Long double-dip risk, short periphery credit risk

- Maintain an aggregate long through core credits – "A muddle-through as opposed to a double-dip remains our economists’ central scenario and we believe core credit spreads already discount much of the near-term downside in the economic data."
- Short periphery corporate credits – "With spreads on periphery sovereigns within striking distance of their YTD wides, we think the recent performance of several periphery credits with a strong domestic bias is overdone. We would short these against a basket of credits that are either geographically diversified or based in core countries."
- Long Italy over Spain – "The spread between Spain and Italy is now at its tightest level since May. While Italy may carry a larger public debt burden, we think Spain faces far tougher dynamics. As such, we’d position for renewed divergence in CDS."
- Long Main over Crossover – "Crossover has outperformed Main over the summer, but now looks less attractive. Upside in HY rests on a rather bullish default rate scenario and continued inflows to absorb supply. We reckon Main is better positioned to weather a prolonged period of low growth."
- Long CDX IG over iTraxx Japan – "iTraxx Japan has outperformed other CDS indices this year for no apparent fundamental reason. Technicals may be strong, but with the Japanese economy showing renewed signs of weakness, we’d rather be long the CDX IG here."
- Long $ bonds over € bonds – "With the drop in the basis swap over the summer, several cross-currency switches from € to $ have started to work again."
- Long European over US credit card debt – "The spread between European and US AAA card debt has narrowed over the last year, but still looks excessive when you consider how similar the fundamental characteristics are."

India: Time to sizzle

- Initiate BUYs on Ruchi Soya, KS Oils; reaffirm BUY on Wilmar "We think Ruchi Soya’s targeted growth, with its exposure to palm plantation and dominant position in soybean processing and edible oil refining in India justify a rerating. KS Oils is the market leader in mustard and capacity utilisation should help it capture further market share, and thus we believe the correction due to corporate governance concerns (post the recent tax raids) is overdone and the stock is looking attractive, trading at just 9.1x FY12F P/E. Wilmar, we believe, is a good proxy to the Indian edible oil market with a leading presence through its JV. We initiate coverage on the sector with a BUY on Ruchi Soya and KS Oils and reaffirm our BUY on Wilmar."
- We expect industry growth of 7% and branded sales growth of 25% "Indian edible oil demand is set to rise from 16mn MT now to 30mn MT by 2020F, more than China’s market size today, implying a CAGR of 7%. More importantly, with increasing quality consciousness, rising incomes and consolidation, industry experts suggest branded sales are likely to grow at ~25-30% over the next few years. Branded sales comprise only about 25% of the total edible oil market in India now, but may grow to ~60% of the market by 2015F, as per our estimates."
- Incremental demand will be imported and has to be met by palm "Domestic consumption is expected to outstrip production growth (~2.7%), implying imports must grow at a much faster rate (~15%) to fill the demand. As acreage opportunities are limited in other crops, most of this demand growth will come from palm oil (~20% CAGR). Thus the players with refining / upstream exposure to palm stand to gain market share and volumes, in our view."
- Consolidation is the theme, with few players dominating the market "Due to the recent financial crisis, several poor harvests and reduction in import duties on edible oil, a lot of small scale solvent extractors and refiners have closed down, or been taken over by larger players in the industry. We expect this to be an ongoing trend; as larger players have several key advantages, such as being able to sustain a price war, access to cheaper credit from MNC banks and markets, lower marginal cost of production, and possibility of backward integration."

Asia Result Season: Cracks Among the Consensus Favourites

- ASEAN did better than North Asia, Korea was the worst, Philippines the best — "Looking at the Q2/half-year results and ASEAN had more beats than North Asia. In North Asia, Korea disappointed (33.3% beat) while in ASEAN, Indonesia (48% beat) was the worst. Korea is a consensus underweight, and Indo, the top consensus ASEAN overweight now trading at 100% prem to the region on P/BV, could not manage to surprise. Japan also did well with 63% of companies surprising."
- The much-loved consumer sector failed to surprise, esp vs the likes of tech — "The consumer sector is now 3 stdev above mean valuations vs the market, a strong consensus overweight, and yet failed to surprise. Talk of expectations without surprises. Ex the Japanese consumer names, less than 50% of consumer stocks surprised. The under-owned and cheap sectors like tech or financials did much better and offer greater value. Top prize for surprises goes to the utilities."
- Follow through revisions post results have slowed — "This is to be expected now the low base effect has gone, as has much of the operating leverage. No surprise that for 2011 EPS forecasts are down to just 12%. The third year of the recovery is never a strong EPS growth year so no surprise there. In order to get operating leverage up again, we need to see a pick-up in capex. With capex to sales at a 20 year low, that’s not a big ask."

 

Commodity prices in the thrall of weather and economic sentiment

- "Commodities prices as measured by the CRB indices declined in August following two consecutive months of gains, but price action varied among subgroups and individual commodities. August's two main commodity price drivers were economic sentiment and the weather, which boosted certain commodity prices and suppressed others. Commodities are currently trading skittishly in response to volatile economic sentiment and unpredictable weather."
• "Crude oil prices declined under the weight of deterioration in economic sentiment. (Front-month WTI futures ended August at US$74.70/bbl, down from $78.95 at end-July.)"
• "Gold rose back above $1,200/oz against a backdrop of economic anxiety. (Spot gold ended August at US$1,246/oz, up from $1,169 at end-July.)"
• "Platinum continued to consolidate, edging downward in price. (NYMEX benchmark platinum futures ended August at US$1,523.50/oz, down from $1,576.80 at end-July.)"
• "Copper prices dipped but recovered on expectations of effective monetary easing. (LME copper ended August at US$7,442/t, up from $7,296.25 at end-July.)"
• "Zinc consolidated in a lateral range in sync with swings in economic sentiment. (LME zinc ended August at US$2,061/t, up from $2,022.50 at end-July.)"
• "Aluminum prices fell amid premium negotiations and deterioration in economic sentiment. (LME aluminum ended August at US$2,057/t, down from $2,173.75 at end-July.)"
• "Nickel prices softened as economic sentiment worsened. (LME nickel ended August at US$20,698/t, down from $21,146 at end-July.)"
• "Wheat prices initially rose sharply due to weather factors but retraced much of their gains. (CBOT wheat ended August at US$6.8575/bu, up from $6.615 at end-July.)"
• "Soybeans traded choppily, ending the month nearly unchanged in price. (CBOT soybeans ended August at US$10.10/bu, down from $10.12 at end-July.)"
• "Corn prices rose, lifted by inclement weather and increased demand for US corn. (CBOT corn ended August at US$4.3925/bu, up from $4.0675 at end-July.)"
• "Sugar prices rose again on anomalous weather. (New York sugar ended August at US$0.1932/lb, up from $0.1860 at end-July.)"

Lessons From Japan – Low Yields For Longer But Tail Risk Wider

- "Yield has been trending lower but the decline in implied vol is even more pronounced. As a result, the quality of carry (expected returns divided by implied vol) remains at very attractive levels."
- "We see a problem with tail risk. Implied vol tends to be more expensive vs future realized vols but it performs miserably when it comes to anticipating digital jumps or regime breaks."
- Conclusion – "We will buy duration on dips but look for cheap ways to own tail risk. In particular, we like buying OTM strangle or owning structures such as the progressive income locker."

The US and China look to be stabilizing

- "August releases in the US and China point to momentum stabilizing ..."
- "... as growth downshift continues across Europe and the rest of Asia"
- "Yen strength prompts further downward revision to Japanese growth"
- "COPOM revises neutral real policy rate lower, maintains holding pattern"

UK: Worse lies ahead

- "The economic and financial crisis of 2007-2008 triggered a deep recession in the UK. In 2009, GDP contracted by 4.9%, its sharpest post-war decline (see Chart 1). The British economy is emerging only very slowly from this recession, and is lagging about three months behind its main trade partners, the euro zone and the USA (Chart 2). In the fourth quarter of 2009, GDP grew by 0.4% q/q, after six straight quarters of contraction. By way of comparison, the 1973-74 recession in the UK lasted “only” three quarters and those in 1980 and 1990 both lasted five quarters (see Chart 3). Moreover, the main reason for the recovery in activity in the fourth quarter of 2009 lay in the slowdown in the reduction in inventories, with change in inventory accounting for GDP growth of 0.5 of a percentage point in that period. The acceleration of economic activity in the first half of 2010 (+0.7% q/q) came mainly from the strength of the manufacturing sector, the inventory cycle and global demand. However, the scale of the recession in 2008 is holding back recovery. According to the latest forecasts from the Bank of England’s Monetary Policy Committee given in its May 2010 Inflation Report, over the next three years production is likely to remain below the level it would have been but for the recession. On this point, estimates of the loss of production vary according to the model used. Thus the IMF 1 puts the average loss of production relative to the average trend at 10%, whilst the OECD2 expects a smaller fall, at around 2%. Meanwhile the Institute for Fiscal Studies3 puts the figure at around 7.5%, with the Treasury making a more conservative estimate of -5%. It is true that the contraction of the economy tends to be deeper and longer when it is accompanied by a financial crisis. Thus the fall in production is about twice the size after a financial crisis than in a standard recession."

