into the void · clsa’s technical analyst laurence balanco acknowledges this in his latest weekly...

Christopher Wood [email protected] +852 2600 8516

Thursday, 28 November 2013

Into the void Copenhagen GREED & fear has been on an important recreational excursion to Copenhagen this week. But in America it is Thanksgiving and the Nasdaq Composite Index has exceeded 4,000 for the first time in 13 years post its 2000 tech bubble peak (see Figure 1). This market action fits the pattern for a potential Janet Yellen-influenced parabolic melt up into year-end and even conceivably into the first quarter given that stock market action tends to be most bullish in the fourth quarter and first quarter of calendar years. CLSA’s technical analyst Laurence Balanco acknowledges this in his latest weekly describing the S&P500’s “increased angle of ascent”, while also noting that the “negative divergences” between price, momentum and breadth indicators continue to build (see CLSA research Price Action Derivatives, 27 November 2013).

Figure 1 Nasdaq Composite Index

Source: CLSA, Datastream

Figure 2 S&P500 share buybacks

Note: Data up to 2Q13. Source: Standard & Poor’s

Clearly, the risks are rising on the S&P500. Multiple expansion is driving stock market performance to a far greater degree than earnings while earnings themselves are being driven to a remarkable extent by share buybacks given the beneficial impact of buybacks on earnings per share. Thus, the S&P500 has risen by 26.7% so far this year, while the trailing PE ratio has

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Prepared for: [email protected] Raju R Gopalakrishnan 11/30/13 09:30:13 AM Reuters - Internal Employee ID's - 96



risen by 16% from 16.4x to 19.1x over the same period. While S&P500 share buybacks rose by 18%QoQ to US$118bn in 2Q13 and were up 11%YoY to US$218bn in 1H13, according to the latest available data from the S&P (see Figure 2).

GREED & fear does not claim to be a dedicated US equity strategist but valuation data are issuing warning signals even if valuations are not yet at 2000 or 2007 levels on fashionable valuation yardsticks. Thus, the S&P500 now trades on 25x the cyclically adjusted PE ratio (CAPE), which is based on the 10-year average trailing earnings, just exceeding the highs reached in 1901 and 1966 (see Figure 3). The two previous CAPE valuation peaks higher than the current level were in 1929 (33x) and 2000 (44x).

Figure 3 S&P500 cyclically adjusted PE

Note: Based on rolling 10-year average trailing as-reported earnings. Source: CLSA, Standard & Poor's, Robert J. Shiller

Still while valuations are a useful guide they are clearly not much help from a timing perspective. That is why the key issue for GREED & fear is what might trigger a market correction. The market consensus continues to focus on what is viewed as the most likely cause of a correction, namely the tightening in financial conditions triggered by “tapering”. Still such a hypothetical correction is not so big a deal to GREED & fear since any real equity decline caused by tapering is likely to lead, under a Fed run by Janet Yellen, to renewed easing - just as was also the case under Billyboy and Pinball Alan. Similarly, a correction caused by a surprise geopolitical shock, such as an escalation of the back-on-the-radar-screen Sino-Japanese dispute over the Senkaku islands, is the sort of event that again gives the Fed the excuse it is always looking for to stay easy. In this respect, GREED & fear repeats the point that a Yellen-run Fed has no stomach for the degree of “cold turkey” that will be required to get the American economy off its addiction to unorthodox monetary policy (see GREED & fear – Junky logic, 14 November 2013).

This is why the real threat to equities remains the outcome that GREED & fear has previously outlined here. That is when the American economy fails to re-accelerate as forecast with the end of “fiscal drag”, and when the Fed is forced to admit yet again that its forecast road map is wrong, and that it is necessary to continue quantitative easing or even extend it. At that moment investors will be forced to make a decision. Do they, like addicts, celebrate the injection of more heroin or do they face up to what by then should be startlingly obvious to any unbiased observer? That is that quanto easing has been working far better for owners of asset prices than for participants in the real economy. But even in the case of asset prices its positive influence should start to wane as the returns on those assets decline. And if asset price momentum does not wane then the divergence or void between asset prices and the underlying economy will continue to widen in a way which can only be described as extremely dangerous.

