9% in Tier 1 capital ratio by 30-Jun-2012. The European Banking Authority estimated banks’ capital needs at EUR 106 billion, with Spanish banks requiring EUR 26.2 billion and Italian banks EUR 14.8 billion. It gave them until 25-Dec to submit money-raising plans to national supervisors. Banks that fail to raise enough capital on the markets will first tap national governments, falling back on the EFSF rescue fund only as a last resort.

Finally, they have also agreed to expand the firepower of the euro zone's bailout vehicle, known as the European Financial Stability Facility (EFSF), by four- or five-fold suggesting it could provide guarantees for around EUR 1 trillion. Details are still sketchy but turning this fund into a bank with a credit line from the ECB has been squarely rejected by the Germans. It is likely that the EFSF will be used to insure bond issuance by affected countries, and to create a special investment vehicle that would tap money from both public and private investors within and outside of the euro-zone. 

What does it mean for equities and risk assets? After two months of de-rating driven by perceptions of sovereign defaults and systemic banking risks, we expect the equity risk premium to fall as the tail risk of a disorderly Greek default and banking crisis have been averted. This suggests that the rebound in risk assets that has been underway in recent days may well continue for some time.     

Therefore, we upgrade our tactical assessment of stocks from underweight to neutral. This translates to a three percentage points increase equities in our conservative profile to 18% and five percentage points for balanced and growth profiles to 35% and 55% respectively.

However, we remain cautious in the medium term for a few reasons. For one, it is still critical how all these will be turned into detailed points of action and implemented in the coming weeks. But more importantly, the global macroeconomic outlook remains weak and policymakers having already spent most of their options can't do much about it. Also, investors may just return to focus on the US and the dysfunctional government there just doesn't inspire much confidence either. 

Promising or Just Promises?

Europe appears to be finally gaining momentum in its long and slow struggle towards a solution to the sovereign debt and banking crisis that is threatening its very existence. France and Germany have promised to produce a “comprehensive plan” to end the crisis at this weekend’s European summit on 23-Oct and will present it at the G-20 ministerial meeting on 3-Nov. The plan is expected to encompass three crucial elements: deeper haircut on Greek debt; recapitalisation of European banks; and an increase in the firepower of its bailout fund to prevent contagion to other countries.

Sounds familiar? Sure. The markets have been demanding these actions for some time while politicians were dithering. What is new now and certainly out of character is that a definitive timeframe has been fixed and one that is rather aggressive too. All of a sudden, policymakers in the euro-zone find themselves surfing right up to the curve as markets turned decidedly exuberant in anticipation of a resolution.

Is this the real deal? This is a tough call. That Germany and France have promised to act within such a tight deadline is promising. And markets have rewarded such a bold move with the EUR trading at a 1-month high and equities up more than 10% in the past two weeks. But the devil is in the details and the proof of the pudding is in the execution.

Regarding the amount of haircut, there is still disagreement amongst various countries to accept deeper losses. It was only three months ago that private creditors agreed to a 21% haircut. Germany now wants a 50%-60% write-down while France is resisting because French banks, being one of the largest holders of Greek debt in the region, will be hardest hit. What should the amount be? Too little and the markets will be disappointed. Too much and it will encourage Ireland and Portugal to backslide on their reforms and clamour for a haircut too.

On recapitalisation, what is clear is that banks need more capital. Besides that, little else is clear. There will be new stress tests to determine the extent of additional capital the banking system needs. The stress test scenarios have to be tough enough to be credible but yet at the same time not so demanding that the capital needed to fill the gap is unachievable and risk sending the markets into another tailspin. According to sources, EU leaders are working on a plan to raise anywhere between EUR100 billion and northwards of EUR300 billion. Meanwhile, banks are reluctant to raise capital when their shares are trading at fractions of book value, existing shareholders are resisting calls to pump more capital and governments are weary about using more taxpayers’ money to bail out banks. It is also unclear whether the recapitalisation will be a piecemeal effort on a national basis or a concerted pan-European execution in one go. Germany has stressed that individual countries should take care of its own but France is opposed to that because it could jeopardise its triple-A rating. 

And on more firepower to the EFSF bailout fund, one can only hope that they have achieved a consensus. It is only after a prolonged struggle did the German parliament finally ratified the expansion of the EFSF to EUR440 billion and allowed it to buy bonds in the secondary market as well as to offer credit lines to governments. The same can be said for Finland, the Netherlands and Slovakia. If the EFSF is to be sufficient to backstop the liquidity of the periphery countries including Spain and Italy, it would need to grow to a size of at least EUR2 trillion. And EUR2 trillion implies a coverage ratio of only just about 50%. European officials have to find ways to scale up the fund without requiring another round of voting. They could either turn the EFSF into a “bank” allowing it to leverage up its equity of EUR440 billion through a credit line with the ECB, or alternatively, it could act as an insurer to protect the first 20%-30% of the value of affected sovereign bonds. It is unclear how they will proceed.

One week is a rather short time to manage all these challenges. But then again, this crisis has been brewing for more than a year and a half. With pressure mounting, time running out, European politicians have no more excuses. For once, they have the chance to get ahead of the curve. They should grab it. 