Venture capital adds economic spice

- "Venture capital injects economic dynamism: An increase in VC investments of 1‰ of GDP is statistically associated with an increase in real GDP growth of 0.30 pp. Early-stage investments have an even bigger impact of 0.96 pp."
- "The direction of causality is not always easy to establish. Yet, tests for Granger-causality in the biggest market, the US, suggest that causality runs from VC-investments to growth. There is also substantial micro-evidence that supports this view."
- "Exuberances drive much of the correlation. Taking account of the dotcom boom and bust as well as of the financial crisis leads to lower coefficients."

FOMC Preview: Commitment Issues

- "The main consideration facing the Federal Open Market Committee when it meets on September 21 is whether to commit to a program of Fed balance sheet expansion. Recent economic data have given the FOMC time to postpone a decision on additional quantitative easing measures."
- "Two other stimulus options on the table are modifying the wording of the funds rate guidance in the FOMC policy statement and lowering the 0.25% interest rate the Fed currently pays on bank reserves. We expect neither to be adopted."
- "One change we do expect in next week’s policy statement is a subtle upgrade in the FOMC’s characterization of domestic economic conditions. The complexion of the economic data over the past three weeks suggests that the recovery is no longer slowing but is proceeding at a new, more subdued, pace."
- "Not much new is expected next week, but we suspect further action is coming in the next quarter or two. Given the likelihood that unemployment will remain unacceptably high for the foreseeable future, more quantitative easing is looking more and more like an agenda item for the Fed, whether it actually works to stimulate job growth or not."

Perspectives on the Japanese economy

- "The Japanese economy will not experience any noteworthy change in the next two years:
• Fiscal policy will stimulate household demand at least until next year. Although considered by the government, a sweeping tax reform (with VAT doubled in exchange for a cut in direct taxes) remains up in the air after the change in majority in the upper house. Without this reform, the deficit will widen further and drive the public debt towards 213% of GDP by 2012.
• Domestic savings will finance as usual this additional public debt, in particular corporate savings, and corporate debt will fall to 82% of GDP. Productive investment will admittedly increase, but far less than profits, which will be driven by substantial productivity gains.
• Population ageing will weigh negatively on residential investment, and positively on the unemployment rate. Nonetheless, the household savings rate will not decrease, as preference for the future remains strongly anchored in the behaviour of economic agents (real balance, substitution and Ricardian effects verified).
• Consumer prices will stop declining but nonetheless the country will not pull out from deflation (the GDP deflator will fall and the BoJ’s inflation target will not be met), and accordingly a tightening of monetary policy is unlikely.
• Such a growth regime (+1.3% of GDP in 2011; +1.7% in 2012) guarantees a stable and substantial current-account surplus (3% of GDP). Although desired by monetary authorities, the yen’s depreciation will therefore be jeopardised to a large extent. In view of the new Chinese exchange rate policy, an appreciation is actually far more likely."

Between a rock and a hard place

- "The euro area posted strong growth in Q2, but there are signs that the slowdown in the US and Asia is now beginning to be a drag on euro area growth. We project a slowdown with growth just below trend in the coming quarter."
- "Internal demand has started to gain strength, which makes the recovery less dependent on the pull from export markets. However, the recovery is not fully sustainable until we see declining unemployment and a stronger recovery in private consumption."
- "The unemployment rate has been stable at 10.0% since March. We project that unemployment will begin to decline soon albeit slowly, but this result is very sensitive to developments in labour-intensive sectors, such as construction."
- "The southern European debt crisis is not all over. Lower growth and higher spreads make a harmful cocktail. Targets are still achievable, but depend on reform willingness. Our primary concern is that public support for necessary reforms may falter."
- "The ECB is taking a pause on the exit path. The risk of an economic downturn has increased and the monetary analysis, which shows that loan flows have turned softer in recent months, does not support a more hawkish stance. We expect a first ECB hike in Q4 2011."

What happened at end-2009 and in early 2010?

- "At end-2009 and in early 2010, there was a drastic acceleration in global trade, which contributed to a significant recovery in industrial production and overall activity in exporting countries. To ascertain whether or not there will be a marked slowdown in global trade from the second half of 2010, we have to understand the causes of its very sharp growth from end-2009.
• was it due to permanent causes: economic recovery in OECD countries, sharp growth in emerging countries?
• or temporary causes; restocking after the substantial destocking in the aftermath of the Lehman bankruptcy?"
- "We show that in the United States, Japan, China, Asia and Latin America, imports increased much faster than what was justified by growth in demand excluding inventories, which indicates that they were linked to temporary restocking."

Slowdown, but no recession

- "The switch from an inventory-stimulus driven recovery to a demand driven recovery has proved tougher than expected, as job and spending dynamics remain weak."
- "In the coming quarters, growth will remain below par as the manufacturing cycle will slow and fiscal tightening will provide headwinds to final demand. However, the risk of recession is limited."
- "Economic growth will return to an above trend pace in 2011. Easy financial conditions, easier access to credit and pent-up demand will help the needed rotation towards more demand-driven growth."
- "Core inflation is expected to slow toward 0.5%, while headline inflation will move back into the 1.5-2% range. The risk of outright deflation remains relatively low."
- "Fed hikes have been postponed to H1 12 and the softer outlook increases the possibility of further Fed easing. Currently, we attach a 40% probability to the Fed resuming large scale asset purchases."

China banks: Stronger case for soft landing

- More concrete case for soft landing. "August macro data were encouraging. Two pillars of China’s economy, retail sales and industrial production, came in better than expected. Meanwhile, inflation remained manageable and looks set to decline in magnitude in 4Q10. China appears on track for a soft landing, and this bodes well for banks’ asset quality and earnings outlook."
- Bigger banks have less provisioning risk. "According to mainland press reports, banks may be required to hold provisions of at least 2.5% of total loans. This rumoured requirement will not impact the Big 4 banks, but will add provisioning pressure for smaller banks. We believe this requirement is too crude and unfair, since it does not consider NPL differences. Therefore, its implementation chances should be low. Nonetheless, we believe larger banks have better risk/return prospects amid this uncertainty."
- Turning slightly more optimistic. "We maintain our view that banking stocks will remain range bound in 2H10. Yet, given the encouraging August data and upcoming rights issues from the large cap banks, we believe banking stocks can trade towards the upper end of their ranges. Our top picks are large caps CCB and ICBC. We like CCB as it should be next in line to issue rights in October. Meanwhile, ICBC is a good laggard play, especially after the bank’s stellar 2Q showing."

China banks: Margin and maturity for 2010

- NIM: “the only hope” for positive surprises? "H-share banks reported a strong set of 1H10 numbers, with 20-60% YoY bottom line growth, and continued improvement in asset quality and net interest margin. Looking ahead, we believe sector loan growth should stabilize at ~19% for 2H10 and decelerate in 2011, while NPLs and credit costs are both at low levels with high upward risks. Thus, any positive earnings surprises should be mainly driven by NIM. We analyzed various drivers of banks’ NIM, and concluded that the room for sequential margin recovery is very limited."
- Quantifying the key NIM drivers "H-share banks’ NIM recovered by ~31bp on average from 2Q09 to 2Q10. Based on our analysis, the shift from discounted bills to non-bill loans was the biggest contributor for small banks’ NIM recovery (15-25bp), while the higher LDR helped NIM by ~10bp at BOC, CMB, and BoComm. Longer loan maturity, shorter deposit maturity, better loan pricing, and recovery in treasury yield also boosted margins, though to a lesser extent."
- Expect margin to peak and stabilize "The margin drivers appeared to be running out of steam for 2H10. Discounted bills as % of sector loans was flattish in the past 2mths (-0.2ppt), and may start to rebound as credit demand weakens. LDR in 2H10 should be lower than in 1H10. The maturity mismatch of sector loan-deposit rose to record high levels, and is facing the risk to reverse. Large banks’ margin should be largely stable in 2H10, while CNCB and MSB could suffer margin decline due to the time deposits they gathered in end 2Q10. CMB’s NIM is the most volatile, which may continue to rise in 3Q10, but is vulnerable to any decline in discounted bill yield."
- 1H10 results recap "The big two state banks continued to lead on profitability, provision buffer, and capital. Joint-stock banks enjoyed higher NIM than large banks, but lagged on profitability, due to their relatively low fee income and high operating costs. Loan growth was in line with regulatory guidance, with the property sectors being a key growth driver. NPL ratio reached record low level and credit costs declined further. CMB and MSB appeared tight on core capital, despite their recent capital raising."
- Uninspiring stock performance YTD, watch October "H-share banks' stock prices performed in line with the markets YTD. Most banks traded flattish (except for ABC and CNCB), and the performance converged. We reckon investors are attracted by China's macro story, the banks’ strong balance sheets, and undemanding valuation. Nonetheless, confidence in earnings is low due to the policy risks and asset quality concerns. We believe late October could mark the next milestone, when we may get better clarity on provisions on LGFV l oans, any new property tightening measures, and margin trends in 3Q10."

