Opposition Party Wins Taiwanese Presidential Election

As we expected the opposition candidate Ma Ying-jeou has won the Taiwanese Presidential elections. As we outlined in the entry below this should bode well for Taiwan's economic outlook.

Taiwanese Presidential Elections Being Held Today

As I mentioned in my January 30th post, I believe that the ' China friendly' Kuomintang party, after their sweeping victory in the legislative elections, will win the Presidential elections. Once this occurs it is likely that we will see the new leadership attempt to open direct ties with China allowing tourists, and more importantly investments, to flow freely between the countries. Lets be clear though, the Kuomintang party is not calling for reunification, just for an improvement in ties. With this in mind it will be important to monitor the new officials progress in negotiating with the Chinese government. However, after spending some time on the ground in Taiwan and gaining a rough gauge on local sentiment, I believe people are ready for change, especially change that brings stronger economic growth and more jobs. Thus, we think it is more likely than not the Kuomintang will be successful at reopening ties with China. We anticipate that this will have a substantial positive impact on the Taiwanese economy. I still believe the best way to leverage this potential is through the ETF 'EWT'. In fact we have realized we are not alone in this assumption. Since we first recommended looking at EWZ on Jan 30th it has experienced near 20% gains outperforming the overall MSCI EM ETF 'EEM' by around 23%. This performance is surely on the back of the expected improvement in ties with China and the potential catch-up effect we could see in the Taiwanese economy.

Take a look at the charts below for more details:

Taiwan ETF (EWT) and Overall EM ETF (EEM) rebased to 100: EWT has been significantly underperforming the EM benchmark

Source: BBerg

But that has changed... EWT has begun to outperform EEM and we expect this trend to continue as long as ties with China are improved

Source: BBerg

Chinese Monetary Policy vs. Inflation FIGHT!

*FX data updated on March 27th 2008

Policy makers in China have not only continued their anti-inflationary rhetoric, but have started acting on it. We have seen the RMB reach several new highs verse the USD in recent days (7.01). Additionally, Chinese authorities have increased reserve requirements for the second time this year by 50bp to 15.50%. It does not appear this news has settled too well with Chinese equities markets, which have experienced a significant sell-off from the combined fears of tighter monetary policy, a stronger RMB, and possible global slowdown. As a result, local investors seeking more attractive yields have started moving away from EQ and into the domestic fixed income market; yields have rallied accordingly. We expect this trend to continue.

Fears of a global economic slowdown and tighter monetary conditions have begun to show up in the SSE Composite...

Source: Bloomberg

This was not unexpected, as we outlined in an early posting, this how we expect Chinese policy makers to combat high inflation levels:

1) The Central Bank will increase interest rates, which it hasn’t done since December 07;

2) They will allow the RMB to appreciate at a faster rate;

3) They will implement new or stronger policies to reduce monetary growth. (i.e. Higher reserve requirements).

Additionally, we believe the government will continue to enforce its recent price control measures. With that said it is highly likely the Chinese government will continue increasing reserve requirements and continue appreciating the RMB at a faster rate. Given the recent weakness of the USD, the RMB has weakened substantially against the Euro, which probably implies European officials will begin placing pressure on the Chinese officials for quicker appreciation. We also expect to see increases in the Chinese reference rate, the last increase occurred at the end of December.

The Chinese Reserve Requirement Ratio has been increased steadily with inflation, and will continue to rise...

Chinese officials will continue to speed up appreciation of the RMB to combat inflation...

Investment Idea: We see potential upside in the domestic Chinese Steel industry. We have seen an increase in domestic demand as the country continue to develop and we believe the industry is ripe for consolidation. We may actually see the amount of Chinese steel exports decrease this year due to increased local demand, higher export tariffs, and an appreciating RMB. A reduction in Chinese steel exports could put upward pricing pressures on the global market. We also expect domestic steel makers to increase domestic prices as international prices rise. In fact, Baosteel has already announced price increases and may adjust prices on a monthly basis vs. quarterly previously. This of course will put further pressure on Chinese inflation. Which means it will be important to monitor to what degree government officials allow steel producers to pass costs to consumers. However, for steel, we see plenty of demand and a sticky supply. The bottom line is in 2008 look for higher steel prices, industry consolidation, and fewer exports from China (reducing the global supply). We believe this should directly benefit Brazil (ETF:EWZ), especially domestic iron ore producers. Brazil’s largest exports to China are soybeans and iron ore. However, there is a risk that a global economic slowdown could adversely affect steel demand.

