We have commented a few times in recent weeks on the poor performance of
agricultural commodities and a combination of the end of the quarter
(which we assume has seen a re-allocation of funds away from this
sub-sector) and a significant boost to USDA estimates for the size of the
planted 2011 US crop has resulted in further sharp declines this morning.
At the time of writing Corn's front month contract is down by 74c (10.64%)
while the more widely traded September contract is down by its daily
limit of 30c to $6.48. Wheat is down by 56c (8.77%) in its front month
and 60c (8.71% and also limit down) for its September contract. Pressure is
visible elsewhere in this sub-sector with cotton (Dec) down 4.03% and sugar
3.45%, in what is currently one of the ugliest single sessions for agricultural
sub-sector in recent years.

As well as leaving investors nursing sharp losses today's drop in price
confirms that the use of volatile agricultural commodities for loan
collateral (which as we highlighted a few days ago apparently has become a
popular activity in China) is one of the more foolish responses to
monetary tightening. Should prices continue their downward trajectory we
can expect to hear more on this topic in the weeks ahead. - D-C_1_Comdty.gif -
D-W_1_Comdty.gif -

The June Chicago PMI report came in significantly stronger than expected with
the headline index reaching 61.1, compared to consensus estimates of 54.0 and
May's 56.6 reading. This puts this index back into solid expansion territory
and goes someway to addressing concerns that the manufacturing cycle was losing
momentum. Further support came from the various sub-indexes with New Orders
(red) rising to 61.2 and Production (blue) a very solid 66.9. Even so the
Inventory index (olive) fell back sharply to draw-down territory at 46.9, which
suggests that even after 2 years of expanding production inventories remain
tight. Finally employment (pink) remained very strong at 58.7.

Of course the Chicago PMI report is little more than a teaser for tomorrow's
national ISM report. We note that consensus expectations for this data have
been trimmed to a very moderate 51.8 (compared to a reading of 53.5 in May).
Even prior to the Chicago PMI data relase we were optimistic that this target
could be comfortably exceeded and we see no reason to change our mind in the
aftermath. - chicagopmijun11.gif

Turkey's central bank published its minutes from its recent policy meeting
this morning making it clear that no change in policy is currently being
considered. Indeed the central bank went as far as to claim that "The
overall demand situation does not point at excess heating" which really
suggests that they should consider re-calibrating their economic
thermometer.

Today's data included a GDP report showing domestic growth at 11.0% for the
last year (up from 9.2% last quarter), as welcome as this sort of data may seem
it is clear that this growth is being increasingly driven by excess local
consumption. May's trade data rammed this point home as the trade gap soared to
a new all time record of -$10.1B, well below consensus estimates of -$9.4 bln
(it is worth remembering that consensus was running several bln dollars higher
a few months ago). This takes the trailing 12 month ma down to a new record
of -$7.70 Bln, and the cumulative 12 month deficit to -$92.40 bln. It is
important to note that this deterioration has come largely from surging
imports (up over 40% over the last 12 months) while exports have risen by
a much more moderate 11% (roughly in line with GDP). Meanwhile consumer
credit growth appears to be a growing factor behind local consumption,
with the weekly data now running at an annual growth rate of over 40%
(roughly in line with import growth). As with many emerging markets the
aggregate amount of credit in the economy remains low by western
standards, but this does not mean that credit growth's effect on local
consumption should be ignored.

In contrast to the central banks comments,Turkey strikes us as a textbook
case of an overheating economy. We have argued this point for several
months and we note that others are beginning to come around to our way of
thinking. The longer the central bank persists with its "unorthodox"
policy mix the greater the odds of a market dislocation (particularly in
the relatively weak TRY) taking place in the months ahead. -
W-TUCRTOTL_Index.gif - D-TUTBEX_Index.gif -

As we argued yesterday in our discussion of the Case-Shiller index,
transactional volume and not prices is the key to the US housing market.
While the new home market remains in depression territory the larger
existing home market is bouncing along at the "low end of normal". Further
confirmation of this fact came this morning with the NAR's Pending Home
Sale report. This repaired most of the sharp drop in April, with the index
rebounding strongly to 88.8 (2001 sales = 100). In fact although this data
has been very volatile on a month-by-month basis this has really
represented noise around a surprisingly steady level of activity. The 36
month ma (red line on chart) has barely shifted in recent months from the 90
level with the artificial boost from the housing credit being followed by an
equivalent drop in pending sales following their expiration.

Therefore, before determining that a meaningful change in activity was taking
place we would look for a period of 3 or more consecutive months in which
Pending Sales either rose above 95 or fell below 85. In the meantime the pace
of activity is sufficient to steadily absorb the overhang of foreclosed homes
while keeping prices close to current levels, which while hardly exciting is
also far from the more apocalyptic scenarios that have been floated in
recent months. - D-USPHTOTL_Index.gif -

Yesterday we highlighted an unusual statement by the Chinese Banking Regulatory
Commission regarding the creation of high yield wealth management products and
the attached story gives some background to the developments in the Chinese
bank deposit market that led to this statement being issued. It would seem that
recent monetary tightening has led to some very creative thinking by local
commercial banks, while local savers are focused solely on yield when choosing
where to deposit their funds.

Readers may recall that the run up to the US credit crisis saw the
proliferation of the "SIVs" which offered enhanced money-market yields by
investing funds in structured products. These were amongst the first victims of
the deterioration in loan performance with many SIVs collapsing in mid-2007. If
anything the collateral being used to boost yields in Chinese deposit
instruments is even less appealing.

