To keep the renminbi from appreciating, China’s central bank, the PBOC buys dollars from Cinese exporters in exchange of Renminbi. By doing this, it increases the circulation of Renminbi and therefore can cause inflation. To avoid inflation, the PBOC issues its own debt at the same time as it buys dollars; in other terms it “sterilizes” the excess Renminbi, which is being used to buy this debt.

The PBOC uses dollars to buy US assets, mainly Treasury and Agency bonds. Therefore, it receives interests on US assets and pay interests on Renminbi claims. This forces the PBOC to mirror the United States monetary policy. Indeed, so that the PBOC does not loose money on interest differentials, it needs to set Renminbi interest rates lower than the US ones.

This low interest policy has several consequences:

-       The PBOC cannot use interest rate setting as a tool for its monetary policy. Therefore, it needs to use other tools such as bank reserves ratio or credit control.

-       Households make low returns on their savings and therefore need to save more to reach the same wealth. It therefore holds back domestic consumption and makes China yet more dependent on foreign demand.

-       Cost of capital is low and therefore firms are incentivised to invest in capital-intensive machinery substituting for jobs. A country with labor surplus invests hugely in capital-intensive industry, creating fewer jobs than needed.

-       Even if lending rates are low, deposit rates are even lower, creating a high profit margin for banks. Banks can be complacent and make lending mistakes and it excludes competing sources of finances such as for example the bond market. The financial system stays very inefficient, lends primarily to state-owned companies and creates competitive distortions to the detriment of non-state connected private companies.

First, most of the Street is bullish on the world economy expecting around 4% GDP growth and forecasts a pick up in the US recovery. If you believe the Street, 2011 will be the year of the US. There are some initial signs of a labor market recovery, consumer consumption have rebounded and saving rate seems to stabilize around 6%, ISM index has been expanding for 17 months and bank loan growth has also turned positive. Europe has not yet resolved its problems and three different scenari are conceivable: a) status-quo or a continuation of the current situation aided by global growth, b) an extended bailout by core Europe or a restructuring or c) a deterioration of the situation without intervention from core Europe, leading to an increase in ECB financing and potentially a drastic reshuffle of the EUR.
Upheavals in the middle East have been absorbed easily by the markets and banks are still promoting a bullish case for 2011. Popular trades are:

Corporate exposure:
A preference for equity compared to credit. Banks still expect spreads to tighten but absolute returns are endangered by an increase in rates.
In credit, the Street advocates to overweight high yield compared to investment grade.
Reasons for positive equity returns are the following

• After the recent rally, risk premium remains above average
• P/E are below average P/E during  low rates periods
• The economic backdrop is supportive
• Companies hold a record amount of cash on balancesheet (the ratio of cash over assets is 10.7%) and are expected to use it in Capex, M&A and share buy-backs
• Equity outflows in favour of the bond market is expected to reverse and GS, for example, expects $750bn inflows ($125bn retail, $125bn pensions, $150bn institutionals, $350bn corporates)
• Historically, the third year of a recovery or the  third year in a presidential cycle are of good omen
• There are still a lot of skepticiism regarding the recovery and many investors have not yet participated to the rally

Consistent with their bullish stance, banks are in favour of Cyclical sectors, Small Caps (which would most benefit from M&A)  and high beta stocks in general. This optimism is shared with Core European equities and Japanese equities.

Risks to this thesis exist:

• A US policy gridlock
• Disappointing US economic growth
• European Sovereign crisis
• Municipal finance crisis
• Input cost inflation pressuring margins
• EM inflation leading to monetary tightening and slower EM growth
• Higher interest rates
• Competitive currency devaluation
• Geopolitical risks 

 Emerging Market Exposure:   

The outlook for Emerging Market assets is mixed. Given the inflation backdrop and monetary tightening in those regions, government bond markets do not seem to place to go. As far as equity is concerned, banks have different views. However, we have recently witnessed a rotation from EM to DM  illustrated by three consecutive weeks of outflows out of EM after 34 weeks of inflows.  

