34_Greed and Fear

Christopher Wood [email protected] +852 2600 8516

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The Crimea shuffle Hong Kong Amidst all the sanctimonious waffle which has been spewing out of the Western press on the issue of Ukraine and the Crimea, two points are worth highlighting. First, Russian President Vladimir Putin is enjoying his highest opinion poll ratings in three years. Thus, Putins approval rating has risen from 61% in November 2013 to 72% in March, the highest rating since February 2011, according to an opinion poll conducted on 7-10 March by the independent polling agency Levada Center. Second, American President Barack Obamas support rating is at its lowest ever. The latest NBC News/Wall Street Journal survey conducted on 5-9 March shows Obamas approval rating falling from 43% in January to a record low of 41% in March (see Figure 1).

Figure 1 Putins and Obamas approval ratings

Source: The Levada Center, NBC News/Wall Street Journal Survey

The clear desire of ordinary Russians to get the Crimea back is why Putin has proceeded this week with the formal annexation of Crimea once the referendum held on Sunday had delivered its expected result. But the reason the markets have so far responded with relief is that the sanctions so far delivered by the West are somewhat of a derisory joke in terms of them being focused on an arbitrarily selected group of Russian individuals close to Putin. This implies that the West is not willing to back its tough rhetoric with similarly tough action.

The issue now is whether some form of compromise can be forged between Russia and the West where a degree of autonomy can be allowed in eastern Ukraine recognising what amounts, in some respects at least, to a de facto partition of the country. It should be noted that in his important speech in Moscow on Tuesday, made prior to signing the annexation treaty, Putin signalled he would defend Russias national self-interest if NATO forces proved to be over assertive in what amounts to Russias backyard.

The issue, therefore, now lies with the Wests willingness to escalate matters further in the form of introducing sanctions that really hurt, as opposed to more symbolic measures such as banning Russia from membership of the G8. GREED & fear doubts the West really has such an appetite despite the inflammatory rhetoric of in particular US Secretary of State John Kerry. Any clear headed analysis of the situation by professional diplomats will come to the conclusion that eastern Ukraine is indeed in the Russian sphere of influence which is why the now discredited former Ukrainian president Viktor Yanukovych won a democratic mandate in the

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2010 presidential election. Second, Europe, if not America, has self-interested reasons not to proceed with aggressive sanctions because of the potential economic fallout.

Figure 2 German exports to Russia

Source: CEIC Data

On this point, Germany is the key player. Germany receives about 40% of its gas from Russia. It should also be noted that during all the Cold War years the Soviet Union always delivered gas to the then West Germany, while GREED & fear also hears from a Berlin friend that Germanys current strategic gas reserves would only last for about 90 days. The other point is that sanctions would hurt Germanys exports of mostly machinery and transport equipment to Russia. Thus, German exports to Russia have risen from 5bn in 1999 to 36bn in 2013 (see Figure 2), with 36% in machinery and equipment and 24% in vehicles and parts.

So sanctions would simply result in the potential surrender by Germany of export markets to most likely Asian competitors. Here a bigger picture point should be noted. This is that a natural consequence of the deteriorating relationship between Russia and the West is the corresponding improving relationship between Russia and China. Thus, Putin made a reference in his speech on Tuesday to thanking the people of China for their support on Crimea.

This in turn by way of parenthesis is posing something of a dilemma for Japan where there have been growing expectations within the Shinzo Abe government in recent months that a deal could be signed with Russia ending a 60-year dispute over the so-called Kuril Islands. On this point, Japans National Security Council chief Shotaro Yachi visited Moscow last week to speak with Russian Foreign Minister Sergei Lavrov. Abe was also the first Japanese prime minister to visit Russia in a decade, meeting Putin no less than five times last year. The Japanese prime minister wants a formal peace ending World War II, and a resolution of the territorial dispute over the Kuril Islands. It should also be noted that both China and Japan have a natural interest in buying more of Russias oil and gas. Japan accounted for one third of global liquefied natural gas (LNG) imports in 2013, with 10% of its LNG imports coming from Russia.