An interesting tidbit from China that combines our two primary concerns of
monetary tightening (leading to a scramble to attract deposits) with the
popular of emerging market corporate credit. We are not aware of the details
behind the regulators concerns, but we would note that behavior typically rises
to a fairly egregious level before a warning of this type is issued. It will be
interesting to see if this story develops "legs" in the weeks ahead.

Brazil's private sector loan industry shows no sign of slowing down
despite multiple rate hikes and a number of other restrictive
macro-prudential measures. Total Private Sector loans grew by 1.75% to
1074 Bln BRL in May, keeping the annual growth rate at just over 20%.
Growth was seen across all key categories with most growing in line with
the overall loan total. The one exception is housing credit which
continues to grow at a far faster rate. This rose 3.60% in May and has
increased by 49.80% over the last year. Of course housing credit is
exploding off a very low base, and even after May's increase housing credit
only accounts for approximately 15% of total loans and is still only 27%
of the size of total personal loans (ex housing). Nevertheless growth of this
pace is sufficient to raise questions regarding the reliance of the Brazilian
housing market on mortgage credit. Although some observers have trimmed their
expectation of future monetary tightening in recent weeks, we believe the
robust growth of local credit will encourage a more hawkish stance than
consensus.

One other fact that readers should be aware of is the significant rise in
personal loan defaults in recent months. These have risen from 5.70% in
January 2011 to 6.40% today, which is quite something given the fact that
total loans themselves are growing at over 20% per annum. Although the
actual level of delinquencies remains benign the change in direction is
more troubling. Delinquency cycles tend to trend powerfully over multiple
quarters but often go ignored until they cross a key psychological
threshold. In Brazil's case the 7.00% level looks to be the key level to
watch, with delinqencies on track to cross this barrier sometime before
the end of summer. - D-BZLNPTOT_Index.gif - D-BRCDDEFT_Index.gif -

Despite the attempts of headline writers to get readers excited about the
Case-Shiller index, The April data really underlines just how stable the
existing home market appears to be at the current time. It is true that
this stability comes at a level of activity equivalent to the late 1990's,
and that price stability is equivalent to that seen in late-2002 but this
is very different from the attempts to portray this key portion of the
economy as suffering a marked deterioration in recent months.

April's data actually showed a small rise in the index of 0.66% but this
was not sufficient to prevent the YoY change (which drives the headlines)
falling to -3.96%. Given the drop in the index level seen since last
summer it is fairly likely that the YoY change will continue to decline
moderately over the next few months but unless the actual price index were
to take another sharp leg lower we would not assume anything meaningful
was occurring. As the attached chart shows, the drop over the last year is
insignificant when compared either to the decline of 2006-9 or the run up in
prices that preceded it.

In any case, at this point in the cycle we would be much more interested
in seeing an improvement in volume. Although prices drive headlines, in
our experience real estate cycles are led by activity (both at tops and
bottoms). If a small decrease in price (most likely caused by banks
lowering the asking price on foreclosed homes) was accompanied by
increased velocity of sales this would actually be a good sign for the
overall market. - M-SPCS20_Index.gif -

We note that silver continues to follow its path in 1980 when it last
reached $50 per oz (see attached comparison of historic move). Recent days
have seen a return of selling pressure with the metal piercing important
support at $35 on Friday. Further weakness has taken the metal down to
$33.29 today, the lowest price seen since May 17th. It would therefore
appear that the metal is poised to test key support made up of a
combination of the May low ($32.31) and the rising 200 day ma ($31.86).
The lesson of silver's move in 1980 (and that of other speculative
markets) is that a breach of this support would have severe implications
for silver's price going forwards. The fact that sentiment towards silver
has remained quite bullish increases the dangers at the current time. We
note that Bloomberg (c) carried a survey of 100 commodity analysts this
morning in which the median expectation was for silver to rally back to $49.79
by December 31st (making silver the most popular of 15 commodities).

Again this sort of optimism in the face of the initial wave of a decline is
quite typical of the terminal phase of a popular trade. Finally we note that
the recent weakness in silver has been accompanied by an appreciable decline in
gold (see Friday's Speculator daily). This suggests that pressure is currently
being brought to bear across the entire precious metals sub-sector and this
increases the odds that silver's key support will fail to hold. -
D-SILV_Comdty.gif - silver1980.gif

One of the relationships that we like to keep an eye on is that between
Brazilian consumer confidence and the local IBOV index. Our (unorthodox) belief
is that a sustained high level of consumer confidence often precedes a sharp
decline in financial asset prices, if only because it encourages a central bank
to significantly tighten domestic monetary policy.

