Coronavirus – The Hit To China and Asia

Coronavirus fears have become the dominant the driver of markets, threatening Chinese and Asian growth and fueling a rise in market volatility.  Global equities have largely bounced back since the initial shock waves, but vulnerability remains as the virus continues to spread (latest count 40,514 confirmed, 910 deaths) and the number of cases continues to rise.  China helped sentiment by injecting substantial liquidity into its markets (CNY 150bn in liquidity via 7-day and 14-day reverse repos, while cutting the rate on both by 10bp) but the economic impact continues to deepen.

Today is important for China’s industry.  Many companies open up after a prolonged Lunar New Year holiday though many are likely to remain closed.  The Financial Times reports that many are extending further, with for example Alibaba and Meituan extending to Feb 16 at the earliest.  Foxconn is reportedly not going to resume iPhone production in Zhengzhou, while some regions have told employers in hard hit cities to extend by a week or two.  This suggests that the economic hit is going to be harder in Q1 and for the full year.

The extent of economic damage is clearly not easy to gauge at this stage. What we know is that the quarantine measures, travel restrictions and business shutdowns have been extensive and while these may limit the spread of the virus, the immediate economic impact may be significant. While transport and retail sectors have fared badly, output/production is increasingly being affected. This may result in a more severe impact than SARS, at least in the current quarter (potentially dropping to around 4-4.5% y/y or lower, from 6% y/y in Q4 2019).

China’s economy is far larger and more integrated into global supply chains than it was during SARS in 2003, suggesting that the global impact could be deeper this time, especially if the economic damage widens from services to production within China. Worryingly, China’s economy is also in a more fragile state than it was in 2003, with growth already on track to slow this year (as compared to 10% GDP growth in 2003 and acceleration in the years after).

This does not bode well for Asia.  Asia will be impacted via supply chains, tourism and oil prices.   The first will be particularly negative for manufacturers in the region, that are exposed to China’s supply chains, with Korea, Japan and Taiwan relatively more exposed. Weakness in tourism will likely  be more negative  for Hong Kong, Thailand and Singapore.  Growth worries have pressured oil prices lower and this may be a silver lining, especially for big oil importers such as India.

Catching a falling knife

After a very long absence and much to the neglect to Econometer.org I am pleased to write a new post and apologise to those that subscribed to my blog, for the very long delay since my last post.   There is so much to say about the market turmoil at present, it is almost hard not to write something.

For those of you with eyes only on the continued strength in US stocks, which have hit record high after record high in recent weeks, it may be shocking news to your ears that the rest of the world, especially the emerging markets (EM) world, is in decidedly worse shape.

Compounding the impact of Federal Reserve rate hikes and strengthening US dollar, EM assets took another blow as President Trump’s long threatened tariffs on China began to be implemented.  Investors in countries with major external vulnerabilities in the form of large USD debts and current account deficits took fright and panic ensued.

Argentina and Turkey have been at the forefront of pressure due the factors above and also to policy inaction though Argentina has at least bit the bullet. Even in Asia, it is no coincidence that markets in current account deficit countries in the region, namely India, Indonesia, underperformed especially FX.  Even China’s currency, the renminbi, went through a rapid period of weakness, before showing some relative stability over recent weeks though I suspect the weakness was largely engineered.

What next? The plethora of factors impacting market sentiment will not just go away.  The Fed is set to keep on hiking, with several more rate increases likely over the next year or so.  Meanwhile the ECB is on track to ending its quantitative easing program by year end; the ECB meeting this Thursday will likely spell out more detail on its plans.  The other major central bank that has not yet revealed plans to step back from its easing policy is the Bank of Japan, but even the BoJ has been reducing its bond buying over past months.

The trade war is also set to escalate further.  Following the $50bn of tariffs already imposed on China $200 billion more could go into effect “very soon” according to Mr Trump. Worryingly he also added that tariffs on a further $267bn of Chinese goods could are “ready to go on short notice”, effectively encompassing all of China’s imports to the US.  China has so far responded in kind. Meanwhile though a deal has been agreed between the US and Mexico, a deal encompassing Canada in the form a new NAFTA remains elusive.