China banks: We don't expect CBRC to ask for maximum countercyclical capital buffer in possible new capital norms

- "Possible China version of Basel III. 21st Century Business Herald reported CBRC is considering China version of Basel III including capital, liquidity and leverage ratio requirement. Potential new capital requirement include a minimum core tier-1 ratio of 6%, tier-1 ratio of 8% and CAR of 10%. Banks important to the system may need 1% additional capital. In addition, CBRC may ask for a counter-cyclical surplus CAR in the range of 0-4%. System-important banks would need to achieve this by 2012YE while others would need to comply by 2016YE."
- "Capital and liquidity norms are already very good in China: By international standards Chinese banks already have one of the best liquidity ratios and one of the strongest deposit funding. The existing capital ratio (common tier-1 ratio at 9.5% post rights offering to be completed in the next 6 months) is also well above the global BASEL III requirement. Post the announced equity issuance which is scheduled to be completed by 1Q11, tier-1 equity to assets is at 5% or above. Meanwhile, capital structure is simple, with no hybrid tier-1. We also see room to further boost CAR by about 2.5ppt purely through tier-2 debt (capped at 25% of tier-1 capital)."
- "Further big capital raising unlikely to be accepted by other key government entities. A potential capital deficit depends on the level of counter-cyclical surplus capital requirement. We however believe it’s unrealistic for CBRC to ask for a 14 % CAR, since this means over Rmb1trn capital raising, which we think would be an impossible amount to raise. Moreover, further big capital raising is unlikely to be supported by other key ministries. If CBRC asks for up to 13% CAR for the state-controlled banks, and 12% for other banks, and still allows tier-2 debt to be 25% of tier-1 capital, then we think there will still be limited equity shortfall as capital shortfall may be covered by tier-2 debt issuance."
- "Surplus capital is linked to excess loan growth under Basel III. We think it’s misleading to add maximum surplus capital buffer to mini requirement at all times. The original Basel paper (16 July) shows surplus reserve is linked to credit cycle or credit multiplier (namely credit growth/normal GDP growth). As we expect credit growth to further slow and credit growth/normal GDP growth at 1-1.2x in the next 2- years, we don’t think CBRC will ask for 15% CAR which is based on maximum surplus capital."
- "Stay defensive, policy risks prevents re-rating. Despite solid operating performance, we agree policy uncertainty is looming. While policy risks may not lead to material earnings or ROE impact and may not even be realized, investors do not like uncertainty. In view of the regulator’s “interventionist” approach, together with what can at times be a noisy cynical media and public calling for “social service”, investors may be unwilling to pay higher multiples. We advise investors to stick with bigger banks whose earnings and ROE may be more resilient to policy risk.."

China banks: Medium-term structural challenges

- China Financials Forum: Addressing medium-term structural challenges, opportunities "We hosted the Caixin China Financials Development Forum featuring policy makers such as NDRC/PBOC/CBRC/CIRC on Sept. 9, and the GS/Gao Hua China Financials Corporate Day on Sept. 10 to discuss interest/exchange rate reform, LGP loan risks, property tightening, insurance sector growth / regulation, rural finance and land reform outlook, and consumer protection."
- Interest rate reform: A med.-term challenge, not an imminent risk "Speakers highlighted the need to accelerate interest rate and exchange rate reform in the light of current negative real deposit rates. Key takeaways: 1) interest rate reform is a medium-term challenge for banks, but likely a gradual process rather than an imminent risk; 2) some NIM pressure on big corporates and mortgage loans is inevitable, but should be mitigated by: SME/other corporate loan/deposit spread rise; China’s already relatively low NIM vs. EM countries (e.g. Brazil, Indonesia, India, Turkey); and China banks’ low P/B vs. current ROE, which has partly discounted NIM decline risks, in our view."
- LGP loans: Not a systemic risk, but long-tailed on fiscal reform "Speakers underlined the rich resources, assets, and revenue collection rights of many Chinese local governments, but pointed out potential NPLs from highly leveraged LGPs. Municipal debt issuance will not happen for a while."
- Property tightening: Commercial property less a risk for now "Speakers believe commercial property risk is not a big issue so far given its early stage of sector development, low portion of rental vs. ownership, and property tax applied to reduce speculation, etc."
- Rural finance: Rural housing land reform to be trialled "Speakers believe rural finance should be viable given the high pricing power if risks are well managed. We believe rural housing land reform (piloted in rich areas) could have a significant positive impact on farmers’ personal wealth, consumption and financing activities."
- Insurance: Carefully managed pricing deregulation process "Speakers are positive on the growth potential of insurance. They believe regulators will maintain tight control on solvency margins, and life product pricing deregulation will be carefully managed to avoid any negative impact."

The coming surge in food prices

- "The surge in commodity prices in 2003-08 was the largest, longest and most broad-based of any commodity boom since 1900. The prices of energy and metals surged the most, but it was the agricultural market that saw the most fundamental change. It may not take much of a disruption in food supply to trigger another surge in prices given that the dynamics have become a whole lot more uncertain as a result of new and some increasingly powerful influences acting on both sides of the food supply-demand equation. Indeed, droughts this year in Russia and Kazakhstan and severe flooding in Pakistan and China have sent global wheat prices higher, while meat and sugar prices have hit 20-year highs, despite lacklustre growth in many of the advanced economies."
- "We expect another multi-year food price rise, partly because of burgeoning demand from the world’s rapidly developing – and most populated – economies, where diets are changing towards a higher calorie intake. We believe that most models significantly underestimate future food demand as they fail to take into account the wide income inequality in developing economies. The supply side of the food equation is being constrained by diminishing agricultural productivity gains and competing use of available land due to rising trends of urbanization and industrialization, while supply has also become more uncertain due to greater use of biofuels, global warming and increasing water scarcity. Feedback loops also seem to have become more powerful: the increasing dual causation between energy prices and food prices, and at least some evidence that the 2007-08 food price boom was exacerbated by trade protectionism and market speculation."
- "We assess how a steep secular rise in food prices can affect the macro economy and financial market prices, and we explain how the impact could be devastating for poor countries that import most of their food and spend a large share of personal incomes on food. Such countries may experience: a sharp decline in GDP growth, a surge in CPI inflation, worsening fiscal finances, higher interest rates, a depreciating currency and widening credit spreads. On the other hand, rich countries that are large net exporters of food could benefit."
- "We construct the Nomura Food Vulnerability Index (NFVI), providing a summary ranking of each of the world’s 80 largest economies, in terms of their exposure to another food price surge. NFVI identifies Bangladesh, Morocco, Algeria, Nigeria, Lebanon, Egypt and Sri Lanka as the most vulnerable to high food prices, while at the other extreme are New Zealand, Uruguay and Argentina. We use NFVI to quantify the impact of the 2007-08 food price surge, by comparing the 25 most vulnerable and 25 least vulnerable economies. We find that the most vulnerable group would indeed experience relatively weaker GDP growth, significantly higher CPI inflation, worsening fiscal positions, higher policy rates, widening credit spreads and widening government bond spreads to US Treasuries."
- "In terms of fixed-income strategy, we recommend using a combination of structured products – to buy a basket of agricultural commodities – and relative basket trades – in rates, FX and CDS spreads. We recommend paying 2y interest rate swaps of the 10 countries with the highest exposure to food in their CPI basket against receiving the 10 with the lowest. The impact on FX is more clouded, but we expect owning a basket of currencies selected from those with the lowest exposure to food in the CPI basket and most likely to experience an improvement in terms of trade against a basket of the opposite to be profitable. We use the NFVI in combination with a starting debt-to-GDP threshold to buy CDS protection on those sovereigns most likely to see fiscal deterioration against those least likely to. Trades in the inflation-linked space are limited, but we believe there is value in buying European inflation breakevens against US BEIs."
- "In the equity space, the total market capitalisation of the food sector is tiny compared to that of, for example, financials or property. However, while the investment universe may appear limited, investors ought also to consider companies involved in the shipping and storage of soft commodities, seed and fertilizer producers, and those that produce farm machinery, tractors and irrigation systems. Equally, we would suggest investors consider timber and other industrial soft commodities. We highlight four companies that we believe stand to benefit the most from rising food prices within the Asia ex-Japan region: China Agri-Industries (606HK Buy), China Yurun Food (1068 HK, Buy), United Phosphorous (UNTP IN, Buy) and Wilmar (WIL SP, Buy)."

The Widening Growth Gap

- Emerging Markets and the Global Economy in the Month Ahead "Fears of a double-dip recession and the risk of deflation in the US have risen appreciably in past couple of months. Although our own baseline forecast has not yet moved that far after accommodating recent economic data releases, the downside risks have clearly increased. However, we have been of the view that the main threat to EM decoupling is a credit-crunch-driven sharp growth deceleration and that EM growth (and assets) would continue to outperform otherwise. Recent asset price performance reinforces our view. Since valuations are now less compelling, however, we have narrowed long positions in selected Rates, FX and Credit markets"
- EM Rates -- The Last Drop "We examine whether EM rates have become more sensitive to global drivers and identify those curves which could still benefit from US rates falling further. While most curves would benefit under this baseline scenario, not all will fare equally under risk scenarios. We examine behavior under "double dip" and a mean-reverting "old normal" highlighting the risks in (long-end) Brazil and Turkey. On the other hand, while many of the other curves are similar in terms of exposure to USTs, individual factors lead us to favor curves where further cuts cannot be ruled out (Mexico and South Africa) or risk-adjusted carry still appears high (Poland)."
- EMFX: Protection in Risk Reversals "The combination of unusually low betas and flat risk-reversals (RRs) suggests that we could see a double-whammy of overshooting in both spot and skews should macro data deteriorate. We hence look at defensive risk-reversals in EMFX in currencies where the hedges have highest payout ratios and the currency betas retraced the most."