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GREED & fear was reminded of this point reading an interesting article in the pinko paper on Wednesday which reported that the amount of money in unspent commitments to private equity funds by yield-seeking investors has now exceeded pre-financial crisis levels (see Financial Times article “Private equity’s ‘dry powder’ raises overcapacity concern”, 27 November 2013). But this pile of liquidity is having a hard time finding deals that match its “return” criteria. Thus, the article reported that the value of unspent commitments to private equity funds has surged to US$789bn this year, based on data compiled by research group Preqin. This compares with US$769bn in 2007. But in 2007 private-equity firms led US$776bn of deals, compared with US$310bn of deals so far in 2013.

Figure 4 US inflation (personal-consumption-expenditure price index)

Note: Quarterly data up to 3Q13. Source: CLSA, US Bureau of Economic Analysis

Figure 5 US BAA-rated corporate bond yield spread over 10-year Treasury bond yield

Source: CLSA, Bloomberg

Still, to return to the main point at issue, investors need to watch out for an equity correction triggered by the American economy being too cold. For that is much harder to deal with than one triggered by an American economy being too hot. The reason why it will be much harder to deal with is because it will force an acknowledgment that America still faces deflationary risks.

This issue is, precisely, the topic under discussion in the latest “big picture” report by CLSA’s legendary investment guru Russell Napier (see CLSA research Solid Ground – An ill wind, 25 November 2013). Napier believes that inflation in America, measured by the personal-consumption-expenditure price index, is sooner or later likely to fall below 1% (see Figure 4).

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He also advises that investors should watch corporate bond spreads, TIPS-implied inflation and copper prices as lead indicators for the deflation “tipping point” when bad news is no longer good news (see Figures 5-7).

Figure 6 US 5-year TIPS-implied breakeven inflation rate


Figure 7 Copper price


GREED & fear agrees that these are useful lead indicators to monitor, among others. GREED & fear also agrees that a decline in US inflation below 1% would, logically, lead to real market concern. It would certainly concern Mrs Yellen and the soon to depart Billyboy.

Still for fund managers trying to stay ahead of a trending index, and therefore stay employed, the critical signal to watch is when stocks markets stop viewing “bad news is good news”, and stop believing the so-called “Fed put” can save them.

The timing of such an inflection point is by its nature impossible to predict. But given the dangerous consensus that has assembled around the view that normalisation of American monetary policy is coming, a realisation that quanto easing is never ending and that the American economy is not really accelerating to the extent assumed may just be the catalysts required to reach that inflection point. Still between now and then the American stock market could have made that parabolic spike. Meanwhile, equity corrections caused by renewed tapering/tightening concerns can be bought in a Yellen world since there is an obvious solution

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at hand, namely renewed easing. That is, of course, unless velocity surges and inflation rips hyperinflation-style, at which point the Fed has lost control of interest rates.

But GREED & fear’s base case is, like Napier, that another deflationary shock lies ahead which in turn prompts yet more hyper monetary policy activism while ultimately creates the potential for a hyperinflationary bust. But where GREED & fear has a different tactical view from the Solid Ground thesis is that the base case here remains that Treasury bonds will rally in a future deflationary shock, as they will continue to be correlated with declining nominal GDP growth. Clearly, if GREED & fear is wrong about this, then the Fed loses control much more quickly. In this respect, GREED & fear is taking the view that the fact that the 10-year Treasury bond yield is still 98bp above where it started the year (see Figure 8), despite the peaking out for now of tapering neurosis, is a signal of investors’ cyclical optimism on the American economy rather than indicating a loss of control by the Fed.

Figure 8 US 10-year Treasury bond yield


Figure 9 US existing home sales and pending home sales index

Source: CLSA, National Association of Realtors (NAR)

Meanwhile, the backup in Treasury bond yields has continued to create pressures on the housing market. The pending home sales index has now declined for five months in a row, falling by 0.6%MoM and 1.6%YoY in October to the lowest level since December 2012 (see Figure 9). The index is now 8.3% below its recent peak reached in May. True, the housing market is far from collapsing. Total building permits rose by 6.2%MoM and 13.9%YoY in

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October (see Figure 10). Still the cyclical momentum that excited investors at the start of this year has clearly waned, as also reflected in the Zillow home price index. Thus, the Zillow US Home Value Index has declined for two consecutive months, falling by 0.1%MoM in both September and October, the first MoM decline since October 2011 (see Figure 11). The index is now up 5.2%YoY, down from 7.4%YoY in July.