Idiosyncratic issues in Argentina and Turkey remain a threat to other emerging markets, not because of economic or banking sector risks, but due increased contagion as investors shaken from losses in a particular country, pull capital out of other EM assets.  The weakness in many emerging market currencies, local currency bonds and equities, has however, exposed value.  Whether investors want to catch a falling knife, only to lose their fingers is another question. which I will explore in my next post.

Equity flows to Asia surge

Equity flows to Asia have begun the year in solid form. Although not quite as strong as in 2010 the pace of recent acceleration in flows has been more rapid, suggesting that it will soon overtake the year to date inflows seen over 2010. In total Asia has registered around $4.955 billion in foreign equity inflows. Korea has received the biggest inflows at $2.4 billion followed by India $1.04bn and Taiwan $1.03 billion.

The Indian rupee (INR) has been a clear beneficiary of such flows while the Korean won (KRW) has also strengthened. I suspect that official resistance may have limited Taiwan dollar (TWD) gains but clearly the risk on start to the year has resulted in strengthening inflows and in turn stronger Asian currencies.

Unless there is a disaster in Greece or elsewhere in Europe next week there is little to stop the short term trend but I remain wary over coming weeks and am cautious about extrapolating this trend forward. Like in 2010 and 2011 equity flows began the year strongly only to drop over following weeks and currencies were not slow to follow.

Asian currencies vulnerable to equity outflows

Asian currencies are set to continue to trade cautiously. One big headwind to further appreciation is the fact that there has been a substantial outlook of equity capital over recent weeks. Over the last month to date Asian equity markets have registered an outflow of $3.3 billion in outflows. However, whilst Taiwan, South Korea, Thailand and India have seen outflows Indonesia, Philippines, and Vietnam have registered inflows.

The net result is that equity capital inflows to Asia so far this year are almost flat, a stark contrast from 2009 and 2010 when inflows were much higher at the same point in the year. The odds for further strong inflows do not look good, especially as the Fed ends QE2 by the end of June. While a sharp reversal in capital flows is unlikely, it also seems unlikely that Asia will register anywhere near as strong inflows as the last couple of years.

This will have a significant impact on Asian currencies, whose performance mirrors capital flows into the region. Almost all Asian currencies have dropped against the USD so far this month and could remain vulnerable if outflows continue. Given the relative stability of the USD over recent weeks and imminent end to QE2, the better way to play long Asia FX is very much against the increasingly vulnerable EUR.

The THB has been the worst performing currency this month but its weakness has been attributable to upcoming elections on July 3, which has kept foreign investor sentiment cautious. Thailand has seen an outflow of $812mn from its equity market this month. Polls show the PM Abhisit’s party trailing the opposition and nervousness is likely to persist up to the elections at least. THB weakness is not likely to persist over coming months, with USD/THB forecast at 29.2 by year end.

USD/KRW has been whipsawed over the past week but made up ground despite a continued outflow of equity capital over recent days. KRW has been particularly resilient despite a firmer USD environment and a drop in consumer sentiment in June. Next week the KRW will likely continue to trade positively, helped by a likely firm reading for May industrial production on Thursday. USD/KRW is set to trade in a 1070-1090 range, with direction likely to come from Greece’s parliament vote on its austerity measures.

TWD has traded weaker in June, having been one of the worst performing currencies over the month. USD/TWD does not have a particularly strongly correlation with movements in the USD or risk aversion at present but the currency has suffered from a very sharp outflow of equity capital over recent weeks (biggest outflow out of all Asian countries so far this month). Next week’s interest rate decision on Thursday by the central bank (CBC) will give some direction to the TWD but a 12.5bps increase in policy rates should not come as a big surprise. TWD is likely to trade with a weaker bias but its losses are likely to be capped around the 29.00 level versus USD.