The big question is will they succeed in convincing the markets, or will they disappoint yet again. If the latter, then markets could easily give back all the gains and more, but if the former, then the question is how much more upside can there be. Going by the previous experience in the US in 2009, it can be substantial. In March-2009, US Treasury Secretary Tim Geithner expanded the TARP program to announce a public-private initiative to buy toxic assets from banks paving the way for the banks to be recapitalised. That turned out to be the turning point in the risk markets and equities powered ahead for the next 12 months by more than 80%.

I’m not suggesting we’ll get a similar magnitude of response. For one, while the TARP in 2009 may have removed the systemic risk threatening the banks, the real lifting of financial markets was attributable to the combined global firepower in fiscal and monetary stimulus and quantitative easing.

The world is a much different place now. Governments in the developed world are on an austerity mode even while their economies are moving along stall speed, and central banks do not have much room for manoeuvre with rates already at or near historic lows. The experiment with unconventional policy such as quantitative easing have not yielded much in terms of economic growth but have definitely bloated up the balance sheets of these central banks. And more importantly, investors are less naive. They now know better that you can’t solve a debt problem with more debt. It only comes back to roost at a later time.

For the record, I’m not a pessimist. In fact, as an equity fund manager, my pre-disposition is normally optimistic. I believe we’ll get a strong rebound when we get the resolution. But given the reality, I’m just not as convinced about the sustainability. For me, the best case scenario is that the European crisis is stabilised, developed markets manage a 1-3% annual growth while finding a way to reduce their debts over the medium term without harming the economy too much. But the odds are not high and hence we need to be prepared for a “new normal” in the financial markets with higher volatility and lower returns. This will have strong implications on asset allocation in the next few years. In a high risk-low return environment, the sweet spot in terms of risk profile is skewed towards the conservative. But for now, even though we are cautiously optimistic, prudence would dictate that we change our allocations only when we get more clarity on 23-October.

Asian Equities Held Hostage to External Circumstances

Why so weak?

Asian equities have underperformed since the middle of August as structural problems with the fiscal health of the US and the EU returned to haunt the markets. Once again, Asian and other Emerging Markets (EM) stocks have reverted to their status as the whipping boy when systemic risks rise globally.

 

While the trigger of the weakness was mainly due to external factors, the magnitude of the sell-off especially in the recent two weeks can be traced to positioning. Since the Global Financial Crisis (GFC), investors have piled onto EM assets with impunity. Non Foreign Direct Investment (FDI) capital inflows into emerging markets are at 15-year highs as weightings in market indices gained more prominence for global asset allocators.

It is also understood that the bulk of these investments into the EM were not FX-hedged because of the expectations of currency appreciation due to stronger fundamentals and the need for stronger currencies to contain imported inflation.

In particular, Asian equities have benefited massively from such inflows in recent years as investors are drawn to substantially higher earnings growth as compared to developed markets. Hence, a reversal under current conditions can only exacerbate the magnitude on the downside as investors seek safety and sell both securities and Asian currencies to repatriate their USD money flows.

Impact of capital markets volatility – how it will continue to depress Asian markets

In the near term, sharp market correction posits two immediate impact - margin calls on client positions leading to curtailment of collateral and margins, exacerbating the downside in the near term especially for mid and small-cap stocks, and weaker banks’ earnings, arising from lower client driven capital markets’ activities, lower proprietary positions and higher NPLs. This portends a credit crunch in our view as falling market values force banks to tighten credit further leading to a vicious circle of liquidation.

Value remains undervalued

Where do we go from here? Asian markets have already corrected massively and more so than the US and Europe while valuations have dropped to 10x forward PE vs. 2008 lows of 9x. In terms of value, Asian stocks certainly look attractive. But value alone is an insufficient condition for a sustainable rebound. We need a clear resolution to the European debt crisis. Only then can the markets revert to fundamentals and valuations. In the absence of a resolution, positioning in EM and Asia warns against jumping back into the markets too quickly.

Markets inflexion point will be defined by capital raising/M&A by EU banks

 
Just as the macro events in the developed economies are key culprits for the sell-down in Asian markets, an enlargement of the EFSF and/or a capital call / M&A activities by EU banks should conversely signal an inflexion point in the capital markets cycle.

Expanding the EFSF bailout fund from EUR440 billion to EUR2 trillion should be sufficient to act as a firewall against further contagion in the fiscally weak Europe periphery, while the recapitalisation of European banks will prevent another system-wide credit crunch. Based on IMF’s estimates and assuming 50% write-offs on Greek debt, we postulate at least EUR200 billion is needed for the recapitalisation of the EU banking sector to allay investors’ fears.

Only when the EU banks complete their capital raising (and thereby strengthening their capital position), would investors be more receptive towards potential Chinese policy stimulus, re-expansion of the US Fed's balance sheet, and re-accelerating global growth momentum. Failing which, even with a well-armed EFSF, the EU and developed markets financial sector is likely to enter into a static credit phase, which will manifest itself in economic contraction wrought by financial de-leveraging. We will be patiently waiting for signs of the above inflexion points to redeploying our cash.