In Brazil's case the local equity market has been performing poorly for several
quarters, but cannot yet be said to have truly cracked. Consumer confidence has
declined somewhat from the heady readings of late 2010 (December saw a peak of
124.20) but remained elevated at 118 in May. Meanwhile the local central bank
remains committed to a hybrid tightening cycle that combines traditional
interest rate hikes with more novel macro-prudential measures. This uneasy
equilibrium seems unlikely to remain in place for much longer. One potential
catalyst for disruption is the abrupt closing of the local corporate debt
issuance pipeline. Should this remain shut for a number of weeks it would
represent another significant tightening of local monetary conditions, and one
that is likely to be highly correlated with actual industrial activity, with
negative implications for both local equity prices and consumer confidence. -
brazilconsconf.gif

We have believed for several weeks that gold would eventually participate
in this corrective phase, but would also take longer to crack than the rest of
the commodity complex. Price action over the last two sessions would seem
to confirm this thesis with the metal finally breaking below its 50 day ma
for the first time since its February 2011 break out. At its current price
of $1506 the metal is still only 1% below this support level but given the
recent weakness seen in a number of other senior commodities (such as
crude oil) and other precious metals it seems reasonably likely that gold
has entered a corrective phase. There is clearly some support in the
$1475-$1490 range but our bias has always been that a correction would at
the very least test key long term trend support at the 150 day ma
(currently $1437). This has been intact since January 2009 (with the
exception of a couple of intra-day breaks) and would seem to be a logical
testing ground for the strength of resolve of gold's many supporters. -
D-GOLDS_Comdty.gif -

As QE2 draws to a close it is remarkable to see the Euro$ yield curve fall back
to the extreme position that was in place at the time this policy was
originally implemented.

Attached is a chart that compares the curve of today (black) with that in place
on November 4th 2010 (blue). For readers unfamiliar with the Euro$, it is the
future used to hedge anticipated 90 day US LIBOR rates, and has the advantage
of being a very deep and liquid market out several quarters. The current curve
anticipates no meaningful increase in the LIBOR yield (and hence the FDTR which
typically is 15-25 bp lower) until the start of 2012 and would not see the FDTR
above 1.00% until June 2013 and 2.00% until June 2014.

Although the FRB is clearly on hold for the time-being the current position
strikes us as a potential mis-pricing of possible outcomes. Most of the
disappointing macro-economic data released in recent weeks has pointed to an
expansion which has yet to find its sweet spot (a disappointment from our
perspective) but has not meaningfully threatened the possibility of future
growth. The current Euro$ curve strikes us as unrealistically certain that
tepid growth is the best that can be expected for the US economy in the next 24
months. - euroyields.gif

Discussion concentrates on Crude Oil, US Economy and Media sector.

The US new home market remains in deep-freeze but there was some tentative
signs in May's data that a moderate improvement may be taking place. Total
sales came in at 319K, a modest drop from April's 326K but beating
consensus estimates of 310K. This is the second best monthly sales report
in the last 12 months and marks the first month that 2011 NSA sales have
beaten the corresponding month in 2010 (30K vs. 26K). May's sales also
made another dent in the already razor-thin inventories with houses for
sale falling to a new all time low of 166K (172K in April). At current
sales this still represents 6.2 months of sales but at a more normal pace
of activity this level of inventory (the average single monthly sales over
the last 20 years is 65.3K) would be eaten up in a matter of 10-12 weeks, -
D-NHSLNFS.gif -

One of our strongest beliefs is that the complication of monetary policy under
MPMP is likely to result in some very strange (and unwelcome) responses by
capital constrained industrialists in emerging markets. One of the clearest
examples we have seen is the use of agricultural commodities in China as
collateral for short term loans which are then "re-lent" out at rates well
above the marketplace (the attached article mentions rates as high as 6% per
month).

Similar activity took place in industrial metals earlier this year but was
quickly stamped out by regulatory action. At least a copper stockpile
originally built for a lending business can be stored (at some cost) for a loan
period of time. Perishable goods such as cotton and soy beans are much trickier
to hang onto. Further complicating matters is the fact that stockpiles have
been built at record price levels that are already significantly higher than
prevailing market levels. As the attached long term chart of the S&P GSCI
Agricultural Spot Index shows, this sector has a long history of rapid "booms
and busts" making agricultural commodities even less suitable as loan
collateral. Assuming the veracity of this story it is hard to see this episode
ending well for all concerned.

+------------------------------------------------------------------------------+

Loan Crackdown Sidestepped With Soybean Collateral: China Credit
2011-06-22 16:30:58.622 GMT


By Bloomberg News
June 23 (Bloomberg) -- At a time when China is restricting
access to credit, commodities companies are building record
inventories to gain access to loans.
Copper inventories reached an all-time high in April and
have declined in the past two months after the State
Administration of Foreign Exchange introduced rules to make it
harder to use the metal as collateral, said Jia Zheng, a trader
at Shanghai East Asia Futures Co. Now soybean stockpiles are
rising to record highs as perishable foodstuffs are used to back
loans, said Li Zhao, a manager at Yongan Futures Co., China’s
second-largest futures broker by registered capital.
“We saw such commodity financing activities spread from
traditional bankable collateral material such as copper sheets
to non-typical commodities,” said Judy Zhu, analyst at Standard
Chartered Plc in Shanghai. “Soybeans and cotton, which have a
shelf life, are normally not considered collateral material.”
Commodity traders are seeking to profit as the three-month
Shanghai interbank offered rate jumped 22 basis points to 6.06
percent yesterday, the highest level since the daily fixing was
introduced in October 2006. The rate has risen 145 basis points,
or 1.45 percentage point, this month as the equivalent cost to
borrow dollars in London was unchanged at 0.25 percent. Surging
interest costs have contributed to a slump in bank lending, the
biggest increase in government bond yields among the so-called
BRIC nations and the failure of two Ministry of Finance debt
auctions in five weeks.