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Fed Cuts 75bp

As we expected the Fed cut the fed funds rate by 75bps, and made an equivalent move in the discount rate. What is interesting is that the Fed had two dissenters to the vote, Governor Plosser from Philly and Governor Fisher from Dallas, both wanted a smaller cut. Plosser is a well known hawk on the FOMC, so this was not surprising. However, this combined with a stronger inflation message, could imply the end of strong rates cuts. Keep in mind, the market responded very favorably to the move, despite at one point having priced in a 100% chance of a 100bp cut (the GS and LEH news did help). This also supports the possibility that we could be near the end end of the rate cuts or at least at a point where we see a significant reduction in its magnitude (ie 25bps). Of course the Fed's future reaction will be very reactionary to market news and data.

Investment Idea: We continue to believe home builders may soon become a good play and should be payed close attention to. We will be looking at the ETF 'ITB'

The Week Ahead: Fed Cuts and Bank Failures

Despite the news from Bear Stearns and a weak retail sales report, the Dow actually ended the week up 0.48%. Nonetheless, there isn’t much else to boast about; the NASDAQ ended unchanged while the S&P500 lost 0.40%. However, the CPI release surprised the market by coming in well below expectations and showing no increase for either the core or headline indices. This development was mostly sidelined by the problems at Bear.

But looking forward; this week it’s all about the Fed. Despite the encouraging CPI report the Fed will not view one month’s data as the beginning of a trend; they will remain very vigilant over inflation. However, the news from Bear Stearns and growing trouble in the financial sector will cause the Fed to cut rates by 75bps. We do not believe the Fed will move a total of 100bps given their current concerns over inflation. If the Fed was to move a total of 50bps verses 75bps and the market reacted adversely it would potentially open the window for an additional inter-meeting rate cut, which the Fed would like to avoid. As we have said before we feel one of the best indicators for the Fed’s move is what the market is currently pricing in. The Fed typically does not disappoint the market. (For a more detailed analysis on Fed cuts and inflation please look at our posts from March 11^th titled “Inflation, Inflation, Inflation” & February 27^th titled “Fed Cuts & Inflation”)

Effective Fed Funds rate pre-March 2008, implied Fed Funds rate post, as of March 14th.

Monday March 17th:
8:30AM: Empire State Manufacturing Survey (Risk: Neutral) The Bloomberg consensus survey indicates the market is currently expecting a reading of -6.3, this would be an improvement from last’s month unexpected drop to -11.7, but still in negative territory. This survey is one of the first indicators monthly indicators released covering the manufacturing sector and thus it is used as a tool to help forecast the overall ISM number. A negative reading of this survey combined with negative readings from the Philly Fed and the Chicago-NAPM can indicate a slowdown in the ISM.

9:15AM: Industrial Production (Risk: Downside) The Bloomberg consensus survey indicates the market is currently expecting a reading of -0.1% on production and a 81.3% capacity utilization rate, compared to 0.1% and 81.5% on production and capacity utilization, respectively. The recent slowdown observed in manufacturing could adversely impact production.

Tuesday March 18th: Fed Day!
8:30AM: Housing Starts (Risk: Downside)- According to Bloomberg.com the market is currently expecting housing starts to total 0.99mn. Permits continue to decline, inventories continue rising, we just don’t see much upside potential for this indicator. (For more information please read our post on the Housing Crisis from March 5^th titled ‘How will it end?’)