The Asian Crisis of 1997-8 and the recent US experience during the 2007-8 Global Financial Crisis (GFC) present valuable lessons on inflexion points. Sovereign defaults were a common theme amongst the Asian economies then as massive devaluations in Asian currencies precipitate massive recapitalisation and numerous M&As in the banking sector as non-performing loans and assets ballooned to almost 20% of the system. In 1998, Malaysia set up Danaharta, an asset management company to remove bad assets from banks’ balance sheets and also, it established Danamodal the same year to facilitate the recapitalisation of banks. In Thailand, the Thai Asset Management Company was set up to handle non-performing assets, similarly Indonesia set up Indonesian Bank Restructuring Agency (IBRA) in the same vein. The Financial Supervisory Service (FSS) led an intensive restructuring of the Korean financial industry. Over a six-year period extending from 1998 to 2003, 840 financial companies – including 14 banks – were removed from the Korean market through M&As or liquidation. Despite these efforts, NPL ratios across Asian countries remained in high double digit until 2004, some 7 years after the onset of the Asian Financial Crisis. Singapore banks, which were the best capitalised with Tier 1 ratios averaging 16% then, saw consolidation in the industry from 6 to 3 banks (between 1998 to 2001). And in the US, at the height of the GFC, it set up the USD700 billion Troubled Asset Relief Program (TARP) to recapitalise its banking system. These examples illustrate the need for an asset management program complete with a recapitalisation model in times of severe economic crisis and we believe that the EU is no different in this regard   

 

Asymmetrical Risks Means We Remain Cautious For Now

Global markets continued to fall off a cliff in the past days as faith in policymakers to find definitive solutions to the debt crises and to rejuvenate global growth plummeted. The MSCI World Index has fallen by more than 20% since peaking on 2-May. And just in the past week, the index plunged by more than 7%.

In rapid succession over the past two weeks, announcements by policymakers across the Atlantic to tackle the unemployment and growth issues in the US and the sovereign debt crisis in Europe have failed miserably to inspire confidence. US President Obama’s bold US$477 billion jobs plan announced on 8-Sep and the US$3 trillion deficit reduction announcement on 19-Sep did not change the US outlook much because investors remain unconvinced that his plans will be approved by Congress given the entrenched polar positions taken by the two political camps. In Europe, leaders seem to be only paying lip service to keeping Greece in the euro-zone while refusing to consider more drastic actions to enlarge the rescue fund or the issuance of euro-bonds. In fact, the proposed changes to add more flexibility to the European Financial Stability Fund (EFSF) have yet to be ratified by the individual countries.

To make matters worse, the Federal Reserve reminded us last week of what we knew but refused to acknowledge – that the Fed has run out of good ideas to stimulate the economy. The markets have been looking up to the Fed because they are independent and not bogged down by politics, and are thus able to act decisively when needed.  Unfortunately, that bastion of hope took a beating last week when the markets promptly sold off after the Fed’s FOMC meeting. The Fed’s announcement to “twist” its balance sheet from shorter dated bonds to longer dated assets by US$400 billion was a dud. With long rates already at historic lows, another few tens of basis points lower would hardly change much of consumers or corporate behaviour. The new reality is that the Fed has no more real bullets and that “Operation Twist” is more a gesture than deliverance. That is why the markets tanked.

Clearly, the current market environment is still characterised by significant systemic and cascading economic risks. While we would like to be more constructive on the markets after such a hefty correction, we feel the balance of risks remains asymmetric at this point.

In our opinion, the sovereign debt crisis in Europe is the more immediate risk because it has the potential to roil the banking system and further threaten the already stalling global growth. There are many variables and flashpoints but a resolution to the Greek debt situation (i.e. haircut) in our opinion is a necessary first step for us to become more constructive. We would also want to see a sufficient firewall in the form of an enlarged rescue fund to prevent contagion to other European countries and the banking system. With mounting pressure from investors and from foreign counterparts, we should see a breakthrough in the coming weeks and a resolution likely before end of the year. 

  

Even if we get a resolution and an orderly one, risk assets such as equities, commodities and high-risk debt still have a long wall to climb. Risk assets thrive on economic growth and it is quite clear that growth in this “new normal” of debt reduction and fiscal austerity will be low. And there is not much more policymakers can do to stimulate growth when governments do not have much means to spend and central banks do not have much room to reduce interest rates. In other words, any market rebound subsequent to a crisis resolution may not have very strong staying power.

There are many “what ifs”. What if we do get an elegant resolution in Europe soon and there is no double dip. Or what if we are wrong and a resolution to the debt crisis is not forthcoming, or we have a resolution but a messy one. The odds seem to suggest that the balance of risks is still asymmetrical at this stage. Hence, we continue to advocate caution. The equity exposure in the “conservative” and “balanced” profiles now stands at 15% and 30% respectively.

Our strategy to go East has not yielded much as Asian markets have been held hostage to external macro events notwithstanding their better fundamentals. In fact, Asian currencies and equities suffered their biggest weekly drop in three years as capital flowed out quickly last week. The limitations in terms of breadth and depth of Asian financial markets mean these markets can react violently to swings in capital flows. Although Asian and emerging markets are still our preferred investments, without a breakthrough in the debt crisis, these assets remain extremely vulnerable to external factors.