- Opportunities in Sovereign Credits "We remain constructive on the performance of EM sovereign credit despite our baseline scenario of lower UST yields, as we believe strong inflows will continue to more than offset the negative impact of lower UST yields on credit spreads. We also present our country-specific views on the major sovereign credits and discuss trading opportunities within each of them."

- Revisiting Financial Condition Indices in Latin America "We update our estimates of financial conditions indices in Latin America. The indices include not only real interest rates but also other financial indicators. Our findings suggest that financial conditions in Colombia and Mexico are rather loose, while those of Argentina, Brazil, Chile and Peru are closer to neutrality."

- The Local Markets Analytics Package (LMAP) Expands to Asia "Two years ago we launched our Local Markets Analytics Package (LMAP), covering six local markets in EMEA and two in Latam. We are delighted to now announce the biggest enhancement to the package, with the inclusion of ten Asian local markets, taking the total tally of markets covered to 21. In this article we present an updated guide to the LMAP, building on the original guide from 2008, but with additional material to address some of the questions we have received from readers over the past two years."

Countervailing Forces

- "The latest growth scare appears to be running its course, despite lingering obstacles to a strong rebound. Although financial conditions are providing uneven support for recovery, at present they do not signal further downgrading in recovery’s prospects, especially at its core in consumer spending."
- "Recent signs that consumer spending is on a 2% growth track reflect key tensions in the outlook. Cyclical support from pent-up needs and reviving income are pitted against structural drags associated with balance sheet rebuilding and limited credit access."
- "A flurry of new fiscal policy proposals to support recovery underscores an element of uncertainty weighing on economic decision making. In the current environment, expensing of certain business investments would not likely alter the outlook much. Nonetheless, the new focus on tax policy could be an early sign that an undesirable fiscal drag on 2011 may yet be headed off."

Scenario for 2010-2011: a slowdown is not a meltdown

- "Our scenario rules out the eventuality of a double-dip recession in the US. But while we have always defended the idea of sluggish post-bubble growth, the 3% growth that has been forecast for the US seems over-optimistic. Featuring a downward revision to 2% over the next two years, our new scenario sticks closer to the idea of a sluggish growth rate."
- "It to see how Europe will be able to repeat its fine growth performance achieved in the first half of the year. Against a backdrop of a global slowdown, a soft landing is more likely for the second semester of 2010. We are forecasting annual growth of around 1.5% for the eurozone this year and next."
- "As part of the changed US scenario, we have shifted the timetable for the Fed’s first rate hike to Q1 2012. With growth topping out at 2%, unemployment should prove sticky, which may prompt the Fed to bide its time."
- "The ECB, however, could make its move earlier, as it is in a hurry to normalise liquidity conditions and return to key rates that are more in line with this forecast recovery, however sluggish it may be. We are forecasting a target 1.5% for the minimum bid rate by year-end, with a first move coming in September 2011."
- "There is also talk of normalisation in the bond markets once fears of a new US downturn recede. We are still forecasting a rise in the risk-free rate (from 2.75% for the German Bund and 3.10% for US 10-year paper to respectively 4.0% and 3.80% in December 2011), but the lacklustre recovery and absence of inflation are likely to restrict this upward trend."
- "Once the markets have factored in the idea that the US will see a smooth slowdown, the dollar is likely to regain some of its lost ground. EUR/USD parity should return to its equilibrium level of around 1.22 by end-2010 moving to 1.15 by December 2011."

The outlook for US government debt

- "US net debt has risen fast during the recent recession, to more than 60% of GDP from 36% in 2007. Compared with other OECD countries however, this level is not alarming. Rather, it is the outlook for US debt over the next decade and beyond that is worrying." 

- "Under the President’s current budget proposal the budget will be in continuing deficit throughout the next decade. This will push net debt to 90% of GDP by 2020. Additional fiscal tightening is thus needed to stabilise debt." 

- "The scope for additional fiscal tightening is limited in the short term and largest beyond 2014. A broadly growth-neutral fiscal policy from 2014 onwards would be enough to bring net debt to 60% of GDP by 2020."

Making credit beta work for real: Scaling index risk to information

- "Credit beta – long-only index exposure – appears to deliver little in the long term. What we think works far better is adjusting index exposure between long, short or flat based on slow-moving changes in macro-credit conditions. This is because index returns in the future are semi-predictable based on information available in the present. Nomura’s Credit Scorecard offers a mechanism to benefit from this predictability. The Scorecard has not outperformed a long-only index in every period of time and will not in the future. But it has offered compelling outperformance in the medium term."

Trading Places X

- "The notion of trading markets can last well over a decade. Markets are typically range bound following major economic booms and busts as was seen in the US during the 1930s and 1970s or in Japan in the 1990s. Thus, this past decade’s post tech bubble bursting market and economic phenomenon should not be surprising nor considered unusual and is not necessarily part of a new normal construct, but rather a very old normal repeating itself. Indeed, such patterns can last longer than many investors want them to and it may be more critical to consider the catalysts for change in the future."
- "Several conditions may need to be met for a renewed secular bull market. After the 1930s equity market debacle and the Great Depression, people became so disenchanted with stocks and the financial system that it took high dividend yields to entice investors back into equities. While possibly shocking to some who are unaware of market history, dividend yields fell below Treasury bond yields only after the late-1950s such that stocks were viewed as income producing assets and were not purchased for capital gains. The clear discomfort with equities currently may demand the rise of the dividend again though tax treatment is uncertain."
- "Budget deficit reduction plans and evidence of their implementation are required. Given the explosion of the US debt burden without even considering the demographic pressures that will drive health care spending higher in coming years, it would seem that the investment community may insist on some real proof that the government will deal with these issues in a responsible manner. Since such approaches may prove politically unpopular, it could take another couple of election cycles to convince a wary populace."
- "Technological innovation often has generated opportunity. Throughout US history, a strong entrepreneurial spirit matched with the profit incentive inherent in capitalism, enforced legal protections and personal liberty has provided the fodder for invention and innovation which then blossomed into growth opportunity. The most obvious potential can be detected via the need for a much larger mobile broadband network given the likely penetration of smart wireless devices by 2013 and their insatiable consumption of bandwidth, which is already being strained presently."
- "A growing group of baby boom echo Americans will enter their saving years by 2013. While many pundits focus on aging baby boomers and their desire to supposedly shift assets away from volatile equities into allegedly safer fixed income vehicles, they ignore the baby boomers’ children whose population growth (albeit at a slower pace than witnessed for their parents) suggest a new segment of society that will be saving for retirement beginning in roughly three years. This crucial dynamic is often left out of the demographic debate."

Trend Growth Trending Down

- "We conclude our analysis of trend growth determinants in a selection of euro area countries and find that, beyond a likely lower contribution from labour input, capital accumulation growth is also likely to slow down in coming years in those countries most badly hit by the financial crisis."
- "With major improvements in total factor productivity growth unlikely, the growth decomposition analysis suggests trend GDP growth is likely to significantly decelerate in all peripheral euro area countries in coming years."

Basel III – A government bond friendly latest and potentially final draft

- "Over the weekend the Basel Committee on Banking Supervision released its latest – and potentially final – draft proposal for the forthcoming Basel III solvency and liquidity framework. Both the solvency and liquidity frameworks have been watered down from the original proposals released last December, but are stricter than many had expected. From an interest rate market perspective, the overall conclusion is that the latest Basel III proposals are highly positive for government bonds: i) Banks are still required to accumulate a liquidity buffer primarily comprising government bonds; ii) While banks now face less immediate pressure to reduce short-term wholesale funding, the trend towards higher funding costs, wider lending rate spreads and lower “neutral” policy rates remains intact; iii) The decision to delay the implementation of the Leverage Ratio removes one potential constraint on the current asset allocation into government bonds by OECD banking systems."

Credit Shows Some Improvement but Challenges Remain

- "As with the economy in general, improvement in the credit environment continues, but credit indicators are mixed and the situation remains challenging. The overall loan delinquency rate fell in the second quarter, with all loan types seeing declines from the prior quarter. Some delinquency rates are even down from the prior year, most notably for credit cards. While residential delinquency rates remain far above year-ago levels, the year-over-year difference has come down markedly. Even the much beleaguered commercial real estate sector saw a decline in delinquency rates."
- "Mortgage rates are at all-time lows. While this has led to a resurgence in refinancing, applications to purchase a home remain very low. Thus, while those who are refinancing their mortgages are benefiting from reduced mortgage payments and huge interest savings, those who want to buy a home are either not taking advantage due to concerns about further price declines, or cannot take advantage due to tighter credit standards, lack of a job or lack of equity in their homes."
- "While banks have become more willing to lend, terms and conditions are still tight, and there are differences between large and small banks. Large banks have eased many terms and conditions, while small banks continue to tighten. Standards for prime mortgages have loosened, but banks are still reporting weaker demand for consumer loans, albeit at a lower rate."
- "Consumer credit outstanding at commercial banks finally expanded slightly in the second quarter from the first, but remains below year-ago levels as some consumers have paid down debts and others remain hesitant to take on new debt amid persistently high unemployment and continued weakness in the housing market. Another important factor in the year-over-year contraction is the surge in bank charge-offs, which have quadrupled over the last four years."
- "In the second quarter, the upward trend in personal bankruptcies continued amid high unemployment and the ongoing housing malaise, but business bankruptcies, after a few quarters of declines, edged up as well. Business bankruptcies had declined recently as firms shored up their balance sheets and reported stellar profits. But the rebound in business bankruptcies suggests the business environment remains challenging, which does not bode well for strong job growth in the near future."
- "Although the stabilization in housing has helped to restart consumer spending, the pace of spending growth remains historically sluggish. We believe the housing market will remain moribund which, along with the decline in credit and lack of job growth, suggests consumer spending will not provide much fuel for near-term economic growth. Further adding to our weak spending outlook are historically low consumer purchasing plans. Plans to buy an auto, a home or a major appliance remain in the doldrums. The brief improvement in the spring was largely due to the optimism created by the homebuyer tax credit. However, we were skeptical that the pace of spending seen in the spring was sustainable in part because purchasing plans and income expectations remained severely depressed."
- "The mixed signals emanating from the credit environment suggests we still have a ways to go."