Underground Lending

Domestic soybean inventories have reached 7 million tons,
higher than the 4 million tons to 5 million tons required to
meet demand from food processors, said Yongan’s Li. Loans backed
by the commodity are re-lent in the “underground” market at
rates of more than 6 percent per month, he said.
“The importers buy the soybeans and get them in a month,
and because the line of credit is often 90 days, they don’t need
to pay back right away, so they can lend the money,” Li said.
“Demand has increased because of the credit tightening.”
The central bank has raised its benchmark lending rate four
times since September to 6.31 percent and ordered banks last
week to set aside 21.5 percent of their cash as reserves. New
loans in the first five months, excluding unofficial lending,
totaled 3.55 trillion yuan ($549 billion), 12 percent lower than
a year earlier, central bank data show.

Lending Rates

Smaller companies in Zhejiang province are paying almost
five times the benchmark rate on loans from non-banking
institutions, according to a June 15 report on the website of
the province’s bureau for small and medium-sized enterprises.
The one-year swap contract, the fixed cost to receive
three-month Shibor, has risen 46 basis points this month to 5.01
percent. The yield on China’s 2.77 percent May 2012 bonds
climbed 61 basis points in the period to 3.63 percent. Brazil’s
similar yield rose 11 basis points to 12.62 percent in the
month, Russia’s climbed eight basis points to 4.75 percent,
while India’s fell 18 basis points to 8.07 percent.
China sold 30 billion yuan of 30-year bonds yesterday,
drawing bids for 1.59 times the sale, the lowest since a
similar-maturity auction in June 2010. The central bank also
said it would suspend bill sales today after the Ministry of
Finance sold 13.35 billion yuan of one-year debt at an auction
on June 17, falling short of its 20 billion yuan target.
The yuan strengthened for a second day against the dollar
to close at 6.4629 yesterday, as policy makers sought a stronger
currency to curb inflation. Consumer prices climbed 5.5 percent
in May from a year earlier, the fastest pace in 34 months, the
statistics bureau said on June 14.
The cost of five-year credit-default swaps protecting
China’s government bonds from default climbed 5 basis points
yesterday to 87, according to data provider CMA, which is owned
by CME Group Inc. and compiles prices quoted by dealers in the
privately negotiated market. The contracts protect investors
from losses when a company or government fails to pay its debt.

“No Brainer” Trade

Letters of credit issued by Chinese banks listed in Hong
Kong in 2010 jumped 70 percent, faster than the nation’s overall
trade growth of about 25 percent, suggesting funds were being
redirected into the black market, Bank of America Merrill Lynch
analysts led by Winnie Wu wrote in a note in May.
Wu called using credit lines a “no-brainer” trade as
companies could apply for a six-month letter of credit to import
copper, sell the metal once it arrives and lend out the cash
before they repay the letter of credit at maturity. SAFE’s rules
put limits on the scale and length of such transactions.

‘Mopping Up’

“Customs have tightened the imports of commodity products
recently,” said Peng Qiang, Beijing-based analyst at Cofco
Futures Co., a unit of China’s largest trader of agricultural
products. “What the government doesn’t want to see is that
people import these things only to get credit, rather than to
meet the real demand from downstream users. This prevents
Beijing from achieving the goal of mopping up liquidity.”
Soybean imports by China, the world’s largest buyer, rose
for a third month in May to 4.6 million tons, adding to concern
that supply may outpace demand from the livestock industry after
disease and a drought cut herds. Soybean prices in Chicago
dropped 4.2 percent this year. Inbound shipments may rise to 5
million tons in June, according to estimates by the China
National Grain and Oils Information Center.
“The growth of such collateralized lending has
increased,” said Jeremy Goldwyn, who oversees business
development in Asia for Sucden Financial Ltd., one of 12 ring-
dealing members on the London Metal Exchange. “They are paying
6 to 8 percent on such loans. Sometimes the money is being re-
lent out at 20 to 30 percent.”

For Related News and Information:
To see more agriculture news: NI AGR BN <GO>
Most-read China economy stories: TNI CHECO MOSTREAD BN <GO>
Emerging markets view: EMMV <GO>
China economic statistics: ECST CH <GO>

--Feiwen Rong. With reporting by William Bi and Henry Sanderson
in Beijing, Glenys Sim and Kyoungwha Kim in Singapore, Judy
Chen, Helen Sun and Jun Luo in Shanghai.
Editor: Sandy Hendry

To contact Bloomberg News staff for this story:
Feiwen Rong in Beijing at +86-10-6649-7563 or
[email protected]

To contact the editor responsible for this story:
Jim Poole at 65-6212-1551 or
[email protected]
- spgsciagindex.gif

Federal Open Market Committee June 22 Statement: Full Text

The FRB's June statement reveals a committee who have elected to leave policy
on hold. The text contains an admission that growth has faltered and that
inflationary pressure has built up in recent weeks but anticipates these
deteriorating factors to be temporary. QE2 will therefore draw to a close and
although the FRB will continue to reinvest principal repayments from its bond
portfolios this will result in a much smaller pace of asset purchases and a
neutral impact on the size of the overall balance sheet.

The absence of any dissent was notable in the statement although this is in
part a reflection that some of the "alternative voices" are not currently
eligible to vote. Unless (or until) US economic data starts to paint a more
robust level of economic activity it seems unlikely this reactive FRB will take
any tightening initiative.

 

An interesting article that highlights the sudden freezing of Brazilian
corporate credit issuance. Clearly a 3 week hiatus is not in itself a problem,
but important tops in asset cycles are typically accompanied by a collapse of
new-issuance. Should credit markets remain closed for several more weeks and
then fail to recover to their prior pace of activity this would represent
powerful evidence that the EM credit cycle has started to meaningfully
deteriorate.