A rebound is still possible on oversold conditions. And valuations in certain markets are looking extremely attractive. However, the sustainability of such a rebound will be suspect as long as the situation in Europe remains status quo and the global fundamentals remain weak.

For those with a stronger risk appetite and longer term view, as always, incremental buying on major pullbacks may still be a sound strategy.

Lastly, the recent correction in gold presents attractive entry points for investors looking to add on to their portfolios. We expect the rush into USD as a safe haven would unwind at some point. First, it was gold, then yen and the Swiss franc. But with the Swiss and Japanese central banks stepping in to prevent further appreciation of their respective currencies, markets turn their attention to the USD. With all the quantitative easing and money printing in the developed economies, it wouldn’t be long before the music stops and the only chair left is reserved for gold.

US Job Growth Stagnates

Zero jobs added for August! The US economy slammed into a wall in August. The non-farm payroll was the first concrete data to confirm the weak economic survey figures the past month. Political infighting over the budget and mounting fear of a default in Europe had taken a toll on consumer and business confidence prompting a severe market sell-off in August.

With jobs growth slowing, financial markets wobbling, the odds of a US recession has increased dramatically. After all, the economy only expanded at a 1% pace in the second quarter following a 0.4% gain in the first three months of the year. Consumer spending grew 0.4%, the smallest increase since the last three months of 2009.



Source: WSJ



As can be seen from the middle chart above, this is one of the weakest job recoveries in the past three decades. Given that consumption accounts for 70% of the US economy, the poor employment situation at 58.2% constrains the broader recovery.

All eyes are now on policymakers. Mr. Obama will address the nation on Thursday. He will likely focus his speech on jobs and housing. But a new stimulus is certainly out of the question after the fiasco in Congress last month just to extend the debt ceiling. Without further fiscal means, Obama should forget about grand programmes in government-led jobs creation at this stage and instead focus on government-private sector initiatives which will help small businesses access capital, grow and hire people.

That leaves the ball in the Fed’s court. At the recently concluded Fed powwow at Jackson Hole, Mr. Bernanke did not exude a sense of urgency to initiate further monetary stimulus. His reticence underscores two points in our view. First, he doesn’t want to raise too much expectations as he probably knows his tools and financial power are now limited. Second, there are tensions within the FOMC. The Fed's unprecedented decision at its August meeting to keep short-term rates at near-zero levels until 2013 led to three dissents from Fed governors.

But with zero jobs added in August, we expect the Fed will announce another round of stimulus at the September FOMC on 20-Sep, or perhaps even before. This will likely take the form of manipulating the yield curve by pushing down long-term interest rates while keeping short rates steady (aka “Operation Twist”). The Fed will engineer this by changing the composition of assets on its balance sheet rather than expanding its size as it had done in the previous two rounds of quantitative easing (QE). This involves selling off bonds of shorter maturities and switching into longer dated ones.

How does this help the economy? Apart from generating the so-called wealth effect from rising asset prices, the idea of Operation Twist is that the lower long-term interest rates would drive further business investments and housing demand.

Will it be effective? QE1 and QE2 both generated massive gains in asset markets. Not just in equities but also commodities. But sadly, it hasn’t done much for the actual real economy. The problem is not just about the level of interest rates but rather a clear lack of incentives for lenders to lend and borrowers to borrow. Banks are still nursing their balance sheets after the devastation from the 2008/9 global financial crisis and consumers lack confidence to spend because of job insecurity. Companies facing an uncertain future, protect their profits by slashing jobs and moving investments to emerging economies where there is still growth.

Still, we expect Mr. Bernanke to continue trying. Bernanke got the nickname "Helicopter Ben" from a speech in 2002, in which he proclaimed that deflation was a real worry and that if he had to, he would fly around the country dropping $100 bills from helicopters. Unfortunately, he had been dropping bills on a semi-dysfunctional Wall Street and Congress. Perhaps, that explains his reticence. In his speech at Jackson Hole, he stated that most of the tools that could be used to increase growth are “outside the province of the central bank” – in effect putting the ball back into Congress’ court.

While this policy helplessness is worrying, we believe the Fed’s coming action if implemented correctly (by explicitly targeting a long bond rate just like it does now with the Fed funds rate) should be sufficient to stabilise the fragile markets in the near term.

But until we see policy traction on the real economy, we will continue to re-allocate at the margin into Gold, Asian currencies, bonds and stocks if you have the appetite. I know I sound like a broken recorder on this strategy but like in the proverb – “in the land of the blind, the one-eyed man is king” – Asia does sound like the one-eyed man at the moment.

Revising Down Our Forecast

Over the past month, equity markets have sold off sharply, volatility has spiked and Treasury yields have collapsed to levels not seen since the 2008/09 global financial crisis (GFC). The current sell-off can be attributed to causes such as the S&P downgrade of US credit rating, the enlargement of the European sovereign debt crisis and decelerating macroeconomic data etc. Not least important is that we believe markets are now pricing in an increased probability of recession.