How can we explain the fact that some OECD countries are returning to their pre-crisis growth?

- "Most OECD countries will post far lower growth in 2010-2011 than before the crisis, due to deleveraging, deindustrialisation, the slowdown in wages, etc. But in 2010-2011, some countries are returning to a level of growth that is similar to their pre-crisis growth: Canada, Sweden, Australia."
- "How can this be explained? At first sight, we can think of:
• the fact that some countries benefit from being commodity-exporting countries;
• the fact that in some countries, the maximum indebtedness constraints have not been reached, and that credit can continue to increase;
• some countries’ capacity to generate substantial exports to highgrowth countries, without, for all that, weakening domestic demand; this may possibly be associated with an exchange-rate depreciation
policy;
• the lack of a need for a sharp reduction in fiscal deficits;
• keeping a large manufacturing sector."
- "We show that the following factors are significant:
• the size of commodity exports;
• households’ capacity to continue to run up debt;
• for Australia, the size of exports to emerging countries;
• exchange rate depreciation;
• the lack of a need for a sharp reduction in fiscal deficits"

European sovereign debt concerns back in spotlights

- "As concerns about a US ‘double-dip’ have eased somewhat, European sovereign debt concerns started to attract attention again last week (p.2, p.3 & p.4)."
- "This week’s focus is on US retail sales tomorrow and CPI inflation on Friday, on the German ZEW index tomorrow, and on UK CPI inflation tomorrow and the labour market report on Wednesday (p.2, p.3 & p.4)."
- "The Chart of the Week shows government bond yields of Portugal, Ireland, Greece and Spain. Many names have been used to describe the crisis that already started more than 3(!) years ago. At first, the term subprime crisis was used, but quite rapidly it was called a liquidity, credit and/or bank crisis. Since late last year/early this year, the term sovereign debt crisis has often hit the headlines. Clearly, these are all different kinds of crises, but at least they all appear to be caused by too much debt. As such, concerns about the fiscal situation of the so-called euro zone periphery countries will probably not really fade as long as debt/GDP ratios are high and even increasing, despite the European rescue packages. In fact, the rise of government bond yields of especially Portugal, Greece and Ireland over the last weeks reminds us somewhat of the start of this crisis in 2007 when subprime RMBS spreads widened, thereafter tightened as markets thought that the worst was over, but unfortunately widened again to even higher levels etc. Also over the last few months, yields continued to drift higher, but this remained more or less out of the spotlights as (mainly US) ‘double-dip’ fears dominated. Let’s hope that history will not repeat itself, but we are not convinced that the euro zone periphery countries are out of the woods yet."

What prospects for balance sheet adjustments?

- "The deterioration in the balance sheet situation of households as well as companies is the principal cause of the crisis. As long as the balance sheet adjustments (rebalancing of debts and assets) are not over, we cannot hope for a return to normal in the economies."
- "We look at the state of the balance sheets and to what extent they have been adjusted in the United States, the euro zone and the United Kingdom."
- "The correction in excess debt relative to assets can be done either passively via a fall in real interest rates or via a rise in asset prices, or actively via a rise in savings used to deleverage and rebuild wealth, and by a decline in investment."
- "We can see that the balance sheet adjustment is mainly carried out via a rise in savings and a fall in investment in all countries. It is only in the United Kingdom that real interest rates are low."
- "This adjustment is therefore costly in terms of growth, and also slow (2 - 3 years or even more in the euro zone)."

China appears to be regaining strength

- "On Saturday China released economic data for August which exceeded expectations across the board. While GDP growth could still slow to below 7% q/q AR in Q3, the data released on Saturday suggest the Chinese economy is now bottoming out and is poised to improve in Q4."

- "In Q2 and Q3 growth has been pulled lower mainly by weaker construction activity and inventory cuts. We expect construction activity growth to remain substantially below trend well into 2011 as fiscal stimulus gradually unwinds. Private consumption increasingly looks like China’s new growth engine, although demand for consumer durables has temporarily slowed following the explosive growth last year. Inventory cuts are easing and this should add to growth in the coming quarters." 

- "Export growth has so far been resilient and China’s trade surplus has again improved above USD20bn on a monthly basis. However, we expect the trade surplus to decline in the coming quarters as exports to Europe and the US lose some momentum and China’s import growth improves." 

- "The impact on the property market from the government’s regulatory tightening now seems to have been less than expected. House sales started to recover in August and the expected large drop in property prices has so far failed to materialize." 

- "We do not find the increase in inflation in August from 3.3% y/y to 3.5% y/y alarming. With GDP growth currently below trend, inflationary pressure is easing; we expect inflation to peak in September and decline close to the government’s 3% target by the end of the year." 

- "The Chinese economy currently appears to be very close to where the Chinese government wants it. Hence, we do not expect any major policy adjustments this year. However, we still believe China is in a tightening cycle and, while interest rate hikes are probably off the table for the rest of this year, further regulatory tightening targeting the property sector looks increasingly likely." 

- "This latest economic news has made us more confident that China remains in a tightening cycle. In addition, exports have remained resilient, the trade surplus has improved and the effective CNY exchange rate has actually depreciated since China formally abolished the USD peg in July. With the political focus in the US returning to China’s exchange rate policy, we still expect CNY to appreciate." 

- "While, alone, signs of a soft landing in China should be reassuring for commodity markets, it is important to stress that the composition of Chinese growth now is less commodity friendly, because construction (and temporarily durable consumer goods) is growing below trend."

The immaculate recovery

- "Seems like every time you turn around lately someone in the G3 is falling over. Earlier this year it was Europe: the Greek debt crisis spread across the continent, sovereign spreads rose and, in shades of Autumn 2008, libor-OIS spreads headed wider too. Belt tightening became the order of the day. Growth forecasts were lowered. Market sentiment soured."
- "None of this could be good for Asia, which, after all, exports as much to Europe these days as it does to the US. The region’s central banks, which had begun to tighten monetary policy in March, paused in May and June. No surprise; discretion is the better part of valor. But they resumed their hikes in July and August. Why? Because Europe wasn’t holding back Asia’s V-shaped recovery or its rapidly accelerating rate of inflation like they thought it might."
- "A handful of hikes in half a dozen countries later, it’s the US’s turn to take a spill. GDP growth drops to 1.6% (QoQ, saar) in 2Q10 and fears of a double-dip consume the markets. The Fed makes a symbolic shift back to strict neutrality and, rather than assuaging markets, only convinces them the sky is falling. Private sector hiring, still barely positive, drops to 67k in August from 107k in July."
- "None of this looks good for Asia either. The region’s central banks – still far behind the curve in normalizing interest rates – will once again put tightening on hold. They will, once again, wait to see how things pan out. And they will, once again, resume tightening in very short order."
- "By December, most of Asia’s central banks will be hiking rates again and we expect their ranks will, by then, include China and Indonesia, Asia’s two key holdouts so far (though Indonesia did raise reserve requirements by 300bps at one go last week, a move that’s probably equivalent to two 25bps rate hikes)."
- "How can Asia’s central banks push ahead with monetary tightening when the Fed is discussing QE2 (additional long-term bond purchases)? More to the point: why isn’t trouble in the US and Europe killing Asia’s recovery?"
- "The short answer is: the US and Europe did not contribute to it. Or very little anyway. If you only thrown a nickel into the pot, taking it back out again doesn’t change much."

- "Take a look at the consumption plots on the previous page. It’s important because consumption is the final demand that drives all other final demands, like investment or imports. At the end of the day, consumption drives global growth, period. And who is doing the driving? Asia. Almost by itself."
- "In the two years since Lehman Brothers imploded, consumption in the US has gone absolutely nowhere – it still has not returned to precrisis levels. Ditto for Europe. Ditto for Japan. But compared to precrisis (3Q08) levels, consumption in Asia is up by 18%."
- "Eighteen percent? Hold on a minute. This is Asia – the place that everyone said had to consume more. The place that could only save and could only export. The place that could not possibly grow unless the US was growing because the US was doing all the buying."
- "Yet there it is. Zero buying in the US. Zero buying in Japan and in Europe. And a boatload of buying in Asia. It’s the immaculate recovery – the thing that everyone said could never happen. The pregnant Asian shopper standing next to an utterly superfluous US, JP and EU."
- "That’s why Asia’s central banks will be back in tightening mode soon – because Asia’s recovery is not about the US. It’s about Asia. And there’s nothing fishy and certainly nothing religious going on here. The hard fact and simple arithmetic (that we’ve shown regularly over the past 4-5 years) is that Asia has been growing rapidly for years and, after a few decades, it adds up: Asia is no longer too small to matter. Among other things, this means Asia can and will consume whether the G3 does or not. And it means Asia’s monetary policies will depend more on what happens here in Asia and less on what happens elsewhere in the world."
- "Still, something doesn’t add up. Much of this report (below) argues that Asia is finally starting to slow down. If so, why will central banks start hiking again?"
- "Because Asia’s slowdown is being driven – or, rather, constrained – by the supply side, not by a slowdown in demand. Asia’s V-shaped recovery and double-digit GDP growth over the past 4-5 quarters have exhausted the excess capacity that used to exist. When that happens, output growth starts to fall and inflation starts to rise."
- "Asia may be slowing on the margin but central banks will have a tougher time dealing with inflation, not an easier time. And if the Fed (counter to expectations) goes ahead with QE2, Asia’s tightening will become all the more difficult. And all the more ‘ironic’."