Returning to Germanys situation, GREED & fear assumes that there is a practical limit to the extent to which Frau Merkel is prepared to let relations with Russia deteriorate because of Berlins obligations as a member of NATO. In a related point, there is also a financial limit to the extent to which Germany and the rest of the Eurozone will be prepared to bail out Ukraine, most particularly in the absence of a debt restructuring. In this respect Kiev has been requesting an emergency aid package of US$35bn. Ukraines macro situation is perilous. It has total external debt of US$138bn, of which US$107bn is US dollar debt, and a current account

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deficit of US$16bn or 8.9% of GDP (see Figure 3). But its macroeconomic situation will get even worse if Russia stops selling it gas at the previously agreed discount. Thus, Gazprom agreed in December to reduce the gas price for Ukraine by 33% to US$268.5 per 1,000 cubic metres. Note that the Russian gas company said on 4 March that it will now cancel the discount starting 1 April, citing Ukraines mounting gas debt of nearly US$2bn.

Figure 3 Ukraine current account balance

Source: National Bank of Ukraine, IMF

GREED & fear has gone on at some length about the Ukraine issue partly because it is a potentially historic development in the context of the post-Cold War World but also because media coverage in the West has been so extraordinarily superficial and, frankly, biased. From a market standpoint the key negative point to note is the potential negative dynamic of escalating sanctions. But if the West backs off, then markets will celebrate as has so far been the case this week (see Figure 4).

Figure 4 Euro Stoxx Index and S&P500

Source: Datastream

Returning to more mundane macro issues, GREED & fear continues to engage in Maoist-like self-criticism in terms of whether the view long expressed here is wrong, namely that the American economy is not yet experiencing escape velocity. Here it is useful to point out that recent weeks have seen a pickup in bank lending data in America, driven by an acceleration in commercial and industrial (C&I) loans. US bank loan growth has accelerated from 1.9%YoY in early February to 3.1%YoY in the week ended 5 March, while the growth in C&I loans has accelerated from 8.1%YoY to 10.3%YoY over the same period (see Figure 5).

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A check with CLSAs US banking analyst Mike Mayo indicates that this is not yet seen as significant. Thus, there have been a few such small upticks in recent years which subsequently reverted back to decelerating growth. While the current 3.1% annualised bank loan growth is not only well below the 10-year average of 5%, but also the 2000-2012 pre-crisis average of 8.5%. There also continue to be many anecdotal stories of uneconomic pricing by US banks. That is, banks are using credit as a loss leader to get related fee revenues such as cash management, hedging, FX and trade finance. It should also be noted again that US bank loan growth is running at its lowest rate in eight decades (see Figure 6).

Figure 5 US total bank loan growth and C&I loans

Source: Federal Reserve

Figure 6 US annualised bank loan growth (decade average)

Note: 1930s average starting from 1934. 2010s average up to 2013. Source: CLSA, FDIC

Still bank lending is an area to watch closely in coming weeks and months since the obvious hope raised by rising C&I loans is that it signals the possibility that American corporates are finally willing to increase capital spending, most particularly as the Fed has now provided a positive signal on the economy in terms of its continuing willingness to taper; as reconfirmed in the Feds statement this week with the decision to reduce monthly bond purchases by another US$10bn to US$55bn in April. On the capex-related point, the latest GDP data shows some sign of a pickup in equipment spending on a quarter on quarter basis. Real private non-residential equipment spending rose by an annualised 10.6%QoQ in 4Q13, up from 0.2% growth in 3Q13 (see Figure 7). The same point applies to the monthly data on new orders. US new orders of nondefense capital goods excluding aircraft, a proxy for capex, rose by 1.5%MoM

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and an annualised 6.9%QoQ in January. Still as with the bank lending data, the evidence remains for now far from conclusive. Thus, nondefense capital goods orders excluding aircraft declined by 1.7%YoY in January (see Figure 8).

Figure 7 US real private non-residential equipment spending

Source: CLSA, US Bureau of Economic Analysis

Figure 8 US growth in nondefense capital goods orders excluding aircraft

Source: CLSA. US Census Bureau

The same signs of potential life can be detected from the latest flow of funds data for 4Q13 where all three components of the American private sector; namely the household sector, the nonfinancial business sector and the financial sector, have now increased their borrowings for three consecutive quarters for the first time since 1Q08 (see Figure 9). Still the appetite for borrowing is for now clearly greater among corporates than households reflecting presumably the continuing lack of income growth on a per capita basis. Thus, US household debt rose by an annualised 0.4%QoQ in 4Q13, while nonfinancial business sector debt and domestic financial sector debt rose by an annualised 7.1% and 4.4% respectively. Still the fact that corporate borrowing is picking up will again be encouraging hopes of an accelerating capex cycle.