Chart Source: Bloomberg

Although we had always argued that global economic growth post the 2008/9 GFC would be slow because the unwinding of credit bubbles usually takes years, we never expected a global double dip. We felt that the liquidity and fiscal support by policymakers would provide sufficient stimulus to keep the growth momentum going even if it was not very robust.

In any case, we had expected 2011 growth to be slower than last year’s due to the fading impact of the extraordinary stimulus measures. And we attributed the slower-than-expected economic indicators since 2Q11 largely to the high oil prices wrought by the unrest in the Middle East since the start of the year and the disruptions on economic activity from the Japanese earthquake and tsunami.

However, the disappointing first half GDP growth in the US economy which trickled to a less-than-one-percent annual pace and the expanding sovereign debt crisis on both sides of the Atlantic drove home the point that the structural mass of debt continues and will continue to weigh heavily on global growth.

Unfortunately, unlike 2009, policymakers do not seem to have the will and the wherewithal to solve the debt crisis and to boost their economies. The Fed no longer has the ammunition for another “shock and awe” strategy after stretching its balance sheet to almost USD3 trillion with two rounds of quantitative easing (QE). Even if it did, we know now that its impact on the real economy is at best mixed. The ECB may have climbed down from their dogmatic stance in the past weeks and started buying Italian and Spanish papers to drive bond yields down. But the 0.5% point interest rate hikes since the start of summer must surely look foolish in the current context.

Meanwhile, politicians are all stuck in second gear! European leaders have run out of ideas to solve the debt crisis which is now threatening to move on to the bigger countries including France. The markets are growing tired summit after crisis summit and the band-aid approach with politicians making just enough promises to hold off the rising tide for a few days before the floodgates open to another wave of pessimism. Meanwhile across the Atlantic, US lawmakers are gearing up but not so much to solve the pressing economic problems of stalling growth and runaway debt. Rather they are busy posturing for next year’s Presidential Election.

Our concerns stem from this vicious cycle of pessimism that is feeding the rounds. All this wrangling has taken a toll on consumer and business confidence. The weekly Bloomberg Consumer Comfort Index’s monthly expectations gauge dropped to minus 34, the weakest since Mar-2009. Businesses facing an uncertain future continue to shed jobs at an alarming pace. 

Consequently, we are revising our growth estimates down. Our baseline is for the developed economies to experience slow anaemic recovery for at least the next few quarters. We maintain our base case that a double dip can still be avoided. Recent data suggest the labour and housing markets may be stabilising. The Chicago Fed Index is pointing to slow but positive growth. The Conference Board Leading Economic Index has been higher in 11 of the past 12 months. In the one year leading up to Lehman Brothers bankruptcy in Sep-2008 this measure contracted or was flat for 11 of 12 months.

From a policy viewpoint, the US is now in the hands of the Fed. Congress will remain dysfunctional until after next year’s presidential election. All eyes are now on Chairman Bernanke when he speaks at the Fed’s annual symposium at Jackson Hole this week. Last year, at the same function, he soft launched QE2 under similar threatening environment kicking off a 28% rally in the S&P500 Index that ended in April this year.

We expect the Fed to continue to pump the monetary tap even if the impact is diminishing. The idea is to stabilise the situation sufficiently for the “animal spirits” to return and long enough for a more functioning government after the election.

For Europe, we reckon there are only two possible end-games – break up or speed up towards a “Eurobonds” market. Both are unpalatable options. A break-up would certainly be damaging and painful but may allow affected countries to go back to their own pace with their own policies that are unique for their circumstances. However, there are sure to be consequences that are unpredictable and unintended which may put the entire union at risk.

The other option is to introduce “Eurobonds”. The idea is to replace individual countries’ debt with Eurobonds which are then backed by a joint guarantee of all member states. As expected, strong objections are coming from those countries with strong finances. First, the pooling of debt will raise the rates paid by the most creditworthy. Second, the lower rates enjoyed by the more profligate members will surely remove pressure to right their balance sheets and we are back to square one in terms of moral hazard.  

We believe that the Eurobonds option has a fighting chance to work if it can be modified to account for the above criticisms. Ultimately, the question for the stronger economies is how much is saving the Euro worth, and for the others, how much control are they willing to cede to a central authority.

Alas, politicians are likely to take the path of least resistance and continue to muddle along until renewed pressure to act. With no end-game in sight, we expect volatility to remain high as the global economy is extremely vulnerable to further shocks.

Slow growth and more shocks to be expected. Where does that leave us in terms of investment strategy?

We continue to advocate caution and as always stay diversified and stay within the bandwidths of your strategic asset allocation. But within each asset class, we say go East! Go East to where the fiscal situation is healthier, balance sheets stronger and growth faster. Furthermore, most emerging markets, led by China and Brazil, have taken significant tightening measures to combat inflation. With the notable exception of India, which was late in raising interest rates, they appear to be near the end of the tightening cycle. This also means that when push comes to shove, they have the means for fiscal and monetary stimulus to boost their economies.

In a panic, these markets would often fall as much if not more than the developed markets. But we expect that when the situation stabilises, their superior fundamentals will exert themselves and outperform. We will continue to add Asian equities, fixed income and currencies on dips and market dislocations.