One of our main complaints with macro-prudential monetary policy (MPMP) is
that despite its fancy name and good intentions, it is such an inexact
approach to controlling an economy. In China for instance a series of
hikes to the reserve requirement for local banks had a marked effect on
the the costs of funds for short term borrowings in late 2010, but the
system then apparently absorbed these pressures allowing the 3 month
"SHIBOR" rate to fall back to just over 4.00% in February. Further reserve
hikes were met with indifference by the loan market but recent days have
again seen a surge in borrowing costs, with SHIBOR hitting a multi-year
high of 6.05% this morning. This spike in rates has led to the temporary
suspension of bill sales by the central bank (thus removing a further
drain on liquidity).

Time will tell whether this fixes the problem, and also whether this surge
in rates is related to the end of the quarter (which may be causing a
heightened demand for short term borrowing). At the very least this
increase in borrowing costs increases short term pressures on local
financial markets which have looked distinctly queasy in recent weeks. In
any case China's money-market rates should be watched for further movement
in the days ahead. - W-CHRRDEP_Index.gif -

CNBC Asia Squawk Box interview with Michael Shaoul June 20th 2011. Discussion
covers emerging market corporate credit and developed commercial bank credit
and equity.

Video link: http://video.cnbc.com/gallery/?video=2015529673

As QE2 draws to a close its greatest effect can be seen on the composition
of US Commercial Bank balance sheets. Attached is a chart that shows the
percentage of balance sheets consisting of cash and treasuries (black) and
Cash, treasuries & agency MBS (red). As can be seen the former measure has
soared to a new all time high of 39.34%. This compares to its pre-QE2
level of 29% and its pre-crisis low of 15.3% back in January 2008. If MBS
are included this percentage increases to a remarkable 52.05%, marking the
first time in modern history that the majority of bank assets are being
held in "passive" silos rather than true credit. Of the 3 categories cash
is now the largest at $1923 Bln (up from $1,000 bln in early November and a
mere $281 Bln in January 2008). Treasury holdings are $1,680 Bln (hardly
changed from November's $1,630 bln but much higher than January 2008's
$1,100 Bln) and MBS $1,100 Bln (unchanged since November, data only starts in
2009).

Thus the great impact of QE2 has been on US commercial bank holdings of
cash, which have risen by $923 bln or a little more than the entire QE2
program. As we have stated many times, the impact of QE2 on actual
economic activity has been virtually zero, which is one reason why we do
not fear its demise. It also underlines how unprofitable large cap banking
has become in recent quarters, since these holdings are essentially
worthless at prevailing rates. - M-.BANKCASH_Index.gif - D-ALCBCASH_Index.gif -

Due to a slightly advanced paternity break we have been watching the
markets from the sidelines for the last few days. Our return to regular
commentary sees us focus on the marked deterioration of the emerging market
equity complex. Recent days have seen significant declines with a number of key
markets registering a new 2011 low. India's SENSEX index has yet to follow suit
but this is simply a function of the fact that its Q1 decline was far deeper
than the rest of the complex.

This morning's abrupt decline of 2.04% saw the index touch 17314.38, within
touching distance of the February 11th low of 17295. It comes as no surprise
that support here proved to be strong, allowing the index to trim its losses
and close at 17506, but this is likely to prove to be a brief respite. As the
attached weekly chart shows, the SENSEX appears to be tracing out an important
long term top and a breach of current support would point the index down to our
target of 16,000. This represents a level that was technically significant from
August 2009 (when it formed resistance) through to May 2010 (when it acted
as support) and now also coincides with the 200 week ma. The index has not
traded down below this average (with the exception the 2008 collapse and
2009 recovery) since breaking out in mid-2003. It therefore seems
possible that support at this level will prove sufficient to draw a close
on this particular corrective phase, but it also means that a breach would
be a very poor sign, with much deeper support in the 12700-13500 range (shaded)
becoming a potential target.

Meanwhile there is little sign that foreign investors have started to head
for the exits. Year to date Foreign Equity Investment (See chart) is
basically flat at $106.57 mln, meaning that most of the almost $30 bln
that poured into this market in 2010 remains in place. On the other hand
inflows are running at the 2nd lowest pace since 2002 (2008 being the
worst year when flows were strongly negative). To our eyes this represents
a dangerous combination of heavily exposed investors reacting passively to
very poor asset class performance. We doubt this can continue for much
longer and unless the SENSEX rebounds strongly it is at risk of being a
major focus of capital repatriation in this quarter's allocation process. -
W-SENSEX_Index.gif - D-FIINYTDN_Index.gif -

One of the more peculiar aspects of macroeconomic analysis is the extent to
which one metaphor tends to dominate description of a particular episode.
Perhaps even stranger is the tendency to recycle the same limited choice of
terms from cycle to cycle, despite the fact that most have proved to be very
poor guides to what is actually occurring.

For instance, the recent poor set of US macroeconomic data is fast becoming
enshrined as a "soft patch", with Bloomberg © tracking 272 news stories using
this term over the course of the last week. This is the greatest concentration
of stories since the weeks of July 29th 2005 (300) and May 13th 2005 (440). As
some readers may recall the springtime of 2005 saw a surge in concern that the
2 year old recovery was running aground and although the overall SPX index
suffered only a modest pullback certain sectors such as Steel were punished
very hard (US Steel traded at a P/E of 3.03). By mid-summer these fears were
put aside and the term was never used again in the 2003/7 cycle. Instead, the
later deterioration in housing data was greeted by the far more dangerous "soft
landing" metaphor (the surest sell signal in the market-lexicon) which peaked
at 220 in December 2006.