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Figure 9 US private sector debt growth

Source: CLSA, Federal Reserve Flow of Funds Accounts

For now, while acknowledging that there are signs of a potential inflection point, GREED & fear remains unconvinced that releveraging is really happening in America. This is also the signal still sent by broad money monetary aggregates. US broad money supply, measured as M2 plus institutional money funds and large time deposits at banks, rose by 5.4%YoY in the week ended 3 March, compared with a pre-crisis average of 8.4% during 2000-2008 and a peak of 16%YoY reached in early 2008 (see Figure 10). While the velocity of money, measured as nominal GDP/M2, has fallen to an estimated 1.55x in February, down from 2.03x in mid-2006 (see Figure 11).

It also remains the case that Chairwoman Yellen remains seemingly unconvinced. Still this weeks Fed statement, and in particular Yellens remarks in her first press conference, has had the practical effect of bringing forward monetary tightening expectations from 3Q-4Q15 to as soon as next spring. That said, the Fed statement also reiterated that tapering is not on a pre-set course and that the steps to withdraw stimulus would remain measured.

Figure 10 US broad money supply growth

Note: Broad money measured as M2 + institutional money funds + large time deposits at banks. Source: CLSA, Federal Reserve

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Figure 11 US velocity of money

Source: CLSA, Federal Reserve, Bureau of Economic Analysis

Yellen, giver her dovish credentials, will also be concerned that inflation remains so low. Headline CPI inflation slowed from 1.6%YoY in January to 1.1%YoY in February. Core CPI inflation stood at 1.6%YoY in February, mainly driven by a 2.6%YoY rise in rents. Excluding the shelter component, which accounts for 41.6% of the core CPI basket, core CPI inflation is now running at only 0.9%YoY, the slowest inflation rate since August 2004 (see Figure 12).

Figure 12 US core CPI inflation excluding shelter

Source: CLSA, US Bureau of Labour Statistics

The trend in retail sales is also sending decidedly mixed signals. While US total retail sales rose by 0.3%MoM in February, following a 0.6%MoM decline in January, they rose by only 1.5%YoY in February, the slowest year-on-year growth since November 2009 (see Figure 13). While this can clearly be blamed on the weather, the trend will ultimately be determined by the income growth, or the lack of it, experienced by ordinary Americans. It is certainly the case that a pickup in consumption does not look that convincing if it is only driven by a falling savings rate. And this has been the case of late with US personal savings having fallen from 5.1% of disposable income in September 2013 to 4.3% in January (see Figure 14). It is also worth reiterating that a significant percentage of the increase in consumer debt continues to be accounted for by federally guaranteed student loans. Thus, consumer credit increased by US$172bn over the 12 months to January, with federal student loans accounting for US$112bn or 65% of the total increase (see Figure 15).

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Figure 13 US retail sales growth

Source: CLSA, US Census Bureau

Figure 14 US personal savings as % of disposable income

Source: CLSA, US Bureau of Economic Analysis

Figure 15 US annualised consumer credit flows

Source: CLSA, Federal Reserve

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Back in Asia, a colleague highlighted this week an interesting interview with Abes special economic adviser Koichi Hamada published in Bloomberg News last Friday. Hamada, who is the intellectual guru behind last years hostile takeover of the Bank of Japan, stated in the interview that it is not taboo for the Japanese central bank to double the annual pace of bond accumulation from the current Y50tn to Y100tn, while also adding that it was fine for the BoJ to buy as much as 100% of new Japanese government bond issues.

Figure 16 Japan annualised real GDP growth

Source: CLSA, Japan Cabinet Office

Hamada went on to argue that the 0.7% annualised real GDP growth in 4Q13 reported by Japan was not strong enough (see Figure 16) and added that monetary stimulus was required as soon as May if economic indicators show that the sales tax hike is seriously damaging the economy. This is interesting to GREED & fear since the official line from the BOJ, confirmed again to GREED & fear in meetings in Tokyo last month (see GREED & fear Japan focus, 27 February 2014), is that the central bank is waiting to see second quarter data before moving again on monetary policy.