Equity Flow Reversal Supports Asian FX

Asian currencies have rebounded smartly from their post Japan earthquake lows on March 16. The ADXY (Bloomberg-JP Morgan Asia Currency index) is now at its highest level since September 1997 reflecting a sharp rebound in capital inflows to the region. The performance of Asian currencies continues to correspond closely with the movement in capital flows.

Although almost all Asian equity markets have registered outflows so far this year (total equity outflows -$6.2bn), the trend is reversing. Over the past month there has been a major slowing in capital outflows for most countries in Asia whilst India, Thailand and the Philippines have actually registered sizeable inflows. South Korea is notable in that there has been a sharp increase in equity capital inflows over the past week.

Although there has been much focus on a rotation of capital flows out of Asia and into developed economies this year, it is worth noting that the pattern of equity flows in Q1 2011 has not been too different from that witnessed in the past couple of years. In both 2009 and 2010 equity outflows were recorded over the two (2010) or three (2009) months of the year before a reversal took place. This pattern looks like it is repeating itself.

Clearly the environment for Asian equity markets is not as supportive as it was last year given the belated tightening in monetary policies being undertaken by many central banks and prospects of an end to QE2 in the US. Whilst this will result in some reduction in capital flows to the region compared to last year, the overall outlook is positive. Easing risk aversion (our risk aversion barometer has already reversed all of its post Japan earthquake spike and is trending lower), positive growth outlook and maintenance of low US rates point to more inflows.

One currency in particular that will benefit is KRW, with a further drop in USD/KRW likely over coming weeks. KRW has already strengthened by around by around 2.7% since its post Japan earthquake low making it the best performing currency since then. Further gains are likely; a test of USD/KRW 1100 is on the cards in the short-term, with the year end target standing at 1050.

Why buy KRW? 1) Korea has registered the biggest improvement in equity capital flows recently, 2) KRW has been the most sensitive Asian currency to risk over the past month and therefore benefits the most as risk appetite improves, 3) Estimated Price/Earnings ratio for Korean equities looks cheap compared to its historical z-score according to our estimates. As a result our quantitative model on USD/KRW based on commodity prices, risk aversion and equity performance highlights the potential for significantly more KRW strength.

Global Themes

It’s definitely been a strange start to the year, with markets taking plenty of time to get their bearings. Some general themes have developed but none have provided clear direction. As a result, the path over coming weeks and months is likely to remain highly volatile and in this respect, currencies, equities and bonds will continue to see strong gyrations.

One theme that has been evident since the start of the year is an improvement in sentiment towards the eurozone periphery as hopes of an enlargement/extension of the European Union bailout fund (EFSF) have increased. This is a key reason why the EUR has strengthened this year although nervousness on this front appears to have returned over recent days (note the recent widening in peripheral bond spreads, drop in EUR and European Central Bank purchases of Portuguese debt). It seems that a lot of good news has already been discounted in relation to the eurozone periphery and now markets are in wait and see mode for the EU Council meeting on 24/25 March. There is a strong chance that eventually market expectations will prove overly optimistic and the EUR will drop but more on that later.

The second theme is global inflation concerns, driven by higher food and energy prices. Certainly this has had an impact on interest rate expectations and in some cases resulted in a hawkish shift in central bank language, notably in the eurozone and UK. Although European Central Bank (ECB) President Trichet has toned down his comments on tighter monetary policy compared to the more hawkish rhetoric following the last ECB council meeting, expectations for monetary tightening in the eurozone still look overly hawkish, with a policy rate hike currently being priced in for August/September this year, which looks way too early. The EUR has benefitted from the relative tightening in eurozone interest rate expectations compare to the US but will suffer if and when such expectations are wound down.

Elsewhere in many emerging markets the impact of higher food prices is finding its way even more quickly into higher inflation, forcing central banks to tighten policy. In Asia, the urgency for higher rates is even more significant given that real interest rates (taking into account inflation) are negative in many countries. China has accelerated the pace of its rate hikes over recent months and looks set to continue to tighten policy much further to combat inflation. In India, worries about inflation and the need for further monetary tightening have clearly weighed on equity markets, with more pain to come. Although not the sole cause by any means, in the Middle East and Africa higher food prices are feeding social tensions such as in Egypt.