Also interesting is the fact that we have seen very little use in recent weeks
of last year's metaphor of choice "double dip" (see chart). In part this is
because it proved to be such an embarrassingly inaccurate description of what
was going on and so has fallen into (short term) disrepute. It is also because
as disappointing as much of the recent data has been, it has still pointed in
the direction of a continued expansion, while some data last spring actually
forced its way into negative territory. In any case by definition a "soft
patch" tends to be a short term phenomenon, destined to either melt away in the
face of improving data or deteriorate into a more doom laden descriptive term.
Our expectation is that the former proves to be the case, but perhaps not
before a little more fear is registered in the marketplace. -
softpatchjun122011.gif - softpatchdoubledip.gif

China's monetary data continues to point to a tightening of local monetary
conditions, and while these cannot yet be described as tight in absolute
terms the pace of monetary growth is starting to lag the pace of
investment in the key real estate and fixed asset portions of the economy.
May's data showed M2 growth tick down to 15.07%, the lowest reading since
November 2008 and the second lowest level since May 2005 (the 3 month RoC
shows a similar pace). Of course six years ago M2 was just under 27 Trln
CNY compared to today's reading of 76.340 Trln, so comparing percentage
changes over this sort of period needs some qualification. Nevertheless
the value of China's total housing stock has risen even faster over this
time period as has the annual expenditure on fixed assets which have been
growing annually by 25% or more over this period.

Perhaps more importantly actual loan growth slipped to 551 Bln CNY, the
lowest level since December 2010. On the other hand this data is volatile
and the 6 month ma remains at 671.55 Bln, almost unchanged from April's
level. Again the fact that a lack of loan growth is taking place against a
backdrop of spiralling asset prices should be taken into account, but today's
data does not signal that the Chinese authorities have engineered an actual
reduction in credit issuance, merely that the process of acceleration has
been terminated. We would therefore not rule out further tightening
measures in the weeks ahead, particularly if inflation and housing data
continue to suggest that pressures are building within the Chinese
economy. - D-CNMSM2_Index.gif -

One of the more surprising aspect of the current corrective phase has been
the reluctance of participants to bid up the cost of protective puts. As
the attached chart shows the SPX has now fallen by just over 5% over the
course of the last 20 days which is close to the degree of damage incurred
back in the middle of March. 3 months ago the VXO index spiked to 31.11
(note attached chart shows daily close) while at the time of writing the
VXO remains at 19.27, considerably higher than its sub-14 readings in late
April but still below the key 20 level that typically marks the move into
a "corrective" mind-set. As we have commented on a number of times in
recent weeks, this suggests that participants have finally tired of
over-paying for protective premium early in a sell off, but it also means
that those who have continued to use "volatility products" (rather than
put options) as a direct hedge against equity market losses have found
little protection during the current decline (indeed the VXX ETF has
actually lost 2.84% over the last 21 days).

What this perhaps indicates is that the current decline currently is more
indicative of "an absence of buyers" than an acceleration in actual
selling pressure. With quarter end now just 3 weeks away it may well be
that calendar-conscious investors (and dealer desks in particular) are
becoming increasingly unwilling to add to positions ahead of quarter end.
Unfortunately corrective episodes rarely end without an acceleration to
the downside that is accompanied by some concentrated liquidation, and this
implies that we have further to go before the market is back on a stable
footing. What remains unclear is whether global concerns will remain
focussed on weak US economic data (which actually troubles us only
moderately) or will instead shift to take into account some of the
data-shortfalls in the emerging market complex. The latter stages of this
corrective phase should make this clearer one way or another. - D-SPX_Index.gif
-

Hong Kong Raises Down-Payment Requirements for Home Loans (2)

Yet another example of non-interest measures to tighten an EM asset market. It
is particualrly interesting that foreign sources of capital are singled out,
since the source of most of this money is mainland China which itself is
attempting to reign in credit growth. As the article makes clear there are
already some signs of cooling off in the HK real estate market (we always pay a
lot of attention to transactional volume which has fallen for several months),
and today's measures will only increase the likelihood that the top for this
cycle is already in place.

 

India is widely assumed to be in the midst of an industrial boom but its
official data suggests that a fairly abrupt slowdown has been taking place
in recent months.

Annual growth in Industrial Production slipped to 4.4% in April, well below
consensus estimates of 5.5%. Since this is very volatile data we like to use a
6 month ma to smooth out random fluctuations, and this clearly shows an abrupt
decline to 4.3% compared to a reading of 15.6% in April 2010. This places the
pace of Industrial Production well below the level of local interest rates,
which in turn implies that it is getting increasingly difficult (and
unprofitable) for Indian corporations to fund expansion via the issuance of
credit.