That Hamada has decided to go public with his comments is clear evidence that the reflationists now feel the need to push their case again. It is also a reminder that advocates of monetary unorthodoxy feel there is no theoretical limit to their actions. Indeed if the sort of actions Hamada is advocating prove ineffective it can be assumed that it is only a matter of time before he starts to argue that the BoJ should buy foreign government bonds though this may be controversial internationally given the likely impact on the yen.

Still if this stage has not been reached yet, Hamadas comments are a reminder that a second bout of monetary reflation from the BoJ is likely to come sooner or later, which will set up a new opportunity to go long Japanese equities and short the yen. But for now foreigners have continued to sell Japanese equities as concerns grow ahead of the sales tax increase. Thus, foreigners sold a record net Y975bn worth of Japanese equities last week and have sold Y1.9tn so far this year, compared with net buying of Y15.1tn in 2013, according to data released today by the Tokyo Stock Exchange (see Figure 17).

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Figure 17 Foreign net buying of Japanese equities

Source: Bloomberg, Tokyo Stock Exchange

True, a positive point has been wage increases announced by the major companies. But these continue to be more driven by bonuses than base wages, though any hike in base wages is a positive. For example, Toyota announced last week an average increase of Y2,700 or 0.8% in monthly base pay, the first such increase in six years. But when including the Y7,300 average monthly increase in pay that workers received based on seniority or promotions, Toyota said its workers will get an average 2.9% raise. The automaker will also pay an average annual bonus of Y2.44m, equivalent to 6.8 months of salary, which brings the total rise in compensation to an impressive 7.6%. Still the data for aggregate wages is yet to show any significant pick up. Average monthly scheduled earnings per regular employee, excluding overtime pay and bonus, fell by 0.2%YoY in January, compared with a 0.6%YoY decline in December (see Figure 18).

Figure 18 Japan average monthly scheduled cash earnings per regular employee

Note: Excluding overtime pay and bonuses. Source: Ministry of Health, Labour and Welfare (MHLW) - Monthly Labour Survey

GREED & fears base case on Japanese equities remains that it remains, first and foremost, a high beta asset reflation story driven by a high beta monetary policy and that another equity rally is coming sooner or later led by asset reflation stocks. In this context, blue chip Mitsubishi Estate is now down 31% from its April 2013 high which means that investors should be thinking of buying it (see Figure 19). But the catalyst for that rally may have to be evidence that the BoJ is moving again. Meanwhile, that the Topix has underperformed the S&P500 by 11 percentage points since late January is also a reason to be buying Japan, not selling it (see Figure 20).

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Figure 19 Mitsubishi Estate share price

Source: Datastream

Figure 20 Topix in US$ terms relative to S&P500

Source: CLSA, Datastream

Moving on to China there has been growing focus in recent days on the negative trend in the Chinese property market with a developer going bust. Zhejiang Xingrun Real Estate, an unlisted property developer based in Zhejiang Province, reportedly collapsed this week owing some Rmb3.5bn with only Rmb3bn of assets. But more interesting perhaps is growing evidence that the property market has begun to lose momentum in tier-one cites. Beijing-based Economic Information Daily reported Monday that many real estate companies have lowered prices or launched promotions for homes in Guangzhou. The latest home price survey by the National Bureau of Statistics also shows that the average new home price gains in the four tier-one cities slowed to 0.4%MoM in February, the smallest monthly gain since October 2012. While the average year-on-year growth in new home prices in the four cities has slowed from 19.2%YoY in January to an eight-month low of 16.5%YoY in February (see Figure 21).

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Figure 21 China average new home price growth in four tier-one cities

Note: Average new home price growth in Beijing, Shanghai, Shenzhen and Guangzhou. Source: National Bureau of Statistics

GREED & fear discussed the Chinese property market at length recently with the key message being to watch the data (see GREED & fear China property and JGBs, 6 March 2014). But for now GREED & fears base case is that press hype about Chinas Lehman moment, in terms of bond defaults and the like, is exaggerated. Indeed GREED & fear agrees with an article published in the pinko paper on Wednesday that this is more a case of careful deleveraging, in terms of the authorities trying to introduce some form of at least selective moral hazard (see Financial Times article Chinas Lehman moment is just careful deleveraging, 19 March 2014).