Figure 10 Growth in US building permits

Source: CLSA, US Census Bureau

Figure 11 Zillow Home Value Index

Source: Zillow Real Estate Research

GREED & fear continues to believe, as regards the normalisation theme, that it is a critical point whether the housing recovery was driven at the margin by first-time buyers or by a buy-to-let boom driven by the likes of the abovementioned private equity funds. If it is the latter, as is GREED & fear’s contention, then it is proof of the lack of normalisation. In this respect, the lack of a more convincing bounce in the new mortgage application index remains the best support for GREED & fear’s hypothesis. Thus, while the new mortgage applications index has risen by 7.5% from its recent low reached in mid-October, the index is still 12.8% below its early May high and 64% below its all-time high reached in June 2005 (see Figure 12).

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Figure 12 US new purchase mortgage applications index

Source: Mortgage Bankers Association of America

Meanwhile, aside from the US housing market focus and the hopes invested in the end of “fiscal drag”, the other main less-US centric argument put forwarded by cyclical bulls has been hopes of a revival in global trade triggered by rising PMIs. GREED & fear continues to remain extremely sceptical of the predictive powers of PMIs. In this respect, it is interesting to note that the far more technically accomplished Eric Fishwick is also sceptical. Indeed, CLSA’s head of economic research argues that the global PMI only appears to predict year-on-year change in trade only because of the lag inherent in a YoY comparison. In this respect, Fishwick notes that the nine-month moving average of the global PMI shadows the year-on-year growth in world trade volume almost perfectly (see Figure 13).

Figure 13 Global manufacturing PMI (9mma) vs World trade volume growth

Source: CLSA, Markit, CPB

Meanwhile, the latest data makes clear that global trade growth has yet to take off. Indeed it has been static for the last two years. Thus, world trade volume rose by 0.8%MoM in September following a 0.9%MoM decline in August, and is up only 3%YoY. As for the much hyped PMIs, which remember are no more than sentiment indices, they are if anything rolling over. The US ISM new orders index peaked at 63.2 in August and has since fallen to 60.6 in October. While the Eurozone Composite PMI has fallen from 52.2 in September to 51.5 in November (see Figure 14).

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Figure 14 Eurozone PMIs

Source: Markit

European equities have been enjoying in the past five months a catch up trade with US equities given their relatively cheap valuations. Thus, the Euro Stoxx Index has risen by 22% in euro terms and 26% in US dollar terms since late June, compared with a 15% gain in the S&P500 over the same period (see Figure 15). But, as with the US, the rally have been driven more by multiple expansion than earnings growth, even though it is true that analysts have very optimistic expectations for next year. The IBES consensus expects a 4% decline in earnings this year and 18% earnings growth in 2014.

Figure 15 Euro Stoxx Index in US dollar terms and S&P500


CLSA is not yet at least in the business of selling European equities. Still GREED & fear is extremely sceptical that the Eurozone will enjoy any kind of meaningful cyclical rebound next year. The latest GDP data released two weeks ago certainly shows no sign of it, with Eurozone real GDP expanding only 0.1%QoQ in 3Q13 and down 0.4%YoY (see Figure 16). It also remains the case that private sector loan growth continues to contract. Thus, Eurozone loans to the private sector declined by 2.1%YoY in October, the 18th consecutive month of decline (see Figure 17).

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Figure 16 Eurozone real GDP growth

Source: Eurostat, Datastream

Figure 17 Eurozone loans to the private sector

Source: ECB

This is why GREED & fear’s base case on the Eurozone remains that the risks remain all to the deflationary downside. In this respect, Napier’s latest report makes an interesting point that Nestle has cut prices in Europe as deflation spreads from commodities to consumer staples.

This deflationary backdrop is why it is only a matter of time before Flexible Mario goes more unconventional. The talk is rising of renewed LTROs, as well as a possible decision by the ECB to start charging interest on bank deposits held at the ECB. But as has been pointed out elsewhere, such a move may only prompt banks to start charging negative interest rates on depositors to compensate for the lost interest income. There is now €193bn of excess bank reserves and deposit facilities sitting at the ECB earning zero interest (see Figure 18).