The attached chart uses the 10 year Indian treasury rate to illustrate this
point (since the Indian yield curve is now slightly inverted it would make
little difference if we used alternative maturities). At the current yield of
8.26%, the incremental gains from average national industrial growth lags the
cost of debt service by almost 4%, even before the additional spread for a
corporate borrower is taken into account. In other words Indian monetary policy
is becoming increasingly onerous for the industrial sector, at a time that
industrial growth has already slipped into a worrying torpor. Nevertheless with
inflationary pressures remaining the main focus of the central bank it
seems unlikely that monetary relief will be forthcoming. Although the
local SENSEX index has fallen 10.9% so far in 2011 and the BSE Small cap
index -14.3%, further decline still seem likely in the months ahead. -
D-INPIINDY_Index.gif -

Friday's very poor non-farm payroll data delivered another blow to the
Citigroup Economic Surprise index (CESIUSD) which assigns a large
weighting to this particular report. As a result the CESIUSD fell to
-117.20, a level last seen in late December 2008. Thus according to this
simple measure, data released over the last 90 days has been approximately
as disappointing (when compared to prior consensus) as anything seen in
the post-Lehman collapse. The more reliable 10 week ma is still somewhat
higher at -33.22, but this will continue to fall sharply simply due to
positive data dropping out of the average. On the other hand the daily
index is likely to start to recover fairly soon, if only because economic
consensus is now being trimmed across the board.

Although it is very hard to directly compare daily readings for different
data-cycles it is reasonable to claim that the last few weeks have seen a
lot of very sub-par economic data released. Fortunately, on the whole the
last few weeks have been punctuated by data that has proved to be mediocre
when it was expected to be excellent. This is a great deal better for
market behavior than data that was expected to be bad and proved to be
worse (as was the case in Q4 2008).

One broad measure of the market's response is the Bloomberg Financial
Conditions Index (BFCIUS) which combines bond spreads, swap spreads and equity
volatility measures to give a sense of disturbance or calm in financial markets
(we used this indicator a great deal during 2008 and 2009). As can be seen on
the attached chart, this index has remained comfortably positive throughout
the collapse in data, with the exception of a brief period in March (when
the VIX spiked briefly above 30). This is in marked contrast to the "data
panic" of last summer, when a much more marked deterioration in the BFCIUS
index took place. By and large investors have been much more patient with
the current period of poor data, and outside of the financial sector,
which arguably is a "special case" due to its regulatory headwinds,
equities have drifted lower while credit markets have remained mostly well
bid. We would generally expect to see some more disturbance before a
corrective phase has been completed (and do not expect this episode to be
any different), but the resilience of US financial markets thus far does
indicate some underlying strength that is worth considering. -
W-CESIUSD_Index.gif - D-BFCIUS_Index.gif -

New guidelines from Fitch regarding their treatment of Sovereign Debt
restructuring. These are perhaps a little tougher than would be expected, with
even a "voluntary exchange" representing a "default" if the new securities are
deemed to be issued on less attractive terms than the original. Ratings
agencies such as Fitch do not typically determine the treatment of exchanges by
CDS issuers but they are potentially an influence over this process. It will be
interesting to see if the other 2 major credit agencies follow suit in the
coming days.

The May non-farm payroll report capped off a very poor weak for US
economic data (the Citigroup Surprise index was at -90.90 even before this
release) with total increases to payroll estimated at 54K, well below
consensus estimates of 165K and April's elevated 232K (revised slightly
lower from 244K). Private Sector payroll changes were estimated at 83K,
compared to consensus of 170K and Aprils' reading of 251K. To cap matters
off the unemployment rate (which we care little about but has undeniable
headline appeal) rose to 9.1% from 8.9%. We have been using a 12 month ma
of Private Sector payroll growth to follow the current cycle (since this
removes the distortion of last year's census) and this metric shows a lack
of progress but not an actual deterioration. At its current level of
144.6K, it is lower than we would have hoped to see but still well ahead of
the dismal consensus in place 12 or 18 months ago (red dashed line).

Meanwhile as poor as today's data may be it is still not exceptional for a
single month in an expansion to see a report of this manner. For instance
February 2004 (43K), July 2004 (47K) and November 2004 (64K) were all
notably weak reports that had commentators prematurely announcing the end
of the US recovery. What the data will do, however is accelerate the
process of economic revision, with estimates of US growth being forced
significantly lower across the board. As damaging as the process may be
for asset values, it has surprisingly little to do with the actual ability
of corporations to generate revenue. We had expected US data to worsen
several weeks ago and that we would become mired in a corrective phase,
today's data merely confirms this process is reaching its peak, but gives
little guidance as to the exact path that will be followed. By then end we
would expect consensus to be unrealistically pessimistic and for certain
portions of the equity market significantly undervalued. - M-NFP_PCH_Index.gif
-

Turkey's May CPI report confirmed our suspicions that this is an economy
dangerously close to running out of control. Prices surged 2.42% in the
month, the largest single month's increase since October 2008. This took
the annual CPI rate up to 7.17%, well above consensus estimates of 5.69%
and the target of the central bank. Even though we would admit that some
of the pressures from food prices may prove to be temporary it seems
fairly clear that Turkey's inflationary cycle is in the midst of a
powerful upswing. Furthermore it should be recognized that this is an
economy that has had a CPI as high as 73.2% as recently as 2002 (caused by
a collapse in the Turkish Lira). In other words this is not a society that
has forgotten the perils of an inflationary spiral, making inflationary
expectations a much more powerful force than for many other emerging markets
that last had a brush with hyper inflation 20 or 30 years ago.