Commodities:

There is unanimity on the upward pace of commodities. Banks still overweight agriculture, outlook for oil is positive, same for precious and industrial metals. Silver is preferred to gold as it is not only a hedge against currency devaluation but it is also used industrially and would benefit more predominantly from industrial growth.

Government Bonds

Not very attractive at those levels but unlikely to drive a high downside as far as Treasuries are concerned. Indeed, the steepness of the curve creates some roll premium. The inflation picture in developed countries is not clear and inflation expectations are wide-ranged. This is a theme that requires a whole post and an increase in rates is one big risk factor for the equity market.

There are some other themes I would be happy to have your opinion on:

- Long US or European financials equity ?

- Do Municipal Bonds (or other related assets) provide a cheap hedge ?

- Do you think volatility looks cheap ?

- Short Apple ?

This week was more of the same: positive statistics in he US and renewed concerns for Europe. Stock markets are up mildly:S&P +0.3%, Oil +1.1% at $88.8, Gold -0.90% at 1380, Treasury curve is steep with 10y rate at  3.33% despite a rate decrease at the end of the week. US Retail Sales for November came in stronger than expected at +0.8%. CPI was fairly tame at +0.1%. The message here is that inflation at the consumer level is still subdued despite inflation pressure beginning to rise in producer level and sustained high inflation in commodities. Philly Fed survey came out better than expected. US housing starts also posted a nice come-back in November with a 3.9% rebound. Basically, housing is stabilizing but not really improving.

On the European front, Moody’s made the headlines placing Spain credit rating on review for downgrade and downgrading Ireland from Aa2 to Baa1. The European Summit did not bring any major announcements. The only positive news, which is a sign of the European dichotomy, was the IFO index which rose to a record of 109.9, illustrating again the good health of German economy.

EUR/USD short is working well so far, although movements this week were probably exacerbated by light liquidity.

I wish you all a Merry Christmas. I am off for several weeks of sun in Indonesia and I will resume my commentaries when I am back in mid January.

However, the big story of the week was the surge in bond yields, the 10-year note widening by 21bps to 3.32%. The current message from the US is that it currently focuses on reviving economy and has no intention to getting its fiscal house in order. The results is reevaluated inflation expectations and higher growth forecasts. Indeed, after Goldman Sachs revised up its growth forecast last week, many economists followed this week, including Pimco. There are reasons to be optimistic but the financial system remains fragile and will need constant support from the authorities for several years. When you add Financials and Government Debt, ratios  over GDP are respectively: EU-12 at 164%, US at 191%, UK at 213% and PIIGS at 214%. Therefore I think currently volatility is cheap, the Vix trading at 18% as I expect 2011 to remain volatile with regular sovereign crisis and authorities interventions.

In China where inflation is the major focus though. This week economic data showed industrial output growing at 13.3% in November and inflation at 5.1%. On Friday, the central bank announced a 50bps increase in reserve ratios and there are rumours about a rate hike this week-end.

The euro fell against the greenback after Ireland’s credit rating was downgraded and the region’s political leaders differed about how to contain the debt crisis. I am still short Euro with a target at 1.2650. This is based on the technical picture as well as the fundamental view of a double speed Europe dragged by its weakest links and a US economy with increasing momentum.

This week is bristling with economic news with the PPI and retail sales the first market movers out on Tuesday morning.  The Fed’s FOMC statement later in the day will be parsed for news on QE2 and any upgrades on the economy.  Wednesday includes updates on the CPI and industrial production. The final big mover of the week is housing starts posted on Thursday. In Europe, PMIs and the IFO Survey in Germany will be the highlight to confirm the growth momentum in core Europe.