8:30AM: Producer Price Index (Risk: Neutral/Slight Upside)- According to Bloomberg.com the market is currently expecting PPI and Core PPI to increase 0.4% and 0.2%, respectively.

2:15PM: Fed Announcement (Risk: Neutral/Slight Upside)- We expect the Fed will cut rates by 75bps and continue to hold a negative bias. We expect the Fed will indicate that they will continue monitoring inflation, and that downside risks to growth still exist and will continue to affect employment. They may also mention in more detail their concerns about the financial sector after the Bear Stearns bailout and surprise rate cut on Sunday.

Wednesday March 19th:
None

Thursday March 20th:
8:30AM: Jobless Claims (Risk: Neutral)- According to the consensus survey Jobless Claims are expected to come in at 360K, still above our 350K threshold.

10:00AM: Leading Indicators (Risk: Neutral)- Bloomberg.com currently states a market consensus of +0.3% M/M change for the leading indicators.

10:00AM: Philly Fed Survey (Risk: Neutral)- Bloomberg.com indicates the market is expecting a reading -20.0 verse -24.0 last month. As with the Empire Survey being released earlier in the week, the Philly Fed will be the second release to address the health of the US manufacturing sector.

Friday March 21st:
Market Closed (Good Friday)

Investment Idea:

Please look at the posting from March 9^th. Also, we have begun looking at long dated Citigroup calls as a possible investment idea. At the same time, we are very concerned about Lehman Brothers and expect to see its shares catch a strong bid.

Food or Fuel for Thought?

Energy prices are showing absolutely no signs of abating; those peak oil theorists may be on to something (at least in the short-run). We just don’t see oil prices coming down significantly without a considerable reduction in demand; through improved fuel efficiency or a considerable economic slowdown. Now that we have settled that, we want to tackle a potentially larger problem verse high energy prices alone. That problem is higher energy prices combined with higher food prices. As people search for alternative energy sources, they have begun to tap heavily into the worlds’ food supply (i.e. corn). Ethanol, though 9,000 years old, has had a proliferation recently thanks to lofty oil prices. According to the Renewable Fuels Association just the US is producing around 375,000 barrels per day. This equates to almost 2 billion bushels of corn a year (around 25% of the domestic use), and it’s growing. Essentially, that means 2 billion fewer bushels of corn are going into the food supply for both humans and animals. Of course productivity improvements and new farm land could reduce the overall effect, but not nearly enough to compensate for the sectors rapid expansion.

US Ethanol Production has been increasing drastically

So what does this mean for food?

We are all aware that global food prices are rising sharply for a variety of reasons including weather and demand and supply shocks, but have energy prices had any affect?. Below we outline our view that the increasing in oil prices, have led to a substantial rise in ethanol production, and will have significant effect on food prices and eventually overall CPI. In order to have a consistent time series of agricultural prices we used the USDA prices received by farmers’ data. First off, let’s look at the relationship between WTI prices and ethanol production (chart below). As you can see below the two variables are highly correlated, this makes sense since the price of producing ethanol relative gas drops as oil prices move higher. However, the important question is what effect (if any) does the increased production of ethanol have on the food supply and prices?

High energy prices have been the driver behind the increased production

To answer this question we first analyzed corn price verse ethanol production (chart below). Again we see a strong correlation between the two, with the only anomaly being in 2005. This was caused by a good harvest and the effects of Hurricane Katrina. As we stated early the price of corn is influenced by a number of variables. Given the minimal use of ethanol prior to the beginning of this decade we do not believe ethanol production has had much, if any, affect on corn prices before now. In 1999 only 1.5bn gallons of ethanol were produced a year verse over 5bn today. That’s a lot more corn! Now that we now the production of ethanol can influence corn prices, what is the relationship of corn prices to the food and beverage CPI component and overall CPI?