Figure 22 China renminbi spot rate against US dollar

Source: CLSA, Bloomberg, China Foreign Exchange Trade System (CFETS)

Such efforts should be welcomed. It is certainly premature to take the view that the mainland authorities have lost control. Meanwhile, that the renminbi has continued to weaken (see Figure 22), and that the PBOC has this week widened the daily trading band from 1% to 2%, should be seen as more evidence that the Chinese central bank wants to discourage the carry trade into wealth management products and the like, as well as providing some stimulus for the economy via the weaker exchange rate. In this endeavour it will undoubtedly have had some success. On this point, it is interesting to note that renminbi holdings by South Korean residents surged to US$7.62bn at the end of last month, up from US$310m six months ago, according to an article in the South China Morning Post today (Surge in yuan holdings by banks prompts concern in Seoul, 20 March 2014). This suggests evidence of Chinese banks aggressively raising funds overseas in response to tighter credit conditions in the mainland. But

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because the won cannot be converted directly into renminbi, the deposits are built through a structured project using dollar-won and dollar-yuan swaps.

Figure 23 Jakarta Composite in US$ terms and rupiah/US$ (inverted scale)

Source: CLSA, Bloomberg

Finally, the past week has seen confirmation that Jakarta Governor Jokowi will run as the PDI-P candidate in this years presidential election scheduled to be held on 9 July, with party leader Megawati Soekarnoputri having now given her formal blessing. This has put a further bid under Indonesian stocks with the stock market now up 17% year-to-date in US dollar terms in the context of a rupiah up 6.3% year-to-date against the US dollar (see Figure 23).

Jokowis genuine populist appeal should not be underestimated in a country where the electorate has long been desperate for a new face. The confirmation of his candidacy before the parliamentary election on 9 April also increases the chances that the PDI-P can perform well, and the better the party does the better the chance Jokowi has of managing the parliament if elected president. On this point it should be noted that the PDI-P is the only major political party that has not been part of Yudhoyonos coalition government.

On an entirely separate topic, CLSAs legendary investment guru Russell Napier has finally got round to opening The Library of Mistakes, which is run by the same charity which runs The Practical History of Financial Markets course mentioned here before. Details of the library can be found on the next page.

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The Library of Mistakes- Mundum Mutatu Errore Singillatim

The follies of our youth are in retrospect glorious compared to the follies of our old age.

G.K. Chesterton

The Library of Mistakes is now open in both the real and virtual worlds. Real world visitors will find the Library at Wemyss Place Mews in Edinburgh and will need to register as readers and make an appointment at www.libraryofmistakes.com. Virtual visitors can browse the full searchable catalogue at the website and read The Keepers blog. The Library aims to provide a first class public resource for the study of economic and business history for real world visitors. Online users can search the catalogue to find titles which shed light on our financial past and thus on our financial future.

Anyone who plans for the future will make mistakes. As Mike Tyson famously said, Everyone has a plan until they get punched in the mouth. The Library of Mistakes chronicles those punches investors have had to cope with. Understanding these events will help us all cope with future punches and hopefully stop us reacting with the same old mistakes. Any generation that can invent the iPhone is capable of inventing its own mistakes rather than perpetuating the errors of their ancestors.

The Library is owned and run by the same charitable venture behind The Practical History of Financial Markets course. For anyone interested in joining the course in 2014 there are just a few places left for London in (2-3 October) and here are places available for Edinburgh in April (24th and 25th). If you are interested in attending this year please email me ASAP. Those signing up for the Edinburgh session can visit The Library of Mistakes and help us towards our goal Changing The World One Mistake At A Time (Mundum Mutatu Errore Singillatim).

Russell Napier ([email protected])

Keeper of The Library of Mistakes

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Key to CLSA/CAST investment rankings: BUY: Total stock return (including dividends) expected to exceed 20%; O-PF: Total expected return below 20% but exceeding market return; U-PF: Total expected return positive but below market return; SELL: Total expected return to be negative. For relative performance, we benchmark the 12-month total forecast return (including dividends) for the stock against the 12-month forecast return (including dividends) for the market on which the stock trades. We define as Double Baggers stocks we expect to yield 100% or more (including dividends) within three years.

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34_Greed and Fear

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Transcript of 34_Greed and Fear