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Figure 18 Eurozone banks’ reserves at the ECB current accounts and overnight deposit facility

Source: CLSA, ECB

As for the overall Eurozone picture, it would be even worse were it not for a positive domestic demand contribution from Germany. Thus, German real domestic demand rose by 0.7%QoQ in 3Q13. Still a closer look at the German data suggests domestic demand driven more by construction-related activity than wage-driven consumption. Thus, real construction rose by 2.4%QoQ in 3Q13 while real private consumption increased by only 0.1%QoQ (see Figure 19). This fits in with GREED & fear’s long favoured German asset reflation story.

Figure 19 Germany real domestic demand growth

Source: CLSA, CEIC Data

Still if a German asset bubble is to be expected, as Germans use the opportunity provided by negative interest rates to hedge the risk of a ECB and Euro not controlled by Germans, the overall position of Germany remains nothing like as strong as some like to suggest. GREED & fear has mentioned before the massive unfunded liabilities of the German public sector. But they are worth mentioning again. GREED & fear was reminded of this last week reading an interesting story in the International Herald Tribune on Germany’s dilapidated infrastructure and the lack of funds available to upgrade it (“Austerity takes a toll in Germany; Years of underspending at home make an aging infrastructure inefficient”, 22 November 2013). Meanwhile, Frau Merkel’s newly formed coalition government with the SPD is likely to favour more welfare benefits over infrastructure investment.

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So the Eurozone remains in a deflationary adjustment which is more bond bullish than equity bullish. But the bond trade will blow up if and when the politics deteriorates in terms of anti-euro parties being successful at the polls.

Figure 20 Ireland household debt to disposable income ratio

Source: Central Bank of Ireland, Central Statistics Office

Meanwhile, given the recent triumphal headlines hailing Ireland’s decision to exit its bailout programme, it is worth noting that this Eurozone success story still faces formidable challenges. Thus, Ireland’s household debt to disposable income ratio was still 198.3% at the end of 2Q13 (see Figure 20), though down from a peak of 214.5% reached in 2Q11. While the outstanding balance on mortgage accounts in arrears of more than 90 days was €18.6bn at the end of 2Q13, or 17% of total mortgages outstanding, up from 4.1% 3Q09 (see Figure 21). True, the number looks a little better in terms of mortgage accounts with 12.7% of total mortgage accounts more than 90 days past due, up from only 3.3% 3Q09.

Figure 21 Ireland Mortgage Arrears by amount of mortgage loans outstanding

Note: Private residential mortgage loans outstanding for principal dwelling houses (PDH). Source: Central Bank of Ireland

The above is pointed out to highlight that Ireland remains a long way from self-sustaining recovery. Indeed this sort of debt burden is why GREED & fear is increasingly convinced that, sooner or later, the focus of policy in the indebted West will move away from easy money, as unorthodox monetary policy is discredited, to the inevitability of debt relief. On that point references to “debt jubilee”, as mentioned here before (see GREED & fear - The threats to ‘risk on’, 1 March 2012), can be found in various books of the Bible. Investors now rushing to buy unsecured bank bonds in the rush to chase yield might want to remember that.

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Recent events indicate that GREED & fear has been too sanguine about Thai politics. More importantly exiled former Thai Prime Minister Thaksin Shinawatra has clearly miscalculated in his attempt to push through an amnesty bill designed to allow him to return to Thailand with a pardon. In this respect, the estimated 100,000 yellow-shirt anti-Thaksin anti-government demonstrators who assembled in Bangkok on Sunday were well above expectations while the seemingly pro-Thaksin “red shirts” failed to assemble anything like a similar number. This may be partly because the Yingluck government wants to avoid a confrontation. But it is also because Thaksin has seemingly alienated some red shirt supporters because of their evident realisation that he was willing to “trade” his pardon in return for a pardon of former Democrat Party leader and Prime Minister Abhisit Vejjajiva who is accused of being responsible for the death of 91 red-shirt demonstrators in 2010.

But whatever the background the result for now is a classic political stand-off. Prime Minister Yingluck survived a non-confidence motion today in the Thai parliament. Still it would seem that a general election is coming sooner or later, though there will be a cooling off period on the King’s birthday on 5 December when demonstrations are meant to stop. Note that, technically, a general election does not have to be held until July 2015. But in view of the overt challenge to the current government, most particularly the occupation of the Ministry of Finance by anti-government demonstrators this week, a new mandate is surely required for Yingluck. Still in an ideal world the Thai Prime Minister would like to see the Bt2tn infrastructure bill become law. On this point, the opposition Democrats filed last week a case with the Constitutional Court against the infrastructure bill, which has just been approved by the Senate, arguing that the bill lacks transparency and breaches the budgetary regulation stipulated by the Constitution.