Corn Prices have been influenced by ethanol production

Before we start this analysis lets mention some important direct uses of corn; food, corn syrup, animal feed, ethanol, etc… Meaning corn prices can influence everything from candy to milk. Now with this in mind, we would expect a significant rise in corn prices to eventually pass-through the food chain into every product that utilizes corn. In the chart below we compared corn prices to the food and beverage component of the US CPI on a y/y basis. Again the result was not surprising; the food and beverage component of the CPI has been increasing with corn prices. Given the wide spectrum of uses for corn it is hard to judge the total effective corn would have in the index (at least for this brief analysis), but we imagine it is significant.

Corn prices have helped to drive up the overall food and beverage CPI component

Conclusion:

The massive increase in ethanol production brought on by elevated energy prices has had a significant effect on corn prices. This means that as long as energy prices remain elevated, and corn is used as the primary crop to produce ethanol, we can expect to see the prices continue on this path. Given corns multiple uses within the food industry, we can also expect to see the food and beverage component of the CPI increase as a result. Also as lower value crops are switched over to corn we may also see a rise in the price of other crops as supply comes down. One alternative on the horizon is using switchgrass instead of corn to produce ethanol. It is believed that switchgrass will be a more efficient producer of ethanol and also will not directly impact the food supple, since you can't eat it. However, this is still in an experimental stage and will take time. The bottom line is, so long as energy prices continue to rise and ethanol production along with it, we can expect to continue seeing the food and beverage component of the CPI trending up.

Investment Idea:

If you believe that the price and value of agricultural goods will continue to rise from cross-over to energy products and higher world demand, we recommend purchasing agriculture based ETFs such as ‘MOO’ or ‘DBA’ as a good play on the sector. However, it is important to keep in mind that speculators may have artificially driven up prices in agro indexes, so it is possible that we could see the indices catch a bid in the short-term.

Price of DBA vs wheat, corn, & soybean (rebased to 100)

Chinese Inflation: A Mounting Problem (Update)

The US isn’t alone when it comes to inflationary concerns. Chinese consumer prices continue setting new interim highs, and it is not going unnoticed. February's CPI number came in at 8.7%y/y vs. 7.1%y/y in January. It is important to keep in mind this reading includes the adverse effects of severe winter weather and the Chinese New Year holiday. However, even after these events are factored out the reading remains well above comfortable levels (prices have been trending up since early 2007 from a level of around 1.4%y/y). The data has begun to raise a lot of eyebrows within the Chinese government. Recently, Chinese Premier Wen Jiabao was quoted as saying, “The current price hikes and increasing inflationary pressures are the biggest concern of the people.” So what does it mean?

Inflation continues trending up; as one response we expect policy makers to speed up the appreciation of the RMB

Source: National Bureau of Statistics of China & People's Bank of China

We believe Chinese policy makers will address the rising trend in inflation using the following three policy tools: 1) The Central Bank will increase interest rates, which it hasn’t done since December 07; 2) they will allow the RMB to appreciate at a faster rate; & 3) they will implement new or stronger policies to reduce monetary growth. We also expect the government imposed price controls will remain in place for the foreseeable future. When push comes to shove we feel Chinese policy makers will choose price stability over growth. As we discussed in our last entry on this topic, from February 29^th, food prices have been the primary driver behind Chinese inflation, but recently inflationary signs have started to emerge from the non-food sectors. The longer inflation remains elevated the bigger its effect on inflation expectations. In fact, according to a quarterly survey conducted by the People's Bank of China, inflation expectations have already begun to rise (chart below). This could be bad news for policy makers since a rise in inflation expectations tends to be a self-fulfilling prophecy.

*According to a survey conducted by the People's Bank of China consumers inflation expectations have been increasing significantly with the rise in CPI

Source: National Bureau of Statistics of China & People's Bank of China

*Notes on the Survey of Urban Saving Account Holders (From the People's Bank of China)- The People�s Bank of China conduct a quarterly sampling survey to urban saving account holders nationwide in the form of standardized questionnaire and interview in February, May,August, November each year. The sample size for each survey is 20,000. 4 diffusion indices are derived from the replies of interviewees in questionnaire survey, which reflect the attitudes of people towards current income and price conditions, and the expectations to future income and price trends.