My first target is 1.30 and second target around 1.26

Payroll employment in November increased a soft 39,000, short of the median forecast for a 168,000 advance. Private sector payrolls increase 50,000 in November, following a 160,000 boost the month before and unemployment rate increased to 9.8%. That was a negative surprise in contradiction with the last stream of positive economic numbers: US ISM, US Consumer Confidence, jump in Pending Home Sales, ADP reports, strong Chinese PMI, strong UK PMI. There are numerous potential answers ranging from employers’ reluctance to hire despite higher demand to the possibility that the BLS payroll survey is missing a lot of new jobs created by small businesses. However, the market’s reaction stays subdued as the number was either interpreted as out of sync with other data, or seen as bolstering QE2 and the chances of fiscal stimulus, including extending Bush tax cuts.

The Reuters story about the US backing an even greater financial commitment to Europe stole the headlines and ECB announcement was also key to calm down the market. Jean-Claude Trichet hinted at support from the Central bank and without providing details, the possibility if needed of purchasing government bonds. In addition, while reiterating that current non-standard monetary measures would be only temporary, the central bank also announced that the 1-week, 1-month and 3-month repo operations would be undertaken on a fixed rate, full allotment basis until at least Q1 next year. Note that just a month ago markets were expecting the ECB to announce a return to some form of competitive bidding as part of its exit strategy but the Peripheral crisis delayed this action.

Overall, the market has been resilient through much of the European turmoil. We should note that Ireland, Greece and Portugal combined only account for 7% of Europe GDP while France and Germany account for 50%. Recovery has been strong in Germany and the good performance of the Dax shows that when the periphery issues stirs a weaker Euro, the market viewed it as more beneficial for Germany than sinking peripheral demand.

Next week will be interesting to see if the market manages to advance above November highs or goes back to risk aversion refocusing on Chinese tightening and Euroland tensions. Personally, I will monitor the market and if it fails to make new highs, I will look to put some short-term shorts on, especially on the EUR/USD and FXI, the Chinese equity ETF. Economic calendar is lighter with probably the most important data coming from China (November CPI, industrial production and retail sales). Of notice: central bank policy announcements (Australia, New Zealand, the UK, Canada and, potentially, China), Japan Tankan survey and Q3 GDP, EU industrial production, US Trade balance.

1. Alex Weber has communicated that the EFSF is large enough to tackle funding needs till 2013, and if the worse happens, member countries would contribute more.
According to the Economist, the gross financing needs including redemption and deficit are in 2011 and 2012:
Greece: about €100bn / current bailout of €110bn
Ireland: about €59bn / current bailout of €85bn including bank bailout
Portugal: about €53bn /
Spain: about €334bn / plus around €100bn from Cajas
Belgium: about €83bn
Those numbers seem to be in line with Alex Weber’s comments; however, the big uncertainty is the needs of the financial sector (especially in Spain). The other comment raised by those numbers is the size difference between Spain and the other Peripheral countries. Spain economy is about 5-7 times their size and a bailout for Spain would be a test of the members’ solidarity.

2. There is a theoretical long-term solution to the problem:
The issue with the current situation is that problems are not solved; money is just spent on a short term basis, weakening the strong countries to the profit of the weakest links. However, as the European Council is genuinely working on a longer-term solution and apparently, there are ways to put in place an “orderly restructuring framework”.
The issue is that we have a monetary union but fiscal sovereignty. The Stability and Growth Pact (SGP) was supposed to tackle this problem, coming up with a set of financial criteria to be met by member countries. In reality, it has lacked credibility and was hardly enforced . Even Germany and France asked for amendments when they faced higher deficit in 2005. Therefore, we have a monetary union without discipline. There are two ways to tackle this problem:
a) Amending the SGP to make it more drastic and enforceable. That has been somewhat the role of the IMF for the bailout money. But outside bailout money, it is probably very difficult to put in place. 
b) Creating the possibility for a member country to default. In that case, member countries would be punished by the market rather than a supranational body that has proved politically weak in the past.
Several economists have worked on this framework and this default mechanism could work this way. If a country fails to fund itself on the market, there can be two situations. If the country is deemed solvable by Europe (maybe a specific European institution), then the country will receive funds to help it through this liquidity crisis. However, if the country is insolvent, then debt will be restructured.
That is the idea of the “collective clause” that the European Council wants to include in bond documents from 2013.