Another clear theme that has developed is the improvement in US economic conditions. The run of US data over recent months has been encouraging, confirming that the economy is gaining momentum. Even the disappointing January non-farm payrolls report has not dashed hopes of recovery, with many other job market indicators pointing to strengthening job conditions such as the declining trend in weekly US jobless claims. Manufacturing, business and consumer confidence measures have strengthened whilst credit conditions are easing, albeit gradually. The US economy is set to outperform many other major economies this year, especially the eurozone, which will be beset with a diverging growth outlook between northern and southern Europe.

Although the US dollar has not yet benefitted from stronger US growth given the still dovish tone of the Fed and ongoing asset purchases in the form of quantitative easing, the rise in US bond yields relative to other countries, will likely propel the dollar higher over 2011 after a rocky start over Q1 2011. In contrast, the EUR at current levels looks too strong and as noted above, hopes of a resolution of eurozone peripheral problems look overdone. EUR/USD levels above 1.3500 provide attractive levels to short the currency. Other growth currencies that will likely continue to do well are commodity currencies such as AUD, NZD and CAD, whilst the outlook for Asian currencies remains positive even despite recent large scale capital outflows. The JPY however, will be one currency that suffers from an adverse yield differential with the US as US bond yields rise relative to Japan.

Econometer.org has been nominated in FXstreet.com’s Forex Best Awards 2011 in the “Best Fundamental Analysis” category. The survey is available at http://www.surveymonkey.com/s/fx_awards_2011

What QE2 means for currencies

The sweeping gains for the Republican party in the US mid term elections has sharply changed the political dynamic in the US, with the prospects of further fiscal stimulus looking even slimmer than before although the chances of the Bush tax cuts being extended have likely increased.

The onus is on monetary policy to do the heavy lifting and the Fed delivered on its end of the bargain, with the announcement of $600 billion of purchases of long-term securities over 8-months through June 2011.

Given the likelihood that the economic impact of the asset purchases is likely to be limited and with little help on the fiscal front the Fed has got a major job on its hands and $600 billion may end up being a minimum amount of purchases necessary for the Fed to fulfil its mandate.

The decline in the USD following the Fed decision is unlikely to mark the beginning of a more rapid pace of USD decline though further weakness over coming months remains likely. The USD remains a sell on rallies for now and an overshoot on the downside is highly probable as the Fed begins its asset purchases.

The bottom line is that the Fed’s program of asset purchases implies more USD supply and in simple economic terms more supply without an increase in demand implies a lower price. The USD will remain weak for some months to come and the Fed’s actions will prevent any USD recovery as the USD solidifies its position as the ultimate funding currency.

Nonetheless, with market positioning close to extreme levels, US bond yields unlikely to drop much further, and the USD already having sold off sharply in anticipation of QE2, (USD index has dropped by around 14% since June) those looking for a further sharp drop in the USD to be sustained are likely to be disappointed.

It is difficult however, to fight the likely further weakness in the USD even if turns out not to be a rapid decline. The path of least resistance to some likely USD weakness will be via the likes of the commodity currencies, scandies and emerging market currencies. There will be less marked appreciation in GBP, CHF and JPY against the USD.

The Fed’s actions will continue to fuel a rush of liquidity into emerging markets, particularly into Asia. This means more upward pressure on Asian currencies but will likely prompt a variety of responses including stronger FX intervention as well as measures to restrict and control such flows.

There have been various comments from central banks in the region warning about the Fed’s actions prompting further “hot money” flows into the region and even talk of a coordinated response to combat such flows.

This suggests more tensions ahead of the upcoming G20 meeting in Seoul. Assuming that at least some part of the additional USD liquidity flows into Asia, the implications of potentially greater FX intervention by Asian central banks to prevent Asian currencies from strengthening, will have a significant impact on major currencies.

Already it is apparent that central banks in Asia have been strongly using the accumulated USDs from FX intervention to diversify into EUR and other currencies including AUD and even JPY. Perversely this could end up exacerbating USD weakness against major currencies.

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