Quiet CDS creep highlights China risk
As credit default swaps (CDS) for many euro zone sovereigns have zoomed to ever new record highs this year, Chinese CDS too have been quietly creeping higher. Five-year CDS are around 135 bps today, meaning it costs $135,000 a year to insure exposure to $10 million of Chinese risk over a five-year period. According to this graphic from data provider Markit, they are up almost 45 basis points in the past six weeks. In fact they are double the levels seen a year ago.
That looks modest given some of the numbers in Europe. But worries over China, while not in
the same league as for the euro zone, are clearly growing, as many fear that the real scale of indebtedness and bad loans in the economy could be higher than anyone knows. Above all, investors have been fretting about a possible hard landing for the economy, with the government unable to control a growth slowdown.
The CDS rises have coincided with worsening economic data – state-owned companies’ profits have fallen 8.6 percent in the January-April period from year-ago levels while industrial production weakened sharply in April. Fixed asset investment – a key driver of the economy – has hit its lowest level in nearly a decade.
CDS fell slightly today after Premier Wen Jiabao called for more efforts to support growth. His comments also provided a mild boost to China’s stock markets. Gavan Nolan, Markit’s director for credit research, says Wen’s comments suggest growth is taking precedence over inflation in policymakers’ minds:
On the rocky road to change in China
One thing investors in China thought they could rely on was a steady, if unelected, hand.
Now Chongqing’s political head Bo Xilai has fallen, and in pretty spectacular fashion too. His wife has been accused of murdering a British businessman and his brother had to step down from the board of Everbright Bank. There are rumours the handover of power in the Politburo scheduled for this autumn, when seven out of nine of Chinese leaders are going to retire, could be delayed as the intrigue unfolds.
So what does this mean for investing in the Middle Kingdom? Xi Jinping is tipped for the top, and presuming he makes it to the transition unscathed, one of his tasks will be continuing the internationalisation of the renminbi.
Xi has something of a reputation as a reformer, but that doesn’t necessarily mean he’ll let China’s currency float freely.
John Adams, director of HR China and former manager for China at the Bank of England, said this about Xi at a talk in London this week:
He’s a safe pair of hands and one wonders whether he will take these risks to go ahead with letting the renminbi become internationalised…My intuition tells me he will go for a safe option, which may in fact put China on the wrong track.
Xi also has to sort out China’s financial sector, burdened with bad debt, and make sure an international board is finally installed in the Shanghai stock exchange, Adams said.
For luxury, all that glitters is gold
The year has certainly got off to a good start for luxury companies, with firms like LVMH, home to Louis Vuitton, reporting stellar results for the first quarter. No wonder – according to CLSA Asia-Pacific Markets analyst Aaron Fischer, resurgent emerging market consumers are fuelling a strong growth in the global luxury goods market. Growth in the sector was double its long-term average last year, Fischer says. He has updated his bullish 2011 report “Dipped in Gold” and is particularly optimistic on established brands, predicting global growth of 10% in 2012, slowing slightly from last year’s 14% rise:
However, we expect leading brands to continue to outperform, rising 15%, compared with the street’s estimate of 12%, which seems far too low.
We look for emerging market consumers, especially when travelling, to drive robust sector growth in the medium term, posting a 15% demand compound annual growth rate in the next 10 years.
That should take emerging markets’ share of global luxury demand to 73% by 2020, up from 50% at present, Fischer predicts, with China playing a leading role.
Already in European fashion capitals, and in favourite shopping destinations such as New York and Hong Kong, shoppers from emerging markets account for over 50% percent of luxury sales. And the home-grown brands that populate malls and department stores across China should gradually cede ground to big international players, Fischer says. What’s more these new consumers don’t seem too price sensitive — Fischer estimates that Chanel passed on 20% price increases to customers in 2011, without denting sales.
Luxury brands are also benefiting from the growing sophistication of consumers who aren’t content with knock-offs anymore. Between 2008 and 2011, the proportion of Chinese consumers interested in buying fakes fell by more than half to just 15%, a McKinsey survey found.
Fischer’s top stock picks include handbag maker Prada, which listed in Hong Kong last year. 33% of Prada and Gucci’s sales come from mainland China, according to the report. But he also likes some Chinese luxury brands, naming leading shoe retailer Belle, jeweller Chow Tai Fook and Greater China department store firm Lifestyle.
But how has the luxury sector proved so resilient during an economic downturn? Fischer tackles the Wall Street bonuses equal big watches and nice handbags myth by explaining that only around 5 percent of luxury sales come from the financial sector.
Three snapshots for Wednesday
Euro zone factories sank further into decline last month but manufacturers in Asia upped their tempo to meet growing demand from the United States and China, exposing a widening gulf between Europe and the rest of the world.
Unemployment in the euro zone rose to a 15-year high of 10.9 percent in March – as this chart shows the level of youth unemployment paints a worrying picture:
U.S. private employers hired a far fewer than expected 119,000 people in April, the smallest gain since September 2011, a report showed on Wednesday, adding to concerns that the economy has lost some of its momentum. This chart shows the relationship between the first release of ADP figures and non-farm payrolls which are released on Friday.
Where will the FDI flow?
For years the four mighty BRIC nations have grabbed increasing shares of world investment flows. But the coming years may not be so kind. These countries bring up the bottom of the Economic Freedom Index (EFI) for 2012. Compiled by Washington D.C.-based think-tank The Heritage Foundation the EFI measures 10 freedoms — from property rights to entrepreneurship – and according to a note out today from RBS economists, there is a strong positive link between a country’s EFI score and the amount of FDI (foreign direct investment) it can secure. So the more “free” a country, the more FDI inflows it can expect to receive — that’s what an RBS analysis of 2002-2008 investment flows shows.