Regulations will change, banks will change

- Capital adequacy level to be announced soon — "We think an announcement regarding the Basel III capital adequacy standard and transition period will come early next week. We expect a detailed outline early in October, at which time we intend to issue an amended report."
- Significant revisions — "International agreements on banking regulations, hammered out in Basel, undergo major revisions in roughly 10-year cycles. This round (Basel III) will likely change the framework of banking regulations more than ever before."
- Restrictions on leverage — "In addition to capital quality and volume requirements, regulations where risk assets are the denominator will necessitate securing an additional capital buffer when the economy is recovering. Simple leverage (not based on risk weights) will also need to be made sufficient, so it will become harder to increase capital efficiency via leverage."
- Stabilizing financing — "New regulations regarding liquidity will be added, which will look at whether banks 1) are fully prepared for a short-term capital outflow and 2) can maintain stable financing over the long term. We think Japanese banks are in a relatively good position, but European banks may have to shrink capital to meet numerical targets."
- Road to final proposal — "BIS already detailed some supplementary proposals (capital buffer) and palliative measures (items deducted from capital, etc.) based on discussions regarding the consultative document released in December 2009. After the Basel conference in September, the G20 will agree on a framework in November, with the final proposal to be inked in December."
- Impact on banking sector — "We think major banks and major regional banks in Japan have more or less finished preparations for stricter regulations. However, with scope for leverage-based operations limited, bank capital ratios are likely to fall globally."

On a knife’s edge

- "A flow of disappointing news – particularly in the US – has led us to revise down our global growth expectations. Focus will probably continue to be on the US where the economy is expected to balance on a knife’s edge between recovery and another downturn. Double-dip fears are likely to be an ongoing theme for some time."
- "We now have below-consensus forecasts for US growth at 2.6% and 2.3% for 2010 and 2011 respectively – a downward revision of around one percentage point in both years compared with our June forecasts. We look for the economy to grow by 1.5-2.0% in H2 10 before recovering gradually during 2011. The main risk is that the economy gets stuck at a low growth level. We see the risk of a new recession as very low."
- "In Euroland, activity surprised strongly on the upside in Q2 10, leading to an upward revision of our 2010 growth expectations. We have probably seen the peak, though, and we see the economy growing more in line with the long-term trend at around 2% in 2011 as the export engine loses some steam. Our forecasts for Euroland continue to be above consensus."
- "The Asian economy surprised on the downside during the spring, leading to a downward revision of our growth expectations for 2010. However, we expect Asia to recover during the coming quarters."
- "Inflation is expected to remain subdued and policymakers in G3 will continue to focus on supporting growth. We see a 40% probability that the Fed will start another round of quantitative easing (QEII). The ECB is expected to keep rates on hold throughout most of 2011. Chinese policymakers are sidelined but we expect tightening to resume in 2011."

Emerging Shale Plays Alter Landscape

- Natural Gas Price Outlook — "We are revising our 2010 composite spot natural gas price forecast to $4.50/MMBtu from $4.75/MMBtu. Although a cold start to the year and a record-hot summer helped to tighten the supply/demand balance, continued rig efficiency improvements and a strong pace of capital outlays has driven domestic production to higher levels than originally forecast. For 2011, and assuming normal weather, we are revising our forecast to $4.25/MMBtu from $5.75/MMBtu. Even though we are assuming a 15% drop in the domestic gas rig count by the end of next year, with difficult yr/yr weather comps, the supply/demand balance appears looser than this year. We are reducing our “normalized” price to $5.50/MMBtu from $6.25/MMBtu because we believe that significant running room still lies ahead in numerous North American shale plays, providing acceptable returns at $5.50/MMBtu and yielding ample supply to meet demand for at least several years ahead."

- Glimmer of Hope in 2012? — "Given our current projections, 2012 provides perhaps the first glimmer of hope wherein total U.S. natural gas production peaks in the third quarter of next year at the same time that drilling to hold acreage begins to abate. Hence, our $5.50/MMBtu forecast beginning in 2012 and going forward."
- Longer-Term Oil Price Outlook Unchanged — "We are lowering our 2010 WTI spot oil price forecast to $78.20/Bbl from $81.00/Bbl. Our 2011 and normalized price forecasts remain $85.00/Bbl and $80.00/Bbl, respectively."
- Adjusting estimates and price targets — "Based on our revised commodity price outlook, we have adjusted earnings, net asset value and price targets for our coverage group. On average, we have lowered 2010 EPS/CFPS estimates by 11%/4%, for 2011 by 27%/18% and for 2012 by 13%/26%. Proven reserve NAV estimates have dropped, on average, by 10% while price targets, on average, are now 7% lower."
- Continue to Prefer Oil-Leveraged Names — "Overall, we continue to have a greater proclivity for the more oil-leveraged names. Our top picks are APC and APA."

Still swings in mood next week

- FI Strategizer: "A clear trend for USTs is unlikely to emerge given the light calendar and a cautious investor stance ahead of the September 21 FOMC meeting. In the EMU, the Greek T-bill auction and news on Irish banks should be the main drivers putting pressure on periphery spreads."

- EU Portfolio Strategy: "Just as the double-dip discussion lost steam, another round of credibility erosion moved center stage, although a clear Bund yield rally did not emerge. We return to a modest long duration stance to benefit from renewed uncertainty."

- MM: "Excess liquidity has stabilized in the EMU as shown by the recent 1W and 1M auctions. Portuguese and Greek data show that borrowing at the ECB has not eased in August after the stress test results."

- Trade Idea (I): "The Portuguese curve has cheapened vs. swap at the 15Y and offers an interesting switch with Ireland. Our Z-score system also suggests switching from the BTP Apr15 into the SPGB Apr15."

- Trade Idea (II): "The 10/30Y spread in the UK trades close to all-time highs and has recently started to tighten. We expect the recent trend to gain momentum, also thanks to a slowing in inflation."

- Supply Corner: "There is no liquidity next week, while gross supply should be EUR 25/30bn, with almost an auction per day. 68% will come from core countries, the remaining will come from Italy and Spain. Keep an eye on Tuesday's Greek T-Bill auction (EUR 0.9bn of 26W T-bills)."

- FX Strategizer: "Safe-haven currencies (i.e., JPY, CHF & USD) should remain favored as long as global uncertainty persists. Next week's data are unlikely to cause direction-setting impulses, but large swings should prevail in the medium term too, preventing the formation of clear trends."

- EUR: "We do not expect heavy EUR-USD losses over the next couple of weeks, but we don’t rule out a retest of 1.25-1.20 in the coming months, if EMU worries escalate. A recovery up to 1.30-1.35 may occur only in late 2011, when the ECB starts its tightening process."

- JPY: "The JPY should stay strong and BoJ intervention, if any, may at best contain its rise. A weaker JPY may occur only from 2Q11 onwards, if risk appetite resumes, but USD-JPY is unlikely to rally above 90-95."

- CHF: "The SNB meeting on Thursday will be a crucial test, but we won’t be surprised if EUR-CHF slides to 1.27-1.25 before December. This will limit the room for a pullback in 2H11 that won’t exceed 1.30-1.35."

- GBP: "Cable should be dragged down towards 1.52-1.50 if risk aversion persists and we don’t see great upside potential towards 1.60 before the end of 2011. EUR-GBP should stay locked within the 0.80-0.85 band."

- Pacific Rim: "The three dollars shrugged off risk aversion, but we would handle their strength with care. A more sustained rally may resume in 2H11, when interest rate spreads may offer stronger support in the wake of a less uncertain global scenario and a weaker JPY."

- Nordics: "EUR-SEK and EUR-NOK will fall towards 9.15-9.10 and 7.65-7.60, respectively, but attacks and retreats will remain the theme. Book squaring may weigh on the SEK ahead of the September 19 elections."

Alternative Energy

- We see a rebound in clean energy investment in 2010F …• "Of the total US$177bn pledged towards investment in renewable energy and energy-efficiency measures by governments worldwide, only 14% was utilised in 2009. According to New Energy  inance (NEF), nearly 68% of the clean energy stimulus spending will be in 2010 (35%) and 2011 (33%)."• "We expect government support for clean energy to continue in 2010F and 2011F."• "Total new financial investment in clean energy grew 31% y-y to US$27.3bn in 1Q10 from US$20.8bn in 1Q09, according to New Energy Finance."