3. Is restructuring a viable solution ?
The IMF has argued it is “unnecessary, undesirable and unlikely”, alluding to two main arguments: the exposure of the European banking system to sovereign debt and the fact that European countries run primary deficits. In the euro zone, more than 2 trillion euros in sovereign debt belonging to Greece, Ireland, Spain and Portugal is held largely by German, French, British banks and, in the case of Greece, local banks and pension funds.
As opposed to defaulting emerging countries which have the ability to aggressively reduce deficit, European countries run sticky primary deficits which means that even without paying interest on their debt they still spend more than they collect in taxes. The deficit is about 10 percent of G.D.P. in the case of Ireland and Greece. So abandoning their debt obligations would not eliminate the need for cash, which would become all the more acute because their default would deny them access to international debt markets.

The rosy scenario is the following: till 2013, Europe uses EFSF to fund the liquidity crisis, or the market opens up funding windows to peripherals. In the meantime, the European Council comes up with a restructuring framework. That period gives the opportunity to the banking system to consolidate and recapitalize so that they can absorb more easily a restructuring. If that scenario happens, Euro should rebound and spreads tighten back.  

4. The risks:
The EFSF prooves to be insufficient as contagion spreads and affects Spain and Italy ability to fund themselves.
Political tension between contributing members and Peripherals increase as Peripherals fail to implement austerity measures and bail-outs pile up, resulting in the German refusal to continue to contribute.
Austerity measures lead to recession and widen deficits, making peripherals countries insolvent. Peripherals do not have the possibility to devalue their currencies to boost growth and therefore the question of whether they can survive and grow within the Euro remains relevant.

EC/ECB/IMF staff mission for the second review of the conditionality of Greece’s EUR110bn loan programme. the conditions need to be approved ahead of the EUR9bn third loan tranche is released in December.

15-16 NOVEMBER: Eurogroup/ECOFIN finance ministers meeting

18 NOVEMBER: Greece’s 2011 budget expected to be voted on in parliament

25 NOVEMBER: Partial elections. Loosing t his seat will not take away the government majority but it will weaken it.

LATER IN NOVEMBER: Ireland to deliver its 4-year fiscal plan

26 NOVEMBER: Trade unions in Portugal have called for a general strike

30 NOVEMBER: Deadline for the line-by-line approval of the Portuguese 2011 Budget

2 DECEMBER: ECB faces decisions on its exit strategy: whether or not to return the 3-months LTRO tenders to competitive auctions

7 DECEMBER: Ireland scheduled to deliver 2011 Budget to parliament.

LATER IN DECEMBER: Second vote on the Irish Budget, in the context of the Social Welfare Bill

16/17 DECEMBER: European Council meeting at which draft text for the orderly sovereign restructuring regime is due to be revealed

As I understand it, the Irish situation is the following on a medium term basis:

1. The government is fully funded till mid-2011 so we should not expect an imminent liquidity crisis.

2. The government has proposed an ambitious budget where cuts are larger and more front-loaded than expected.

3. The most important medium term risk is that the budget is not approved. In that case, Ireland will probably turn itself to the EFSF and the IMF for assistance and we should expect quite a lot of volatility.

4. If the budget is approved, then Ireland will probably embark on a charm offensive (just like Greece did after its bail-out) and attempt to raise money on the market. There is a large likelihood that it succeeds but if it fails, it will need as well the EFSF/IMF help.

5. Then on the longer term, the market will monitor whether the budget cuts are sustainable or lead Ireland to an economic crisis that pushes the deficit even further down.

The other important piece of data was coming from China where CPI has reached 4,4% in October, its highest level in 25 months. That illustrates the risk of the Fed quantitative easing for the emerging economies. Emerging economies have an output gap close to zero and therefore do not need the same accommodative policy than developed countries. Importing lax monetary policy risks introducing inflation and asset bubbles. Several countries are looking at either tightening their own monetary policy  (in response to the CPI number, China has increased bank reserve requirement ratios) or introducing capital controls to prevent asset bubbles.