So back to the BRICs. Or BRICS if you add in South Africa (part of the political grouping though not yet included in the BRIC investment concept used by fund managers). The following graphic shows Russia languishing at the bottom of the EFI, China just above Russia and India third from bottom. Brazil is sixth from bottom while South Africa ranks two places higher.
At the other end of the spectrum is tiny Singapore. Its EFI score is double that of Russia and between 2002-2008 it attracted FDI equivalent to 50 percent of its economy. Russia in contrast saw negative net FDI (outflows exceeded inflows)
What comes next will be interesting. China grabbed the most FDI in absolute terms in the past decade (around $1.3 trillion or almost half the $2.1 trillion flows to the 21 leading EMs) but RBS notes this is slowing. That’s because China’s low-value manufacturing base is becoming less competitive relative to the rest of Asia and stringent restrictions remain in place in many sectors. Corruption, red tape and general business-unfriendliness prevail. ”The decreasing allure of China from a manufacturing perspective means the country is at risk of suffering a decrease in FDI inflows in coming years,” RBS writes. The bank also notes the nature of FDI into China is changing: half the 2011 flows went to real estate.
On the other BRICS:
Turning point for lagging emerging stock returns?
Over the past year emerging markets have broadly lagged an upswing in global equity markets, yielding cumulative returns of 4.5 percent since last August. That’s less than half the return developed markets have provided (see graphic below).
But there are two reasons why a turning point may be approaching. First the positioning. Foreign holdings of emerging equities have plunged in the past six months and according to research by HSBC they are at the lowest in four years. That’s especially the case in Asia, where fund managers have been jittery about China’s growth slowdown.
International funds appear to have responded aggressively to signs of a slowdown in emerging market economies, the bank observes, adding:
This could be a positive signal for emerging equities if economic conditions subside…particularly for Asian markets where holdings are lowest.
Valuations are the other attraction. Emerging equities are trading around 10 times forward earnings —a fifth below developed market peers. In China, which comprises about 18 percent of the main MSCI emerging equity index, valuations are near record lows. EM valuations have been “sustainably lower” only back in 2002 or during the depths of the 2008 crisis, notes James Bristow, who runs a global equity portfolio at U.S. asset manager Blackrock in London.
Three snapshots for Thursday
Initial claims for state unemployment benefits slipped 2,000 to a seasonally adjusted 386,000, the Labor Department said. The prior week’s figure was revised up to 388,000 from the previously reported 380,000.
The four-week moving average for new claims, considered a better measure of labor market trends, rose 5,500 to 374,750.
Brazil’s central bank raised its key interest rate for a fourth straight time on Wednesday as it seeks to rein in persistent inflation, and indicated more rate increases could be on the way soon. This follows a 50bps rate cut from India earlier in the week.
from MacroScope:
Foreign investors still buying American
Overseas investors have yet to sour towards U.S. assets despite high government debt levels, according the latest figures on capital flows.
Including short-dated assets such as bills, foreigners snapped up $107.7 billion in U.S. securities in February, following a downwardly revised $3.1 billion inflow for January. At the same time, the United States attracted a net long-term capital inflow of just $10.1 billion in February after drawing an upwardly revised $102.4 billion in the first month of 2012.
The data showed China boosted purchases of U.S. government debt for a second month in February, but also some waning of demand for longer-dated securities.
Still, recurring fears that foreign investors might be scared off by high levels of U.S. debt have thus far proven overdone. Writes Millan Mulraine at TD Securities:
Overall, the massive foreign flow into U.S. assets in March suggests that US securities continue to enjoy healthy global appetite in time of fear (Treasuries) and times of hope (equities). The reallocation from Treasuries to shorter-term securities in February is broadly consistent with the risk-on tone that prevailed during the month, reversing the trend of the past few months, when concerns in Europe resulted in the flight to quality.
Even the downtrend in Treasuries may have been short-lived, said George Goncalves at Nomura, as evidence by the recent drop in benchmark 10-year yields to around 2 percent:
March bulls give way to April bears in emerging markets
The dust has settled on a scintillating first quarter for emerging markets but the cross-asset rally of the first three months has already run out of steam. A survey by Societe Generale of 69 EM investors shows that over half are bearish — at least for the near-term.
This marks quite a turn-around from the March survey, when 80 percent of investors declared themselves bullish on emerging markets. What’s more, investors are currently running very little risk and 47 percent of hedge fund respondents (these make up half the survey) feel they are over-invested in EM. (The following graphic shows the findings — click on it to enlarge)
Almost a quarter of the hedge fund and real money investors are neutral tactically on the market, compared to just 4.5 percent last month. Serious optimism has dried up, SocGen commented:
Looking at the distribution of answers, it is quite clear that the mega-bullish investor on EM has disappeared at this point.
The return of worries about the euro zone debt crisis, U.S. growth and a slowdown in China have all contributed to a higher degree of pessimism on financial markets. It’s not all gloom though. Looking at emerging markets over the next 3 months, sentiment does pick up, with 64 percent of investors bullish. So this falling out of love with EM could be a temporary blip.
Only 13 percent of investors were more bearish on a 3-month time horizon than over the next two weeks. That included 83 percent of real money investors that believed in an improvement in the GEM outlook from two weeks to three months.
Three snapshots for Friday
JPMorgan profit beats expectations:
In China the annual rate of GDP growth in the first quarter slowed to 8.1 percent from 8.9 percent in the previous three months, the National Bureau of Statistics said on Friday, below the 8.3 percent consensus forecast of economists polled by Reuters.
Italian industrial output was weaker than expected in February, falling 0.7 percent after a revised 2.6 percent fall the month before, data showed on Friday. On a work-day adjusted year-on-year basis, output in February fell 6.8 percent, compared to a revised 4.6 percent decline in January.