- … but performance of clean energy stocks has been divergent…• "performance of clean energy stocks, especially solar, has been lacklustre YTD, owing to several factors"
1) "Uncertainties over government subsidy plans"

2) "Looming cuts in feed-in tariffs (FIT)"
3) "Difficulties in raising funds for renewable energy projects"

- … nevertheless, countries across the world remain committed to clean energy technologies.• "G-20 countries account for more than 90% of total clean energy investment"• "Over the past five years, their investments in clean energy have grown more than 5x"

- Latest industry trends and key investment themes• Market:
1) "Global new energy end-market demand growth is shifting from Europe to Asia and the US, with wind power continuing to be the technology of choice, followed by nuclear, biomass and solar."
2) "We believe the changing nature of Europe and Japan as a manufacturing and technology location in the broader global sector context, while outsourcing to lower-cost Chinese manufacturers, should increase, owing to pressure on ASPs and margins along the value chain."
3) "Renewable energy as a challenge and opportunity for other sectors."• Policies
1) Short term — "FIT or other financial incentives are critical to trigger demand growth."
2) Long term — "National portfolio standards play a significant role in promoting renewable energy, sustaining its growth and attracting investments."
3) "China, Germany and the US have a higher probability of emerging as market leaders in clean energy technology."

• Solar:
1) "Subsidy cuts in European countries should lead to increased outsourcing to China; this should benefit Chinese solar players such as JA Solar, LDK and Renesola, which have exposure to non-brand OEM businesses."
2) "Strong growth in solar end demand, along with solar companies’ focus on cost leadership and efficiency to maintain profitability amidst falling ASPs, should lead to strong order inflows for European solar equipment manufacturers, such as SMA Solar and Centrotherm."• Wind:
1) "We find Chinese wind turbines component manufacturer CHST in a sweet spot, as it should benefit from the company’s strong position in China, as we expect China to remain one of the top wind countries, and have great export potential due to its impressive cost competitiveness."
2) "European wind turbine players, such Vestas and Gamesa, should benefit from their diversification of manufacturing base outside of Europe as it would help them to meet customers’ demands more effectively."
3) "Europe will be the main growth driver of the offshore wind market and we expect the global offshore market to grow 113% y-y in 2010F and 111% in 2011F. The offshore wind segment will be the next growth driver for the Chinese WTG market as attractive locations for onshore wind farm development have already been exploited. Potential beneficiaries are Vestas and Repower in Europe and Sinovel, China High Speed and Goldwind in China, in our view."

• Nuclear:
1) "New build in Asia is set to be dominated by China, India, Japan and Korea, while that in the rest of the world is likely to be more widely spread."
2) "However, ex Asia, three countries stand out as having significant new build aspirations over the next 15 years. They are Russia, where we see 16 GW of capacity additions, the US (12GW) and the UK (10GW)."
• Key beneficiaries:
1) Solar: JA Solar, Yingli, Wacker Chemie, SMA Solar, Centrotherm and Ulvac;
2) Wind: China High Speed, Vestas and Gamesa;
3) Nuclear: KEPCO, EDF, GDF Suez, E.ON, Toshiba Plant Systems & Services, Hitachi, Toshiba Corp, Tokyo Electric and Kansai Electric;
4) Geothermal: Energy Development Corp.

Offshore drilling in very deep water

- "Big Oil has had a terrible year so far. The explosion on 20 April that killed 11 men and sent BP’s Deepwater Horizon drilling rig to the bottom of the Gulf of Mexico set off an environmental, commercial and political firestorm that may take years to extinguish. The catastrophe raises uncomfortable questions
about the offshore oil and gas sector’s operational safety standards, about the regulatory frameworks within which it works and, by no means least, about the insatiable demand for energy that increasingly is sending exploration companies into more difficult and potentially hazardous territory."

Japan: Stocks unlikely to move off their bottom until year-end at the earliest

- Severe deterioration in market sentiment points to bottom for share prices: "Sentiment on the Japanese equity market worsened markedly between August and early September, and many signs evident in previous phases where Japanese stocks fell to lows came to the fore again. The September QUICK survey of stocks indicated a severe deterioration in stances on both the portfolio weighting of Japanese equities and the economy/corporate earnings among equity managers at Japanese institutional investors."
- Recession unlikely: "We think the Japanese economy is highly unlikely to fall into recession between now and the end of 2011. The focus of market concerns about the global economy is on trends in the US economy once policy stimulus is withdrawn. However, in both Japan and the US, business managers have recently been reining in capital expenditure and employment as they take a cautious view of the economic outlook. In the past, both countries have tended to fall into recession following capex adjustment. With companies curbing capex, we see little possibility that either economy will enter a recession given the current absence of surplus capacity."
- Earnings estimate revision index likely to bottom in late 2010 or 2011 Q1: "Reflecting the building sense of economic slowdown of late, the earnings estimate revision index for Japanese companies has been falling. We think this index will need to bottom out before Japanese equities can form a major bottom from which to rally. We see late 2010 as the earliest timing for such a move, and think the most likely timing will be 2011 Q1. Critical to this are developments on the monetary and fiscal policy front, especially with the US economy expected to remain anemic through end-2010. Whether or not Bush era tax cuts will be allowed to expire as initially planned at end-2010 merits particular consideration. Another key issue is global inventory adjustments in the electronic parts and devices industry. Trends in this industry are closely watched as a leading economic indicator, as they often reflect marginal changes in the global economy. The industry's inventory/shipment balance has worsened recently, and looking at the past 10-year average cycle we think the balance will continue to deteriorate until around March or April next year."
- Investment strategy: "In view of the above, we project that Japanese equities will form a major bottom from which to rally from late 2010 onward. With share prices at or near lows, however, we do not recommend lowering portfolio beta values. To raise portfolio beta value, we continue to recommend trading companies and construction machinery manufacturers, and from this month we also include automakers. We believe trading companies and construction machinery manufacturers will benefit from an expected alleviation of concerns about Chinese economic slowdown. For automakers, we expect the market to react to excessively steep share price declines owing to negatives such as yen strength and the end to eco-car subsidies."

Lower debt yields should drive confidence

- "Firms have taken advantage of falling corporate bond yields and investor demand to issue new debt; this should support equities and global business confidence"
- "The improvement in financial conditions should help the Fed to proceed with a steady policy on September 21"
- "Political developments are likely to be significant during the next few weeks as EU countries complete their 2011 budgets, and with the focus on US mid-term elections and the forthcoming DPJ President election in Japan"
- "With the contribution of net exports to GDP growth swinging back again in China's favour, FX-related tensions could re-emerge"

Regional Implications of China’s Wage Inflation Part 1: Reshaping the Regional Production Chain

- China’s wage inflation could alter the wage cost rankings within Asia1 — "Wages of unskilled labour in China may accelerate 15-20% in coming years from 10- 15% over the past decade, further eroding China's relative cost advantage. Out  of twelve Asian economies, China has risen from being third lowest in terms of hourly manufacturing wages in 2000, to being the sixth highest currently."
- China’s wage “catch-up” may reshape the regional production chain — "While the relocation of labour intensive activities could benefit lower cost regional economies, strong incentives exist for firms to retain production within China, including the large domestic end-market and China’s diverse array of cost structures which effectively allows it to replicate the pan-Asian production network within its own borders. Moreover, to the extent that it incentivizes higher wage coastal regions to automate and shift towards higher value added production, China’s coastal regions may over time compete more directly with Asian NIEs which compete on technology rather than low cost."
- Relocation in electronics and low tech; catch-up in capital intensive sectors — "Our Revealed Comparative Advantage (RCA) analysis identifies the activities where China has a comparative advantage in production, the activities that are likely to relocate, as well as the likely winners and losers of this reconfiguration. Low tech sectors aside, we think labour intensive activities within E&E production, including telecomms and household appliances, may see greater pressures for relocation out of China or into inland provinces. More capital intensive sectors where China has the greatest scope for catch-up include chemicals, autos, pharmaceuticals and semiconductors."
- MY, TH winners in med/high-tech, JP, KR, SG potential losers — "Within the medium and high tech space, Malaysia (electronics, high-tech consumer goods) and Thailand (electrical, autos) could benefit, especially in labour intensive areas. Korea and Japan (autos, machinery, high-tech consumers), Singapore (electronics, pharmaceuticals, non-road transport, high tech consumer goods) and India (metals, non-road transport, pharmaceuticals) could face greater Chinese competition in capital intensive sectors, as higher Chinese wages spur automation and technological/productivity catch-up."
- IN, ID, VN, Cambodia, Sri Lanka to gain from relocation in low tech space — "Within the low tech space, there are few losers given limits to automation. By becoming relatively cheaper, countries with marginally lower RCA scores than China would potentially benefit. For garment/textiles, India and Indonesia are bigger beneficiaries, while Vietnam could gain in low-tech consumer products. Bangladesh, Cambodia and Sri Lanka with currently higher RCA ranking vs. China would continue to hold comparative advantage in low-tech production."

$175bn+ of balance sheet headroom by 2011… but can they resist another cycle of overpriced M&A?