Aside from this, the G20 offered few concrete measures to change economic policy and did not move the market. Cisco dropped 16% after hours on a weak outlook. In Europe, the most important data was Q3 GDP released on Friday; it showed that growth eased overall in Europe, including Germany.

Overall, my view is still unchanged. I believe that given the long past rally, the market needs a correction and I will be in the camp of those who buys on the dips.

Next week, the spotlight will stay on Ireland and potential intervention of European leaders. We also have a series of economic data in the US: retail sales, PPI, CPI and industrial production and in Europe: EMU CPI, Germany PPI and UK retail sales.

- Resurgence of Quantitative Easing (QEII) : the Fed has announced that it will buy $600bn Treasuries over the next eight months and will reinvest maturing mortgage bonds on its balancesheet. In its Washington Post article, Ben Bernanke explains the rationale for such policy: lower long-term interest to foster corporate investments and help the housing market, support asset prices to create a wealth effect and entice consumers to buy. Given the current discussions with trading partners, he did not mention the dollar devaluation but it is probably also a well received secondary effect.
Goldman believes that given where inflation and unemployment are (the two main data the Fed targets), it is likely that the Fed will continue QE and move beyond this initial announcement. Therefore, at the moment I feel it is dangerous to go against the Fed’s objective of reflating assets and short the market.

- Double-dip probability has decreased substantially: Economic indicators have rebounded since the Spring sell-off. This week, again, potentially the two most important indicators showed strong results: ISM data were better than expected at 54.7 (a number above 50 contradicts double-dip possibilities) and unemployment numbers also surprised on the upside with a creation of 130,000 jobs.
Tomorrow’s data certainly represent a risk. But the launch of QE and the ability of the Fed to still be responsive helps to minimize the market impact of any data disappointment, at least for a while.

- Money flows are now going back into equity: From May 2010 to October 2010, we have seem 20/22 weeks of outflow from Equity. Over the last four weeks we have seen a cumulative inflow of $7.41 billion, and this is the largest 4 week cumulative inflow since February 28, 2007.  In addition, IG bonds experienced their first weekly outflow in over 4 months with $83.6 million exiting the asset class.
Looking at valuation bases on earning consensus, credit is close to the richest level against equity, seen since the mid 80’s.

- Political change has been well perceived by the market: The most immediate consequence of the Republican’s victory is an increased likelihood that all of the 2001/2003 tax cuts will be extended before they expire at year end. On the other end, it will be now virtually impossible to pass a new fiscal stimulus and a split majority is a recipe for gridlock, not welcome when the economy is still struggling.

- Corporates stay healthy: This theme remains true and as pointed by UBS strategy, there is a likelihood corporates start releveraging. Corporates have materially increased profit margins and will no longer be able to rely on this to create RoE. Sluggish recovery will not support major turnover increases either. So releveraging appear to be the most effective tool to create RoE. In addition, corporate balancesheets are extremely healthy: when compared to profits, UBS finds that debt levels are nearing 30-year lows. Further, cash and equivalents on balance sheets in the US non-financial corporate sector totals nearly $1.5 Trillion or 6% of total assets. Finally, valuations between rich corporate and cheaper equity also support this strategy.
If corporates start releveraging through share buy-back, dividend increases, M&A, Capex investments (etc…), that will be supportive to PE expansion and the equity market.

Next week will be less exciting as the only main event in the US is the trade balance. We will also get data on GDP and Industrial production in Europe. Finally, let’s expect discussions on currency devaluations and international feedback on the Fed’s policy.
Investors will have time to digest the past news and set sails for the end of the year. As far as I am concerned, I have dropped my short biais for now and would wait for a dip (after a very strong run up) to be long equity. Given the low volatility, VIX is back to 18% area, I am going to look as well at long volatility strategy as there are still problems that could reemerge at any time.