Portugal became the third euro zone country to seek a rescue from the EU as the nation’s fiscal situation and political crisis pushed borrowing costs to record levels. Bloomberg reported the rescue sought may be worth as much as EUR 75 billion. This comes as no surprise as the markets have long priced in this possibility. Portugal faces bond redemptions totalling EUR 9 billion due by 15-June. The trigger came as PM Jose Socrates resigned on 23-March after parliament rejected his proposed budget cuts. We continue to see the debt situation in the periphery as untenable. The taxpayers and public are bearing the brunt of the debt load. Ultimately, a debt restructuring may be inevitable. The question is soon or later. Trade them if you wish but we are avoiding the bonds of Portugal, Ireland and Greece. Spain and Italy are in much better shape and markets are giving their bonds the benefit of the doubt as spreads against German bunds fell recently. Interestingly, the announcement had limited impact on the EUR which went on to top 1.43 handle.

The ECB hikes, BOE holds. On Thursday, the European Central Bank (ECB) raised interest rates by 25 basis points to 1.25% for the first time since July 2008, while in a separate meeting the Bank of England (BOE) left rates at a record low 0.5%. The contrast cannot be more stark given the inflation rate in the UK is 4.4% - double the target – while “only” 2.6% in the euro-zone. Unlike the ECB which pushed ahead nonchalantly with a well-flagged rate hike even as Portugal became the third euro-country to seek a bailout, the BOE continued to judge the UK economic recovery too shaky to withstand higher rates. The ECB might have been emboldened by the market view that Portugal is likely to be the last to seek aid and that Spain has decoupled from the crisis. The fall in Spain’s bond yields over the past month reinforces the view that the market is optimistic that Spain is moving in the right direction to address its fiscal problems. Still, we are not convinced that the risks have entirely gone away. With the EUR at a 14-month high, unemployment rate stuck at 20% and a combined public-private debt load in excess of 3 times GDP, watch out for aftershocks!

The FOMC minutes of its March 15 meeting revealed a tension amongst Fed policymakers over the path of monetary policy beyond the completion of USD600 billion of bond purchase programme or QE2 in June. The hawks, most notably Plossner, Fisher and Kocherlakota, argued that the Fed should move to a less accommodative stance given the strength of the economy whilst the doves led by NY Fed Prez William Dudley noted that the recovery remains tenuous and argued that loose policies are needed beyond 2011. The implied probability of a rate hike from current target Fed Fund rate of 0.25% from the futures market remain below 50% by the end of the year. At the heart of the debate are differences in opinion over how much core inflation is rising and where the natural rate of unemployment lies in this current cycle. It seems the Fed’s central tendency is 5.5% and with current unemployment rate at 8.8%, the central bank has room for loose policies. But the hawks argue that it should be as high as 7.5% and that current policy stance could be unnecessarily loose spurring inflationary pressures ahead. While this may sound academic, the fact that the debate failed to recognise the potential secondary effect of higher food and energy prices on overall inflation is for us critical. We feel that there is a real risk that the Fed may end up behind the curve.

Once again, China showed its penchant to raise rates on a public holiday. On 4-April, the last of the 3-day “Tomb Sweeping” holiday, the PBOC boosted its benchmark one-year lending rate and deposit rate for the second time in 2011, by 0.25 point each to 6.31% and 3.25% respectively. Even though we have been expecting another rate hike this quarter, the timing was a bit surprising and could signal that the inflation rate for March may be much higher than 5% or even above 5.5%. But truly, we think it underscores policymakers resolve to get ahead of the curve to defuse signs of overheating. That said the job is not done yet as the deposit rates remain well below the CPI. We expect another 2 rounds of 0.25 points hike by end of summer and also open market operations by the PBOC to drain liquidity. By then, we expect CPI would have moderated below 4% to more or less in line with deposit rates. We are beginning to see the end of the underperformance of Chinese stocks and would advocate adding on weakness for those still unexposed.

Japan suffered the biggest aftershock on Thursday night since the 11-March earthquake. The 7.1 magnitude temblor near the site of last month’s quake sent the operator of the stricken Fukushima nuclear plant to evacuate workers. Fortunately, there have been no signs of changes in radiation levels or damage to the reactors. Again, this laid bare the emperor’s new clothes. As one commentator puts it, the nuclear technology we have today to generate power is “half baked” because we have been smart on how to start a nuclear reaction but less so in stopping it. And because we can only contain the process and not stop it, the nuclear fuel remains highly radioactive and has to be stored away for decades. Should we continue to allow ourselves be served “half-baked” dishes? We reckon this is a major setback for the nuclear power industry with significant impact for decades. In the near term, oil, gas and coal will be well supported.

After days of tense negotiations and partisan bickering, US Congress leaders reached a last minute accord to slash USD 38 billion from federal spending this year to head off a shutdown of the government. Expect more of this partisan brinksmanship in the coming months with a renewed vigour from the members of the conservative new House majority.