The base case must, for now, be that if a new election is called then the pro-Thaksin Puea Thai party is again likely to win. It currently has a majority in parliament with 265 of the 500 seats. This is, of course, the longstanding problem facing the anti-Thaksin opposition in the sense that they do not have the support to win based on the laws of universal suffrage. This is why the “yellow shirts” must be hoping that the Thaksin aura has been badly damaged by his effort to negotiate himself a pardon based on the Democratic leadership also gaining immunity from prosecution.

Still if this is a possibility, it remains far from proven that the Thaksin phenomenon is broken. While the opposition’s willingness to occupy government offices might also risk alienating middle class supporters who value stability. This week’s headlines will certainly not help the tourism industry as peak season approaches.

Figure 22 Foreign ownership of Thai stock market

Note: Based on the SET100 universe, excluding Siam Makro and Golden Land. Source: CLSA, SETSMART

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Meanwhile, from an investment perspective, the Thai stock market has so far fallen less than on previous political scares in recent years. This is, presumably, because investors have learned that it proved wrong to sell during previous periods of political instability. Still foreigners have been selling and can clearly sell more since they still own an estimated 29.7% of the market; though down from a peak ownership of 38% reached in March 2008 (see Figure 22 and CLSA research Thai Truths – Not All Heading South, 25 November 2013 by head of Thai research Suchart Techaposai). In aggregate, foreigners have sold Bt152bn worth of Thai equities so far this year (see Figure 23).

Figure 23 Cumulative foreign net buying of Thai stocks


The positive story for Thailand remains the Asean connectivity theme, given the country’s strategic location, and the Yingluck government’s ambitious infrastructure plan. GREED & fear’s base case it is that this will all kick in, sooner or later. But for now this can only be a hope not an expectation given the recent turn in events. As for stock market valuations, they are not demanding but the risk is clearly slowing growth. CLSA’s universe of 44 Thai companies trades on 11.7x 2013 forecast earnings and 10x 2014 earnings. Consensus earnings estimates have been downgraded so far this year by 7% and 5% for 2013 and 2014 earnings respectively.

Figure 24 Thailand private consumption index and consumer confidence index


From a domestic demand standpoint, consumption has been slowing all year. Real private consumption declined by 1.2%YoY in 3Q13 while the private consumption index fell by 6.1%YoY

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in September. The consumer confidence index has also declined from a recent high of 84.8 reached in March to 76.6 in October (see Figure 24). This slowdown will now be exacerbated by the political uncertainty, while the hoped for boost to investment from the infra projects now looks less assured. For such reasons GREED & fear would not be too negative about the surprise rate cut announced on Wednesday by the Bank of Thailand when the policy rate was lowered by 25bp to 2.25%, most particularly given that headline inflation is running at only 1.5% (see Figure 25).

Figure 25 Thailand CPI inflation and BOT policy interest rate

Source: CLSA, Bank of Thailand, CEIC Data

Still the rate cut does mean that Thailand will be more vulnerable if there is renewed tapering neurosis. As for external demand, GREED & fear’s view on the global economy means there is no reason to expect a big surge in exports. So far this year Thai export growth has remained marginally negative in US dollar terms. Thus, Thai exports fell by 0.7%YoY in US dollar terms in October and were flat in the first ten months of this year (see Figure 26).

Figure 26 Thai export growth in US dollar terms


This is why, to be interesting in a relative Asia and emerging market context, the Thai story needs the infra-related Asean connectivity theme to kick in. For now GREED & fear will hold off asset allocation changes pending a hoped for near-term visit to the country. But, clearly, Thailand has been an underperformer year to date with the MSCI Thailand index having fallen

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(%YoY, 3mma) Thai export growth in US$ terms




by 9.6% in US dollar terms so far this year, compared with a 1.1% gain in the MSCI AC Asia Pacific ex-Japan index (see Figure 27).

Figure 27 MSCI Thailand relative to MSCI AC Asia Pacific ex-Japan


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(1/1/88=100)MSCI Thailand relative to AC Asia Pacific ex-Japan


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