- A prolonged period of supernormal free cash flow "By the end of 2011, we forecast balance sheet headroom of over $175bn for the UK-listed mining sector. In the last cycle, over exuberant M&A destroyed value for shareholders. The past few weeks have seen three potential acquisitions in the sector (BHP/Potash Corp, Vedanta/Cairn India and ENRC/Camrose), and we do not like any of them. In the current cycle, we think investors should favour those companies most likely to return excess capital. We highlight Rio Tinto and Antofagasta here."
- Pushing out the commodity price peak "We have pushed out our assumed cyclical peak for commodity prices and mining industry earnings to 2012, in line with Nomura's view for a modest recovery in OECD economic growth. In specific cases, we have increased our medium-term commodity price forecasts to reflect worsening supply lags (mainly copper). We continue to forecast the majority of excess cash to be generated from copper, iron ore and coking coal exposure, and our new commodity price forecasts remain the most bullish versus consensus for these commodities."
- Valuation and top picks "Rio Tinto (Buy, TP £59) remains our top pick, driven by iron ore exposure and a renewed discipline to M&A after overpaying for Alcan. We retain our negative view on BHP (Reduce, TP £23), and we downgrade our recommendation for ENRC (Reduce, TP £9.5) from Buy previously. We reiterate our positive view on the miners with valuations still undemanding. However, we also recognise the additional risks (political, fiscal and M&A) that an environment of high free cash flow brings, and we have widened the spread of discount rates applied to our NPV valuations across the sector."

The International competitiveness of the Turkish economy: some stylised facts

- "In the first quarter of 2010, the scale of the recovery in the Turkish economy caused some surprise, with GDP growth of 12% year-on-year, against an average of just 2% for the four countries of Central Europe (Poland, Hungary, Czech Republic and Slovakia) and a further contraction in GDP in Eastern European countries (Bulgaria, Romania). In the second quarter, on the basis of trends in industrial production, the gap between Turkey and Central and Eastern European countries narrowed significantly. However, Turkey, which has emerged swiftly from recession, gives the impression of being an economy that whilst vulnerable to the international environment is more solid than its European neighbours."
- "The budget deficit is likely to be lower than in all Central and Eastern European countries apart from Bulgaria in 2010 and probably again in 2011, with the return to growth and the increase in the exchange rate helping reverse the snowball effect(1). Moreover, although unemployment is still higher than it was before the recession, it has eased since mid-2009 (which is not the case for other Central and Eastern European countries). Lastly, underlying inflation remains under control at below 5%."
- "Thus the Turkish economy displays satisfactory macroeconomic fundamentals. In addition, both the
banking system and businesses withstood the recession well. Lastly, the trade balance remains the economy’s Achilles’ heel, and it could worsen if the 2011 elections led to a relaxation of control over the budget."
- "In fact, in June 2010, the current account deficit was nearly $21bn, cumulatively over the first six months of the year, or nearly three times the Chart in the same period of 2009. As a percentage of GDP and over the full year, it remains modest at around 4% of GDP, compared to 5.6% on average between 2005 and 2008, but not far off the alert threshold, which is generally set at 5% of GDP. Does the Turkish economy suffer from competitiveness problems? The purpose of this article is to identify some of the factors that will help answer this question. In the first section we will examine the usual aggregate indicators: apparent and structural trade balances and price competitiveness indicators. We
complete our analysis by summarising the main trends in the structure of international trade in goods and in the country’s share of export markets (part II) before drawing our conclusions."

China’s Struggle with Capital Flows

- Opening up capital accounts in China may exaggerate excess liquidity near term — "Recent measures by China to encourage outbound investment likely aims to alleviate excess domestic liquidity and to help diversify excess FX reserves. But as policy continues to support exports, the reserves would only become more excessive in coming years."
- USD assets have already been reduced sharply, further cuts difficult — "We update a study by Brad Setser on China’s reserves and US asset holdings. We found that USD’s share of China’s total FX reserve assets had fallen from 73% in end of 2008 to 58% in June 2010. USD’s share of new FX purchases has been cut to about 30%. Given that the US accounts for a majority of China’s trade surplus, it would be difficult to further reduce purchases of USD assets."
- China’s total FX assets already exceed $3 trillion — "After folding in FX assets on the books of the central bank and the rest of the banking system, we found an extra $566bn on top of the $2.454tn published by SAFE."
- FX reserves may continue accumulating at $250-300bn in the next few years — "The trade surplus is likely close to $200bn this year, at par with $197bn in 2009. We see the surplus staying at $150-200bn over the next couple of years. Moreover, net FDI and portfolio inflows could each contribute $50bn a year."
- Offshore RMB settlement may actually boost FX reserve accumulation — "When appreciation expectations are alive, businesses would pay for imports with RMB rather than use FX revenues from exports, which would be used to buy more CNY. The result is more CNY abroad and more FX in China’s reserves."
- Market implications — "China would likely still invest one third of new reserves in USD assets ($80-100bn a year), possibly favoring agency and corporate securities, as long as the recovery doesn’t falter. USD’s share of the total portfolio should still fall. Euro, EM and commodity currencies would likely pick up the bulk of the remaining new reserve accumulation. Investments in Japan could be risky with already expensive yen."
- Investing excess reserves would have international repercussions — "Exporting the massive amounts of liquidity could be destabilizing for smaller economies, potential for political friction. This issue would only grow as China reduces the weight of USD in its expanding portfolio."
- Overseas direct investment (ODI) and portfolio outflows face hurdles — "We do not doubt the potential for China to export capital, but ODI must overcome the state owned stigma to be more accepted abroad. QDII must overcome the poor performance stigma from the first batch of funds. Further privatization and financial market liberalization could help improve these conditions."

France: Can foreign trade be a growth engine?

- "During the last cycle, French growth was mainly - not to say exclusively - based on domestic demand, especially household consumption. While it has markedly - and permanently - weakened, it would seem that foreign trade has now taken over the role of driving force of activity. That is in any case what the latest national account figures suggest, excluding effects of changes in inventories, since France pulled out of recession in the spring of 2009."
- "For our part, we believe that French foreign trade has primarily benefited from a series of favourable and temporary factors, against the backdrop of a sharp pick-up in trade after the post-Lehman collapse in global trade. Insofar as structural problems persist, we remain relatively sceptical about the probability of a rebalancing of French growth to the benefit of the export sector. The weaker domestic demand will only just generate a smaller negative contribution of foreign trade over the next two years."
- "We therefore remain relatively pessimistic about French growth prospects for 2012."

Sovereign doubts still linger for Greece: Earnings/ratings changes as tough times continue

- Economic uncertainties continue to weigh on investment case "Despite the progress being made by the Greek government on deficit reduction, risks and uncertainties still lie ahead. The recession has intensified and bond markets remain sceptical (as shown by the continued high bond spread/yields). In this context, and although on cheaper valuations and having significantly underperformed peers, we remain cautious in our outlook for Geek banks relative to the sector."
- Waiting for consolidation "The IMF stability fund of EUR 10bn, to help strengthen Greek banks, and potential consolidation among the major Greek banks means there could be significant changes in the structure of the Greek banking sector in the coming months. We estimate that some mergers could generate value of up to 40% of the combined market caps."
- Rating changes/earnings downgrades "We remain negative on Greek banks relative to European peers. We downgrade our earnings estimates by c. 48% over the period 2010-12.
• Upgrading Alpha to Buy. Based on valuation and exposure to Greek bonds we upgrade Alpha Bank to a Buy rating from Reduce. New price target EUR 7.0 per share.
• Downgrade NBG to Neutral. Independently of the rights issue, but based on our outlook for profitability we reduce our rating on NBG from Buy to Neutral, new price target EUR 9.0 per share (price target reflects rights issue)."

Wealth, indebtedness and investment

- "Since the second half of the 1990s, in the United States and Europe, there have been fairly strong correlations between:
• the debt burden of companies and their market capitalisation (except in the United Kingdom);
• investment by companies and their market capitalisation;
• households' debt burden and their property and financial wealth (predominantly property wealth in the United States and the United Kingdom)."
- "We use these correlations to try to ascertain the length of the period of deleveraging by households and companies."
- "We find that, to be consistent with market capitalisation and household wealth:
• the debt ratio of companies must decline by a further 5 percentage points of GDP in the United States, and 10 percentage points of GDP in the euro zone;
• the debt ratio of households must decline by a further 12 percentage points of their disposable income in the United States, 6 percentage points in the euro zone and 15 percentage points in the United Kingdom."

Dollar/euro exchange rate: The only thing we can predict is high volatility

- "The dollar/euro exchange rate has shown very high volatility since the beginning of the crisis, between 1.18 and 1.60."
- "We believe this will continue, as the exchange rate between the dollar and the euro depends on numerous factors that may play in opposite directions and are perceived one after another by the financial markets:• the growth prospects; they are poor in both cases, but the financial markets, which believed in markedly stronger growth in the United States, now have to revise this belief;• the US external deficit and external debt: they will not disappear unless US households save more;• the developments in the sovereign debt crisis in the euro zone: for the time being, the news is good (reductions in fiscal deficits, countries are able to issue), but uncertainties persist."
- "From May to July 2010, poor figures were published in the United States, the US trade deficit increased and the public debt crisis in the euro zone became less acute, leading to a rise in the euro. But there are now poor figures in the euro zone as well, and, in the future, bad news about certain budgets, perhaps a rise in the US household savings rate, which would be consistent with the changes in their wealth. Together, these factors account for our forecast of high volatility in the USD/EUR exchange until end-2011."

Readings

It's a big purchase, so why not invest some time in basic financial analysis - WaPo
Why, Suddenly, Is It 'Comrade' Lord Keynes? - IBD
What do the “good” trade numbers tell us? - China Financial Markets
China, Japan, America - New York Times