EQUITY

The MSCI World is within spitting distance of its recent 52-week high in mid-February. The current uptrend remains firmly intact supported by fundamentals and valuations. However, with the strong rebound after the earthquake in Japan, the markets are beginning to be technically stretched making it vulnerable to pullbacks in the near term. Further rises in oil price which topped USD113 bbl in New York at the end of the week could potentially spoil the party. In a month where the global carnage and disaster struck, the swift rebound in the markets smacks of market complacency even if you can make a case that the risks thrown by these concerns are transitory. We would like to take a more cautious approach as we do not discount a weaker second quarter due to softer US consumption and higher oil prices. A repeat of 2Q10? Also, we are beginning to mull a reversal of the DM vs. EM trade in favour of EM.

FIXED INCOME

Policy normalisation in the DM may come earlier than expected. We remain underweight global bonds and underweight duration. Where we are more neutral is in EM hard and local currency debt where the rate hike cycle has reached an advanced stage.

FOREIGN EXCHANGE

The carry trade is strong. The JPY and USD are the global funding currencies as investors do not expect rate hikes in these two economies any time soon. The JPY should remain ranged at 83-87 as the forces of repatriation and intervention play out over the next months. But given Japan has the weakest economic profile within the DM majors, we expect the JPY to gravitate towards 90 making it a strong carry trade currency. EUR continues to be supported by a hawkish ECB but the euro is overbought technically.

• In the US, the key non-farm payroll survey published on Friday confirmed an improvement in the US labour market. Net job creation in March came in above expectations at 216k (consensus: 190k) and February’s figures were revised upwards. The more indicative private sector job creation numbers were up sharply for the second month running at 230k and the unemployment rate dropped by 0.1 point to a 2-year low of 8.8%. Also, noteworthy is that the bulk of the jobs came from services (199k) while manufacturing slowed slightly. These strong figures corroborate the robust readings in the ISM manufacturing and non-manufacturing indexes of late. We feel the mix of strong economic momentum with still accommodative policies supports our tactical overweight stance in US equities. 
• In China, manufacturing growth accelerated for the first time in 4 months easing concerns that China’s tightening policy may lead to a hard landing. The Purchasing Managers’ Index (PMI) rose to 53.4 in March, 0.6 point lower than consensus but higher than February’s 52.2. This is evident that government policies are at least gaining some traction. But with consumer inflation still topping the government’s 4% target in the first 2 months, we see no change in PBOC’s tightening stance as inflationary pressures remain high with prices of commodities still moving up, especially energy. There is a higher than even chance that interest rates will be raised again this quarter. 
• Speaking of commodities, the S&P GSCI index of 24 raw materials continued to climb for the week rising to 725 on Friday which is just a touch below the 2-year intraday high of 731 reached on 7-Mar-11. Food prices are now 15% above the 2008 high. We feel the market is underestimating the risks stemming from climbing commodity and food prices. As food and energy accounts for a much larger share of the consumer baskets in emerging markets (EM) than in the developed markets (DM), headline inflation rates have been rising strongly across the EM over the past few months. This, in turn, has led to EM equities underperforming DM on concerns of policy risks and higher rates.  
• But with ever higher prices, we are now seeing the same headline effect in the DM. Inflation in euro zone unexpectedly rose in March to 2.6%, the fastest in more than 2 years. It looks quite likely that the ECB, whose president had been prepping the markets for it, will raise interest rates by 0.25 point from a record low of 1% on 7-April. According to market watchers, this will be the first time since the 1970s that Europe would lead in a tightening cycle. The EUR had been on a tear since a month ago when the central bank dropped hints of their impending move. How can this be good for Europe we just cannot fathom. The stronger currency and higher rates will further retard the efforts by peripheral countries to rein in their fiscal problems. 
• The failure of the euro zone summit on March 24-25 to resolve a funding issue for a permanent rescue mechanism to be introduced in 2013 strangely had little impact on the EUR. It barely dented the currency recent inexorable ascent. The Brussels gathering did little to help Greece, Ireland and Portugal, the zone’s most troubled economies. Their situation is getting worse—and Europe’s leaders bear much of the blame. No wonder Portugal’s 2-year bond yields briefly surged beyond 10% during the week on its continuing debt woes and credit rating downgrades before trading back to the 8% level. In fact both Portugal and Greece had to suffer ratings downgrade during the week. We believe a restructuring is inevitable for Greece and Ireland and maybe even Portugal and the earlier the better. These economies are on an unsustainable course, but not for lack of effort by their governments. Greece and Ireland have made aggressive budget cuts. Greece is trying hard to free up its rigid economy. Portugal has lagged in scrapping stifling rules, but its fiscal tightening is commendable. In all three places the outlook is darkening in large part because of strict policy prescriptions at the core’s insistence to slash budgets regardless of consequences to growth. And you’d have thought they had learned a thing or two from the Asian Crisis in the late 90s. 
• Finally, while Japan’s nuclear crisis continues to hog the headlines, markets have seemed to regard the situation as contained and localised judging by the speed of the global equity market rebound. We are a bit less sanguine not least because the nuclear situation hasn’t improved but also the impact on global supply chain especially in the auto and IT sectors may be underestimated and underappreciated at this early stage.