The current "do little" monetary polices of the local central bank, and in
particular its reticence to raise interest rates, are risking a break in
confidence for local capital markets. Thus far participants have proved
surprisingly patient with Turkey's deteriorating data. This does not mean
that they will remain so should data continue down its current path.
Typically there comes a point at which the risks are seen to outweigh
rewards leading to an abrupt outflow of capital and a rapidly depreciating
currency. At that point it becomes extremely hard for a local central bank
to restore order and confidence, even if local interest rates are forced
rapidly higher. It is our belief that the risk of such an episode is
growing in Turkey at the current time. - D-TUCPIY_Index.gif -

The attached article (in which we are quoted) is a good summary of the state of
the emerging market credit cycle. We continue to expect this to be a source of
considerable woe during the second half of 2011.

The ISM Manufacturing survey for May continued the recent run of US macro data
shortfalls. The overall index (black) came in at 53.5, the lowest reading since
September 2009 and well below consensus estimates of 57.1 and April's reading
of 60.4. Coming on top of this morning's ADP number we can expect to see a
considerable increase in "economic angst". Nevertheless, May's ISM data does
not point to a slowdown in economic activity, but perhaps it does signal the
end of the period of remarkable acceleration for manufacturing activity
following the devastating draw-down of 2008/9.

At 53.5 the overall index is still signaling a comfortable expansion and
although we would like to see the index settle somewhere above 55 in the months
ahead, May's reading is acceptable on a stand-alone basis and is equivalent to
the level of this index for most of 2005-2006. Perhaps the worst data in this
month's report came from New Orders (red), which showed flat growth at 51.
Again several months at this sort of level would be cause for concern but a one
month reading following some of the strongest months on record merely indicates
a stabilizing of New Orders following several months of unusually rapid growth.
Production (blue) showed a more moderate decline to 54, which is still
comfortably positive. More encouragingly the Inventory (olive) data remained
low at 48.7, suggesting that it may be capacity constraints that are causing
the moderation in production growth. Finally the employment metric stayed
strong at 58.2, which is important give the weakness of other employment
metrics.

Our initial take on this data is that it falls well short of a slowdown, but
may indicate that the expansion of manufacturing activity may be moderating to
a more normal pace after the sharp "V" shaped recovery in 2009 and 2010. -
ismmay2011.gif

As most readers will be aware US macroeconomic data has been fairly poor
since the middle of March with a series of misses for employment data
(this morning's ADP payroll report being the latest example) being at the
heart of the deterioration. What is interesting to our eyes is how
resilient the overall US equity market has proved to be in the face of
this data, which is a marked change in behavior from that of a year ago.

If we use the Citigroup Economic Surprise Index (CESIUSD) as a guide to
the quality of recent data (the methodology behind this index has many
flaws but at least they are consistent) we can see that yesterday's
reading of -71.4 was actually lower than any reading seen last summer. The
10 week ma of the index (see weekly chart) has fallen to -12.22 and while
this is still somewhat higher than last summer's low point at -40 it is
only a matter of time until this is surpassed given that the strong
positive data from March is now dropping out of the calculation. This
suggests that although the last few weeks of data have been better in
absolute terms than that of one year ago they have actually been more
disappointing when compared to consensus.

The response of the overall US equity market on the other hand could not
have been more different. From April to August last year each down-tick in
macro-data was matched by a decline in the SPX index (see daily chart),
with both the CESIUSD and SPX indexes bottoming at the end of August and
then climbing rapidly together for the next 6 months. However, the collapse in
the quality of economic data since March has been greeted by little more than
a shrug by the overall equity market and the index is still up 1.42%
since the start of the quarter. This suggests that equity investors have
become much less macro-driven in recent months, but have instead taken
their cues from a more "bottom up" appreciation of what have been
excellent corporate earnings. Certainly one difference between the two
period is an absence of corporate hand-wringing this time around. Most
earnings statements last quarter were accompanied by decent guidance
whereas a year ago many corporations seemed to be unhealthily focussed on
using (what proved to be erroneous) macro data to guide investors.

It may of course simply be that the market's nerve has yet to crack, and
we would certainly allow for a greater corrective move than we have seen
in recent weeks. Nevertheless the fact that participants no longer seem to
follow macro-releases with the same alacrity is a change that is worth taking
into consideration at the current time. - D-CESIUSD_Index.gif -
W-CESIUSD_Index.gif -

ADP's Payroll report for May kept up the recent run of weak economic data
for the US economy, with new private sector hiring estimated as being a
mere 38K jobs compared to a consensus 175K new hires. There is no obvious
reason for such a shortfall and our belief that it will prove in time to
prove to be part of the volatile arc of data during this period of
expansion but coming at the tail of a number of other poor reports it is
likely to harden the belief that the US economic situation has started to
stagnate.

We remain resistant to this notion and believe that most economic data can
only be used to generate a sense of trend using longer term moving
averages (6 to 12 months). Used in this manner the ADP report shows
employment growing by 176K over the last 6 months and 120K over the last
12 months. Both these figures are similar to readings in the spring of
2004 (a period which included a very poor reading of 31.7K in January
2004). We would certainly accept that we have not seen the sort of acceleration
in emplyoment that we hoped to see a few months ago, but the pace of
improvement over the last few months has been sufficient to generate strong
corporate earnings and we do not expect this to change anytime soon.

Given that the more widely followed (but no more accurate) BLS
payroll data is released this Friday we would expect the ADP data to have
limited market impact, but a similar shortfall in the senior data would
prove quite unnerving for participants. - D-ADP_LEVL_Index.gif -