EQUITY

• The current uptrend is intact supported by fundamentals and valuations. We believe equities should continue to grind higher over a 12-18 month horizon. But trading would be volatile as markets try to scale the ongoing concerns highlighted above including the MENA revolt and uprising which continued to push oil prices higher.

FIXED INCOME 

• Policy normalisation in the DM may come earlier than expected. We remain underweight global bonds and underweight duration. Where we are more neutral is in EM hard and local currency debt.

FOREIGN EXCHANGE 

• The recent EU summit failed to dent the enthusiasm for the EUR as the market is pricing in at least 75 bps rate hike for EUR by end 2011 following hawkish ECB tone on inflation. The Fed meanwhile is still keeping its USD600 billion quantitative easing intact. Such diverging policy paths should provide support for EUR, which is testing resistance at 1.4282, despite continuing woes in the periphery. Perhaps the EUR may take a breather and retest 1.40 after the any rate decision by the ECB on 7-April. Meanwhile, the JPY should remain ranged at 83-86 as the forces of repatriation and intervention play out over the next months.

As we ponder over the possibility of a nuclear nightmare in Japan, global stock markets staged a rebound after two days of losses. Is this the start of a V-shaped rebound?

The heavy and indiscriminate selling over the past 2 days was pretty much a knee-jerk reaction to a nuclear catastrophe scare on top of the negative shocks to demand and supply chains that the earthquake and tsunami have wrought. From the peak in February, the Nikkei index plummeted more than 20% as of Tuesday.

If it were just the earthquake and tsunami, then a fall of such magnitude would have presented a buying opportunity as Japan will eventually recover as a society and as an economy as tragic as the events have been. Just for perspective, the Nikkei fell after the Great Hanshin earthquake of 17 January 1995 by about 25% over a period of 5-6 months. It can be argued that the bottoming process then was compounded by an over-valued market and prolonged by the collapse of Barings in the UK.

However, the nuclear disaster brewing now is the wild card. We are in essence dealing with a binary event – either a nuclear meltdown or no meltdown. In this binary bet, you buy if you believe in the no meltdown scenario and sell if you agree. With the nuclear situation still fluid with both positive and negative news flows, we see the 5.7% rebound in the Nikkei today as largely short covering, although there are surely some investors taking the binary bet.

The worry is not about the quantifiable impact of the natural disasters on the economy and industries. The fear is of the unknown and the unquantifiable implications of the current nuclear fallout which could range from controllable radiation leaks with minimal implications on the local and global economy to a level 7 nuclear disaster of the magnitude of Chernobyl. And Japan is not Chernobyl. It is the third largest economy in the world and accounts for a fair bit of the global supply chain especially in high value added technology.

No, we are not about to make the binary bet. This is not like making a call on interest rates or a currency bet. Official statements do not help as they are usually less upfront. But from what I’ve been reading about the Fukushima nuclear reactors, a complete meltdown seems unlikely. Still, we keep a watchful eye on the developing situation and we’ll use technical indicators to guide us in any entry levels. We will keep you posted.

Patience...

Japan’s nuclear crisis deepened today as the third blast at the Fukushima Daiichi Nuclear Power Station forced the evacuation of emergency workers and the Prime Minister Naoto Kan to warn of a clear possibility of nuclear radiation leaks. Markets took a turn for the worse on news of elevated radiation readings in Tokyo, pushing the Topix index to its worst two-day plunge since 1987 and dragging other major stock markets along with it.

As we know, markets do not like uncertainty. At this point of writing, there is still much confusion as to the real status of the nuclear fallout. Given that, we expect the markets to trade on news flows with a bias to exaggerating the risks. We feel there is further downside risk in the near term but it is not easy to quantify. The best strategy as always is to remain well diversified.

We feel there are opportunities to invest in this crisis – in coal, oil and gas as well as construction and building materials companies – but now we need some patience. We will keep you updated on further action.

Japan crisis...

The triple crisis in Japan – earthquake, tsunami and nuclear – will have a negative impact on global growth in the short term. The scope of the damage is yet to be assessed but will likely exceed the 20 trillion yen in damage sustained during the Kobe earthquake in 1995.


The chart below shows the Topix index performance after the 1995 earthquake. The index fell by 21% and bottomed 5 months later before rebounding to pre-earthquake levels only 11 months after the earthquake. During this period, construction, real estate and medical product industries outperformed while insurers, high-tech and cyclical sectors underperformed. Power companies stocks did well the last time. But with the nuclear crisis brewing, they are unlikely to repeat the positive performance.

Going by the previous experience, it may be too early to participate in any reconstruction recovery. Opportunities may be found in the construction sector. But with rolling power blackouts, it remains to be seen how industries will be impacted in the coming months. After all, Japan relies on nuclear power for one-third of its electricity needs.

The JPY was well-supported in the last earthquake. But with massive liquidity injection of 15 trillion yen by the Bank of Japan, the yen has started to erase earlier gains. The repatriation of yen by Japanese companies and investors in the coming weeks should support the yen at current levels.

Meanwhile, the near term market outlook remains mixed with the focus on Japan and the Middle East crisis. I remain optimistic in the global outlook and would become more aggressive on the buy side at lower levels.

 * Chart from Citi Investment Research